December 6th, 2011
by Guest Author Lance Roberts of Streettalk Live
The markets surged 7% last week on the back of news that the worlds remaining central banks that have the ability to “print money” have now gone “all in” to save the world.
On Wednesday the announcement that the U.S. Federal Reserve, European Central Bank, Bank of Japan, Bank of England, Swiss National Bank and Bank of Canada would lower the rates on currency swaps, as well as lower pricing on existing US Dollar swaps, provided a massive liquidity bazooka for global financial system.
From the announcement:
[The Banks] are today announcing coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions is to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.
The Federal Reserve also made the following comments in relation to the U.S.
U.S. financial institutions currently do not face difficulty obtaining liquidity in short-term funding markets. However, were conditions to deteriorate, the Federal Reserve has a range of tools available to provide an effective liquidity backstop for such institutions and is prepared to use these tools as needed to support financial stability and to promote the extension of credit to U.S. households and businesses.
While the markets are surging from the direct injections into the financial system, more on that in a moment, the important take away here is that the world is in FAR WORSE shape than we have previously discussed.
These are emergency funding measures and are done in order to hopefully prevent the next liquidity crisis. With the banks in Europe already on the edge of failure our suspicion is that a major bank on the brink of collapse spurred this action. However, we are unlikely to learn of the events that pushed the central banks to this course of action for several years. The fact is that a globally coordinated intervention of this magnitude is no small matter.
We Have Seen This Before
For all of the hype and midweek exuberance it already has begun to wear off as the reality that the December 9th's deadline for the ECB and the Eurozone to formulate some concrete plan of action, and the near-impossibility of the task ahead, is leading to some reservations about chasing the market into the yearend close.
And since this past week was the biggest one week rally since October of 2008; I thought a perspective from a NYT’s article by Floyd Norris would be appropriate.
October  was the worst month for the Standard & Poor’s index of 500 stocks in 21 years — since the 1987 stock market crash.
But the final week was the best week for the market in 34 years.
As befits such a wild month, it was the most volatile in the 80-year history of the S.& P. 500.
The huge gains of the final week were reminiscent of the sharp recoveries from bear market lows in 1974 and 1982. Both of those moves came while the economy was mired in recession, as it almost certainly is now.
If Monday’s stock market lows prove to be the low prices for this cycle, the bear market will have ended with the S.& P. 500 down 46 percent from the peak it reached in October 2007. That would make the bear market almost, but not quite, as bad as the 1973-74 bear market, which ended with the index down 48 percent.
The accompanying chart shows the months, from 1928 through the present, when the S.& P. 500 had at least five days with 4 percent moves. Most of them were during the 1929 crash and the Great Depression. Until now, September 1932 held the record for the most days with big moves, at eight.
Two days during October ended with the index leaping more than 9 percent, something that had happened only nine times in the previous 80 years.
For the week, the S.& P. 500 was up 10.5 percent, the best weekly gain since a 14.1 percent rise in the week that ended Oct. 11, 1974.
The period from 2003 through 2007 — when there were no daily moves of at least 4 percent in the United States — became known as the “Great Moderation” to some economists. That very lack of volatility encouraged investors to take more risks by borrowing money, and encouraged others to lend it.
All of the big days in September and October came after Lehman Brothers was allowed to fail. That Lehman was not deemed important enough to save signaled to investors that there was risk where they thought there was none and caused a sharp tightening of credit for many borrowers, despite efforts by central banks to push interest rates down.
The big advances, on Oct. 13 and again on Tuesday, came as hope grew that the financial system would be protected. The first came on the Monday after the Group of 7 finance ministers promised to take steps to protect banks. This week’s big move came amid indications that central banks would aggressively cut interest rates.
Such wild volatility may be an indication that a bottom was reached. The biggest week since World War II did come at the end of the 1973-74 bear market, and the biggest week in the 1980s, a gain of 8.8 percent, came just after prices hit bottom on Aug. 12, 1982.
Or the wild moves could just show how baffled investors are by a series of events unlike any they can remember.
Of course, we now know several things:
1) October wasn’t the bottom and the market slid to its ultimate bottom in March of 2009 – nearly four months later.
2) The interventions by the Fed at that time did not solve the real financial crisis that was setting in – just merely postponed it.
3) The big advances that occurred in the markets were indicative of the bear market that engulfed investors.
Of course, while the markets “hope” for a better outcome; the reality is that these actions to boost liquidity to financial institutions are unlikely to solve the longer term fiscal instability of the Euro region. However, it does potentially prevent a near term freeze in the liquidity markets as witnessed in 2008 with the collapse of Lehman.
We have seen this exact same thing play out before with the last time that we had coordinated efforts by the central banks back in early September. While it provides a short term boost to the market for a few days; ultimately the more dire global landscape took the markets down.
What To Expect
So, while this week’s announcement caught the markets completely flat footed, which is exactly what was desired, it promulgated a massive short covering squeeze in all major asset classes from stocks to commodities. The viability of that rally will be important to watch.
While the actions are supportive it is very difficult to say for how long because the world is still very much engaged in a deleveraging process that will, and must, continue. The drag from deleveraging on the economic system is something that liquidity injections can't cure but rather postpones. The deep funding problems due to the sovereign debt crisis will still have to be addressed but the issue to dollar liquidity has at least been temporarily resolved.
While Wednesday marked the biggest "risk on" day this year it followed a downdraft last week that was equally as negative. Which makes it extremely confusing for investors which is maybe why even with the surge in October and a flat November investors still yanked funds out of the market.
The ICI flow of funds index continues to show that investors remain skeptical of the markets and are continuing to pull money out of equity funds and pile into bond funds. Of course, this negative psychology is being fostered by the wild swings in the market which has become an event/news driven market rather than an investable one.
This past week’s move, for example, was not set by news from Europe, which ranged from the inconclusive to the disappointing, but rather from global central banks, and some better than expected, although not great, economic data in the US.
The important takeaway here is that there is not an easy case that justifies the magnitude of the global market reaction in the last week. In reality the cut in the interest rates on dollar swaps addresses the problem of a liquidity shortfall in important parts of the European banking system. However, the slow-motion run on European banks by money-market investors will not just magically stop as the action does not address the underlying causes of the withdrawal which is the fear of another financial crisis equal to 2008 or greater.
The recent market action highlights two relevant features of the existing market context. From Barclay’s;
The first is the power of positioning, both financial and sentimental. If markets have been range-bound for the past couple of months, it is not because they have been subject to weak or static fundamental drivers. It is because they have been subject to very powerful but contradictory pressures, driven on the one hand by deep anxiety about weak fundamentals and substantial tail risks, but offset on the other hand by an equally powerful market context created by bearish sentiment and defensive positioning. Market participants seem as fearful of missing a market updraft as they are of getting caught in a downdraft. Nothing new here, but something to remember next time markets seem to be in a "meltdown" mode.
The second feature is the hunger for the kind of policy response that investors heard about on Wednesday. After a year during which policy in key advanced economies has been, on balance, not wholly convincing, even small steps forward are disproportionately welcome. It is in this context that we await the outcome of the December 9th EU summit, and announcements in the run-up thereto, including (for example) the anticipated announcement of the Monti government's economic and fiscal reform program. Some investors, at least, seem to have come around to the view that things have finally become scary enough to expect EU policymakers to address the underlying problems more definitively than they have been able to do so far. We think the stakes are high in the policy announcements that are made in the coming week.
With that we very much agree. Market participants have been conditioned like Pavlov’s dogs to respond to the ringing of the Wall Street bell even when odds are stacked heavily against success. Furthermore, while we all have “hopes” that the Eurozone gets their act together to prevent an economic contagion – “hope” as a function is not an investment strategy.
However, it is very likely the European Central Bank will announce more actions leading up to their December 9th meeting to address the collateral side of the equation to try and stabilize the Eurozone. However, it is unlikely that these short term efforts to boost liquidity to financial institutions will solve the longer term fiscal instability of the Euro region. It does, however, potentially prevent a near term freeze in the liquidity markets as witnessed in 2008 with the collapse of Lehman.
Less Downside – Not A Lot Of Upside
One thing did occur this past week to the positive. There is now less risk to the downside in the U.S. stock market due to the intervention at least in the short term. Whether or not these interventions solve the longer term problems that face the economy and the markets both domestically and internationally remains to be seen - but as we know from past experience - when the market is flooded with liquidity; the banks will flood it into the financial markets driving risk assets higher.
The market has broken above the resistance levels of the previous trading range that existed from July - September between 1120 and 1220 on the index. With the liquidity push into the market it is very likely that the markets will make another attempt at the "neck line" resistance level from the topping process that began in 2011.
We stated in this past weekend's newsletter that investors should look at raising cash at the 1200 level should the markets get there. However, with this global intervention our advice is to now “wait and see" what happens over the next few days and weeks.
Sometimes inaction tends to be the best course of action when volatile events occur. We definitely do not advise chasing the rally until the squeeze on managers is complete. This past week was also the end of the month so mutual funds needed to window dress their portfolio’s which provided additional buying impetus.
One thing we want to watch closely is oil. With oil prices surging past $100 a barrel again this past week; the negative implications to the consumer driven economy through rises in inflationary pressures may be felt sooner rather than later.
Therefore, it will remain important, at least from a risk management perspective, that in the near term the "risk on" bet may work. However, for longer term investors it will be important to keep a watch on the global and domestic economies as the negative implications of massive liquidity boosts are generally felt in the pockets of consumers.
Have a great week.
Why Warren Buffett Is Buying, and You Should Be Too by Keith Fitz-Gerald
About the Author
Lance Roberts, the host of "StreetTalkLive", brings fundamental, technical and economic perspectives, combined with a unique focus, to the day’s news helping listeners understand how it impacts their money. Lance has been in the investing world for more than 25 years - from private banking and investment management to private and venture capital. Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation's biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.