Is the financial storm over?

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The credit crisis may not be over yet, but we seem to be at an important juncture with governments around the globe attempting to address the root of the problem.

The most recent capital injections and federal guarantees have caused a sharp reduction in default risk as shown by Bespoke’s index of bank and broker default risk (measured by credit default swap (CDS) prices). “Last week, default risk was factoring in a scary likelihood that the entire industry would actually collapse,” said Bespoke. “So far this week, our index … has declined by a whopping 67% and is at its lowest level since June 23rd!”

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Although this is a good sign for both the credit and equity markets, one would also like to see a significant retracement in measures of lending confidence such as the TED spread, i.e. the difference between what banks charge each other for three-month loans (three-month dollar Libor) and what the Treasury pays (three-month Treasury Bills). This measure of risk aversion and illiquid repo conditions is still at elevated levels, notwithstanding yesterday’s decline of 19 basis points.

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Source: Plexus Asset Management (based on data from I-Net Bridge)

The major fall-out of the debt crisis is that the world is in recession, which will probably deepen as the path of destruction widens. Unemployment, budget deficits, the impact of the collapse of equity prices on personal wealth, and the effect thereof on spending over the next year or two, await us in the coming quarters.

Not only does the broader economy still face many challenges, but investors are particularly concerned about the earnings outlook and the implications for valuation levels. I believe Bill King’s (The King Report) viewpoint may very well be on the money: “Once again we must reiterate that the current US deflationary environment has not been navigated since the early thirties and this time it really is different due to the hundreds of trillions of dollars in derivatives. So until stocks fall to grossly undervalued levels by verifiable balance sheet standards, one should remain extremely cautious.

“Those playing the ‘E’ in PE and other earnings metrics have been getting slaughtered because earnings historically are overestimated by analysts and in a deflationary environment they fall faster than most people can imagine. So you can toss earnings metrics overboard for awhile.”

One could argue that stock prices are oversold, creating the potential for a further advance through year-end, especially if credit spreads tighten (i.e. normalize) further. However, stock market valuations are not at the same oversold level as prices, arguing that a secular low may not necessarily have been reached. The third quarter earnings season should provide part of the puzzle.

Related articles:
Stock markets – a reversal of fortune?
What it would take for me to become bullish

 

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3 comments to Is the financial storm over?

  • Very nice to see something positive for a change :)

    Thanks.

  • We have been watching Roubini for a long time on myinvestorsplace.com … he has been right so far… do you think he could be wrong… We have seen some many gurus go wrong from Prechter to Joe Granville..what do you think??

  • Dan Modricker

    The day the DJI experienced a 1000 point trading range, closing at the upper end of that range, I sensed the bottom had been touched. It was enough for me to buy into the market; effectively averaging substantially lower.

    One must believe AND ACT when blood is in the streets. It’s not enough just to believe! And if it takes 10 years for my energy fund to return to its Leap Year level … so be it. Mauldin has taught me well to be patient and dispassionate.

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