More weak data, hedge-fund selling seen this week

Date: Monday, October 27, 2008
Author: Madlen Read, Associated Press

NEW YORK (AP) — In a typical recession, stocks start recovering about six months before the economy does. The crisis we're in right now, however, is anything but typical: Lending is frozen, hedge-fund selling is happening on a massive scale, and economic troubles have spread all over the globe.

As a result, it's possible the economy will need to show signs of strength before the stock market stabilizes and regains steam. So with readings getting darker by the day, expect more of the same this week: extreme volatility.

"Volatility's here, and it's here to stay," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research. Last Friday, the Dow Jones industrial average finished down 312 points, "and it seemed like a victory."

The Dow finished last week down 5.35 percent, the Standard & Poor's 500 index lost 6.78 percent and the Nasdaq composite index dropped 9.31 percent. That week wiped out nearly $800 billion from shareholder wealth, as measured by the Dow Jones Wilshire 5000 Composite Index.

One bright spot was that the market did not hit the trading lows reached Oct. 10, when panic appeared to be at a peak. But that doesn't mean the market has hit bottom. Between 2000 and 2002, the S&P 500 fell 50 percent from peak to trough, and so far that index is only off 44 percent from its Oct. 9, 2007 peak.

"I'm not sure that the market has gotten to the point where you think, 'It's been beaten up enough.' No one knows how bad it's going to be," said Tim Knepp, chief investment officer of Genworth Financial Asset Management.

Even if stocks have seen their lowest levels, an upturn is not necessarily around the corner.

"When will that occur and what will spur it? Good economic news should, but who knows when that will happen," Detrick said. The Dow's recent range of about 8,200 to 8,600 prices in "a major recession, the biggest recession since the '30s. Hopefully it's wrong and this is a tremendous buying opportunity, but no one knows."

Economists are not optimistic about data this week on new home sales, durable goods orders, third-quarter gross domestic product, personal spending and income, and consumer confidence. All these reports are anticipated to show continued weakness — GDP in particular, which is expected to come in negative.

Investors are also worried that this week's earnings reports from companies such as Kellogg Co., Kraft Foods Inc., Procter & Gamble Co., Visa Inc. and Colgate Palmolive Co. will reveal signs of an even weaker-than-expected consumer.

The Federal Reserve is expected to lower interest rates by at least a half-point to 1 percent this week. But the rate reduction is already priced into the market and unlikely to calm its restlessness.

One reason: The credit markets remain incredibly constricted, even in anticipation of another rate cut. Bank-to-bank lending rates are down from their highs earlier this month, but are still lofty by historical standards, suggesting that banks continue to hoard cash instead of lend.

This is a troubling sign for companies that rely on banks and the credit markets for borrowing. Demand has all but dried up for bonds issued by companies with less-than-ideal credit ratings — a huge problem that has yet to be fully felt by the real economy.

"Every week credit markets remain dysfunctional is doing unknown damage to the macro economy," JPMorgan stock analyst Thomas J. Lee wrote in a research note Friday.

Another reason the market is likely headed for more turbulence is the enormous amount of deleveraging going on. When investors like hedge funds deleverage, it means they are getting out of debt and risky assets and building up their cash levels.

Some of the recent deleveraging is due to risk aversion, but some of it isn't even within the funds' control — investors are asking for their money back, so the funds have to cash out other assets. Often, these assets are typical safe-haven investments like big-name industrial stocks and commodities, because they're the only things that can be sold in the current environment.

"Sectors that traditionally and intuitively should be defensive are really getting punished," Knepp said.

Knepp used the S&P 500's utilities group as an example; this should be a strong sector right now, but it's down about 35 percent year-to-date. Another favorite asset during times of crisis — gold — has fallen 20 percent since the beginning of October.

Amid the credit market strains and hedge funds' deleveraging, economists are still adjusting their forecasts downward — just last week, economists at both JPMorgan Chase & Co. and Citigroup Inc. lowered their U.S. estimate for fourth-quarter GDP to a drop of about 4 percent.

And economic troubles keep spreading to new countries. On Sunday, Kuwait's Central Bank stepped in to support one of its own big banks and said it was considering guaranteeing deposits — one of the first signs that the global financial crisis is spilling into the Middle East after slamming countries in other parts of Asia, Europe, and the Americas.

So, with the economy and the markets in uncharted territory, waiting for the dire headlines to end and gauging investors' sentiment is in some ways more helpful than looking at historical charts and technical factors like price-to-earnings ratios.

According to JPMorgan's Lee, "valuations, in our view, will not define the bottom, but rather an abatement of risk aversion."