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After a big rally in March, how far will markets correct?

The much anticipated correction in equity prices appeared to have arrived on Monday with the Dow Jones down 3.6%, S&P500 -4.3%, NASDAQ -3.8%, and the FTSE -2.5%.

The much anticipated correction in equity prices appeared to have arrived on Monday with the Dow Jones down 3.6%, S&P500 -4.3%, NASDAQ -3.8%, and the FTSE -2.5%. The fact that overhead resistance is now being encountered is no surprise given stock markets have staged the biggest rally since 1938. It was never a matter of “if” but only when stock markets corrected the sharp rise of around 30% since the significant major lows in March.

The key question now is just how far will stock markets correct? The market consensus seems to be anticipating a retest of the March lows and another tumultuous period along similar lines of 2008. This illustrated clearly the level of short interest in the US stock market which is now approaching levels last seen in 2008.The perception of risk is thus heavily skewed to the downside.

But the market consensus is seldom correct. For this reason and others, we continue to believe that the major lows were set back in March and will not be breached. Yesterday’s volatility was not only overdue but keenly anticipated. The bears also have to contend with the fact that there is a mountain of cash sitting on the sidelines that will prove to be a formidable barrier.

In the US alone the amount of cash in bank accounts is approaching ¾ of the entire stock market capitalisation, or around $9 trillion. This cash has predominantly been accumulated out of fear and fund managers are now faced with the prospect of having to invest it. Many of whom have completely missed the rally up from the March lows and have become increasingly frustrated on the sidelines.

In recent weeks and in direct response to the rally, the bears have steadily increased their positions, with the short interest in financial stocks now at record levels of around 7 percent of the sector’s total outstanding shares on issue.

In our opinion, any sell off will likely be shallow and met by steady buying, emanating from both fund managers carrying too much cash (and who have underperformed their benchmarks since March), and short covering by hedge funds. We believe a correction in the order of 10% would be the most likely scenario, despite the current pervading gloom.

It is also important to remind Members that the stock market can go up whilst the economy remains in a depressed condition. In other words stronger economic data is not necessarily an essential precursor for higher stock prices. Having said that some green shoots are beginning to emerge within the global economy.

After the volatility last year, business appears to have caught its breath and is now well down the path of rationalisation, with unemployment spiking upwards. Corporate activity is also on the rise. In the US, PepsiCo is bidding for two of its independent bottling operations while Oracle has launched a bid for Sun Microsystems. In Australia, corporate activity within the resources sector has steadily escalated over the past few months and looks sure to continue throughout the year.

More deals, takeovers and mergers will follow, and all point to the significant value that is now emerging in the market. This is an important phase of the bottoming out process and a key sign that the bear market (which is now approaching 18 months) is nearer the end than the beginning.

The earnings season is well underway in the US and “better than expected” seems to be the catch cry on Wall Street in recent weeks. Better than expected results for the economy, for the banking sector, and in some cases, company earnings.

In the fourth quarter of 2008 real economic growth in the US contracted at an annual rate of 6.3%. Estimates for the first quarter of 2009 indicate a similar contraction. But recent data releases suggest the pace of economic contraction is beginning to subside. In other words, the picture of the US economy is not one of depression, but of deep recession instead.

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