Banks send out a strong signal on the property market

published 11 July 2007

In the main, these last two weeks, stock markets have done little more than consolidate; that is, excepting the Chinese market where there has been very considerable weakness.

Two weeks ago we suggested that Chinese investors may well take the opportunity then, because the Shanghai A market had regained its earlier high, to bail out. Action since suggests that is exactly what has happened, with a double top clearly in place as a result. Foreigners, who are not permitted to purchase the Shanghai A stocks but instead can buy the Shanghai B stocks, have continued to be big sellers. since its high on the 22nd May, it is now down 33.3%.

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The Real Estate sector of the UK stock market continues to subside. Since January it is down nearly 20% and very considerably underperforming the FTSE 100, which over the same period has been positive. Several of the major banks have sold their expensive head offices and other premises and leased them back, getting top dollar for the assets and, at the same time, leasing when rent yields are at historic lows their action probably confirms a significant property market top.

Property funds which have proved to be very popular over recent years because they have done so well could now be a dangerous trap. The funds that invest directly in property rather than equities are, by their nature, very illiquid. Because the underlying investments are commercial buildings, the valuation of these funds depends upon periodic inspections by surveyors. The risk is that if investors decide to take their money off the table and properties have to be sold to create liquidity to meet redemption requests, then serious problems could arise and fund values could be marked down very sharply. These investments are prime candidates for big problems as the credit crunch gets underway and in the future as they are marked to market rather than, at present, to valuation.

Another key stock market sector that has underperformed this year is the financial sector which is exactly what you would expect if a credit crunch is underway. This year the Bank Sector of the UK stock market is down 7.5% and technically, has carved out a very imposing top. Strong stock markets since 2003 have been largely driven by the financial sector which has benefited from the massive global credit expansion. Over that period, the number and size of financial transactions and associated fees mushroomed. The share prices are now implying that the credit expansion is ending. Every 0.25% hike in short-term interest rates is another debilitating blow to the banks whose previous gung-ho' lending will now come back to haunt them, financially and reputationally. See the recent and highly critical report from the FSA on UK subprime mortgages.

On Monday 25th June a hundred plus clients and friends attended our London seminar and listened to our guest speakers, one of whom was H "Woody" Brock, the renowned American Economist. Coincidentally, the seminar was just a couple of days after the Bear Stearns announcement that two of their hedge funds were in trouble. That news triggered Woody, from his hotel in London, to send a memo to his global clientele, amongst whom we number, his memo can be read on our website, www.rhasset.co.uk.

Since the Bear Stearns news broke, the financial press have endlessly reported the developing issues. The Daily Telegraph reported that Anthony Bolton, the highly respected Fidelity Fund Manager, likened CDOs to the split capital trust sector. When speaking at Monaco at the Fund Forum 2007, he said "It reminds me a lot of split-capital investment trusts, they were based on models and assumptions. It turned out the models were wrong and that led to collapses" We at RHAM would also add to that a similar comparison but to the with-profit life assurance investment process which brought about the demise of Equitable Life and disgrace for the whole with-profit industry - and inflicted huge investment losses on countless investors.

Since March this year, the characteristics of the VIX chart have dramatically changed and suggest a new scary level of unease for asset markets. The published chart this week is for the period from 2002, the American stock market made its post-2000 low in October 2002. For most of that period, starting from early 2003 until 2005/06 the VIX was in decline. From 2003, except for intermittent spikes upwards, the price action was contained below the 30-week moving average. That was until March this year when it all changed. Since then the action has been entirely above the 30-week moving average.

We used to call the 30-week moving average the boom-bust line. Long-term declining markets trend down below the 30-week moving average whilst long-term rising markets trend upwards, supported by the 30-moving average. A sustained move from one to the other, which we have here, is often a leading indicator of an imminent and critically important long-term reversal. Technically, this chart is saying to us that the VIX is going only one way and that is UP. Whilst this technical situation persists, one must be concerned for asset markets. This indicator, for the time being, is the most important one of our Four Horses of the Financial Apocalypse to watch.

The recent period has been noticeable for two important warnings, the first from the IMF, who are reported as saying that the US economy could still stall and slip into recession. They said that growth was uncomfortably close to the 2% stall speed associated with past recessions although other factors normally associated with recession, such as rising unemployment and hikes in interest rates, were absent. But they also said that consumption could weaken on the back of the ongoing housing market slowdown and that the current benign financial conditions could tighten.

The other was from the Bank for International Settlements (BIS) known as the Central Bankers' Bank, who consider the credit spree "could trigger a repeat of Great Depression", the result of years of loose monetary policy having fuelled a dangerous credit bubble. They said that virtually nobody saw the Great Depression of the 1930s or the crisis that affected Japan and South East Asia in the early and late 1990s. Each downturn they said was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a new era had arrived. The unforecastable nature of a financial crisis was also mentioned recently by Alan Greenspan who, in a private talk which was reported by one of the attendees, said that in his eighteen years at the Fed, not one of the financial crises that occurred was predicted.

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