All hell can break loose if worst fears of investors are realised

Fears of contagion have resulted in tumbling indices but a bounce could be at hand, writes PROINSIAS O'MAHONY

MAY HAS been a bruising month for investors. Well-publicised sovereign debt woes mean a host of European stock markets, including the Iseq, are now in bear market territory (defined as a fall of 20 per cent or more).

Fears of global contagion have resulted in the MSCI World Index tumbling by 14 per cent since its April peak while the SP 500’s double-digit decline means that May is shaping up to be its worst month since February 2009.

Is it a run-of-the mill correction or are we witnessing a more pronounced bout of market weakness? How oversold are indices? Might a near-term bounce be at hand? Exactly how unnerved are investors?

The most well-known gauge of investor panic is the Chicago Board Options Exchange Volatility Index, or VIX.

Often known as the fear index, the VIX’s long-term average is about the 20 mark. It surged past the 40 level last week, however, a level seen only 3 per cent of the time since 1990. That remains way below the levels registered in the aftermath of Lehman’s collapse, when an all-time high of more than 80 was recorded.

However, before Lehman’s fall, there had never been a reading above 50. The moments of greatest panic occurred during the financial crisis in Russia in 1998; the panic engendered by the collapse of the Long-Term Capital Management hedge fund months later; WorldCom’s bankruptcy at the tail end of the dotcom crash in 2002; and the September 11th terrorist attacks in 2001.

The VIX’s recent high point is actually slightly above those levels, indicating just how spooked investors are by the potential euro zone fallout.

Elevated VIX readings tend to be associated with climactic sell-offs. Near-term bottoms were registered on all but one of the aforementioned examples. The exception, of course, was Lehman, when soaring VIX readings persisted for months and stocks continued to plummet as the global financial system unravelled.

Unsurprisingly, European volatility is just as marked. The VStoxx Index, which measures the cost of protecting against European market losses, recently hit 50, its highest level in 15 months.

Both the VStoxx and the VIX have fallen in recent days although it is too early to say if the panic is subsiding, given that huge swings in either direction have been the norm in recent weeks.

As for share prices, bear market falls in excess of 20 per cent have been seen in China and in each of the troubled piigs states (Portugal, Ireland, Italy, Greece and Spain).

Analysts at Bespoke Investment Group note that prices are most stretched to the downside in Australia, Spain and Italy, where each index was at least 17 per cent below its 50-day moving average this week.

“Nearly all” stock markets are more than 10 per cent below their 50-day moving averages, Bespoke says. Given that the norm is that “just a few” will hit such levels during a global pullback, it is clear that most indices are “as oversold as they’ve been in a long time”.

That’s certainly the case for US indices. By Tuesday, 89 per cent of stocks were trading at least one standard deviation below their 50-day average, Bespoke notes, something that hasn’t happened since the dark days of 2008.

Fewer than 2 per cent of stocks were trading above their 10-day moving average while just 6 per cent were trading above their 50-day average.

Such readings are only ever registered in times of enormous stress. Not only is the latter reading lower than any seen during the cyclical bull market between 2003 and 2007, it is on a par with the very worst readings of the vicious bear market of 2000-02.

Even then, single-digit readings tended to mark near-term buying opportunities. They tend to indicate indiscriminate selling, an assumption that is given weight by the fact that every major SP 500 sector has fewer than 10 per cent of its components trading above their 50-day average.

However, oversold markets can become dramatically oversold and this indicator simply failed to function during the most panic-ridden moments of the banking crisis, when the percentage of stocks trading above their 50-day average actually fell to zero.

The sentiment picture appears more mixed. An excellent contrarian indicator, retail sentiment surveys typically show a large increase in bearishness in times of trouble. That hasn’t happened in the present crisis. However, investment newsletter writers have turned dramatically bearish of late; contrarian-minded analysts describe this about-turn as indicative of the kind of capitulation typically seen at near-term bottoms.

The latest Merrill Lynch survey of global fund managers, meanwhile, confirms an uptick in bearishness, especially towards Europe. Compared to the US, Europe is viewed more negatively than at any time since 2003.

Analysts at Goldman Sachs and Morgan Stanley see the recent falls as presenting an obvious buying opportunity, with the latter slashing their recommended cash weightings.

Evolution Securities economist Ian Harwood says markets are fretting over “what might go wrong rather than focusing upon what is actually going right” (improving global economic data).

Harwood is “highly sceptical” that sovereign debt default fears will spread beyond Europe.

Celebrated Swiss investor Felix Zulauf, who predicted the carnage of 2008, thinks differently, warning that massive budget deficits will derail the global recovery and that any rallies should be sold.

That is echoed by Société Générale’s Albert Edwards, a long-term bear who cautions that the US and Europe are “one cyclical mishap from joining Japan in outright deflation”.

Irrespective of analyst differences, the level of global panic and the oversold nature of indices suggest that the conditions for a short-term snapback rally are in place.

The lesson from Lehman, however, is that all hell can break loose if investors’ worst fears are realised rather than neutralised.

In other words, it typically pays to buy when there’s blood in the streets but bleeding can sometimes lead to haemorrhaging.