After first showing signs of weakness on May 7 ahead of the publication of the much-leaked results of the US banking sector stress tests, the Dow posted a high at 8587 the following day.  The market then drifted down for a week, reaching 8230 last Friday (May 15).  The Dow then staged a rally and exceeded its May 7 high by just 5 points (close enough to call it a double top), reaching 8592 in the first hour’s trading on May 20, before rejecting this level and selling off to close near its lows for the day.

During the day yesterday (May 21) the Dow dipped below 8230 and created a lower low in the process, suggesting this market correction has further to run.  There may be a bounce back towards 8405 today though, ahead of the holiday weekend.

Just how much further the indices are going to correct is the key question nobody knows the answer to.  If the Dow gave back half of its rally off the 6 March 6470 low then that would equate to a fall of just over 1,000 index points which would severely rattle the bulls and have the bear camp screaming that we are heading back down below the March lows towards 5,000.

Expect the “Sell in May and go away” crowd to also make some more noise soon about the markets topping out.  Objectively we have had a sustained 11-week rally, there is corporate supply of fresh equity emerging (especially in the banking and REIT sectors) and the markets are due a rest after the Q1 results season.

However it is still early enough to protect any gains you have and see how the markets pan out over the coming months (and two daily closes above 8587 would cause a change of view).  However if the Dow does give back half of its recent rally then there are support levels at 7450 (Nov 2008 lows) and 7280 (20 Mar 2009 close and 61.8% retrace), around which it will be worthwhile paying attention to how the market behaves.

The head of the ECB Jean-Claude Trichet was most insistent during his press conference after the latest ECB meeting that their proposed purchases of €60 bln of “covered bonds” (mostly mortgage-backed securities issued mainly by German banks) did not mean that the ECB was commencing quantitative easing.  His exact words during the Q&A session of the press conference were “we are not at all embarking on Quantitative Easing”. 

Instead the €60 bln covered bond purchase plan was presented as providing “enhanced credit support” to the covered bond market which will help to improve the spreads, depth & liquidity of this particular market, seen by the ECB to be in particular trouble at the moment.

The Bundesbank has clearly dug its heels in over the ECB going down the road of QE and has compromised by agreeing to throw €60 bln instead at the covered bond market.  Good to see the old City adage “If there is a problem then throw money at it until it goes away” has been taken on board by the burghers of Frankfurt.

Meanwhile the Bank of England has taken that particular City adage to heart by expanding its QE program from £75 bln to £125 bln.  And if that does not do the trick then expect the BoE to throw even more money at the problem…there is no shortage of money to spend when the BoE can just print it (even if they describe this printing as “electronically crediting the accounts of those instituitions” which sell securities to the Asset Purchase Facility).  The BoE is aiming to ease the flow of credit throughout the economy by purchasing gilts (mostly).  It hopes the selling institutions will re-invest the proceeds elsewhere, thereby boosting asset prices & tightening credit spreads.  It also hopes that some of this money will leak out into the wider economy and end up as spending on goods & services.  By restricting their buying to gilts, the BoE will be unlikely to lose money as they are financing their purchases at near-zero rates of interest and will likely hold the gilts to maturity.  By spending a big percentage of the Government’s borrowing requirement, the BoE is also hoping its purchases will help to avoid private borrowers being “crowded out” by the deluge of gilts being issued.  Expect the BoE to spend much, much more than £125 bln before its Quantitative Easing program comes to an end.  They truly are going to throw a great deal of money at this problem until it goes away.

Lets take a close look at the last secular bear market to see what we can learn.  The last secular bear market lasted 16 years, starting in 1966 when the Dow traded at 969 on a p/e of 23 (the era of the Nifty Fifty – growth stocks thought to be so promising that is was worth paying any p/e to own them).  It ended in August 1982 with the Dow at 770 on a p/e of 8.

Price swings of the Dow between 1973 and 1982 reveal that investing was anything but a waste of time during this period after the actual price low in the index and up until the next secular bull market commenced.

This can be seen by following the broad swings of the Dow during these 8 years.  The price action of the Dow can be summarised as :

From a high of 1,067 in Jan 1973, the Dow fell to a low of 573 during Oct 1974,

Rally to 692 in Nov 1974 and down to a final (secondary) low of 570 during Dec 1974 – just 3 points below the October low.

Rally to touch 1,000 in Feb 1976 (at this point the Dow had essentially halved and then doubled back to where it started, all in the space of 13 months.  No-one could be certain whether they were in a new bull market or still in a bear market at this time).

Spent the rest of 1976 trying (but failing) to break decisively through 1,000; closing at 999 in Dec 1976 after a high of 1,026 in Sep and a low of 918 in Nov 1976.

Down throughout 1977 to a low of 736 in Mar 1978 (which was a 61.8% Fibonacci retrace of the 570 to 1026 rally). 

Rally to 917 in Sep 1978 (retest of the Nov 1976 low), then back down in two months to 779 in Nov 1978.

Spent the whole of 1979 trading in a range between 800 and 900  (6th Oct 1979 was Paul Volcker’s Saturday Night Special where he raised the discount rate from 11% to 12% and said that interest rates would be raised to “stratospheric levels” in order to squeeze out inflation).

Rallied to a high of 918 in Feb 1980 (double top with the Sep 1978 high).

Fell 20% in less than two months to a low of 730 during Mar 1980 (just 6 points below the Mar 1978 low).

Then rallied 38% during the rest of 1980 to reach a high of 1,009 in Nov 1980.

Back down the following month to 895 in Dec 1980 then rallied to 1,031 in Apr 1981 but fell to 807 in Sep 1981.

Rallied to 899 in Dec 1981 and then fell to 786 in Mar 1982 with a secondary low of 784 in June 1982.

So there is plenty of money to be made as share prices rally, fall back, range-trade and derate all at the same time.  Even if you don’t have access to a charting package, you can get a real feel for these price swings by simply hand-drawing them on graph paper.  The exercise would not take very long and it will be very rewarding as it will generate confidence in the discipline of regularly banking profits and subsequently buying back into the market even as we trace out the rest of this secular bear market, which has been in place since Dec 1999 in the case of the FTSE.

From a practical investor’s perspective it pays to follow your favourite large cap stocks and be disciplined about taking profits on part of your portfolio when the indices near resistance and be equally brave to buy back into the market at support levels.  The history from the 1973-1982 period teaches us that horizontal support & resistance levels are important in derating markets which have historically shown a tendency to range-trade.  It is important to keep your portfolio sectorally diversified because in order for the index to attain a high, the rally must be led by at least one sector with several other sectors participating in the rally too.  Hopefully your particular shares will be keeping up with their sectors and you will have a choice of profits to take when the index reaches an important resistance level.  Similarly with buying back in after the index declines to a support level.  Good luck with the rest of this secular bear market.

AV disclosed in their recent Q1 results that they have strengthened their IGD solvency position, boosting the measure from £2.0 bln (31 Dec 08) to £2.5 bln (31 Mar 09).  They have achieved this primarily in two ways. Firstly by increasing their hedges on their equity exposure such that a 40% fall in markets will only reduce their IGD solvency by £200 mln (as opposed to £800 mln at 31 Dec 2008) but still leaving themselves able to profit from a rally such that a 40% rise in equity markets will boost their solvency by £800 mln (it feels like they have bought put options in order to achieve this asymmetric pay-off profile).  Secondly AV have announced that 35% of shareholders have taken up the scrip dividend offered in conjunction with Aviva’s 19.91 pence final dividend for 2008.  In this way AV effectively retain an extra £200 mln of earnings that would otherwise be paid out as a cash dividend.  Aviva are so pleased with this take-up that they plan to offer a scrip dividend alternative for the 2009 payout as well.  In reality the recent scrip dividend is the equivalent of a 2.5% stock placing for cash, and as such it is mildly dilutive to earnings per share. Issuing scrip dividends also increases the cash cost of paying an unchanged dividend in future years.

However, the bottom line to all this is that Aviva’s 33 pence annual dividend has just become even safer and the likelihood of a rights issue recedes even further into the distance, and the risk of the NAV being undermined by a dilutive rights issue recedes along with it.