WEEKLY ECONOMIC ANALYSIS: October 30th, 2009

Provided by TEAM Financial Services

"All objects, all phases of culture are alive. They have voices. They speak of their history and interrelatedness. And they are all talking at once!"

- Camille Paglia

Items for discussion

There have been two important developments in the past two weeks that most readers are probably not aware of. The central banks of Australia and Norway both raised their interest rates. This has coincided with the market carnage of the past two weeks. TEAM believes these developments are important over the intermediate to long term, as it is indicative of an end to the global synchronized monetary regime that has existed over the past twelve months.

Since the financial crisis took full force last fall, central banks around the world have followed fiscal stimulus with monetary stimulus. Spending has increased by governments around the world while interest rates have been slashed. Fiscal deficits have exploded and rates have remained at record lows. The fact that two central banks have moved to begin removing some monetary stimulus is indicative of something we expected to be inevitable. Countries were never likely to maintain a uniform perception of reality or their self interests.

If we are correct, then we are likely early in the transition towards the third of the three crises. The financial crisis morphed into an economic crisis, and now we believe that government responses and policies around the globe are likely to usher in a global currency/funding crisis. While we may be in the beginning stages of this transition, it could take quite a period of time until the crisis becomes main stream and dramatically impact the broader economy and financial markets.

Market/Economic Climate

Something we learned long ago is that if one makes an economic or market forecast long enough, then one is likely to be correct….eventually. After fighting our shadow for a few months and preparing for the correction of substance that was seemingly never to arrive, it appears to have finally arrived. We had communicated a basic scenario for the fall which we expected to play out and it now appears possible. It appears that renewed concerns about the durability of the economic recovery have many investors running for shelter.

The major stock market averages are down about 6% from the peak reached just seven trading days ago. That rate of decline would be on par with the June-July mini-correction over the summer, but we expect this correction to be deeper. Our base case scenario is a correction to evolve into 10-15% decline from the recent peak around 1,100. Market sectors hit hardest in the initial stage of this correction have been those sectors that lead the March-October move higher. Financials, energy and materials have been hit the hardest. Small companies have been hit harder than large companies, and foreign (especially emerging markets) have been hit harder than domestic.

At this point, TEAM believes the unfolding correction may end up being similar to the 4-6 week correction markets suffered in May-June of 2006. Economic fundamentals remained strong on a global basis during that correction, which was largely a purging of excess optimism on an intermediate term basis. Major market rallies/bull markets often experience three major phases. Phase one is when the rising tide lifts all boats and low quality stocks tend to outperform. Phase two is typically ushered in via a correction in which many of the low quality stocks never recover. These stocks, as a group, typically make their peak at the end of phase one. Phase two unfolds with investors upgrading their portfolios into higher quality company stocks and leadership narrows in the market. Breadth and advance/decline indicators typically begin to diverge as fewer and fewer stocks participate in the advance. Phase two can include a new market high in the broad market averages, but it does not have to. Phase three includes the final stages of the exhaustion in the market and the transition to the beginning of the bear market.

At this point, TEAM believes that phase one has ended and that the current correction should usher in phase two. Client portfolios have been structured to weather this transition for several weeks – about two weeks premature as it turned out. While shorter term market forecasts are always treacherous, our base case is for the current correction to be quite violent in both directions and last into late November. We expect to maintain significant portfolio hedges until we see signs that the correction has exhausted itself. At that time, it is very possible that we may significantly reduce or even eliminate portfolio hedges and add addition positions to portfolios.

Of course, it is possible that we’ve reached a major market peak and that the market will simply crumble into a major collapse. While this is a very low probability in our opinion, we always approach market declines with a disciplined process that waits for some signs of stability prior to increasing portfolio risks.

Humor for the Weekend

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.