Monday, May 24, 2010

Is it a Correction or a Reversal?

Stock prices stabilized on Friday, but it felt like the selling ended more because of exhaustion than because of some return of optimism.

Since early May, the Dow Jones Industrial Average has lost almost 10% of its value -- officially known as a market correction. But the big question on everyone's mind: Is this just a correction or the start of something worse, a new bear market?

Despite Friday's rally, the Dow ended the week down 4% and firmly in the red for the year. The results were just as bad for the Nasdaq Composite (down 5% for the week) and the Standard & Poor's 500-stock index (down 4.2%). European and Asian markets logged similar declines; oil and gold prices were also down.


So what's going on? Is it 2008 all over again? Or is this just a pause in the market recovery that began over a year ago and, until now, hadn't seen any serious setbacks at all?

Bulls point to rebounding growth in the U.S., robust corporate profits and a very friendly interest-rate environment. Bears talk darkly about Europe's fiscal problems, signs of a slowdown in China and the headwinds of new financial-industry regulation.

During the past few weeks, the bears have had the better of the argument. But Friday's modest recovery shows the bulls can still score points. During tense times such as these, Wall Street professionals often look for key "tells" that will provide a clue as to the market's future direction. Good "tells" are key skirmish points in the market between bulls, who generally want to see prices go up, and bears, who want to see them go down. The winners of these skirmishes tend to win the bigger battle.

Here are four "tells" that will, ah, tell us which way the market is headed.

1 Oil prices: When the global economy hums, it needs more of the black stuff. Thus, oil prices are widely seen as a proxy for global growth. When oil prices rise, quickening growth is on the horizon. When prices decline, look out below.

Oil prices also reflect a lot of other issues. Since oil is priced in dollars, a rally in the greenback, all things being equal, will reduce prices. Also, if folks fear unrest in the Middle East or in other volatile oil-producing locales, such as Nigeria, prices could spike.

For the past year, oil prices as a global growth proxy, despite the other issues, have held up well. Oil prices bottomed early in 2009 at just over $30 a barrel and then zoomed higher even before it became apparent that a global recovery was under way.

Oil is down about 20% from its recent high of $86.84 a barrel. But even at around $70 a barrel, it is up about 14% from a year ago. If oil can hold above $70 and edge back toward $80, that would indicate that fears of a global slowdown are receding.

2 GE stock: In March 2009 as the stock market cratered and panic raced through the system, General Electric shares headed sharply lower, closing at the devilish level of $6.66 a share. GE, the only original member of the Dow Jones Industrial Average still in the measure, traded as though it was headed into oblivion.

But GE recovered from those lows. Investors came to understand that the maker of everything from jet engines to light bulbs wasn't about to go out of business, despite some curious and ill-considered actions at its financial unit. Since that time, GE stock more than tripled, rising to $19.49 in late April.

Since then, though, it has pulled back to $16.42, a jaw-dropping fall of 16% in less than a month. GE is an important tell for two reasons. First, it has a huge global footprint and is in many different industries. Second, its finance arm isn't completely out of the woods. When concerns arise about the banking system, GE gets another kick in the shins.

GE has already dropped quite far. If it continues to fall, even just a little bit, it's painting a dark picture of the future.

3 The euro: Up until recently, most people in the U.S. got along fine without thinking about the euro much. Sure, a trip to Paris might spark an examination of exchange rates, but otherwise the euro just kind of moseyed along in its own European way. That's all changed, of course.

Today we see headlines about riots in Greece, austerity measures in Ireland, fiscal issues in Spain and problems in Portugal. It's like the great summer vacation has moved from the travel section to the business pages.

It can be distracting keeping track of European issues (Did you know Malta is in the euro zone? Did you know Malta is a country?), so the easiest way to make sense of all the grim European headlines is to simply track the euro.

The key element is the pace of the euro's move. It's not necessarily problematic if the euro is dropping (it is down 14% against the dollar this year). It is, however, not a good sign if it is dropping very quickly.

The euro is at about $1.25. If it stabilizes or even drifts lower at a leisurely pace, that would indicate that the euro-zone crisis is abating, which would help U.S. stocks. A fast move down will prompt chatter of intervention and make a bear market more likely in the U.S.

4 The KBW Bank Index: The financial crisis began as a credit crunch that eviscerated the banking sector. When things are bad in Europe, bank stocks, especially the big European bank stocks, fall most sharply. When things look better, they put in outsized gains.

Tacked on top of this, but frequently overlooked amid the civil unrest in Athens and jitters stemming from the Flash Crash of a couple weeks ago, is the fast-approaching new regulatory environment for the financial system. The Senate last week passed its reform bill and now both houses of Congress will hammer out a final law. The G-20 group of nations is working on global banking reforms.

The KBW Bank Index -- which tracks big banks -- will tell us if those regulations are going to bite very hard or merely sort of hard. A really sharp bite will create one more headwind for the broader market. Given how Germany's unilateral move against short-selling rattled investors last week, we shouldn't overlook how new finance-industry regulations might affect the broader market.

The KBW Bank Index fell 16% in the last month. On Friday, however, it was up nearly 4%. That would be a positive indication in what is still a "fulcrum sector" in the market.

Write to Dave Kansas at