In our previous Onassis newsletter (see: Is the bear market about to make a comeback?) we said that at the time of writing February was proving to be another positive month for the world's stock markets. Everybody now knows that on the 27th February, that situation changed dramatically. The Shanghai market fell about 9%, its biggest decline for nearly nine years and then in its wake, the Dow, which at one point on that day was down over 500, closed 415 down.
Market action since the end of February has been lacklustre, particularly for the Dow, the words dead' and cat' come to mind when viewing the bounce. The next key technical support level for the Dow is 12000, if it does not hold, expect big sell-offs. We would not be surprised if there is some more bad stuff to come. So far, in percentage terms, major markets are not down a huge amount; the long overdue correction of at least 10% is still overdue.
Economist, Andrew Smithers, of Smithers & Co. Limited who quite recently estimated that the US stock market is 77% overvalued and the UK 68% overvalued, wrote in his World Market Update published on 28th February:
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"In view of the overvaluation of stock markets, yesterday's break could be the start of the second leg of the major bear market which started at the end of March 2000. The rising credit spreads in the corporate market, following the problems with the sub-prime mortgage market is a signal which would cause us most concern."
Key threats to market stability
Credit spreads, the yield difference between the best quality bonds and the worst quality bonds, have widened a little; recently they were as narrow as they have ever been when J P Morgan's High Yield Index was only 279 basis points above Treasuries. The increase so far has been to 323. At times of previous credit crunches, spreads have widened to 800, even 1000.
Two of the key threats to market stability are widening credit spreads and the rising value of the yen.
Widening spreads would impact considerably and put pressure upon the whole private equity business. Prices offered would have to fall to less attractive levels to compensate for increased debt servicing costs from rising corporate bond yields.
The "carry trade" would be severely damaged by a combination of a higher yen and lower assets prices. It is typically based upon borrowing yen and then investing in higher yielding non-yen assets with loads of gearing. Any rise in the yen would be a signal that the carry trade is probably unwinding, assets being sold to repay yen loans.
Another clue to developing conditions is provided by the stock market performance of companies such as Merrill Lynch and Goldman Sachs. These huge investment banks have, over recent years, profited massively from the liquidity driven financial business. If the market now perceives a slowing of such leveraged transactions, their share prices will be hit hard which, as you can see from the published chart of Merrill Lynch, is what has happened. Since its high in early 2007, Merrill Lynch's share price has fallen almost 20%, indicating a current jaundiced market appraisal of their future earnings growth.
Other stock market indicators
Our Four Horses of the Financial Apocalypse have been snorting, whinnying and bucking. There is a real danger of them breaking into a wild uncontrollable gallop!
The white horse - false peace - The Volatility Index (VIX)
A sharp increase in volatility, but as yet not decisive. The previous VIX breakout occurred in May and June last year, the peak of that was 23.81. This recent breakout has so far peaked at 20.41. If this change is serious, then expect the VIX to head very much higher.
The unique economic conditions of global leverage, if unwound, could easily lead to a new all-time high being set for the VIX above 56.74. Fear has returned and suddenly the need for insurance is more important; except now insurance is a lot more expensive than it was only a week or two ago.
The red horse war and destruction The Philadelphia House Market Index
The US housing market news remains pretty grim. Sales of new homes in January fell by 16.6%, the biggest amount for thirteen years. House prices, year-on-year, fell 3.1%.
In the FT, Martin Wolf, recently wrote a piece headlined "Equities look overvalued, but where is the turning point?" He identified some of the key dangers ahead:
Markets will overreach themselves, so generating a destabilising correction (has this started?)
Reduction in excess savings outside the US and a tightening of the world interest rates (credit spreads have started to widen).
Slowdown in US productivity growth (is already underway).
A shift in global monetary conditions that threatens the soaring profitability of the US financial section (see Merrill Lynch chart).
Of all the risks, he said that the biggest one is that the end of the US property boom will persuade US households to tighten their belts at last, thereby ending the US role as the world's big spender before the big savers (Asia) are prepared to spend in turn.
Note: The words above in brackets are ours.
The sub-prime mortgage market goes from bad to worse, led by America's second largest sub-prime mortgage provider, New Century Financial Corporation, whose share price has collapsed over 80% to 3.94. On 5th February it was 33.08.
The black horse famine and unfair trade Dow Theory
How quickly circumstances change. Two weeks ago we reported a very belated positive stock market confirmation using Dow Theory. The Transports had finally made a new high to confirm the new high achieved some months previously by the Industrials. Part of the theory does suggest that a long delayed confirmation is a weaker signal than a quick confirmation and this one certainly fell into that category. The subsequent, simultaneous decline of both the Transports and the Industrials reverses the weaker positive signal into a new negative signal.
The pale horse sickness and death The Inverted Yield Curve
Where inverted yield curves exist in the US and the UK that situation has become more so rather than less so. The inverted yield curve is often an indicator of a future recession.
Alan Greenspan has recently spoken twice about the risk of a US recession this year. His latest statement said that there was a one-in-three likelihood. Merrill Lynch have economic models which suggest a 55% chance of a US recession this year. As we have said before, once a recession becomes official, which it does on two consecutive quarters of negative growth, the stock market should already have made its lows. The probability therefore, is that this year, we are going to see much lower stock markets and that could happen quite soon if a US recession is to occur in before the end of this year.
On the other side of the coin, Hank Paulson, US Treasury Secretary and Ben Bernanke, Fed Chairman, have come out with market calming statements, but that's no more than you would expect. Their job is to calm nerves not to stretch them.
We recently reported a modest purchase of Japanese stock market funds. These investments have weathered the storm quite well. Although the Japanese stock market has, like other markets, declined, the yen has appreciated so those new investments so far are under no threat.
The bear funds still being held have benefited.
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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