Over-valued, over-bullish and over-bought: that's one expert's view of the US stock market. Its future direction will influence markets almost everywhere, including the UK property - so what can we expect?
In the UK, the buy-to-let market has received a lot of publicity because yields have plunged. According to a buy-to-let recent study, reported by the Daily Telegraph, almost a third of the investors have been landlords for only a year or less, most will have utilised mortgages with discounted interest rates early on but which, in due course, revert to market rates significantly above the level of rental yields.
This is precarious for those investors who have to rely only upon future capital gains to deliver a benefit. Historically, investments such as buy-to-let are genuine long-term investment opportunities only when the rental yields significantly exceed interest rates, so that over time the tenants pay for the property. As a general rule, we would say that when the reverse applies, as it does now, it is a time for selling not for buying.
Early reports this year about the UK housing market suggest some weakness is creeping in. On 13th January, Jim Pickard and Scheherazade Daneshkhu, reported in the FT that the housing market had started to cool, even before the Bank of England's rate rise. On an annual basis, as measured by the Financial Times' House Price Index, house price inflation fell for the first time in 15 months. For the year to December, it rose by 6.8%, lower than the 7.4% recorded in November, the first fall in annual growth since October 2005.
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Can US stock market strength continue?
The US stock market, which in the end will influence the direction of markets almost everywhere, continues to be strong. The Dow Jones Industrial Average this week made another new all-time high. However, the momentum has slowed, broadly speaking, nothing has changed to encourage us to believe that 2007 will be a good year for stock markets. For the time being, risk is being ignored as optimism and liquidity run riot. Those who think that nothing can ever go wrong because everything seems to be all right, should remember that major setbacks always start from levels where optimism is at its greatest.
In the previous issue we commented upon the January barometer' "as goes January, so goes the rest of the year". So far, the Dow Jones Industrial Average is modestly higher, closing on Wednesday 24th January at 12621, this compares to the first trading day of the year when it opened at 12463.
Our Four Financial Horsemen of the Apocalypse are delivering mixed signals:
US stock market indicators: The Volatility Index
At the time of writing, both the horse and its rider are comatosed, the latest figure for this vitally important index is 9.89. One is forced to wonder just what needs to happen for fear to assert itself.
Andrew Smithers of Smithers & Co Limited dealt with this important issue, headlining his report "Credit Spreads, Stock Market Volatility and Outlook". His conclusions were as follows:
1. Corporate buying supports the stock market, and this is likely to continue so long as credit spreads remain tight.
2. It should therefore be helpful, for the purpose of market forecasting, if changes in credit spreads could be forecast.
3. It seems that the stock market volatility is a leading indicator of credit spreads. This reinforces our view that a sustained rise in stock market volatility would be a serious negative indicator for the market.
By sustained', he means a rise in volatility which extends for more than three months. However, the danger is that by the time three months of higher volatility has elapsed we would expect the stock market to have already fallen considerably.
In an earlier issue we reported that the Dow Jones Industrial Average is in record-breaking territory for the number of trading days since its last correction of 10% or more. That timeframe has now extended to 970 trading days. There have only been two longer periods in 1956 1020 days and in 1997 1723 days. The other eight occasions since 1929 have ranged from 617 days to 960 days. Of the ten declines that occurred, all but three were 20% or more.
US stock market indicators: the Philadelphia House Market Index
This Index of US house builders has recently performed well. From its 2005 high, it fell 33% but since its low of July last year it has reclaimed just over 50% of those losses. A declining stock market usually falls steeply, then recovers somewhat before falling again.
It would be most unlikely for the housing market problem in the US to have ended with just a whimper. House prices are driven by supply and demand and the supply, as measured by inventories remains very high. The real figure is even worse because cancellations are not added back. To get a handle on what that means, Toll Brothers reported cancellations of 37% of all contracts signed in the fourth quarter. It is common knowledge that house builders have endured massive cancellations of contracted sales.
New house prices do not take account of incentives. On this, the Miami based Lennar, the third biggest house builder, reported that in the fourth quarter 2006 incentives were four times those offered in the fourth quarter 2005, increasing from $10,500 per house to a massive $47,300 per house. Not surprisingly margins are down from 27% to 14.4%.
Don Tomnitz, CEO of DR Horton, recently said: "Nationally, the market is yet to hit bottom. Right now we don't see anything on the horizon that would change that picture."
US stock market indicators: Dow Theory
As can be seen by the chart, the Transports still fail to confirm the new high for the Industrials. Such non-confirmation is a significant and adverse signal for the market, suggesting extreme vulnerability.
American Fund Manager, John Hussman, recently explained that the American stock market is at present characterised by the following:
Over-valued: The S&P 500 sells at eighteen times earnings at a time of peak earnings.
Over-bought: The S&P 500 is at a four year high. A correction is long over due. (We have already covered that).
Over-bullish: According to Investors' Intelligence, the percentage of bullish advisers is very high.
A fourth element is that three month money treasury yields are higher than six months ago.
John Hussman has studied market history and found that when such a regime exists, it has always been very quickly followed by an abrupt and significant sell-off. Furthermore, almost in every case, and historically there have been eight, the market has been no higher several years later.
US stock market indicators: The Inverted Yield Curve
The yield curve remains inverted. Short-term interest rates are higher than long-term rates a condition that has persisted and which, in previous times, has been a reliable forecast of economic deterioration.
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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