US markets may have more downside

I think many of us are quite familiar with the US financial crisis that has been raging for the past one year. After the takeover of Bear Stearns by JP Morgan in May (with backstops provided by the Federal Reserves), many investors thought the financial markets would be able to find a firmer footing. I guess they were very wrong. Things are deteriorating so fast now that people will not easily forget this September. This September will be remembered as the "Black September", like Monday, 19th of October, 1987 will always be remembered as the "Black Monday".

In just 10 days, some of the biggest names in the US financial markets had either imploded or bailed out or taken over. On September 7th, Fannie Mae & Freddie Mac were placed into conservatorship of the Federal Housing Finance Agency. On September 14th, Merrill Lynch was acquired by Bank of America. On the following day, Lehman Brothers filed for bankruptcy protection. This morning (September 17th), Federal Reserves announced plan to acquire 80%-stake in American International Group ('AIG') for USD85 billion. Who is next? Goldman Sachs? Morgan Stanley? Who knows?

Some people are beginning to wonder why the US stock markets drop so little in the face of so much problem. Todate, the US markets have declined by 20-25% as compared to a 80%-drop in the KLCI during the Asian Crisis of 1998. One of the missing ingredients could be a currency crisis-- something that is unlikely to happen as long as the US Dollar is the global reserve currency. Nevertheless, I believe that the US stock markets are likely to drop further.

From Chart 1 below, we can see that the S&P500's 100-day SMA had cut below its 200-day SMA and the 200-day SMA had cut below the 400-day SMA. The 400-day SMA had hooked down. The last time the 400-day SMA hooked down in early 2001, the S&P500 entered into a bear market that lasted for 2 year (to early 2003)- losing another 25% of its value.


Chart 1: S&P500's daily chart as at September 16, 2008 (source: Yahoo Finance)

I have also appended below the Dow Jones Composite Average, which comprises 65 stocks that are all components of either Dow Jones Industrial Average or Dow Jones Transportation Average or Dow Jones Utility Average. The 400-day SMA of this blue-chip barometer is still flattish & has not hooked down yet. Its 100-day SMA & 200-day SMA had cut below the 400-day SMA. The last time this had happened, was in 2nd half 2001 when this index dropped about 25-30% over the next 1 & 1/2 years.


Chart 2: DJ Composite's daily chart as at September 16, 2008 (source: Yahoo Finance)

Should we avoid our local stock market if the US stock markets were to enter into a pro-longed bear market. Looking at Chart 3 below, we can see that the KLSE had a mini-rally during the 2001-2002 period. Part of the reason could be that our stock market had dropped very sharply in 2000. The same may be said about our stock market today, i.e. it had dropped about 35% from its peak of 1524 in January.


Chart 3: KLCI's monthly chart as at September 16, 2008 (source: Quickcharts)

In conclusion, I am bearish on the US stock markets, which may have more downside. While I am bearish on our local stock market, I believe that our downside may be limited. This is not inconsistent with the scenario outlined in my earlier post dated September 11th (go here) where our bear market could last until the middle of next year.