Sunday, March 1, 2009

Where's the bottom? More pain to come.

Justin Mamis has given us some insight in what to look for at the time of the bottom, and we have covered this before but let's look at it again.  While the current market has met some of the criteria for a Mamis bottom, we still have not had the utter surrender and then the kickback on worse news.  We tried to do some of that the first week of January when rotten economic reports were met with rallies... however, this rally failed miserably and we are now at new lows.

Mamis postulated a chart that looked at different phases of the bottoming process.  My thought is that we have not reached the "D" phase yet where the positive news is met with denial and retracement to "DD".  We really have not had positive news to disbelieve as yet.  So currently, I think we are either before or after "C", and I would favor before.  In other words, the worst is yet to come.

Three Scenarios for the coming weeks/months:

1) Death spiral whereby the bad news begets more stock price deterioraion and the cycle goes on in the fashion that we saw in the last deflationary recession from 1929 to the eventual bottom in 1933.  Slow, painful death of confidence with a vicious cycle of  job losses, equity decline, etc.  The factor that speaks in favor of this scenario is that in the one-dog study of the last century this is the only other deflationary cycle that we have seen, and maybe they all go with unrelenting agony for years.  Of course, the counter position is that Dr. Bernanke and Dr. Romer, Obama's Chairwoman of Council of Economic Advisers, are both students of the Great Depression and seem to  have learned the lesson that unleashing liquidity from central banks coupled with the immense stimulus from the US and Chinese governments can increase consumption and hasten the recovery, unlike what happened with the tight money policies and tariffs of the early 1930's.

2) Wall of Worry begins to take place from the recent lows as depicted in the Mamis chart from E to H.  In my view this is not likely happen since we have not met all the criteria of Mamis' thesis above.  We have had no good economic news that is met with disbelief which speaks against this scenario.  But, the MACD on the bottom of the chart does show some divergence which gives this scenario some possibility.

3) Capitulation to new lows followed by a quick bounce and then smaller retracement.  In other words, we have yet to see the "C" bottom as depicted by Mamis.  I favor this scenario.  The wash out must occur on decent volume with much gnashing of teeth and worldwide consternation with perhaps significant unemployment and labor unrest in less developed markets such as Eastern Europe.  Blood in the streets.  We have just not seen enough evidence of pain that should correlate with the amount of lost industrial production.

I favor this last scenario although the graph is not really drawn to proper scale. The lows could still be several weeks or even months away and we may have a choppy market with gradually lower trends with aggressive fits and starts for quite a while. 

 Marc Faber recently referenced some research that looked at the 1974 (at left), 1982 and 1991 bottoms and noted that from peak to trough in stock price took approximately 400 to 600 days and we have only been at this for 350 trading days since the peak.   So, although the descent in stock prices has been more dramatic with a steeper slope than other recessions, the time series analysis may indicate that we have longer to go, ie, it takes investors time to regain enough confidence to begin purchasing stocks. 

Furthermore, those were inflationary recessions have a different character and tend to finish quickly once the punch bowl of excess liquidity is removed.  Thus, the deflationary nature of the current crisis would speak to even longer prolongation from peak to trough if we use the 1929 to 1933 deflation as our only example, especially if the current populist cry against deficit spending is heeded by our political leaders.  There is no evidence that deflationary recessions resolve more quickly than inflationary recessions, althought the numbers to study are small.

The important factor to remember and get straight is the difference between inflation and deflation.  If we treat this like 1974 and tighten monetary and fiscal policy then we will re-live the early 1930's again and exacerbate the worldwide depression.  So while I may like Rick Santelli as an infotainer and provider of emotional angst (who doesn't like to get the adrenaline pumped), I respectfully disagree with him on this issue.

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