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Two signs the crisis for financial shares may be abating

Party hatStock markets have been falling for months, led by a collapse in confidence in the financial system and plunging bank stocks. In the UK we’ve seen Northern Rock crumble, while in the US the investment bank Bear Stearns lived up to its name after jitters led to rumours which led to a run on its assets, ultimately forcing it towards bankruptcy and into the arms of JP Morgan.

I happened to watch some of Washington’s investigations into the Fed-backed buy-up of Bear Sterns on Bloomberg yesterday. The CEOs of both Bear and JP Morgan were there to account for themselves, sitting side-by-side as if in some slow bit of a Shakespearian tragedy. (You can read JP Morgan’s testimony over on Forbes).

I’ve also watched Fed chairman giving evidence in recent months defending his attempts to alleviate the blockage in the credit markets, and his deep cuts in interest rates.

What’s all this mean, apart from that I need to get out more?

When markets stop falling on bad news, things often get better

I’m not the first person to notice the trend, in fact I’m certain I read it in some old biography of a market trader, probably Jim Slater. But anyway, one method – not foolproof, and highly subjective – of reading a bear market bottom is to look out for a cessation of market falls on bad news.

The markets have been relentlessly falling on bad news for months, but this week they seemed to have had enough. When UBS announced its writedowns due to sub-prime loans had doubled, shares actually soared in the US and the UK.

The BBC’s excellent Robert Peston believes markets rose because traders were relieved UBS had come clean at last:

Markets rose because of relief that UBS (and Deutsche, on a much smaller scale) had made a clean breast of its losses and the hope that other banks will do the same. The expectation would be that when the full damage has been exposed, the proper rebuilding can start.

I’m not so convinced. Rather, I believe stock markets inherently want to rise. At the risk of sounding glib, markets rose despite bad news from UBS, because those investors left are optimists.

Most people believe markets will go up in the long-term, which is why we save via pensions and ISAs, and why looking back historically, selling at the bottom a trough always seems idiotic in hindsight. When things get jittery though, people forget the long-term picture and fear deep temporary losses, particularly institutions who are judged on their performance over 12 or even 3 month periods. As a result, they begin to sell their holdings down.

Eventually, though, everyone who is going to sell on the generally accepted bad news has sold. In this view of the world, markets stop falling on bad news because everyone who is still in accepts things are bad. They may be right or wrong in an expectation that the situation will improve, but they’re not going to get easily spooked by yet more evidence of banker folly. They know the bankers were silly, silly, silly.

There’s more good, bad news: You’ll sometimes hear it argued that the collapse of a bank signals a market bottom. Once a bank has failed, policy makers really sit up and do almost anything to avoid a systemic collapse. We’ve already seen this in the UK, where Mervyn King’s stance on moral hazard went out the window when Northern Rock failed, even if he kept talking the talk.

Equally, in the US, the Bear crisis has got everyone in the same room, leading to Government working directly with private institutions to shore up the financial system (for a profit for JP Morgan, of course).

The only way for stock markets is up (or down)

Could markets fall further? Absolutely, unequivocally, yes. Long-time readers will know I don’t believe anyone can predict the movements of stock markets in the short-term.

One clear risk is that while all the above is true for financial stocks and the markets, arguably none of this gloom ever made it into the wider world, particularly in the UK which is only just starting to see house prices fall as a result of the credit crisis. New ‘bad news’ that has nothing to do with banking, housing, mortgages or daredevil bankers could set off a fresh wave of selling.

Still, I’m confident enough to plan to fill my new ISA allocation with share investments when the 2008/2009 tax year starts next week. I like buying investments cheap, and the above signs are enough to make me greedier more than fearful with at least a portion of my cash reserves.

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