Are stock market levels sustainable?

Our view is undiminished that major stock markets are overdue a significant correction. Even more, we believe that the primary bear market that commenced in 2000 is unfinished business and if that is correct in the future stock markets will make new lows below those set in March 2003, when FTSE 100 was 3277.

UK stockmarket: FTSE 100 experts are bearish

The most recent high for FTSE was set on Thursday 16th November at 6257, following this there was a sharp sell-off down to 6000. The rally following that sell-off is so far to 6218. Bear fund positions will come under pressure if 6257 is exceeded and will give us cause to reconsider the holdings and more likely than not, reduce exposure significantly. We can only watch and wait and act if necessary.

Our bearish view is supported by Anthony Bolton, Manager of Fidelity's Special Situations Fund. He has recently bought a FTSE 100 put option, as portfolio protection, equivalent to 25% of the fund value, so sure is he that the FTSE is at an unsustainable level.

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There was a recent gathering of Britain's leading financiers at Plaisterers Hall, City of London. Most of them were recent recipients of record bonuses and by nature are generally bullish; a straw poll was taken. They were asked if there was likely to be a significant downturn in the next two years and 81% put their hands up.

US stock markets: inflation concerns

The US Fed continue to express more concern about the inflation risk than for the economy slowing, with a general agreement that the housing market and the economy will have a soft landing. The housing slow-down, they maintain, will not meaningfully affect the American economy. We find that implausible and much of the data supports our view.

The Institute for Supply Management's (ISM) Factory Index for November was at 49.5, following 51.2 in October, causing American recessionary expectations to increase considerably - a measure below 50 signifies economic contraction. A few days later however, the ISM Non-Manufacturing Index (service sector) rose to 58.9 from 57.1 in October, economists had expected a fall to 56. Because the service sector represents 80% of the US economy, analysts quickly latched on to this to further support the soft landing theory.

Senior executives of American corporations (insiders) are surprisingly bearish and they know what's going on. In November insiders sold $4.5 billion of stock whilst they bought only $33 million. A huge ratio of 136 to 1, the highest it has ever been. Another bearish indicator is to be found in the regular poll done by Investors Intelligence, who found 59.8% of advisers bullish and 23.9% bearish such an extreme measure of this survey is a reliable contrary indicator.

Stock market indicators: conflicting signals

It is hardly surprising, given the circumstances, that with markets priced for perfection various indicators are pointing in different directions.

The white horse - false peace - The Volatility Index (VIX)

In the previous issues we said that should the VIX simultaneously break above the level of 12 and above the eight-week moving average, that this should cause market concern to escalate. It is surprising therefore that the break above this level that occurred on the 28th November, and was reported in the previous issue failed to develop. Since then the VIX has fallen back close to its lows. This protracted level of complacency is extraordinary to behold.

The white horses' twin senior grooms, Ben Bernanke and Hank Paulson, should be complimented on the calmness they manage to induce upon this otherwise skittish beast. Both are now in China, the purpose of their visit to persuade China to allow more currency flexibility and let the renminbi to rise against the US dollar. Their success might turn out to be a wrong move, a strengthening of the renminbi might, dare we say frighten the horses' triggering as it probably would, a sharply weakening dollar.

The red horse war and destruction The Philadelphia House Market Index

To some extent it is not surprising that the Philadelphia House Market Index has enjoyed a strong move up. Based on a soft landing for the housing market, house builders' stocks looked to many too cheap in the summer and have attracted buying interest.

However, the hard news that we are hearing paints a more serious picture. Readers may recall that a few issues ago we said that there was to an auction of residential property in Florida and that the outcome of that auction would give an indication of where this market was headed. We now have some data: there have been two auctions that we have read about, the first was in Key West; two hundred potential bidders turned up, initially a good sign. The lots offered were protected by a minimum price requirement; not one bid reached that price and so not one house was sold. The closest bid was $149,000 short. The most expensive house had a minimum price of $6 million, the best bid was less than $3.5 million the auction was a disaster.

The second auction was in Naples, it had no minimum price so the properties were sold. As an example, a three-bedroom house with a pool sold for $671,000, that same house changed hands in 2005 at $809,000. Another house which a year ago changed hands at $1.35 million sold at auction for $880,000. On average sales were 25% below prices of a year ago. Auctions uniquely price the market for the prevailing conditions. These two auctions did not seem to know about the soft landing!

Ownit Mortgage Solutions of California have been forced to close down. They were a significant sub-prime mortgage bank. According to Barons, Ownit would sell loans that it originated to Wall Street, which repackaged them as Mortgage Backed Securities (MBS). As Dow Jones Newswires reports, issuers of the MBS can force Ownit to take back loans that go into default. Ownit ran out of cash to purchase the bad loans back from the street.

Barons also report that credit derivatives that are based on the lowest tier sub-prime mortgage securities have plunged.

According to Grant's Interest Rate Observer, there are many warning signs of trouble in the sub-prime mortgage market, even loans made in 2006 are turning bad. Apparently, this year, one in three have chosen pay option loans, these are loans where the full amount of interest is not paid and instead it mounts up; once the loans reach 115% of the original amount, they are reset causing payments to increase by up to 150%; as one concerned borrower said "If I could afford that, I wouldn't have needed this loan in the first place".

The black horse famine and unfair trade Dow Theory

Might the black horse be making a claim for leadership? The most recent activity has been a further divergence. We can look at some technical levels as early clues of what next to expect. The most up-to-date chart of both the Industrials and Transports shows that they have both broken their up-trends. For a clear signal that Dow Theory is calling a top to the stock markets, the Industrials next need to close below the level of 12000 whilst the Transports need to close below the level of 4600. Confirmation of closes below each of those levels would be a major signal that the expected correction is under way. Conversely, if the two arrowed highs are both exceeded then stock markets, more likely than not, will continue to move strongly higher.

The pale horse sickness and death The Inverted Yield Curve

Although long-dated yields have firmed a little since last we reported, the inverted yield curve is still emphatically in place. It is a classic harbinger of recession.

Will the American stock market fail and if it does, will it affect the rest of the world. We think it will and to support that view, we report the recent words of Dr Hans Sennholz (Author and Lecturer of Austrian Economics and Professor emeritus of The Foundation of Economics), "If there ever should be any doubt about the stability of the American economy, worldwide demand for the US dollar would decline, damaging the surge of consumerism and slowing the very growth engines of export countries such as Japan, China and many others. The whole world will feel the American instability"

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 https://www.rhasset.co.uk/