Make no mistake, we are in the grip of a vicious bear market. In bear markets, investors can do one of two things. Succumb to fear and ‘get out’; or be very careful, preserve capital as best they can, and be ready to take advantage of the attractive stock prices that bear markets inevitably produce.
At Fat Prophets we encourage our Members to do the latter. Dumping shares for no other reason than fear creates the sort of opportunities we are hoping to find. Our aim is to take advantage of fear, not be held hostage by it.
To this end, over the past six months or so we have mostly been recommending gold, oil and commodity based companies. In our weekly commentaries we have cautioned against buying into this falling market and have instead recommended accumulating cash. This is still our position and we will discuss the outlook for markets in a moment.
But for now, keep in mind that we are in a bear market and that no investor is immune from declining share prices. To paraphrase Richard Russell, octogenarian editor of the Dow Theory Letters; everyone loses in a bear market, he who loses least, wins.
So don’t be disheartened by paper losses, everyone is experiencing them. If you’re genuine about being a long term investor, experiencing a bear market is one of the best educations you can get. We’d guess that more lessons are learned in a six month bear market than a 6 year bull market.
One other point to make about a bear market. Money flows from the small caps to the large caps. Many small caps have been hit hard despite having sound earnings, business models etc. As the need to raise cash from margin calls sweeps the market, the smaller, illiquid stocks are usually the hardest hit.
In our view many small cap stocks are trading well below their actual value. So if you’re holding sound companies at the smaller end, sit tight. But in bear markets, stocks can trade below value for some time so we would caution against rushing in to buy more at this point.
We’ll discuss the factors driving the market lower shortly, but first let’s see what the charts are saying.
The ASX200 dipped below 5100 last week, reaching the lowest level since September 2006, around the time the private equity circus came to town. Technically, the decisive break below 5490 and continuation below the January low of 5186.8 marks a significant deterioration in the outlook for the ASX200.
While near-term indicators are becoming increasingly oversold, this is normal for a bear market and does not necessarily point toward an imminent rebound. However, bear markets are characterised by sharp rallies and given the sizable falls we have seen recently, a ‘relief’ rally would not be surprising.
But any rebound attempt in the near-term is likely to struggle while below 5500. A clear break above 5770 is needed to ease downward pressures and shift focus back to a revival of upward momentum. Even so, we see this as an unlikely event over the next few months.
More realistically, having broken through the January lows, we see the 5000 level as the next major target for the ASX200. Below here and we’re looking at moves into the 4770 / 4760 region. As marked on the weekly chart, this coincides with a 50% retracement of the 2003 to 2007 rally and the June 2006 low.
So from a charting perspective, the short term outlook remains bearish. The main source of anxiety is the ongoing contraction in global credit markets. The latest shoe to drop has been margin calls on hedge funds who have made leveraged bets (borrowed against the asset) on high quality US mortgages. This has resulted in forced selling, lower prices and a fresh round of margin calls.
These hedge funds, such as Carlyle Capital Partners and Peloton Partners, have largely invested in high quality, AAA rated mortgages. The problem is they have leveraged their exposure and the fall in value of all mortgages, not just subprime, is resulting in margin calls.
This is the deleveraging of the financial system in action. The process first starts with a fall in value of poor quality assets, then moves up the quality ladder. Anything backed by too much debt is at risk. The hedge fund industry will take a very long time to recover from this unwinding process.
The message is that in such an acute deleveraging process, no asset is entirely immune. When large amount of debts need to be repaid, there is a rush to liquidate assets. There are generally no buyers for the poor quality assets, so higher quality assets are sold to raise cash.
This is why making sense of price movements in this type of market is very difficult. For example, we are now seeing evidence of liquidation in commodity markets and resource stocks in general. We wouldn’t be surprised to see this continue for some weeks as this sector is a ready source of funds (i.e. large, liquid) for those looking to pay down debt.
Irrespective of what happens in the short term though, we are still of the view that we are in a secular bull market for commodities. While a correction in commodities would not be surprising, our strategy is to continue holding through the duration of the bull market and buy the dips.
Regardless of the near term price action, we believe the commodity sector is underpinned by strong fundamentals. Given the turmoil in the credit markets, the US Federal Reserve is odds on to lower official interest rates by at least 50 basis points when they meet next Tuesday. But do not be surprised to see an ’emergency’ cut before then, perhaps by 75 basis points. Such a move would push real interest rates even further into negative territory, which is of course bullish for commodities and precious metals in particular.
