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Tuesday, August 20, 2013

Market Thought... assessing a market crash

Back in June, Doom-and-Gloom Faber suggested the market can decline by some 20%. Didn't happen. Not yet anyway. But he is still singing the same tune.

The bearish scenario that is to bring such destruction are rising US rates. Specifically from the Fed loosing control of the bond market.  Every time I hear this argument I scratch my head and wonder,  what exactly is the magical number to which the bond market assumes the Fed has lost control?

In late June, this every chatter was to blame for a declining market. Its the Bro-down of all Bro-downs!

I do not know what the magic number is on the treasury, but I do understand patterns. Two years ago the rates were higher, with weaker employment figures and the existent threat of an Europe with an inactive ECB. Yet the US market rates have not exceeded levels seen with worse macro economics.

So how can the bond folks, and the press peddling their garbage, suggest (with a serious face) that the Fed has lost control over the bond market.  (Maybe if the Feds were not involved the treasuries would already be near 3%.)

The above, in relation to the current economic back-drop does not seem like the reason the market is rolling over.  But it doesn't matter as to what is true, its the moment's perception of truth that matters.  And right now, the perception seems to be turning.

Fundamentally, there is merit in caution.  Below are projections based on SP500 eps estimates, assuming the market is given a multiple of 17. (A trailing multiple of 17 suggests a fully priced market, with nice expectations going forward.) For the quarter ending in September, the market should be priced near 1641. The market is above this price despite the recent declines.  

If additional negative perceptions are allowed to seep through, then the market multiple can compress toward 15. (A trailing multiple of 15 suggests a normal market with reasonable expectations of earnings and little pricing of financial shock risk.) For the quarter ending in September, the market should be priced near 1448. If the market sees this multiple compression, the SP500 will decline by 12%.

The longer term charts suggest SMA supports for the SP500 near the mid 1400 level.

Some negative perceptions that can facilitate such multiple compression:

1. Escalated violence in the Middle East.

Syria can be on the brink of an international war, depending how US and Russia play their cards. Egypt, and one of the largest-economic-affecting transport routes (Suez Canal), seems to be on a path to chaos.

2. European wild cards.

There is always something fucked up that can happen in Europe. (Their craziness and stupidity is probably worse than our Congress.) Berlusconi is in the news again, this time threatening to disrupt the government, thereby putting at risk Italy's recovery.

3. US corporate earnings slow.

A slow earnings growth rate typically merit a lower trailing multiple.

4. Japan's abenomics implodes

Japan has gone all-in with their current stimulus plan. It must work. If it does not, there will be some messy market situations in the not too distant future.

5. China economic transition

So far so good, but the transition to a more consumer orientated economy is still being played out.

One very big positive:

Money is flowing out of bonds, at a sizable clip. This money will be put to work where the trends are working. And the longer-term trends are working for equities.  Especially in a decent macro-economics at play and global central banks facilitating loose policies.

If there is a market decline, its not likely going to be 20%.  (Unless something happens with Japan.) 

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