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Headed For a Normal 20-30% Correction

by: Roger Nusbaum August 08, 2007 | about stocks: DIA / IEV / IMH / IVV / LUM / SPY    

Roger Nusbaum

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Add Luminent Mortgage (LUM) and Impac Mortgage (IMH) to the list of mortgage calamities. Also the market breadth has not been too hot.

Companies getting pasted and poor market internals is what happened back in the Internet meltdown too. This is just a little factoid, not an analysis or a prediction.

In terms of analyzing this, the market does not cut in half twice in one decade. I suppose it is possible but in terms of realistic probabilities; I would say no. However these little under-the-market's-hood items could, like before, lead to a sizable but probably overdue decline.

This year we have had two mid-single-digit dips and people freaked out. If you look at market history, get yourself a Trader's Almanac, you will see that 20-30% declines happen often enough that they should be thought of as normal. A decline of that size will happen at some point in some market cycle which will then help put a 6% decline in much better perspective than was portrayed last week.

Whenever the next bear market starts we should expect a decline of more than 20%. I have no idea if the current mortgage/liquidity issue will be the tipping point or not but the yield curve has been in varying states of inversion for a long time which is an unhealthy condition for financial stocks, and financial stocks are vital to the market and lubing the chassis for the economy.

Problems in the financial sector often come home to roost. This might be happening now or it might not. There are arguments on both sides of the debate and they sound plausible, but I can't get away from the fact that inverted curves lead to trouble. Combine that with money that was too cheap and too abundant for too long and you have a recipe for recession and bear market. NORMAL recession and bear market, not apocalypse.

I don't know, nor do I feel the need to predict the timing of the next recession. This merely pops us as a risk with a decent probability. For now stocks are flirting with rolling over but have not really done so yet.

Do what you want with this but I have been concerned about this for a while and continue to be so now.

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This article has 11 comments:

  •  
    Aug 08 08:36 PM
    Roger,

    Good comments, pays to be a little cautious right now, regardless of
    timelines. Thank God somebody else sees risk right now, I thought
    I was the only one there for awhile.

    James Biringer
    Reply
  •  
    Aug 09 12:15 AM
    What makes you think Paulson, and his scheme using "excess" tax receipts as 7-day loans to the primary brokers won't reverse the so-called correction? Any proof all these "loans" that David Fry has posted are ever repaid? Were you writing about the "v" reversal after the Feb 27 selloff so quickly? Like that's historically normal? You don't think they used all those billions in loans strategically to buy XLF, SPY; DIA promising a 100pt rally to Bush today,when he took the podium? Just coincidence they added his speech to the Treasury meeting today? And the 4 million shares bought of DIA in the last minute today was pure coincidence? And the buying of the SPY cash futures premarket to wipeout overnight losses and thus gap- open a short squeeze is all coincidence ,preventing any selloffs since Feb 27? If this so-called 6-7%correction recovers to Dow14K in a week or two, I guess you'll chalk it up to normal? Read Fry's posts, he asks questions.
    Reply
  •  
    Aug 09 03:09 PM
    irenderit, i was calling for the Q1 fast decline to resolve to the upside quickly.

    randomroger.blogspot.c...
    randomroger.blogspot.c...
    Reply
  •  
    Aug 09 01:09 AM
    When people look backwards to see whats coming they often forget that our markets today have evolved. I am in no way saying that large corrections are no longer possible; what I am saying is that any analysis that reads "we will see big corrections because we saw them before" is overly simplistic. So, what was "normal" in the past is not necessarily what we can expect in the future. It seems obvious but when everyone's looking for explanations and making predictions it is easy to forget that past results are not indicative of future performance.

    JBS
    Reply
  •  
    Aug 09 03:10 PM
    fair point. the context of my commentary on this subject is to have a trigger point for defesnive action, don't get emotional and try to keep on top of current events so you don't get blindsided
    Reply
  •  
    Aug 09 07:14 AM
    "When people look backwards to see whats coming they often forget that our markets today have evolved. I am in no way saying that large corrections are no longer possible; what I am saying is that any analysis that reads "we will see big corrections because we saw them before" is overly simplistic. So, what was "normal" in the past is not necessarily what we can expect in the future. It seems obvious but when everyone's looking for explanations and making predictions it is easy to forget that past results are not indicative of future performance."

    This is certainly within the realm of possibility, but I think this is highly problematic. IMO, the primary tool for making forward-looking decisions and considering possible future scenarios is past historical experience and past quantitative data. If one starts with the premise that the past is meaningless, then where does that leave you? It leaves you at basically making hunches and guesses based on absolutely nothing. My thought is the past represents a combination of both fundamentals and human psychology. I believe human psychology never changes so the cycles of the past are likely to be repeated in the future in a similar (but not exact) way.
    Reply
  •  
    Aug 09 09:56 AM
    It would appear to me that the weaker financials, builders, etc. are probably still in trouble, while the higher quality issues get punished along side them because of the trading dynamics of ETFs, mutual funds, and hedge funds. It would also appear to me that the amount of "mandatory invested financial wealth" in retirement holdings and pension funds, etc., put a floor underneath the market that may prevent declines as deep (in P/E, yield, and other value measures) as deeply as we incurred in the past. Of course the same pressure has increased the upward push on those measures, so overall market declines, peak to valley, may be just as large.

    The past is meaningful because it provides clues.... including the clue that it sometimes takes awhile for relative quality in the same industries and sectors to show.
    Reply
  •  
    Aug 09 10:18 AM
    Past cycles can be of limited use in future predictions. While there are lessons to be gained from studying history, this approach has definite flaws as well. You can say the market has changed, and matured, and globalized, and resembles little the market of 1929 or 1979, but that does not really help you predict 2009. Events of an unprecedented nature will be a part of the next decade, any of which could have huge impact, potentially much larger than the mortgage failures, including:

    1. Oil at $150 a barrel due to "peak oil scenarios" or expanding wars around the globe.
    2. Global warming impacts to farming & agriculture, etc.
    3. The dollar collapses against world currencies to a new low.
    4. China replaces us as the "#1 superpower nation."
    5. A serious plague, earthquake, hurricane, or terrorist strike in the continental USA.

    Any of these, or a combination of them, could take the Dow down by half, to 6000. Personally, I am usually a bullish investor and have done well in the last year on Apple, Cisco, RIG, XTO, etc. but it is highly possible that a "perfect storm" of events could set the markets in the USA back for a decade or more of bearish trends. Where to stay safe? Who knows? Cash, CDs, foreign bonds, gold -- your guess is as good as mine.
    Reply
  •  
    Aug 09 03:12 PM
    WRT to looking back...am understanding of history combined with assessing what is going on now can be combined into a forward looking analysis.
    Reply
  •  
    Aug 09 06:11 PM
    FWIW,

    I can't help but think I'm hearing faint echoes of "Things are different now"....last heard circa 1999/2000, etc. While I certainly agree its unlikely that a future meltdown would "exactly" mirror a prior event, if one suffers a 50% "haircut", does it really matter whether circumstances were identical to a prior time, or whether one was bent over the barnyard fence and "ravaged" by an unforseen "Black Swan"?
    Reply
  •  
    Aug 09 11:45 PM
    It is interesting to watch the ebb and flow of billions of dollars as just the froth on the rolling waves of international finance. In my view, a credit crunch is just the nomenclature banks use in order to raise interest rates on mortgages without stating their true agenda: greed. Dow up or down 300 points? It makes no difference, because that action is just the market movers casting wide nets to take out the riff raff trying to make a quick buck on the short-term trends. Who are the actual losers in the hedge funds? Probably anonymous foreign interests, private investors looking for the gravy train, and a few unfortunate college endowment managers who overreached their market knowledge. There are no losers among the very rich; that is the important lesson to take away from this.

    When banks actually start to lose money, the Fed or other central banks inject liquidity rapidly, because after all, the Fed is a private business, not part of the government. If a slowing economy is desirable to thwart inflation, it is not that inflation is dangerous, but rather that the rich want to drive down the price of real estate so that they can buy it up cheap from the little guys in order to begin the next thrust of development and ownership.

    The concept of laissez-faire capitalism is a smokescreen for market manipulaton on the grandest scale in history. I grant that sometimes the big players are at cross purposes and do not act in unison, which leads to counterexamples, but this anomalous model has a certain simplicity that other explanations lack.

    So let's make some predictions, based on the theory of manipulation, and see if they come to pass.

    . More hedge funds will fold, but their clients will be relatively small investors. The hedge fund managers and financial institutions will come through unscatheed, as will the cynical rating companies that led the public to believe their leveraged investments were safe.

    . Residential real estate prices will drop another 20%, at which point they will stabilize as mammoth holdings are accumulated by REITS controlled by foreign interests. Interest rates will then mysteriously fall, inventories will vanish, and construction will resume -- with illegal immigrant tradesmen ironically forming the customer base for the very residential real estate they are building.

    . The dollar will remain relatively steady against foreign currencies, not because it should, but because it's kept there. As someone recently said on Kudlow (to Kudlow's consternation), we have financed our war with foreign money. Now that the Chinese have us on a short leash through their complete control of long-term interest rates (their recycled dollars buying our treasuries), we must dance to their tune economically. The Chinese currency is linked to the dollar, so they don't care much how strong or weak the dollar is. They will continue to increase exports to us, and since we have become totally dependent on their cheap goods, already priced into our consumption budgets, we would put our economy into free fall if we tried to curb imports, which would reduce consumption.

    . The stock market will end at Cramer's predicted 14,000 plus, not because of any rational valuation, but because that is the level where the amount of market cap increase will float enough new money in the economy to make up for the drains elsewhere, as foreign interest buy up this country (and other countries, too; we're not unique).

    . There will be no big stock market correction. Normally, it would take asset deflation to bring down interest rates and thereby increase the spread on interest rates between savings accounts and loans, which helps the banks. But in the current Looking Glass economy, the rates are controlled by the Chinese (and perhaps by Fed open market operations), so no deflation is necessary. What we can predict with relative certainty is that there will be no significant inflation, because that might actually benefit borrowers, as they pay back their debt with inflated dollars. In today's world, we love individual debtors, because they pay the vigorish, but they can't be allowed to actually benefit from their loans in constant dollar terms.

    . Stocks with global exposure will rally, because they are independent of our economy, and the rest of the world is doing far better than we are. I favor big tech, agricultural genetics, overseas pharmas (not limited by our regulations), jewelers (the rich get richer, and need jewels), food producers (we are breeding more people), luxury hotels -- you get the drift.

    . Gold will rally precipitously, but not until the vultures are poised to pick our infrastructure carcass clean. This picking will not happen in the well moated financial world, but rather in the world of natural resources and large scale undeveloped real estate holdings. The Chinese will inexplicably begin to sell treasuries at a discount on the international secondary market, gradually divesting themselves of their core dollar holdings and accumulating Euros and commodities futures. The dollar will suddenly weaken as the Chinese dump dollars and treasuries directly and relentlessly on the primary market. Interest rates will spike, and the Fed will come to the rescue with inflated dollars to buy the waterfall of unwanted treasuries. As the dollar weakens, the Chinese will buy dollars with their gold and Euros, and immediately use those dollars to buy up our industrial and agricultural base. The resulting demand-driven price inflation will spearhead a rally in real estate and a rise in interest rates, which will strengthen the dollar somewhat, but not enough to offset gold's rising store of value. When the music stops, everyone has a chair except the American taxpayer.

    Anyway, it's easy to make predictions. The hard part is to make accurate predictions. We'll see what happens.
    Reply
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