Correction Overdue
Technically, a correction is long overdue. As Dick Green of Briefings.com wrote last year, “The current bull market began in October of 2002. That was when the bear market of 2000-2002 ended when the S&P hit a cyclical low of 769. Since then, the S&P 500 has risen 81% in a little over 49 months. The market was choppy through May of 2003, but since bottoming, there has not been a market sell-off of 10% or more. That is the degree of retracement that most technical (chart) analysts would call a correction. (A decline of 20% or more is usually termed a bear market.) “. “In addition, the S&P 500 has made a spectacular run since July 19 of this year. In just four months, the index has risen 14%. During that period, the index has not had a correction of as much as 2.5%”
In addition to the overdue technical correction, market bears have been also worried about fundamental/structural issues in the US economy, such as debt burdens of US consumers, inflation threat and growth slowdown, or “stagnation” all combined. Those worries culminated last summer during bond and equity market sell off. Before that, Stephen S. Roach, Chief Economist of Morgan Stanley, had been calling international attentions to the structural problems he sees in US and world economy, including global imbalance (US twin deficit) and other issues mentioned in the above.
Goldilocks Economy
Market bulls (their view represented by the father and son market research team of Charles and Louis Gave, who is the co-author of “Our Brave New World”) look for and see the bright side of the coin: the benefits of globalization, the technological and financial revolution, productivity growth, less economic volatility and so on so force. Fundamentally, the bulls sees a world economy as drastically different ones before and after the fall of Berlin Wall. Before the fall of Berlin Wall in 1989, Fukuyama (A political scientist) actually wrote a book titled “The End of History”. He argued in the book that Marxism as an ideology challenge to capitalism has ended. Well, what happened in the next decade is the mass participation of world capitalist economy by China, Russia and other countries, which has definitely changed the world economy as we know. If nothing else, China’s huge trade surplus has helped greatly in reducing inflation and financing bond market in US in recent years.
Since last summer’s market minor correction, market participants seem increasingly accepting the bull’s view of economy, and US economic data has been painting a picture of goldilocks economy. Both bond and equity market has since rallied, although interrupted a couple times by alarms of economic slowdown sent off from brief drops in US dollar and commodity market.
Where Fed Stands?
I believe Fed (and other western central banks) sees both sides of the coin: On the one hand, the US consumers'huge debt burden and twin deficit, excess liquidity and potential inflation threat are definitely worrisome structural issues in US economy. That’s why Fed has not reduced rate despite of housing slowdown, and sometimes makes hawkish comments on rate prospects. On the other hand, as Bill Gross of Pimco noted, the Fed knows too well that the debt and asset-dependent US economy has to grow on average at least 5% a year nominally to pay its bills (servicing debt, cost of fund or long-term bond yield is about 5%). “5% is how fast we grow and 5% is what we owe; the two rates are thus symbiotic, one feeding off the other when the economy is in balance.” “If 5% is the magic number and 4% is where we’re likely to hang out in 2007, then the Fed will likely respond sometime within the next six months with a series of cuts intended to restimulate growth along with its key asset markets (primarily housing).”
In his testimony to Congress yesterday and today, Bernanke did not talk like what Bill Gross wrote, but he is certainly not hawkish, and market rallied. Before the testimony , WSJ reported that "Strategists from Lehman Brothers in New York said the address (Bernanke’s testimony) is usually a "curve reshaping event," with the front end of the yield curve - the spread between the two- and 10-year note yields - leading the subsequent rally or sell-off. Since 1998, the event has moved 10-year yields by a median of nine basis points after the testimony, analysts said." Well, the 10-year bond yield dropped more than 10 basis points to about 4.706% in the past two trading sessions’ bond rally.
What Is the Game for the Rest of 2007?
US economy as well as other economies in the world is becoming increasingly debt or asset(two sides of one coin) dependent, and therefore the economy is very sensitive to the price of debt or asset, which is debated and determined on a daily basis by the financial market.
Our today’s financial market cannot really be called “invisible hand”, if we can borrow this term from Adam Smith. Adam Smith’ time is different from today. Today’s economy is better described by John Maynard Keynes. On the one hand and on surface, asset (bonds, equity, currencies and commodities) prices are debated and determined on an almost 7/24 basis by private individual and institution investors based on their knowledge, information, emotions and sentiments in their pursuits of profits. On the other hand, due to the nature of today’s monetary system (non gold- standard) and because the supply of money and short-term bond rate (to a certain extent) are determined by Fed, Fed’s view of economy and monetary policy can influence financial market significantly. I would say there are three structural players in the market, bears, bulls and Fed. It seems that for 2007, Fed is not on bear side, as Bill Gross wrote in his “The 5% Solution”: “at least for 2007, and if it lowers rates sometime within the next six months then the U.S. bond bull market will gain renewed vigor”.
If bull is in control in bond market, it would be very hard for bulls not in control in equity market, corrections (10% or 2.5%) or not. I would call stock the “heart of market” if bond is the “mind of market”. As we know “heart” is full of emotions, swing back and force between fear and greed, despair and exuberant, often in extreme ways, and that’s where the honey ( money) to be made, at those extreme points. So far we have been talking all in FA (fundamental analysis) to guess the directions of market this year. To grab honey in the trading , TA (technical analysis) is the key. Aside from “buy and hold” part of our portfolio, trading seems a must these days.
Just like our real economy, financial market is also featured with financial innovation and the resultant leverage. Even pension funds now days are leveraged and equipped to their teeth with various “innovations”. Everybody and his brother are somehow leveraged and maximizing for short-term gains, whether in real economy or financial market, just to pay the bills (cost of funds) and/or to meet performance, no choice. So, trading game is on, and as in any competitive gaming, a player could end up in either direction. To play in today’s financial market, like in any other business or gaming, we need to have competitive edge, which is to be learned and sharpened through practicing and thinking, in both FA and TA.
