Dow Jones (8885)  S&P 500 (944)  Nasdaq Comp (1711)

Why do I choose a market that I cover every week as this weeks “Hot Topic”? The equity markets around the globe have during the past months dominated all other markets, and last week proofed that swings in US stocks dominate equity markets globally. It’s fair to expect that US will loose dominance in the financial world but right now it’s not the case. I decided to give the US stock market a reality check by exchanging more views with you than normal regarding this subject.

As mentioned last week, a rebound would be a good guess after such steep falls lately. Rebounds are natural, and the P/E values, they look so low. On 9^th January this year Dow traded at 15,5 ( S & P 500 at 16,0) but at Friday close P/E for Dow was at just 11,7 (S & P 500 at 11,6), so some fund managers speaks about going tactical long (another word for short term position taking).

We are all a bit afraid of not being long shares when the upturn starts, so if this feeling becomes more outspoken and widespread, then we won’t see the lows from 1½ weeks ago once more.

Two important issues in such markets has always been, to try to judge what is priced in the market and how does the reality looks like.

Reality – 2½ years ago I changed my view from bullish to bearish on USA, mainly based on a feeling of weakness in the housing market. It’s now a common view that to turn the US economy a stable housing market is needed (and preferably rising), as there will be no positive impulses externally. I agree, but how to do it? Friday we got another very grim US housing market number, and there is a huge oversupply of single homes suggesting that prices should go lower, at least if one believes in the supply and demand curve.

A major driver behind last Monday’s rise in US equities was the US government USD 250 billion injection in selected US banks. I doubt that it will happen too often, but the underlying thinking is not wrong. With a higher solvency US banks can lend money into the housing market. Smart thinking, but people rarely understand how much capital is needed to rescue banks, so I fear that the capital injections will go to write off’s. More public money will be needed, and the next round is going to be difficult.

Once there will be free capital to lend out to coming house owners I hope that the work flow has changed at some US banks, otherwise the lending process might slow. Today’s credit scoring system for private people in USA is an almost standardised process, that has replaced credit scorings within the banks. At some banks the scoring was also combined with mortgage lending through financial advisors for private households. To re-establish a proper risk management I think that the quasi outsourcing of credit scoring and even the credit application process needs to be sourced back in again. If these very important working routines partly have disappeared, it takes time to rebuild them (and it increases the cost base for banks). The oversupply of single family homes and a dysfunctional credit process within some banks will result in a sluggish housing market for long time. The consumer engine will hardly get any fuel from this source, depressing the domestic demand in US for even longer time. I would never claim that any bank anywhere do not have correct work flows, but just point out, that there most likely is a way to go before the lending system is back on track……  

The low P/E’s, yes they look low but we constantly needs to tell ourselves that they represent historical numbers and just tell us that stock prices has gone down. Reality is that we don’t know much about estimated 2009 earnings, meaning the cash flow from the shares is unknown and the risk should send stocks lower. Last week one big US producer (though in the automotive sector) gave some guidance for 2009. It pointed towards a 15 – 20% correction of the equity price to keep the current P/E ratio of 10.

A recession is partly priced in the US equity market, making some fund managers open for tactical positions. But the scale of a possible recession is not priced in. If growth is +0,2% or -0,2% it almost has the same effect but -1,0% instead of -0,2% is serious, and secondly, how will the recovery be? V-shape or L-shape…….We are used to V-shape recoveries, but the world is in deeper troubles than seen for Long.

We haven’t seen the full scale negative effects of the downturn yet, so it’s difficult to price in.

I respect if investors buy US shares now to try it out, but it’s what I call emotional buying against reality. Like I mentioned last week, you can buy if you think the financial crisis is over and it also caused the problem (which I don’t think is the case). This week you can buy if you think recession is priced in the current stock market prices.

Recession is the right risk to trade, so when you think the market has priced enough (or even better, too much) recession in the prices, it’s time to buy shares. Today, I would judge it’s when S & P 500 is trading around 820. If and when this target is reached we of course need to review the market again.

Short term this week the swings will be dominated by earning reports as we only have a very limited number of fundamental data.

Among the company reports I watch are American Express on Monday. Tuesday it’s Apple, Dupont and Yahoo, McDonald’s and Wachovia on Wednesday, on Thursday it’s Microsoft.   

Targets: Dow Jones (7730)  S&P 500 (820)  Nasdaq Comp (1489)

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