Archive for February 19th, 2007

The Market – Important Events that Will Shape the Market

The Bank of Japan is about to make a rate decision that could have far-reaching ramifications.  If the BOJ does raise the overnight rate to 0.50%, the Yen carry-trade could face some significant unwinding and much of the market liquidity we currently have could dry up.  Though I find this scenario above unlikely as a 0.50% rate is still comparatively cheap to that of holding other assets, any concern that the Yen could appreciate significantly could make a significant unwinding of the carry-trade more likely. 

Certainly, what would really hurt the carry-trade and global liquidity is if the Japanese economy suddenly strengthens and provides support for higher rates.  Again, though this is unlikely over the next quarter, the market would have a liquidity scare.  Now, if you add to this the Fed becoming more hawkish, then the double whammy could be very intense.

So what are the key bearish and bullish factors facing the market?  On top of a potential liquidity crunch, add the growing quagmire of the sub-prime mortgage backed market fallout (which hardly anyone seems to really think is going to be a problem as a lot of market participants feel that derivatives, CDOs in particular, have successfully spread default risk so much so that securities loss is almost unthinkable), plus add a continued housing shakeout leading to a reduction in construction jobs, tightening lending standards, and fall in consumer mortgage equity withdrawals, and you suddenly are faced with a very different environment than the one currently priced in.

Then, throw in declining earnings with somewhat mediocre outlooks, a low risk pricing environment, plus a market that is hitting new record highs, and you just have to ask, ‘who the hell wants to lead the charge in the face of this risk?’

Now if you look at what could move the market up, a falling Fed rate would be one consideration as the economy softens.  But then of course, the economy would have to soften in the tightrope goldilocks fashion because usually a softening economy is bad for the market.  Or you could consider increased liquidity, but where would the increased liquidity come from especially when most of the world’s major central banks are in the process of tightening and the BOJ certainly can’t add too much more liquidity than it currently provides.  What about a sudden increase in company earnings?  Well, companies have already guided for some mediocre quarters based on tough comps and market conditions, and if anything, a lot of companies are attempting to spruce up earnings with job cuts, but of course, those are bad for the economy as well.  We could have an earnings surprise to the upside for Q1, but that is unlikely.  Another possibility is the US economy could strengthen more than expected, but the Fed has made it pretty clear they would consider any strengthening as potentially increasing inflation of which they are eager to combat.  The subsequent increase in the Fed rate would likely not be appreciated by the market.  So what about share buybacks and PE leveraged buyouts?  Certainly, those are already providing some market support as companies have recently announced massive buyback packages and 2007 is already famed as the year of the private equity LBO.  But these two efforts are simply icing on the cake, and I don’t believe they have the firepower to make a market trend up over the medium to long term.  Finally, what about an increase in P/E multiples supporting the market?  The S&P 500 is already trading slightly above its long-term average, and as we are in the 5th year of this bull-market run, does it really seem reasonable to think multiples will continue to expand?

Basically, if one compares the probability and likely market effect of the basket of potential bearish events versus the probabilistic likelihood and effect of the basket of potential bullish events, the scales seem to tip very much in the favor of the bearish camp.  With that said, the market has a tendency to spike upward before establishing a downtrend, so the next few months should be interesting as these events pan out.

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