Here are his first impressions of the recent carnage and where we stand today:
1) While more equity volatility is to be expected, there's a good chance we've seen the low in the S&P 500.
This conclusion, it must be said, has nothing to do with sifting through the trade blotters and performance details of suffering hedge funds, a projection of consumer spending over the next six months, or a firmly held belief that the Fed will cut rates 0.50% in September. Rather, it is based on his reading of the chart, which is his only tool for objectively assessing the price action while he was gone.
The S&P 500 has sketched out a pretty textbook A-B-C correction, albeit a deeper one than originally anticipated. The A wave, from the highs down to 1427, represented an 8.2% decline. The B wave, back to 1503, retracement almost exactly 61.8% of the A wave. And Wave C, that most painful of waves, has had a peak to trough decline of 8.9%.
That Wave A and Wave C are roughly equal in magnitude is a good sign that the correction has fulfilled its objective. Moreover, the bottom was marked by a bullish candlestick, with a long downward wick and a small positive daily return. That is generally a reversal signal. That the bounce from Wave C has eclipsed the Wave A low also suggests that the pattern will not morph into a more bearish type structure.
From here, I would expect a bit more upside, culminating in failure, and then a noisy downmove that fails somewhere around 1400, give or take. That will likely be the dip to buy.
2) The Fed has changed its tune, but that doesn't guarantee a rate cut
Jim Cramer's rants remain misplaced, in my view. Natural selection mandates that a normalization of volatility conditions will weed out some traders and portfolio managers who are ill-equipped to deal with the new reality, just as natural selection has dictated that US autoworkers have seen job losses because of Detroit's inability to manufacture high-quality automobiles at a competitive price. Cutting rates because some hedge funds are closing would be a grave, grave error, and merely propagate the next financial asset bubble.
However, it is also the case that a permanent increase in borrowing costs, lower household equity wealth (on top of continued reductions in household housing wealth) , and the recent inability of the money markets to clear does represent new information. The move in the discount rate looked largely symbolic to me, and it is possible and perhaps even likely that it will eventually be seen as such.
More important was the change in bias, reflecting the potentially pernicious impact of higher borrowing costs (which seems likely to be a feature of the landscape for some time) and lower household equity wealth (which, if equities remain weak, would no longer offset housing) on economic growth and employment.
However, it doesn't seem quite right to assume that a September cut is a done deal, as some investors mistakenly did immediately after the August meeting. In a sense, the surest way to a rate cut is to experience more pain; the more pleasure that markets feel over the next four weeks, the less likely a rate cut (which is presumably the whole rationale for the risk asset rebound) is to pan out.
All the more reason, then, to expect more volatility over the next few weeks.
3) As noted previously, a lower Sharpe ratio for risk trades does not necessarily mean a negative return for risk trades
I has debated internally this morning whether we have seen the 'death of the carry trade' and/or the 'death of the equity dip buyers.' His answer to both of those questions was 'no.'
Liquidity has, in his view, been the primary explanatory variable in the superb performance of most risk asset markets over the past several years. And while it seems quite clear that liquidity conditions are less easy now than they have been in some time, it does not necessarily follow that they are restrictive.
Yes, cash markets have seized up, but I would suggest that that was down extreme risk aversion in the wake of the credit crunch, not necessarily because of insufficient liquidity. To put it another way, just because liquidity was the solution does not necessarily mean that it was the problem.
Global liquidity conditions remain moderately easy, in my assessment, because of the EM central banks- i.e. the BRICS. That China was rumoured to be the buyer of last resort for Bear Stears tells you much of what you need to now. VIG has plenty of cash and no internal risk manager that shrieks every 20 minutes or 2% (whichever comes first.) As such, they and other SWFs are sitting in the catbird seat; private sector investors have been selling assets almost regardless of price, which naturally sets up some nice bargains.
Should equity and other risk asset weakness continue, i would expect these guys (and others, such as Warren Buffett) to step in and starting buying up quality assets on the cheap. And, that, ulimately, should help drive decent if not spectacular risk asset returns moving forwards.
