Don't bet the ranch on a rebound

By Jim Jubak

Since this downturn began on May 10, the Dow Jones Industrial Average ($INDU) is down 8% as of the June 13 close, the Standard & Poor's 500 ($INX) is down 7.5%, and the Nasdaq Composite ($COMPX) is down nearly 10.7%.

So when will this correction be over? It's certainly a legitimate and important question. But at the moment, it's the wrong question.

Instead, investors should be asking this: What are the odds that what has so far been an almost classical correction could turn into something worse -- a prolonged downturn that puts an end to the long-term rally that now stretches back to March 2003?

I don't think that rally is over yet. But there is no doubt that it is getting long in the tooth, and that the world's central banks seem perversely determined to put the global economy -- and thus the rally -- at risk. The next four months or so are likely to be critical. By the fall, I think the data will show relatively clearly if the rally is intact or if central banks have managed to kill the goose of growth.

A correction is a downward move that interrupts a stock market rally to correct the speculative excesses that always build up as a rally progresses. The average bull market correction since 1970, according to Sam Stovall of Standard & Poor's, is 13%. After the correction, the rally resumes from a new and sounder foundation.

So far we've clearly got Part 1.

Central banks take away the candy

The recent plunges put this market within striking distance of the traditional definition of a correction as a 10%-to-15% drop in the major stock market averages.

I don't think investors have to look far to find the initial cause for this correction. As I've written about frequently recently (see my column "Can bankers save the world? Investors say no" from June 6, for example), the world's central banks first released a flood of money at extremely low interest rates that produced speculative excess in the price of assets from homes to copper. Traders used money borrowed at 1% to leverage their own capital and make massive bets in everything from the bonds of Iceland, New Zealand and Turkey to commodities such as copper, gold and houses from San Diego to Spain.

Now these same central banks have decided that it's time to take the punchbowl away by reducing the supply of money and raising the price that speculators have to pay for it. The move toward tighter and more expensive money is taking place simultaneously around the world. On June 9, for example, the central banks of South Korea, India, Denmark, South Africa and the euro currency union all raised interest rates.

Too much money chasing the hot asset

Realizing that money is becoming more expensive -- and will get even more expensive in coming months because the Bank of Japan, the European Central Bank, and, quite probably, the U.S. Federal Reserve are likely to raise interest rates again -- speculators have unwound leveraged positions. That selling has whacked the speculative excess out of the hottest markets.

The hotter the market had been, the bigger the correction. Gold, for example, which had hit a May peak of $732 an ounce, prompting talk of gold at $1,000 an ounce, closed at $613 a ounce on June 9, a drop of 16%. Copper, an even hotter market, has shown even greater volatility. The July contract for copper closed at $3.27 on June 9. That's a drop of almost 9% in a week. The Indian stock market (using the Sensex Index of the Bombay Stock Exchange) had soared on inflows of global hot money, then fell 26% between May 9 and June 8.

This part of the correction, although painful, has been healthy. Too much money has been chasing the hot asset of the moment, producing huge and unsustainable short-term gains. In many cases, the correction merely took the price increases of this last speculative period out of the market. So, for example, from Feb. 1 to May 9, the Indian stock market climbed 26%, almost exactly equal to the fall from May 9 through June 8 in the recent correction.

No place to hide

This correction has been especially painful -- and scary -- because speculative excesses had built up in so many asset classes that the drop in prices left equity investors with no place to hide. If you had added gold, as I had, as a hedge against inflation and market volatility, you still took it in the neck along with everyone else because speculative money had flowed into and was now flowing out of gold. Same with copper miners, oil drillers and timber producers. Stocks that in other kinds of market could be counted on to move up when the market as a whole turned down, went down too as the central banks rattled their monetary swords.

In recent days, I've seen signs that this correction of speculative hot-money excesses is drawing towards a close. I'm not saying that price declines are over -- just that prices are starting to react normally again to the flow of news. Speculative money flowing out of commodities doesn't overwhelm all other considerations. So, for example, on June 9, crude oil climbed $1.28 a barrel to $71.63 on worries about supply disruptions in Nigeria and the possibility that a tropical storm was brewing in the Caribbean Sea.

The market is shifting gears. Selling by speculative, leveraged investors of hot asset sectors is gradually giving way as the driving force of share price declines. Taking its place is the worry that central banks will take the current round of interest rates hikes too far and tank economic growth in the second half of 2006.

Sacrificing growth to prevent inflation

Talk from the central bankers themselves is feeding into this fear. Federal Reserve officials including Chairman Ben Bernanke, Vice Chairman Donald Kohn and various and sundry Federal Reserve presidents and governors have all weighed in recently on the dangers of inflation and the need to prevent expectations of future inflation from gaining a foothold.

Sure, these Fed officials have admitted, growth is slowing. And sure, as Kohn admitted under Senate questioning, the data on inflation and growth look backward and measure where we were and not where we are now. But the Fed seems willing to sacrifice growth on the altar of inflation prevention.

The Federal Reserve isn't alone in this rhetoric -- and it is by no means the bank most willing, in its rhetoric at least, to sacrifice growth to inflation prevention. That honor goes to European Central Bank President Jean-Claude Trichet, who raised interest rates by 0.25 percentage points on June 8 to 2.75% and lowered the bank's forecast for economic growth in the euro-zone to 1.8% in 2007 from a prior forecast of 2%. (The bank is calling for growth of 2.1% in 2006.)

Bond traders sense a slowdown

The bond market isn't helping, either. If bond investors feared inflation, they'd be demanding higher current yields -- and lower current bond prices -- to offset the decline in the future value of their bonds. But instead, bond prices are climbing and yields are falling -- exactly what happens when bond investors think the economy is likely to slow in the future.

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