The Fine Line Between Confidence, Complacency

Source : The Business Times, April 7, 2008

THERE’S a fine line between confidence and complacency and markets are currently treading dangerously close to it - the US Federal Reserve’s actions may have calmed some nerves for now, but there is the very real likelihood that Wall Street has moved too far into a complacency zone and may not have fully appreciated the magnitude of the slowdown ahead.

One sign of this, for example, is that experts including Fed chief Ben Bernanke himself are still debating whether the US is in recession, as if there is any doubt. At last week’s Senate testimony, Mr Bernanke said the US economy ‘may contract’ in the first half, clearly reluctant to admit present reality.

Research house Ideaglobal, however, has no qualms calling a spade a spade: ‘The US economy saw some unequivocally bad news on Friday. Non-farm payrolls revealed that the US economy shed 80,000 jobs in March, versus a loss of 76,000 in February and 76,000 in January. The February and January numbers were revised upwards from 63,000 and 22,000 respectively which add up to -67,000 in back-to-back revisions…

‘The data clearly confirms that the US economy is in recession. As a result, expectations for a 50 basis point cut by the FOMC (Federal Open Market Committee) at its April 30 meeting rose to 36 per cent from 20 per cent on Thursday.’

Ideaglobal also expects more downward revisions in the months ahead. ‘The recession that has yet to enter its most intense phase will continue to extract a painful price in terms of overall output and productivity… we expect the shape of the recession will see one trough reached in spring 2008 and another in the early winter of 2009.’

Either confident or complacent - readers should judge for themselves - is BCA Research, which said in its second-quarter strategy outlook that the bear market has ended and that investors should start buying now. ‘Our sense is that monetary reflation may be slowly winning the battle against deflationary pressures coming from the housing meltdown, financial de-leveraging and retrenchment in banking activity,’ said BCA.

It used various indicators to arrive at this conclusion, including sentiment indicators like insider buying/selling and the spread between the two-year Treasury and federal funds rate. In its haste to call a market bottom, BCA may have forgotten that the end of a bear market does not necessarily herald the start of a new bull market.

DBS Bank recognises this important point in its second-quarter regional equities strategy in which it said ‘we remain cautious about the second quarter because of the buildup of risks in the US credit market and economy. We expect earnings forecasts and downgrades to bite, leading to further adjustments in stock prices globally’.

It added that although expectations are that the US will recover in the second half, it believes the negative news flows have yet to run their course as risks increase.

‘The conviction for a second-half recovery now is not as high as compared to the first quarter. Risks we are seeing now include: 1) magnifying of US credit rick, 2) balancing of US inflation risks that could lead to a lack of relief from rate cuts, 3) little bearishness in terms of growth and earnings forecasts, implying room for downward revisions, 4) a potential Europe slowdown that has not been priced in, 5) high correlation between US and Asian equity markets, 6) a slowdown in Asia’s growth on its own cyclical dynamics.’

A best-guess is that the ‘confidence’ in stocks over the past fortnight has come solely because short-covering has helped to keep the upward momentum going, aided no doubt by hedge funds which have had an awful first quarter and are looking to quickly redeem themselves.

In other words, markets know that the excesses built up over six years cannot be purged in a few months but are riding the momentum for the time being, in the hope that the Fed’s actions have bought them enough time to make some quick money.

DBS is probably right in saying that investors should ‘go defensive’ in the second quarter because it’s unlikely that markets can continue to shrug off repeated doses of bad news as they seem to have done in the past week, nor can they cope when below-par earnings start to be reported.