Gut-wrenching panic, halfhearted resolve now the hallmarks of mkt sentiment. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth-management firm based in Philadelphia.

Summary

Large daily swings in stock prices seem to have become a fairly common event.
In contrast to the first half of the year when the market sentiment gauges teetered between mere happiness and pure ecstasy, market sentiment now vacillates between gut-wrenching panic and halfhearted resolve.
Fortunately, fear and loathing do tend to be a precursor to better, more placid times in the market.
As the necessary condition for more placid times, the market is looking for a cut in the federal funds rate.
The only problem with this scenario is that even if we do get a cut in the funds rate, it will not directly and immediately relieve the market's concerns by addressing the value of collateral on the balance sheets of financial institutions.
As a result, while potential Fed rate cuts will probably have a positive impact over time, the daily bumps may be with us for a while.

Review and outlook

Investors have awakened most days recently and decided what the market would, as my thirteen year old daughter would say, "obsess" about. On some days, they seem to take a cheery view and anticipate that the markets will be lifted to new heights thanks to rate cuts by the Federal Reserve. On other days, investors conclude that we are looking into a deep, dark abyss caused by a deteriorating housing market and a more difficult lending environment. This is actually the usual story for the market. In contrast, though, to the first half of the year, where the optimists ruled the day, fear is now quite pervasive.

There are a variety of fear gauges that we can use to measure the markets' mood. One popular measure of fear is the VIX index. It would be nice if the "VIX" was short for vixen. Then I could tell you an interesting little anecdote about how the behavior of vixens is closely correlated with the stock market. Alas, "the VIX" is nothing more than a technical term for an index of the implied volatility derived from the prices of options on the S&P 500 stock index. You can actually interpret the markets' mood with a little bit of math and equations used in thermodynamics.

When the VIX is low, the investors who price options are assuming that market volatility will be relatively low. When the VIX is high, as it is right now, then these investors are assuming lots of ups and downs.

Historical VIX levels2 January 1986 - 29 August 2007 |image1| Sources: Glenmede Investment Research and FactSet

Fortunately, this is somewhat of an effective contrary indicator. As shown in the table below, when the VIX hits a high, the market tends to produce a strong positive return over the subsequent 12 months. When the VIX is over 30, as it was this month, on average the market earns 16% over the next 12 months.

|image2|

Another market sentiment tool worth considering is the percentage of stocks in an index that have outperformed their 50-day or 200-day moving average values. When fewer than 30% of the stocks in an index are trading above their 50- or 200-day moving average values, the market tends to produce above average returns. As of August 28th, only 22.5% of the stocks in the Russell 3000 Index were above their 50-day respective moving averages.

Russell 3000 constituentsPercentage of stocks over 200-day and 50-day Moving AveragesThree years ending 29 August 2007 |image3| Source: Factset

Finally, it is worth looking at ISI's survey of the net equity positions of hedge fund managers. This is the level of the net equity exposure by hedge funds. Over the past few weeks, hedge funds have reduced their exposure to the equity markets in the wake of a substantial amount of volatility.

|image4| Source: ISI Research

Once again this is a contrary indicator. When hedge funds reduce their equity exposure, the stock market tends to do relatively well over the next six months.

|image5| Source: Glenmede Research and ISI Research

So how can we break this wave of fear? One thing that helps is simply time. The market is a very emotional beast, whipped around on a daily basis by the hopes, dreams, and daily profit and loss statements of short-term traders. Markets tend to fall on uncertainty. As information comes out that relieves the uncertainty, then markets tend to recover.

In this case, fear is being caused by lending, or to be more precise, the lack of lending. As we outlined in a prior commentary ("Collateral Damage," August 15, 2007), lending depends on the ability of borrowers to provide adequate collateral. The sub-prime mortgage mess has called into question the value of that collateral.

The 4.75% solution

The solution that the market craves is for the Fed to step in and reduce the Fed funds rate. Indeed, a change in the Fed funds rate would be consistent with history. Historically, the average length of time that the rate has stayed at the same level is five months. It has now stayed at the same level for 14 months.

Federal Ope Market Committee: Fed funds target rate |image6| Sources: Glenmede Investment Research and Haver Analytics

It appears that a Fed Funds rate cut is in the cards. The Fed Funds futures market would certainly tell you that there is going to be a rate cut. The fact that the Fed has already cut another rate, the Discount Rate, would indicate that change is on the way.

There is one small problem with a rate cut. It does not directly fix the sub-prime mortgage problem. At this point, the sub-prime mortgage issue is more of a financial problem than an economic problem per se. The credit markets will not fully calm down until it is clear (1) that all of the losses associated with the mortgage markets are realized; and (2) that no more significant write downs will occur. Unfortunately, that process takes time, as these illiquid securities get revalued across the globe. (Peter Zuleba, our director of fundamental research, notes that, somewhat surprisingly, we haven't seen the collapse of a major financial institution yet, although a few hedge funds have collapsed.)

Until that time, the equity markets will probably remain on pins and needles, prone to daily gyrations. The good news is, as strategist Ed Yardeni points out, that with a Fed funds rate of 5.25%, the Fed has plenty of latitude. They may not be able to relieve all of the anxiety in the credit markets. By lowering the funds rate, however, they can reduce some of the delinquencies in the mortgage market, induce lenders to make loans in other parts of the economy, and reduce the cost of carrying an inventory of assets. Until that time, we have to cope with fear and lending. -FWR

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