Markets

Too Many Bears for a Correction to Begin?

By Conrad Aenlle

Updated on: January 17, 2010 / 4:38 PM EST / MoneyWatch

If there's one thing that contrarians can't stand, it's a crowd. The presence of a few like-minded individuals is fine, but when their view starts to become popular, they start to question their view.

The stunning rally in stocks this year in the absence of clear signs of an economic recovery has led some market observers to suggest that a correction or something worse is due. The list includes me and, far more important, such respected and noteworthy figures as Jeremy Grantham at the fund management company GMO and Mary Ann Bartels at Banc of America Securities-Merrill Lynch, whose thoughts have appeared here and here.

Such wariness has not become commonplace, but it seems to have grown more prevalent in the last week or so. A report issued Tuesday by State Street Global Markets cited a sharp decline this month in investor confidence worldwide, to a reading of 100.8 from 108.4 in October.

The timing is odd, as the stock market often catches an updraft around this time of the year that lasts into January. Perhaps investors' faith has been eroded by recent commentaries such as these on the Seeking Alpha website:

Marvin Clark, in "10 Reasons to Believe That We're in a Depression," highlights the technical deterioration that has appeared in the stock market in the last few weeks, including heavy trading volume on down days and light volume on up days.

Clark also contends that the economic growth recorded in the third quarter - revised down Tuesday to a 2.8 percent annual rate - is uninspiring considering the kitchen-sink stimulus programs that have been needed to produce it. As for the run of corporate earnings that have been better than expected, he notes that it is due at least in part to cost cutting achieved through mass layoffs.

A second post on the site, "The Weak Dollar Crowd Is Too Confident," written by Accrued Interest (I'm guessing that's not the name on his or her birth certificate), focuses on the potential impact of an unwinding of the so-called dollar carry trade.

Speculators have been borrowing dollars at interest rates close to zero to buy assets such as stocks, bonds and commodities. They make money twice over - as those assets gain value and as the dollar declines, something that happens to a currency when it is borrowed heavily.

This is the sort of bright idea that works great right up until the moment that it doesn't. The carry trade creates distorted valuations for the dollar and for the assets that are bought. When a catalyst comes along that throws the process in reverse, such as a change in Federal Reserve interest rate policy, valuations tend to snap back with vicious speed and often overshoot their starting points.

"Just think about what's going to happen when the Fed actually hikes rates," Accrued Interest says. "There are so many dollar shorts out there. We will be looking at the mother of all short-covering rallies. And the carry trade crowd is going to get absolutely crushed."

The same may happen to innocent bystanders in the stock market. The writer forecasts a decline in stocks of as much as 30 percent.

In the third alarmist post, "Why the Stock Market Should Crash," Charles Hugh Smith makes a case similar to Clark's. He emphasizes that he is not forecasting a crash, but he does say that if the stock market accurately reflected economic conditions, a crash is what would happen.

The three pieces make well reasoned arguments, although their conclusions may be a bit over the top. There is a tendency, especially when writing for an Internet audience, to foretell stupendous developments instead of ones that are meaningful yet ordinary.

Even if they are broadly right, however, the proliferation of opinion questioning the recovery in stocks and the economy, plus the strong seasonal trend, makes it more likely that they - and I and others - are not right right now. It looks as though the correction will have to wait until the crowd thins out.

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