We reported previously that a highly regarded analyst to the investment industry, Lowrys, said that recent stock market volatility is greater than at any time for 55 years. Also, David Schwartz, the renowned stock market historian, said that bear markets have always followed, if in May for a protracted period, stock markets have fallen significantly, which is exactly what happened this year. Declines in such a developing bear market, he says, are likely to be significant, at least 27%.
There is a growing consensus that 2007 will be a period of recession in the United States. If that turns out to be so, then the time to be worrying about investment markets is right now because recessions are lagging indicators of future stock market action.
Two consecutive quarters of negative growth are logically preceded by a period of deteriorating economic conditions that are singularly bad for asset prices. So, from now on should be a period of concern and we think it is very likely that the May decline will lead to much lower prices this year for most of the world’s major stock markets.
Stock market action, post May, so far has been a little better, markets have clawed back some of their losses but have now reached a level where progress has stalled. Markets are struggling to gain further upside traction and to our eyes they look poised to fail. If so, charts will carve out the sort of important technical tops associated with major sell-offs.
US economy 2007: technical watch
Recently, we also highlighted some technical levels to watch which collectively would in our view, confirm the very worst (Four bear market signs to watch out for). A review of these follows:
a. FTSE 100 to fall below 5,500. Intraday on 13th June 2006 the FTSE 100 recorded a low of 5,435, but from there forged a clawback and is now at about 5,800. FTSE 100 needs to fall back below 5500.
b. The Dow Jones Industrial Average to fall below 11,000. This level was exceeded to the downside in June. As with the FTSE 100, the level was recovered and at the time of writing, the price is fractionally above 11,000. We now consider the new key level to be 10,666.
c. The Philadelphia Housing Index to fall below 225. That level was exceeded, the price has remained below it and we consider this very significant. The global economy of the world almost entirely depends upon the US housing market remaining secure, so that US consumers can continue to live beyond their means. The recent lack of any recovery, in spite of modest recoveries in major stock market averages, is a sinister indicator and one of the most important clues to what we should expect next.
d. Volatility Index (VIX) the level of 25.6 was never reached. For that level to be exceeded, portfolio managers will need to be very scared, enough to load up on S&P 500 put options to protect their portfolios. When the VIX exceeds 25.6 that alone will be a huge signal.
US economy 2007: debt crisis concerns
Recent action by Deloittes to set up a company doctor service for debt crisis indicates quite clearly that informed market observers are moving into positions to benefit from what they and we fear is to come. Ian Lynman, of Deloittes said:
“There are clear signs that we are nearing a turn in the credit cycle. We are not going to attempt to call a top of the cycle, as that’s fairly pointless. But the level of debt that companies have taken on suggests that there will be problems down the line perhaps by Christmas that will become apparent, perhaps in the New Year, but we are certainly getting closer to a turn in the cycle.”
The Bank of England has also warned of the risk that exists in the very high level of corporate debt levels. The Daily Telegraph, in its Business section, on 12th July went as far as to produce the headline: City faces meltdown if debt crisis hits.
Whether or not the debt crisis hits companies remains to be seen but certainly the heat is rising on both sides of the Atlantic for consumers. In the UK, accountants, Ernst & Young, say that average incomes have risen but most households’ mortgage and fuel costs have increased by even more. They calculate that the average household has 10% less to spend than five years ago and to make matters worse, for ten of the last eleven months, unemployment, as measured by benefit claims, has risen and is now at its highest level of 956,600 since January 2002.
Last year, a survey by the Office for National Statistics came to the conclusion that the average UK householder was living beyond his means to the tune of about £5,000 a year. It’s not difficult to understand how this process of over-spending is achieved – financing the service of existing debt out of further borrowing. House-owners in such a position, periodically refinance their various outstanding balances into a bigger mortgage, usually with a specialist lender who charges higher rates and who is not fussy about levels of income and previous poor credit history.
Such a mortgage lender is the Kensington Group whose shares on Wednesday, 12th July, fell 14% following their announcement that the number of borrowers whose accounts were 90-days or more in arrears had increased to 9.6% from 8% a year ago. These are invariably borrowers who are at the end of their tether. Theoretically, if their houses are worth enough they can again re-mortgage their unaffordable mortgages with another specialist lender. But as lenders of this type discovered about fifteen years or so ago, when house repossessions were commonplace, there comes a point when debtors who are financing debt out of further borrowings hit a brick wall and suddenly and irrevocably default. Is it surprising that personal bankruptcy levels in the UK are at record levels?
US economic growth slows
Stock market declines tend to commence when economic growth is high but fears of weakening start to build. Once recession has arrived, asset prices are already much lower. Necessarily, the future of the bear market, should we be right, will largely be centred upon what happens in the US. A recent survey of 56 American forecasters, concluded that growth looked set to slow, inflation to rise (we don’t necessarily agree with that) and some fear that Fed tightening will overshoot – it may already have done so.
As much as 70% of GDP is down to the good old consumer who, having no savings, can only continue by increasing his debt levels. On that point it is worth picking up on GaveKal’s recent report, they have calculated that in the 1980s, US consumer debt grew at 2.5 times GDP, in the 1990s at 3 times GDP. In order to sustain the asset bull market, it needs to accelerate to 4 times GDP ad nauseam, what can’t continue must end. It has been reported that retail sales growth in the US has stalled.
Also, reported by Associated Press, is that consumers face challenges in handling debt, we quote “rising interest rates and higher gasoline prices are putting the squeeze on consumers’ budgets, and many are finding it harder to keep up with their bills. Credit counselling agencies say that consumers are coming in droves seeking help”. Howard Dvorkin, president of the non-profit making Consolidated Credit Counselling Services Inc., in Fort Laudedale, Florida, said that: “consumers are carrying an inordinate amount of debt, they don’t have any savings to fall back on if things don’t go right.”
The world is hoping for an orderly unwinding but that, we suspect, is unlikely because people who lend money tend not to be kind to those who default, and default they surely must unless asset prices rise indefinitely. We read recently in the Daily Reckoning (a recommended read for anybody interested in these matters) that consumers now depend on new debt for 90% of their cash flow. Historically, household incomes were sufficient to generate a cash surplus after consumption and debt services; that, in the US, is no longer true and the same applies to many consumers in the UK.
US economy 2007: US property and Asian markets
The latest news on the US property market:
• Builders have been walking away from land purchase options losing the deposits they paid of above 10%.
• The number of existing and new single family homes for sale is at record levels.
• The Home Buying Intentions Index is at its lowest level since 1991.
In spite of our long-term optimism, the Japanese stock market flounders at about 15,000 for the Nikkei Dow. We patiently await the opportunity to buy back into that story as we also do in certain of the very important emerging markets such as China and India. Markets in Asia will, in the future, be core holdings for any successful portfolio. However, in the short-term America’s problems, that seem now to be becoming more serious, are likely to affect the world. Following that, Asia’s time will certainly come.
For the time being, portfolios continue to hold UK bear funds. We expect these, over the coming period, to benefit very considerably.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit http://www.rhasset.co.uk/