Why the stock market upside won't last

The Dow Jones may have hit an all-time high in the last week, but the indicators that really matter depict a grimmer outlook for the markets. What warning signs should you look out for? And how can you prepare for a downturn?

A momentous week given that the Dow Jones Industrial Average has made a new all-time high - a matter of considerable significance but which seems to fly in the face of what we consider to be pretty hard-nosed commonsense. Whether or not the other US stock market averages and the world's major markets in general, including FTSE 100, will follow the Dow higher remains to be seen. For the time being at least, we are not persuaded that the big picture has materially changed just because this particular stock market average, comprising only thirty large-cap US stocks, seems to be sending out a different message.

What the the other indices and indicators telling us?

The S&P 500, which is far more appropriate as a measurement of the US economy, is still 11% below its all-time high and the NASDAQ Composite Index is potentially many years away from regaining its dizzy 2000 high of 5132 from its current low level of 2291.

Nonetheless, it would be wrong to disregard what has happened and who knows, it may even be possible no matter how unlikely that the American economy could enjoy a soft landing of its housing market, following which everything could move safely ahead.

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A few issues ago, we identified four key indicators, that we dubbed "The Four Horsemen of the Apocalypse". In our opinion they are overwhelmingly pertinent to future stock market conditions. Each fortnight we intend to comment upon these - any significant change in one that is, in due course, confirmed by the others, will tell us all we need to know.

Stock market volatility

The white horse false peace The Volatility Index (VIX) is a measurement of fear in the market, it has settled back near its lows and is telling us that there is at present, no fear - complacency is rife. Stock markets in general will remain secure whilst this indicator remains subdued. There is no doubt that fear will re-enter this market, the important question however, is when?' We would guess that will probably be when the market suddenly realises that the US house market is not going to enjoy a soft landing but instead suffer a hard landing. We have published the updated VIX chart, the level of 24 is key, above that watch out!

The US housing market

The red horse war and destruction The Philadelphia House Market Index. In spite of American stock markets' recent strong performance, this index of US house builders has, over recent weeks, just held the line. Of our Four Horsemen, this surely is the leader. In due course, we expect it to cut loose from its period of grazing and like any horse once startled, suddenly and destructively gallop off scaring the other three and dragging them along with it. The Fed Chairman, Ben Bernanke, is well aware of the danger and recently said "A substantial correction is underway in the US house market but it has not so far had a big effect on the rest of the economy."

American house prices are definitely falling, the median house price sold is 1.7% below the price of a year ago, the fastest fall since November 1990 and the second biggest fall in this survey's 38 year history. Right at the sharp end, house builder Lennar have reported a sharp drop in margins and admitted that the slowdown in the market was faster and deeper than the company had expected. Whiskey and Gunpowder's website published a newspaper advertisement (depicted on the front page) recently run by D R Horton.

To conclude on the US housing situation, we would quote the recent remarks of the highly regarded David Gartmann, who last week wrote "Specs (speculators) who bought two and three and four houses in order to flip them and turn a hopeful profit, now find themselves unable to even rent their holdings and face bankruptcy. Rest very much assured, we shall be reading of bankruptcies amongst builders, building suppliers, real estate agents and specs in the course of the next several months. To think otherwise is naive."

Dow Theory and the Yield Curve

The black horse famine and unfair trade Dow Theory. The concept is quite simple, if both industrial and transportation sides of the US stock markets are not behaving similarly, then something is seriously wrong and that can't continue. The Dow Jones Industrial Average has just made a new all-time high, the Transportation Average is well below its high, a protracted period of non-confirmation exists which is a very bad sign.

The pale horse sickness and death The Inverted Yield Curve. Both in the US and the UK, short-term interest rates are higher than long-term yields, a situation that cannot persist if the economy is to continue to grow. Ask yourself this simple question, if you were making a loan where the interest rate was set every 15-years or making a loan where the interest rate was set every 3-months, is it likely that you would accept a lower rate in respect of the former? Yet that is the situation that exists right now. In the US, the 30-year yield is 4.72%, the Fed's fund rate is lower at 5.25%. In the UK, the 15-year yield is 4.39% whilst base rate is lower at 4.75%.

How this affects our investment strategy

Our strongly held view is that the upside for major stock markets is very limited unless a dramatic change takes place in respect of our four indicators. Three of them are flashing danger and the fourth, the VIX is not, but that could change overnight. Should it happen, the reversal of sentiment, as fear takes over, could be quite dramatic.

Portfolios' current investments in bear funds, if they are to prosper, need the FTSE 100 to fall. So far, the price of this investment is holding up okay but should the FTSE 100 follow the Dow Jones Industrial Average and make a new high for the year above 6137, we would consider our stop loss had been hit and those positions would be closed.

If our bear fund stop loss is hit and strength continues to accrue in the American stock market, then we will, without question, be looking very closely at the Japanese stock market, the Chinese stock market, the Indian stock market and possibly other Asian markets with a view to taking new positions.

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/