Everyday investors say that they are looking for direction in today’s equity markets.
They want to see whether the markets are heading for bearish times of doom and gloom or whether they are back on a bullish run.
Bulls and bears, beware. There will be no definitive direction in the equity markets until 2009.
There are several reasons why.
Based on an analysis of the nation’s current financial and political conditions, two key milestones will mark either the downfall or the resurgence of the U.S. equity markets.
First is the end of the subprime related write-downs. At some point, the big banks will have to make clear that they have found all of the bad mortgages on their books and have accounted for all potential losses.
Remember, the subprime crisis really began back in July 2007, when two Bear Stearns hedge funds came to a screeching halt after revealing that they had lost billions of dollars and nearly all of their value due to subprime related losses.
At that point, Wall Street was served notice. The subprime era had begun, and everyone needed to account for their losses.
To date, Wall Street banks have taken approximately $150 billion of subprime related write-downs, according to Standard & Poor's (S&P). S&P estimates that total subprime losses will amount to $285 billion.
It should also be noted that investment banks themselves have had significantly higher estimates for overall subprime losses: JPMorgan Chase estimates$325 billion; Morgan Stanley and Goldman Sachs each figure $400 billion; UBS estimates subprime losses will hit $600 billion.
For the record, I don’t believe that subprime losses will reach the $600 billion that UBS estimates.
As we approach the one-year anniversary of the Bear Stearns hedge fund crash, Wall Street must remember that time is running out.
Investors will only put up with subprime losses for so long before they start asking questions. For instance, are major banks hiding losses in other unprofitable units and using the subprime meltdown as a scapegoat? While that may or may not be the case, investors will only have so much patience before things get ugly.
Based on the current write-downs to date and S&P’s total write-downs forecast, I believe that we will see the end of the subprime related losses, or more likely a slowdown in subprime losses, a year from now, by the middle of 2009.
While the total amount of subprime losses may exceed $285 billion, I don’t think that investors will put up with $10 billion to $20 billion in fresh write-downs every quarter for the major investment banks for that long.
Investors want to know how deep the losses go. If they feel that the losses are unending, investor sentiment could start to erode, and with it the health of U.S. equity markets.
Yet if the investment banks significantly decelerate write-downs by mid-2009, investors will have confidence that the worst is behind them.
Fundamentally, the markets must trade down to some degree to absorb all of the losses that the subprime meltdown has caused. But it will be investor confidence, or lack thereof, and the end of the subprime era, that moves the markets one way or another.
The second key milestone that will give us direction in the equity markets is the U.S. presidential election and the first 100 days in office of our new president.
Say what you will about Wall Street liking a Democrat or a Republican. Bottom line is, Wall Street likes predictability.
Wall Street wants to know what the future will be, and prices those future events into trading.
That is how Wall Street responds to events such as rate cuts, and it’s how they respond to political change.
The first 100 days of the new U.S. president, whether it is Barack Obama or John McCain, will give Wall Street guidance on corporate taxes, windfall profits taxes, capital gains taxes, and even inflation.
If the U.S. has a president who will significantly raise the federal budget with billions of dollars in new government spending programs, mostly likely the United States will either have to print new money or borrow from abroad, both of which will further deflate the dollar.
If we have a president who increases capital-gains taxes, we may see investors move their money away from Wall Street.
The effects of these decisions will give clear direction to the markets. At that time we will see whether corporate America and investors will be burdened with new taxes or encouraged to make new investments.
Right now, Wall Street has no clear direction on where its future is heading. The market might appear to be on the road to recovery, then see major losses. It might take a nose-dive, then investors go bargain hunting and make a run on equities.
That’s why we’ve seen such a see-saw equities market so far this year.
Until these two major milestones occur, a good decision for most investors looking for clear direction in today’s equity markets is to stay out.
A smart place for investors is in conservative, inflation-hedge investments that offer safety and solid returns while the market is given time to find its footing.
In the mean time, bulls and bears beware. The best may be yet to come, but the market has not yet spoken.
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