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Wednesday February 18, 2009

Will Investor Confidence Ever Return?

The area Matter - By Pankaj Kumar

Of course it will, but the million dollar question is when?

AS the world grapples with the current economic turmoil, economists and market watchers are predicting that well, we may be in for a rough ride ahead, things will get better in the later part of this year with some predicting an early recovery in the second half while mostly now expect recovery to be in place only in 2010.

With the assumption that the world is expected to see a recovery in the later part of 2009, what are market predictions then?

Well, according to historical perspective, stock markets tend to recover between three and six months before the real recovery sets in and hence if expectations are there that the US economy is projected to record a tad growth in the third quarter of 2009 (which by the way will only be known some time in late-October), this means that the stock market should see recovery from April.

The above analysis is only valid if one actually sees the growth of the world’s largest economy returning in the third quarter and what if that diagnosis is proved to be wrong? Will investors assume that it will be good to position on equities as early as April?

Well, I don’t have the answer and, to me, it is not something cast in stone that the equity markets’ recovery will be dictated by the GDP growth. The next question you would then like to know is: “So, how do I know when should I buy into the market?”

While economic fundamentals largely dictate market direction, it is without doubt that the market is all about confidence and expectations.

Hence, if investors expect that the US will see economic growth in the third quarter, is market expectation of a stock market recovery somewhere between April and June a correct assessment or otherwise?

Again, this would be a moving target as economists will likely change their outlook as and when new evidence is obtained. Which data points these well-known economists will be gauging too will have significance to their respective outlook.

While we may be fixated by US data points, investors too are warned not to ignore similar data points out of the European Union, Japan and even China.

The recent sharp decline in trade data from countries like China, Japan and continuous weakness in OECD Composite Leading Indicators suggest that we are going into a deep trough period and we may stay there for a while if not longer.

These data points must be observed not in relation as to how bad they turn out to be compared with the preceding period or previous year but, more importantly, against market expectations.

It is the expectations that matter to the market and nothing else, as what is expected has been priced in the market while if the data is above or below expectations, then indeed this is the surprise, and that is where we will see how markets react.

It is only when we see a consistent manner in which some of these economic data points are not only able to meet expectations but exceed them for a period of time (let’s say two to three months) can we then conclude that we are indeed seeing the light at the end of the tunnel.

While some may argue that these data points are too far apart to make an informed decision as they are released either on a monthly basis or worse, quarterly.

To rectify the situation and to be more on the ball, Bloomberg had recently introduced some interesting charts that depict economic conditions on a weekly basis and I think this will be good for investors to track.

The first is Economic Cycle Research Institute (ECRI) Weekly Leading Index Growth Rate, which gives early signs of deterioration/improvement of the US economy and the second is the Bloomberg’s Financial Conditions Index (BFCI), which basically helps investors to track the level of financial stress (measured in standard deviation) affecting the US and world economies. The BFCI is updated on a daily basis.

Hence, while we may be pre-occupied waiting for the next data point to emerge, the above two indicators, which are available on a weekly basis, perhaps could be early tell-tale signs that the worse is indeed behind us and that confidence is returning to the markets.

Based on current readings, both the indicators are telling us that the worse may be behind us (for example, a negative reading of as much as -30 to -24.7 on ECRI and -10.18 std deviation to -4.12 for the BFCI) but they are still no where near “normal” levels.

We need to observe the ECRI and BFCI returning to less than -10 and -2 respectively before we can safely say, yes, confidence is back and let’s pile up our market positions.

(Source: The Star Online, 2009)

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