Shares Investment: Fear And Pessimism At A Peak – Sign Of A Meaningful Rebound? (04 Jul 2008)

Fear And Pessimism At A Peak – Sign Of A Meaningful Rebound?

It is already July and we have yet to see any signs of the US economy showing strength after a series of rate cuts by the Federal Reserve. We have yet to see housing prices stabilize despite efforts to stem foreclosure, and we have yet to witness a sustained fall in oil prices despite political rhetoric aimed at bringing down high energy prices.

US Treasury Henry Paulson had just made a remark hinting that the European Union is beginning to show signs of a slowdown, which is in spite of more than 1 billion Euros being injected into the region during the European Championship whereby spending by ladies was said to outstrip their male counterparts.

Does it mean that we should always be buying consumer stocks that focus on the female market?

The spending pattern at the just concluded European Championship shows that football is not just men’s business, but women’s as well.

The conclusion of the European Championship also draws the curtain on a wretched first half of the year whereby stocks have been battered without a meaningful reprieve. Just for the records, the Dow Jones Industrial Average (DJIA) has lost 1,882 points, or 14.2%, while the Straits Times Index (STI) lost 447 points, or 13.3% - since the start of the year.

At other regional bourses, the Nikkei shed 1,405 points, or 9.6%, while the Hang Seng fell 6,108 points, or 22%. The poor performance of the Hang Seng Index this year could be attributed to an anemic China market, which has seen the Shanghai Composite lost 2,610 points, or nearly 50% of its value!

How on earth did the Chinese market fall so badly when its economy is still growing by double digits year after year?

We can probably say that the Chinese market, despite its high growth economy, has been overvalued at price earnings ratio of 30-40 times for certain stocks. We can also argue that high inflation and austerity measures adopted by the Chinese government to cool the economy have contributed to widespread selling.

The falling Chinese market has also taken its toll on the local bourse, with almost all China plays taking a hard beating especially in the month of June.

Together with a weak STI and rapidly falling prices of China plays, investors here have lost a lot of confidence. Fear factor is high and pessimism is widespread, as investors fear that stock prices will keep falling without any reprieve.

Does It Mean That We Are In For A Rebound?

Time and time again, in the history of the stock market, prices tend to rebound when fear is at a high while prices tend to fall when optimism is at its peak.

If we were to follow this principle, then the stock market is ready to rally since fear factor and pessimism is high and markets are oversold.

Conventional wisdom will tell us to sell while a contrarian approach is giving us a buy signal.

Should we buy? Should we go against the trend whereby everybody is selling?

Although the fear factor is high, we have not seen a capitulation – or a single piece of bad news – that will take prices down on heavy volume. Instead, the stock markets are drifting lower and lower on moderate volume.

This is not a healthy sign, especially when the DJIA has broken all previous support levels. The break below 11,600, which was the previous low, is a sign that the US market is losing momentum and investors have lost patience.

While there is likely to be a rebound anytime soon, this rebound could be met by heavy selling because the recent trading theme suggests that investors are more than ready to sell on any rally on the lack of good news, which comes at a premium and is rare. There has been nothing but bad news on the US employment scene, inflation data and oil prices.

Should a rebound occur, expect the DJIA to first test the 11,800 resistance before attempting to head for 12,100.

Do Not Fight The Tide For Now

In view of a lack of good news amid an inflationary environment where oil prices are high and the economy generally weak, it is very likely that the long-term trend remains on the downside.

However, as mentioned earlier on, a rebound could come anytime and investors should make use of this opportunity to take some profit unless the macro trend shows signs of turning and the DJIA makes a dash past 12,000.

I have mentioned in previous issues that I have been waiting for the effects of the rate cut to materialise. Now that we are in the third quarter, we have yet to feel the effects of the rate cut. After a 1% growth in the US economy in the first quarter, it is likely that the US could fall into a recession in the second quarter. If the rate cuts do work, we should see growth in the third quarter, which could spark off an “economic recovery” theme and result in a rally.

What About The STI?

The STI has largely mirrored the performance of the DJIA this year, falling by 13.3% compared to the DJIA’s 14.2%.

Although the DJIA has broken below its previous low, the STI, Hang Seng Index and the Nikkei have held up pretty well and are safely above the previous lows. This could be attributed to the fact that Asian economies “remain healthy and unscathed from the subprime mortgage crisis in the US”.

There could be another bout of selling towards 2,830 before the STI can stage a rally.

In the meanwhile, investors need to see the STI crossing 3,000 before confidence can creep in. Should a rally take place in the region – a strong one, I mean – it should pay to bet on the China plays, which have taken a beating despite valuations remaining attractive.

Written By Gabriel Gan on 04 Jul 2008