Treading The Thin Line Between Turmoil And Crisis

Source : The Business Times, August 13, 2007

Wall Street Insight
Don't assume the bounce of US stocks on Friday will continue this week, warn strategists

DESPITE suffering the biggest single-day loss since Feb 27 - when the sub-prime mortgage crisis first came to light - the Dow Jones Industrial Average, along with the other two major US stock indexes, actually finished a panic-laden week with gains when last Friday's closing bell sounded.

But Wall Street stock market strategists warned that investors should not assume that Friday's bounce back at the close from what had been shaping up to be another trading session of steep losses will be continued this week.

'If we hadn't seen all the central banks coming in with announcements that they were intervening in the markets to inject liquidity into the global financial system in order to encourage borrowers and lenders, and assure investors, we'd have had another rout in the stock market on our hands on Friday,' said Joe Battipaglia, chief market strategist at Ryan, Beck.

With uncertainty still running high over how much further the credit crisis could spread and how many hedge funds and mortgage lenders could end up failing, Mr Battipaglia said he expects a fretful beginning to what is almost certain to be another volatile week. 'I don't know if we're going to end this coming week in positive territory or negative territory, but I'll tell you one thing I am certain of: there are going to be at least a couple of days of one per cent or more swings for the indexes.'

That scenario is sure to further raise the blood pressure of plenty of investors and Wall Street traders.

'We're getting close to a breaking point now,' said Hugh Johnson, chief investment strategist at Johnson Illington Investors, who has been through many selling panics in more than three decades as an investment professional.

'We haven't seen an all-out panic yet, but it could very easily happen. The move by the central banks, for instance, on Friday assured the financial markets that the central banks are ready to step in in time of crisis, but by Monday it also could send the signal that they're so worried about the situation because there's much worse yet to come,' he said.

Mr Johnson added that he thinks it's just as likely that the stock market will start a bottoming process sometime this week and possibly show signs of lower volatility. 'We've taken some hard hits here the last few weeks, but the fundamentals are holding up very well, and investors might start thinking it's worth dipping a toe back into the market and seeing what buying opportunities exist after a 6 or 7 per cent pullback,' he said.

Indeed, Citigroup chief investment strategist Tobias Levkovich, who predicted that the US Federal Reserve would step in to provide liquidity to the system to keep the credit market breathing, believes the time is ripe for investors to buy large caps, the IT sector and big pharma.

'We expect that the equity markets will continue to churn, but the degree to which the VIX (the Chicago Board Options Volatility Index) has soared argues for a strong recovery in the next one to three months,' he said.

On Friday, the panic in the credit markets nearly swamped equities, but stocks came back after the Fed injected US$38 billion in liquidity into the system to keep rates from rising above its target level, and central banks in Europe, Japan and Australia followed suit.

After being down more than 200 points on Friday morning, the Dow closed down just 31.14 points, or 0.2 per cent, to 13,238.54. The Standard & Poor's 500 eked out a gain of 0.55 points to close at 1,453.64. The Nasdaq Composite shed 11.6 points, or 0.4 per cent, to 2,544.89. For the week, the Dow finished with a 0.4 per cent gain, while the S&P 500 added 1.4 per cent and the Nasdaq rose 1.3 per cent .

The turmoil had the Dow closing with swings of more than 100 points in three out of five sessions. Despite the reassurance of the US$62 billion the Fed injected into the credit system on Thursday and Friday combined, and a promise to do more of the same in order to keep the Federal Funds rate at its 5.25 per cent target, investors will face the likelihood of another week of turmoil spreading from the sub-prime mortgage crisis.

'No one has a handle yet on how far the sub-prime crisis will spread into other areas of the financial system,' said Alan Alvarez, a money manager at First Equity Capital Management. 'Until investors get a solid idea of how bad things can get, panic is just the next announced failure of a major hedge fund away,' he added, referring to last Thursday when French bank BNP Paribas said it has suspended three of its funds that have exposure to US credit markets.

That spurred concerns that liquidity problems in the United States, caused by increasing problems in the mortgage markets, were spreading globally, and sparked a 387-point swoon in the Dow. Those deep fears over the credit market and the fallout from the US sub-prime mortgage industry will continue to dominate the markets in the coming days, but Wall Street analysts will also be keeping an eye on several key economic reports due out this week.

The Producer Price Index and the Consumer Price Index, scheduled for release tomorrow and on Wedenesday respectively, should give traders a good view into inflationary pressures. The Fed in its announcement last week signalled that it would not consider a rate cut until it felt certain that inflation was well under control.

With calls for the Fed to cut rates in order to prevent a credit scare induced recession already on the rise, a benign inflation report will only make those calls louder. Retail sales for July are due today. Second-quarter earnings season has been all but ignored during the turmoil of the last few weeks, but US companies continue to turn in surprisingly strong results, with a year-on-year earnings growth rate of 7.9 per cent.

With nearly 90 per cent of S&P 500 companies having reported, earnings season is winding down. But 18 S&P 500 components, along with the final three Dow components are scheduled to release results this week.