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Get ready to buy

Created:

7 October 2008

Updated:

15 October 2008

Written by:

Simon Thompson

The events of the past fortnight certainly have all the ingredients needed to mark an intermediate equity market bottom: multiple bank bail-outs across the globe; panic selling by investors; the largest points falls in the US stock market since the October 1987 crash; and volatility, as measured by the Vix, Wall Street's gauge of fear, rising above 50, its highest level ever.

This distress has been mirrored in the credit markets, with credit default swaps - in effect, insurance against default on corporate bonds - spiking along with the cost of borrowing money in the wholesale money markets. To complete the dismal picture of heightened investor risk-aversion, commodity prices have tumbled on concerns of a global economic slowdown.

Interestingly, the S&P 500 has now plunged down below 1062 - that is 20 per cent below the index's 200-day moving average of 1327. As of Tuesday 7 October, the index futures were trading at 1047. As I noted last week ('A trade for bulls and bears', 2 October 2008), I have been watching the S&P 500 like a hawk to take advantage of a buying opportunity if it ever got down this low. True, we still have to navigate through October, a treacherous month littered with major market lows in the past. In fact, the month has a fine record of being a bear killer, marking the trough of no fewer than 11 bear markets in the US since 1945.

And there is plenty to be concerned about in the near term. Having voiced serious concerns about the distress signals emanating from the credit markets ('Jaws of death', 8 September 2008), the situation has got worse, not better, since then. To recap, I have been closely monitoring the euro:yen exchange rate ('Initiation climax', 15 September 2008) as this has been a fantastic indicator of intermediate bear market troughs since the credit crunch began in August 2007. In effect, the cross rate is a measure of investor risk-aversion, as the low-yielding yen has been used as a cheap source of funds for the carry trade. So, when the yen appreciates against the euro it is a sign that investors are unwinding these currency positions and becoming more risk-averse. Unfortunately, the euro:yen rate has plunged from €1:Y156 to €1:Y138 (see chart below) in the past 10 days, implying that September's stock market lows will not, as I had previously thought, mark the low point of the bear market this year.

In addition, I have been keeping a close eye on the TED spread, which is the difference between three-month Libor (the London Interbank Offered Rate, which is based in euro dollars, so is also called The Euro Dollar (TED) Spread) and the yield on three-month US Treasury bills. Libor is simply the interest rate banks charge each other to borrow in the wholesale money markets. Pre-credit crunch, when money markets were functioning normally, the TED spread would have been no more than 50 basis points. However, last week it spiked to 400 basis points, implying evident financial market distress (see chart two). To put this into perspective, the TED spread is even wider now than during the October 2007 stock market crash. This matters because there is no way equity markets are going to put in a sustainable countertrend rally as long as both the TED spread and euro:yen exchange rate are showing signs of distress among investors and financial institutions.

The good news is that, with risk-aversion so high and distress levels extreme, all the signs are that an intermediate bear market low is not far away. In my opinion, the most obvious and likely catalyst for a reversal of this downtrend would be for central banks to indemnify the banking sector (for a fee, of course) from counterparty risk in the Libor market. Backed by a sovereign guarantee, banks would once again be willing to lend to each other and elevated Libor rates would start to deflate and alleviate the stress in the financial system. True, bad banks will go bust, but the fee paid to central banks for underwriting the counterparty risk will help offset potential losses to tax payers under this scheme.

Trading strategy

Having waited the best part of a decade for the S&P 500 to drop 20 per cent below its 200-day moving average, the buying opportunity I have been looking for has now arrived. To average into the trade, and to mitigate risk, I have split my capital for this trade in four and bought a 25 per cent position in a long Barclays iShares ETF (TIDM: IUSA) with the index at 1047. I will buy another 25 per cent position on every 1 per cent fall in the index after that. Remember, in the past 33 years this trade has a 100 per cent track record of showing a profit (average gain over 10 per cent) one month after the S&P 500 has fallen 20 per cent below its 200-day moving average.

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