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Fear and Uncertainty Remain After AIG Bailout

"The U.S. government seized control of American International Group Inc. -- one of the world's biggest insurers -- in an $85 billion deal that signaled the intensity of its concerns about the danger a collapse could pose to the financial system. The step marks a dramatic turnabout for the federal government, which had been strongly resisting overtures from AIG for an emergency loan or some intervention that would prevent the insurer from falling into bankruptcy. Just last weekend, the government essentially pulled the plug on Lehman Brothers Holdings Inc., allowing the big investment bank to go under instead of giving it financial support."

Wall Street Journal, 9/16/2008

The Feds have once again taken unprecedented steps to assist/takeover a public company just as we were on the cusp of more dramatic selling of stocks. A few very early observations:

  • After falling 600 points (4.95%) on Tuesday, stocks in Japan were up over 250 points in the first two hours of trading today. After the initial surge, the gains have fallen back to a gain of 140 points.

  • U.S. stock futures were down this morning indicating a somewhat muted and fearful response to the AIG bailout.

  • The Fed's loan to AIG carries a two-year term, which means more losses are expected over the next 12 to 24 months. The Fed's bailout is not simply a short-term loan to help AIG get through a temporary liquidity shortage.

  • If AIG ran into problems, there are other companies who most likely have similar problems. The markets are in "who's next?" mode, which could result in wild swings on bad news, especially bad news from financial firms.

Markets May Be Approaching A Temporary Bottom

The two charts below say we may be approaching an intermediate bottom. The chart of the Volatility Index (a.k.a the VIX) is a way to measure market participants' fear of potential losses. Markets tend to make bottoms or reverse trend when fear levels are high. Conversely, markets tend to top or peak when people are confident more gains lie ahead. The green circles show the last three market tops in 2008 (a low reading on the VIX). The pink circles show the bottoms made in 2008 (a high reading on the VIX). The dark green box shows the VIX as of Tuesday's close. A VIX reading in the mid 30s is more indicative of an intermediate (temporary) bottom rather than a bottom which would put an end to a bear market.

The VIX peaked in the mid 40s in 2002, so there is room for more downside in stocks. Yesterday's high on the VIX was roughly 34. The VIX frequently had readings above 34 between July 10, 2002 and October 24, 2002. The S&P 500 fell 19.6% from July 10, 2002 to the eventual bear market bottom on October 9, 2002, which shows a reading of 34 on the VIX probably does not signal an end of the bear market. However, a reading of 34 on the VIX can signal we may be approaching a multi-week rally in stocks.

When a significant number of stocks are making new highs on an exchange, it is bullish. When there are significantly more stocks making new lows then new highs it is indicative of a weak market. When the number of new lows versus new highs gets to more extreme levels, it can signal selling exhaustion or investors "throwing in the towel". The chart below shows the number of new highs minus the number of new lows made on the NYSE. Market tops made in 2008 are shown in the red boxes. Market bottoms made in 2008 are shown in the blue boxes. The reading as of Tuesday's close is shown in the dark green box. During the last bear market, the lowest reading was -907, which occurred on July 24, 2002. After the reading of -907, stocks staged a powerful bear market rally gaining 24% from the July 24, 2002 lows. The 2002 rally lasted four weeks. Tuesday's reading was a -1,014 indicating a strong desire to sell stocks.

These indicators should not be used in isolation. The VIX could move higher and the NYSE New Highs - New Lows could move lower. However, the indicators and the government's announcement concerning AIG should not be ignored. The best chance for a somewhat permanent bottom in stocks would be for it to occur after another round of strong selling. If new developments support some type of bottom, then defensive positions would become less attractive and growth investments would become more attractive. We are not there yet, but we appear to be moving closer. These indicators do not necessarily point to "the bottom", but they do point toward a possible change in the intermediate trend occurring relatively soon. Any negative news could trigger more declines in a fragile market.

A 23% Decline Makes Valuations More Attractive

The S&P 500 fell 23% from its intraday high made on October 11, 2007 to intraday low made on Tuesday, September 16, 2008. We have entered a range in stock prices where valuations are beginning to look somewhat attractive (less overvalued). Just like the technical indicators above, valuations should not be used in isolation. Cheap stocks can get cheaper.

Risks remain at elevated levels and the economy still faces serious obstacles on the housing, banking, and employment fronts. Therefore, any stock rallies should be met with a prudent dose of skepticism. If the markets rally on Wednesday (or in the coming days), it will be important to see how they act in the last hour of trading. A strong finish Wednesday would be a good sign. A weak finish may indicate the market feels more problems lie ahead, which is most likely the case. A heavy cash position remains prudent for the time being.

 

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