Are we done yet? No, expect a lot more decline

Many interesting things happened this week, which seems like it lasted for months. The two events that caught the most my interests are the rise of the USD in spite all the bad news against it and also the big surprise comes at the Market decline following the Senate vote on Friday which passed the bailout bill. Though it is kind of rational to have had this decline, I wasn't expected the market to behave in any rational way (see my previous post on the Bernanke+Paulson PUT).

So the several trillion USD question is: Are we there yet? Has the market correction been overdone and is it a good time to buy bargain stocks?

The short answer is: No, we're far from there!

The long answer follows.

1- The Market is at historically high level still. Even after this sharp correction, the S&P 500 has a PER of above 25. The Dow Jones IA and the Russell 2000 still have a negative EPS and hence no PER! See graph below. The profits declining sharply in the best case, and big losses on the normal cases, the markets are going to have a hard time maintaining the current levels.

2- The VIX hit all time high but this is irrelevant. As you can say on the graph below, the VIX hit an all time high this week and has been trading at historical high levels for the past week or two. Many consider this as a good opportunity to buy stocks on the cheap as it is considered that VIX levels of about 40-45 are signs of market bottoms (see chart below). Unfortunately, the VIX has been computed only since the early 90's which makes it irrelevant since we are currently in uncharted territory. There has been no crashes since the early 1990s, there has been the TechBubble bust but it's not comparable to what we are living today. That's the reason why I have kept my PUTs so far and with now regrets. I might change my stance in the next few days because:

The VXO might be more appropriate for these kind of comparisons. And if you take a look at the chart below you will see that it hit 60 during the 87 crash. So there's a lot more to go for the volatility as well, contrary to what I have read here and there. Of course this doesn't exclude a short term sucker-rally, since so many just have been bottom fishing for the past 12 months.

VIX (click for bigger image)

VXO (click for bigger image)

3 - The US Markets haven't really declined since mi-July, despite the disastrous news piling up and the big sucker rally in the USD is not going to help. As you can see on the chart below, the Dow Jones and S&P 500 are almost flat since mid-July in EUR terms.

Dow Jones Industrial in various currencies (click for bigger image)

S&P 500 in various currencies (click for bigger image)

What to expect next?

• I think the market starts to realize that the $700,000,000,000 bailout is not going to change anything and is going to be a big waste, a drop in the ocean of derivatives and other ABS and MBS... Bill Gross, the person who is going to make the most profit out of this and who is going to be totally bailed out even dares asking for $500,000,000,000 for the bailout! It's easy to see that the $700 billion won't be enough as the Fed increased his balance sheet by about $600 billion worth of illiquid toxic junk in just 2-3 weeks! This is a massive 55% increase!
  
• Stephan Karlsson explains that the dollar rally is due to central banks interventions. Which makes sense to me, since the bailout could have created a run in the USD and a collapse of both the US Dollar and of the Treasuries. So basically what this means, is the the Europeans and Asians will, willingly or more likely unwillingly, take part in this Bailout Bill, by buying overvalued (valueless!) USD in exchange for their own currency. The whole bailout bill was about buying assets at above market price right? So we can expect a drop in the USD once the interventions end.
  
• The massive intervention in the USD pushed the prices of commodities a lot lower and lead the path to a probable surprise rate cut at the Fed. This could be the very last bullet in Bernanke's arsenal, and I don't think he will keep rates that high for a lot longer. Why not a Fed Fund rates of 1% within the next few days? I think it's very likely.
• The SEC extended the ban on short selling for another couple of weeks. Another intervention that will not only decrease confidence in the markets, but also make any drop steeper since there will not short covering during big downward moves.