When do we hit a bottom?

Posted by Daniel Harrison, Oct 16, 2008, 4:32pm

So ... suddenly, the market turned up 4% or so.

Unfortunately, this is less likely anything to do with equity valuations being at bargain prices, and more to do with index option expirations, many of which take place Friday. This should by all accounts be somewhat expected: there are usually spikes in the market at this time of the month (such as around Sept. 19 when the same thing was going on), and some index options cannot be traded on the expiration date (various Dow and S&P options in particular).

Which again raises the question: when do we hit a bottom? Much of the recent talk of hitting a bottom in the stock market is probably misplaced, and definitely too narrowly focused. The truth is, in a bear market a bottom has less to do with how cheap equities become relative to earnings, and more to do with other macroeconomic factors (as is true in a bull market very often, too).

Likewise, the issue with the various bailout packages is not so much that they are politically problematic, but that they try and correct the microeconomic climate, rather than the macroeconomic one. (For example, a reduction in the Japanese interest rate would have had more effect than the Asian, European, and U.S. ones combined).

There are four factors combined that most probably trigger the "buy" signal: the value of the dollar, the value of the yen, the price of gold, and the price of oil. When these four factors hit favorable valuations all at once, equity prices will probably see a big rush in buying. Here's why:

Dollar: a continued decline in the value of the dollar is bad news for global importers whose currency is pegged to the dollar. Many of these countries, particularly those in the middle east, depend upon imports for sustainable economic growth. While a weak dollar kept the U.S. from entering recession in the second quarter this year, that's a short term fix. It's much more important that currencies tied to the dollar feel flush so that they begin spending in the global economy.

Yen: Conversely, a massive devaluation of the yen is needed in order free up the much-debated existence of that far eastern market called the "yen carry trade" (to around 115 yen vs. dollar). Whether the yen carry trade -- the process of borrowing money in Japan and investing it elsewhere at higher interest -- exists or not is open to dispute. What is not open to dispute however is the psychological impact a weak yen has on global risk appetite. Its significance is even more pronounced this time round due to the current credit freeze. A drop in the yen also makes Japanese exporters much more profitable, therefore keeping consumer goods prices imported from there profitable.

Gold: Gold is a widely misunderstood commodity, mainly because so many people think of it in its traditional capacity as a hedge against inflation and defensive asset. Gold is more a defense against earnings growth than inflation today. That's why if you chart the period where gold suddenly took off, it more or less coincides with the hedge fund boom. This is because so many funds store excess cash in gold today, given the wild swings in currencies. Also, given riskier and riskier bets to outperform, gold is an attractive storage commodity to defend against the huge returns funds anticipate. In other words, gold is a harbinger of cash: as the price rapidly increases, it means hedge funds expect higher returns.

Oil: This goes without saying: we need lower oil prices in order to make growth sustainable. But we need them for a longer period of time, than say, two weeks.

The problem with the outlook described above is that many of those asset classes don't necessarily move naturally among one another in those different ways. But as with anything in the financial world, that's not to say they can't -- and won't.

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Posted in: FOREX
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