Corrections or Bear Markets in Asset Prices, Part II
YESTERDAY’S EDITION is a long-term forecast. Near term, I envision a scenario whereby credit growth slows down and the economy moves into either a very low-growth or recessionary phase.
Why? Since US debt growth has driven asset prices higher in the last few years and allowed US households to extract funds from their assets in order to sustain increasing consumption, it is likely that home and stock prices, which will no longer rise and more likely may go down, will have a pronounced impact on economic growth rates. In this respect, it is important to understand the following. While the Fed fund rate has increased from 1% in June 2004 to 5% at present, lending standards in the housing industry have continued to decline.
This was one reason why debt growth has accelerated since the second quarter of 2004, as Kurt Richebächer demonstrated above. In fact, Bridgewater Associates produced recently a very telling figure showing what has been happening in the housing industry since 2002. Mortgage borrowings have begun to rise at a much faster clip than residential construction (see Figure 15). (I am sure the optimists will think that this trend is also sustainable.)
As Jason Rotenberg of Bridgewater Associates points out, the difference between mortgage borrowing and residential construction is the “largest ever” and shows by “how much housing has added to growth in recent years through mortgage borrowing (with over a third of that money flowing to non-housing spending) and construction”.
Now, here is the bad news. First, the dismal performance of homebuilding shares since last summer, given their low valuations, seems to indicate that conditions in the housing market are likely to be far worse than the official statistics suggest. Two, as Bill King pointed out in one of his recent daily missives, and quoting the Chicago Tribune , mortgage defaults are on the rise.
According to the Tribune , “In Illinois during the first three months of 2006 nearly 13,700 properties entered foreclosure, up 32% from the fourth quarter of 2005, according to an analysis by property tracker RealtyTrac Inc. The numbers are grimmer elsewhere in the Midwest. Michigan and Ohio, battered by automotive-related job losses, together recorded 45,000 mortgages entering some stage of foreclosure in the first quarter.
Those are increases of 91% and 39%, respectively, compared with last year’s fourth quarter. Nationally, foreclosures are up 38%, higher than in any quarter of last year, RealtyTrac said… ‘The increases we’ve been seeing in foreclosures don’t even reflect the worst-case scenario that could happen when the $2.7 trillion in adjustable-rate mortgages are reset over the next 18 months’ said Rick Sharga, vice president of marketing at RealtyTrac” (emphasis added).
No matter how optimistic (or desperate) bank and sub-prime lending officers might be, I suppose that, at some point, even these optimistic folks will do the totally unthinkable and tighten lending standards somewhat, as they did in the early 1990s. Also, given the high level of adjustable-rate mortgages that will be reset in the next 18 months, it is difficult to see how much tighter the Fed can become!
Nevertheless, housing, the most significant driver of the economy in this expansionary phase that began in November 2001, is unlikely to provide much economic stimulus in future. Granted, some observers will contend that a housing slowdown will be offset by an increase in salaries and wages, but such an increase would also lead to higher inflation and make it next to impossible for the Fed to cut interest rates.
In short, whereas I do expect central banks to embark anew on massive “money printing” in future, and to flood the system with even greater liquidity injection than they have done since 2001, for the next three to six months or so, global liquidity may not rise sufficiently to keep the global economy on its growth trajectory and asset prices from declining.
An Attempt to Structure a Shorter Term Investment Strategy
My readers will know from past reports that I am a firm believer that central banks will print money to save the system from imploding under the ever-increasing economic and financial imbalances. Therefore, under a money-printing regime, the Dow can easily rise over the next six to ten years to 33,000, while it loses value in real terms (that is, against gold – with the result that sometime in the future one Dow Jones Industrial Average will only buy five ounces of gold or less).
Obviously, under these conditions, the US dollar will also lose value against gold and against the currencies of countries that are endowed with a more responsible central bank (Switzerland – I hope…) or which are economically far more competitive than the US (China). Needless to say, in a money-printing environment, 30-year US government bonds will be one of the worst possible investments. But, this is all in the long term. For the next six months or so I envision the following.
Equities around the world will weaken further and US home prices will decline. US consumption will slow down or could even temporarily decline, as consumer sentiment turns decidedly down and leads to an increase in the saving rate. Corporate profits will begin to disappoint badly as the huge financial gains that boosted profits in the last four years no longer grow, or decline.
As a result of a US consumption slowdown, the US current account deficit, which flooded the world with liquidity, will no longer expand at the same rate as between 1998 and 2005 (or possibly even may contract temporarily), thus withdrawing an important source of liquidity to the world. Foreign economies will slow down or run into some problems as industrial commodity prices sell off, or no longer increase. This will add to a “relative” tightening of monetary conditions. (Remember what happened to the Middle Eastern stock markets.)
In asset classes jargon, the above scenario, which I expect to unfold over the next few months, would imply the following:
US bonds , an asset class about which most investors have been very negative recently, could rally somewhat, as economic news begins to disappoint and as there is a modest flight to safety. In addition, portfolio managers and the asset allocation crowd (or momentum players) who successfully rode the 2002-2006 bull market in global equities and achieved total returns in excess of 100%, may opt to raise some cash and shift from equities into short-term bonds.
The US dollar could benefit from a reduction of risk appetite among the investment community, as the money that chased high yields and high returns in countries such as Brazil, Indonesia, Turkey, and India, to mention a few markets, is repatriated. I have to admit that this is a low-confidence forecast, since a weaker economy in the US could also adversely affect the US dollar. (In addition, I would expect the US dollar index eventually to break down below its support around 80.)
US equities have broken down from a rising wedge with heavy volume and with significant momentum (see Figure 18). The technical implications are usually bearish and further downside risk exists. Also, as can be seen from Figure 18, huge overhead resistance now exists for the S&P 500 between 1280 and 1325. As I pointed out in the April report, entitled, “A Simpleton’s Guide to Economics and Investment Markets”, the Dow Jones seems to have traced out a “three peaks and the domed house” formation from where a significant decline usually follows. In addition, the “Hindenburg omen” gave several sell signals in late April.
Sell signals do occur when unusually large numbers of stocks both reached one-year highs and lows but prices continue to climb. The Hindenburg omen sell signals occur only seldom. They indicate a highly unstable stock market. Whereas their record is not perfect, Hindenburg omen sell signals preceded the crash of October 1987, the Long-Term Capital Management collapse of 1998, and the bursting of the “Internet bubble” in 2000.
Emerging market equities , which were not only the crowd trade of 2005 and early 2006 but which also became extremely overextended, are among the most vulnerable asset classes over the next few months. The Istanbul Stock Exchange National 100 Index dropped in a few days by 25%, while Russia, India, and Brazil were off by about 20% (see Figures 19 and 5). I should like to remind our readers that no matter how favourable the fundamentals of an economy appear to be, equity markets can be totally out of step with the economy – as was the case for Chinese equities between 2002 and 2005 when they fell by 50%.
Emerging economies’ currencies have also suddenly begun to weaken. The Turkish Lira lost 15% within just a few days, and the Brazilian Real fell by an almost equal amount. Currency weakness and slumping stock prices led to a double whammy for investors in these countries. Some readers may wonder what caused these emerging economies’ currencies to suddenly weaken. In Latin America, a populist socialist move is well under way, and in many other emerging economies the domestic price level has increased very significantly in the last few years. In the case of Thailand, my impression would be that prices have increased by about 50% over the last four years – admittedly, from an extremely low level. Another reason for currency weakness among emerging economies may have to do with the “flight to safety” referred to above, and with an impending decline in commodity prices.
Industrial commodities are vulnerable to a global economic slowdown. Granted, we are in an environment where almost all economies of the world are expanding, but this is the situation today, now! Driven by declining asset prices, the global economy could slow down abruptly and lead to temporary disappointing demand for industrial commodities. At the risk once again of being wrong, I still believe that copper prices have a significant downside risk (see Figure 21). Gold prices could come under further pressure, but the monetary aspect of gold should probably lead to an outperformance of gold compared to industrial commodities whose prices depend on global economic growth. Still further weakness to below US$600 per ounce wouldn’t surprise me. Among the commodities, complex agricultural commodities may entail the lowest risk. However, when asset markets come under pressure, all assets can suffer – though obviously to varying degrees. In this respect, I would avoid the purchase of the overhyped and momentum-driven ethanol stocks for now.
Residential real estate , especially in the high-end condominium market, also appears to have considerable downside risk. Compared to a few years ago, during my travels I am now seeing a surprising number of cranes building trophy condos in urban centres all over the world, as well as trophy second homes in resort areas. When the Asian crisis occurred in 1997, it hit well-to-do people the hardest (the leveraged large asset holders). Now, looking at the immense profits the “money” and other “asset shufflers” such as real estate speculators and private equity managers have achieved (not to mention the CEOs), I wouldn’t be surprised if, for a while at least, a payback time dawns upon the financial industry and the (in my opinion) overpaid CEOs. A good contrary indicator may be The Economist’s April 29 – May 5, 2006 issue, which had on its cover: “On top of the world – Goldman Sachs and the culture of risk”. It is worth noting that Goldman Sachs’ shares topped out in a most timely fashion on April 20 and formed a “head and shoulders” between early April and mid-May.
Furthermore, I was pleased to read that, last year, some of my friends earned in excess of US$500 million. (According to the Financial Times of May 26, 2006, the top 26 hedge fund managers earned US$363 million, on average, in 2005.) As I indicated in earlier reports, whenever there is a concentration of earnings in one sector of the economy – in this case, among us “money shufflers” – and our great achievements make headlines in the media, the end is near for that sector!
(I would be surprised if there were any fund or hedge fund managers in the 1970s who earned more than US$10 million per annum – another sign of how money has lost its purchasing power – read “inflation”.) Of course, there is hope for our financial nirvana: Mr. Bush just appointed Henry (Hank) Paulson, former CEO of Goldman Sachs, as US Treasury Secretary. And guess whose interest he is more likely to protect? The common man, the workers, the middle class – or his buddies on Wall Street?
So, I am looking forward to the time when my friends among the top hedge fund managers will – thanks to another “money printer” in the current US administration, a group of politicians whose superior intellectual capital far outweighs the negative impact of the US current account deficit – earn a trillion dollars each. (By then, an ounce of gold will probably sell for around US$1 billion, while billionaires will be about as common as millionaires are today.)
But, let us hope for now that the market’s reaction to the appointment of Mr. Paulson won’t be as negative as it was following the appointment of the chief money printer to the Fed, when both bonds and the dollar subsequently tanked.
In any event, for now, as outlined above, I see some dark clouds hanging over the financial and luxury goods sector, including the art, collectibles, and trophy wife market.
July 7, 2006