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Date: 2010-05-17
Familar Patterns

THE MARKETS HAVE RELATIONSHIP ISSUES, ones that have spilled into the open in recent weeks.
Patterned market interactions that the most active, leveraged investors became too comfortable with in the first four months of the year -- volatility in decline, growth-attuned risk assets on the rise, markets gaining comfort with the global recovery story -- were clearly upended as the Euro-centric financial stresses became intense enough to send the U.S. stock market down more than 13% from its recent high, as of Friday morning's low.
More nuanced relationships have also become frayed, at least temporarily. For instance, the CBOE Volatility Index (ticker: VIX), a gauge of prices paid for protective stock-index options, surged above 45 Thursday. Outside of the aftermath of the Lehman collapse and the 1987 crash, it has spent time at such a level on only a handful of occasions; in each prior instance, stocks already were down about 20% from a recent high.
The bulls are suggesting this means traders are cringing too fearfully in response to an uptick in market risk, while the wary read it as a foreboding sign of a change in the market trend for the worse. It's not yet possible to say which interpretation right.
The pacing and sloppiness of the selling pressure across commodities, credit and equities suggests someone -- or, more precisely, a large group of someones -- was caught badly offside pressing the weak-dollar/strong-risk-assets trade. The suppressed volatility of the February-April stretch was telling too many trading models it was safe to make bigger bets, where now the extreme jumpiness is screaming at them to shrink portfolios in a hurry.
With all this going on, the most relevant question is whether these breakdowns in previous relationships are part of just another gut check, like the 6% to 9% setbacks that came in the run off the March 2009 market low, or whether the broader trend, and with it the tactical rules of thumb, have changed.
In the words of MKM Partners economist Michael Darda, are the markets sustaining an aftershock of the 2008 crisis, or a relapse? He votes for the aftershock scenario, and if he's right, most of the downside has been sustained for now. But everyone involved in the markets today has a pretty fresh memory of the way the markets laid waste to well-tested indicators of "overdone" moves in 2008 into 2009.
In addition to revisiting the stock-index levels touched briefly during the May 6 air pocket, the Standard & Poor's 500 index's drop into Friday morning's low was halted right at the 2010 low, which was set as the January-February pullback bottomed. Comparing other conditions now with conditions then may offer hints about how afraid, or greedy, to be at this point.
The Bloomberg U.S. Financial Conditions Index, a composite of market-derived measures of liquidity and risk appetite, remains dramatically above crisis-vintage levels, but declined more than three times as far during this selloff as it did in February.
And it's probably no accident that recent investor skittishness came as some domestic economic clues (unemployment claims, the leading-indicators index, building permits) have softened a bit, and with the Chinese market down big, whereas most of the numbers were surprising for the better over the winter.
The U.S. market's valuation based on expected 12-month forward earnings is right back where it was at the February low. Binky Chadha, chief strategist at Deutsche Bank in New York, notes that each of the market retreats since March 2009 ended with the S&P 500 forward multiple right near today's 13.
So, if the rules that covered market rhythms for the past 14 months still apply, the signs offer some comfort for those still in the market, and in fact suggest the makings of at least a sharp rally soon. Again, if.
THERE ARE VARYING DEFINITIONS of cheap, unloved and financially sound companies, and no single one works all the time. So Morgan Stanley global strategists ran eight different screens to focus on stocks that qualify as attractive -- and not so attractive -- under several valuation, growth and sentiment gauges.
Among the U.S. stocks that qualified as attractive under more than one of the screening approaches were Baxter International (BAX), GameStop (GME), ConocoPhillips (COP), Western Digital (WDC) and Time Warner (TWX). The list of those that came up as overbought and/or over-loved featured Wynn Resorts (WYNN), Royal Caribbean Cruises (RCL) and Whole Foods Market (WFMI).

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