At the start of April, when most major stock markets were in good shape and at new highs, we commented upon recent significant stock market weakness in Iceland, a country with a population of only 300,000 population.
We posed the question: Could it be the start of something more serious, leading to a risk of contagion throughout the world?' We said then that the answer was probably yes. Now it is quite clear that there has been a dramatic deterioration in the appetite for equities.
Credit rating agency Standard & Poors recently reported that US corporate profits were standing at a forty-year high as a proportion of GDP. Companies have spent over $100bn on share buy-backs, 25% more than a year ago, and cash in their balance sheets is at 7.4% of market capitalisation, the highest level for 20 years.
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Here lie a couple of important clues. Firstly, because profits are mean reverting, further earnings growth from such dizzy levels is most unlikely (which would meaningfully undermine share prices). One simple reason for this is that as corporate profits rise, competition increases, causing profits to fall: a process that is irresistible.
Secondly, strong economies benefit from companies borrowing to invest, the money they borrow being provided by private sector savings. In the Alice through the looking glass' world in which we live today, there are no private savings. Households borrow to spend, whilst companies see no value in investing to grow their businesses. Instead they buy back their shares, a practice that is not much good for the economy but does help hold the share price up and ensure that share options continue to bloat the pockets of the senior executives.
Until April/May this year, major stock markets, emerging markets, commodities including gold and energy all rose and, since then, have fallen in unison. Such a close correlation cannot continue. Along the road these markets will de-couple: some will continue to decline, whilst others will bottom out and become huge investment opportunities.
Those that fall the most, probably the Asian stock markets (China, India, Japan, etc.) will be the most interesting. In due course they will stabilise and return to strength - but not yet, we think.
The return of the bear market: deteriorating confidence
Why has sentiment deteriorated so much? We can remember very clearly, prior to the 2000 stock market sell-off, that our warnings of what was to come were ignored by the polite and laughed at by the impolite! Hardly anybody agreed with us. This time round, our views are more widely shared. The reason is obvious. In 2000 optimism was high because the bull market had been in place for 25 years and nothing could go wrong, people could only get richer.
For those who had seen the FTSE 100 climb from its 2003 low to 6000, the bear market experience is still fresh in their minds. So faced with the threat of a return to square one, they demonstrated a very natural tendency: they became protective of their wealth. A flight to safety when alarm bells start ringing is to be expected.
As we have reported over and over again, one important key to the puzzle is the US housing market. The Philadelphia Housing Market Index chart has now failed, plunging below its key support level of 225 and signalling serious problems for the US and the global economy.
Correlated with the US housing market is the US jobs market because, over recent years, the housing market has been the single biggest source of new jobs in the US. So it is not surprising to learn that, on the back of a crumbling housing market, new job creation is also declining. The recent figures make illuminating reading: February 2006 200,000; March 2006 175,000; April 2006 126,000; May 2006 75,000.
The return of the bear market: how to invest for harder times
Successful investments, going forwards from here, will probably be inversely correlated with the stock market, making bear funds an obvious choice. Our model portfolio is 30% exposed to this opportunity. The Gartmore UK bear fund is constructed in such a way that it increases in value by reference to the percentage losses that FTSE 100 suffers.
A few weeks ago, we listed four technical indicators that we expect to signal the next bout of stock market weakness. Two of those have been hit: the Dow Jones Industrial Average has closed and remained below 11000, and the Philadelphia Housing Index has collapsed below 225. For the time being, FTSE 100 has managed to stay just above 5500 and the VIX (volatility index) has yet to exceed 25.6.
Going forwards, should the Dow Jones Industrial Average and the Philadelphia Housing Index remain below their key levels and if FTSE 100 closes decisively below 5500 and the VIX finds its way above 25.6, then the floor under the stock market will probably open up!
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/
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