Market Vulnerability Persists
Victor HugoSo the long awaited JSE pullback, setback, correction, softness, pause, breather, consolidation, sell-off or reversal is underway. The label you'll choose depends to a large extent on sentiment -- but also on good hard fundamental factors and the relativity of technical factors. How big and how long? Which label will it be, when we look back at year-end? Briefly, my research suggests more downside especially in the US and Europe in the next two months, which can be uncomfortably big, but perhaps some buying opportunities for JSE investors in South Africa around mid- year if basing action confirms. The dip can be big enough and the risks of long sideways work from lower, are enough not to just rely on a wait and hold and hope strategy.
To answer the question how big and how long the selling or stagnancy scenarios, JSE investors need to take a view on global trends, local factors, the Rand [therefore the US$], interest rates and individual sector prospects as well as on confidence factors- sometimes referred to somewhat disparagingly as "sentiment".
The answers decide your market investment strategy. Whatever the "value" arguers say, the bottom line for markets is the amount of confidence investors have in prospects. Value based on earnings expectations is just one of those prospects.
Global Factors: as forecast, markets have been selling lower. The key factors are whether global growth is in trouble or not - then also - what are the chances of recently negative sentiment developing into outright fear, the way it did in 1998 and in May 2002?
From May 2002 to May 2003, the JSE Alsi 40 fell 37.2% and took two years and 19 weeks to October 2004 to get back to May 2002's highs.
From April 1998 to September 1998 the JSE Alsi40 fell 44.2% and only reached April 1998's levels again in December 1999, one year and 35 weeks later.
The JSE could now be at the two-year cycle candidate for a big correction in a typical four-year bull that started in 2003.
What about the mother of all bears in last two centuries' history, which followed the crash of 1929 on Wall Street? The Dow Jones Industrial Index fell 89.5% for 34 months from October 1929 to July 1932, then took 22 years and four months to get back to 1929 highs -- and that does not measure the reduced buying power of the US$ during that time.
Of course we all rationalise and say to each other - it won't be likely to happen again. A favourite argument is we are much better at managing the global financial system now than then.
Confidence does not always respond to management attempts though. Look at some more examples: the rebuild of confidence despite best "management" efforts can take years, as the 20 year Dow Jones Industrial Index range between roughly 600 and 1000 between 1962 and 1982 showed. If you had owned shares in all the companies making up the index and in proportion to the index during that time, you would have experienced roughly 25% (or greater) drawdowns 6 times. A market timer's environment, not a buy-and-hold one.
There followed a 37% drawdown between December 1968 and May 1970. Or how about a 44% drawdown from December 1972 to December 1974? Only from August 1982 did a new long-term bull market start, finally delivering the goods with a massive increase of 1528% to January 2000 (11750) - although with a 41% setback along the way in 1987.
Interesting though, since January 2000, for five years -- again the Dow has done little: It has ranged between roughly 7500 and 11500, about a 38% range, but not done much. Along the way, the US$ has fallen in buying power relative to the Euro by some 64%. A nightmare for those who do not use momentum-investing methods and rely and "value."
At what point will Wall Street investors become resigned to the fact that a 1982 to 2000 type of bull run may not happen for some years again?
When that penny drops, investors will dump stocks and want to get into hard assets, with a ripple effect worldwide. I think that scenario is brewing. The Fed managers may even be forced to try to manage confidence with interest rate cuts again, despite the damage that will do to the US$ and inflation down the line. After all, interest rate cuts are almost all tool they have left, now that a 64% weaker US$ ("managed weaker") hasn't helped much in 5 years.
After six weeks of the Dow down and the US$ weak, the confidence managers even thought best to ask the President to come on CNBC on Tuesday morning to tell everyone that all is well with the US$ and growth and the markets. Whispers are that the US government are so worried, maybe the next rabbit Mr. Bush will pull out of the hat - and he is brave enough - is to announce that his government plans to introduce a low, flat tax (Russia did 13% with great success).
Replace all those intricate income, capital gains and estate taxes with a flat tax and a national sales tax. That would put all those highly trained yuppies and grey haired tax avoidance advisers to work more productively elsewhere. A move like that would indeed soften recession and adjustment pains - help growth -- and even assist Wall Street. Let's see.
Although the US still shows brave growth figures - Mr. Bush is not saying much about record US national, state and personal debt levels nor about the trade deficit. The whole growth applecart is financed on debt and trade deficits. The problem the US has is to juggle consumer spending and debt and confidence in the system. The most recent industrial revolution that fuelled the eighteen-year bull from 1982, information technology, is arguably in its mature years. Now there is a nation worrying about its national and personal retirement provisions and economic health. The US has to go through major adjustments.
The Dow falling 25% back to 2002 lows as a soft landing? Or the Dow falling 39.7% to a typical support area at 6160 relative to 1974 lows? Or how about a really hard fall of 52.6%, landing at 4840, where technicians know is a major support as well? I hear that "Oh no, falls like this won't happen this time…"
Why not? The US economy has pressure on every side - and what expands (1974 or 1982 to now), contracts. The world has got used to relative peace after years of the US carrying most of the cost. And economic fundamentals are increasingly vital when confidence turns.
Energy prices are also squeezing. Catching up to where it "should" be at $95. According to Adam Hamilton of www.zealllc.com, the middle of the 40-year range of CPIX adjusted oil prices would have the oil price at $95 today. Arguably still cheap at $55. He points out that oil is just above its First Gulf War spike, but still well below its high real levels from 1980 to 1985 or so. The increasing demand from Asia is another upward price pressure. The actual recoverable supply at current cost of extraction is also running out. Does that put recent oil price buoyancy in perspective?
Incidentally - have a look at Mr. Hamilton's illuminating remarks on the relationship between gold and oil. A $1600 gold price in two or four years?
The problem Asia has is that if the US consumer doesn't buy more and more of its goods, growth slows. And the problem the US has is Asia's goods are getting "gooder" and cheaper. The US is now predominantly a service economy. To its consternation, Asia is also starting to produce services "gooder" and cheaper. So what is the next engine of US growth going to be?
Transforming its energy and other consumption habits, reducing debt, making more new technology to enable more to work less, making more peacemaker weapons, hopefully producing more food and better health and education services, also beyond its borders. Doing more on the Moon and Mars. Hardly great growth stuff.
In the short term, adjustments from generational cycles (I call 1974 or 1982 to now -- a generational cycle) implies a bit of pain, lower earnings, more debt repayment, more focus on "hard assets" as investment habits change. It also implies the cost of change as the world realises that perhaps the best growth will come from developing areas and commodity producers, not the US.
Put it all together and a Wall Street moderate landing, falling 40% to near 1974 lows in the next couple of years, does not look so "off the Wall." Every bear market starts from still high Price Earnings Ratios as now - then moves to low P/Es over several years. By the time prices are down, no-one wants to look at a share, only at hard assets.
Hello more boom to come (after the next hiccup) in the 8- 12-year commodity cycle, of which we have arguably only had four years. As economist Chris Hart points out, if you adjust the CRB Reuters Commodity Index for CPIX, commodities are still cheap on a 30-year view. Good news for sunny South Africa, Russia, Australia, Canada.
However that does not mean that your favourite Rio Tinto, Billiton, Kumba, Anglo, Anglogold, Implats, Mittal, Sasol, Sappi are going to be immune from confidence issues along the way. Even the best get hurt in market worries - as previous 40% and 60% sell-offs in resources followed by charging bulls -- show.
It has been a very difficult time for JSE investors since 1998. Big swings up and down. Now the risk, I believe prospect -- of big swings again. We're in one as the last month has shown.
Or maybe some sideways non-performing years from here, or after a dip? Enough worries to make those who are sensible, rush to find "safe investments" or at least resilient ones that are less likely to leave you being persuaded to sell in a dip. Or how about making cash to buy the next base once new momentum confirms? See our comments on getting defensive in Turning Point newsletter #849 of 8th April.
Others are already convinced that safety is in hard assets such as property. Well, while South Africa stays in a decreasing interest rate environment, as I believe it is, the property bulls should be fine. As long as they are choosy what they buy, what they pay relative to rentals achievable -- and save up for when tough times come again. Don't take on too much debt - ready for the day when tenants don't pay regularly and interest rates or municipal rates and taxes again rocket and everyone is a seller.
The property bull in South Africa is making the JSE Property Loan Stock sector even take on some "defensive" sector attributes, like healthcare. A place to invest when worry or fear levels for other sectors rise. There are not many places the JSE investor can go for safety though.
The main risk is probably from local factors, such as politicians doing and saying things to discourage foreign investment, just the way the good old Nats did. I didn't like hearing about government wanting to regulate judges even more. The rest of the world and thinking South Africans know that every social and economic disaster in history, started with the government of the day interfering with the Rule of Law. This aspect is being watched closely.
Nor should Mr. Mbeki be telling "The Economist" (4th April) his government intends to accelerate the transfer of wealth from white to black. What happened to the ideal of a non-racist, democratic, free economy?
Back to safe havens. RSA Gilts - or Treasury bonds as they are called in some countries, could still be at attractive buying levels on a two-year view. Could it be that Mr. Bush and team have to again start cutting rates in the US this year to lessen recession impact? The RSA 157 13.5% 2015 Gilt and the US 30 Year Long Bond yield trend profiles say so. The Rand's resilience after a surprise rate cut says so. The weak US$ and Wall Street says so.
If the US even breathes it is putting its rate hike bias on hold, SA gilt yields with their still attractive return differentials, become even more attractive. And even though South Africans are happily consuming and buying from outside on credit, interest rate hikes on technical evidence may still be a year or two off if the resources boom continues as expected.
As nervousness in global markets increases, I guess the US$ will be the earliest indicator for breather or dump on world markets next.
23 April 2005
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Victor Hugo is an independent market strategist and asset manager. His information is published in South Africa and in global media. Janet Hugo is a Certified Financial Planner with specialist knowledge in life assurance, estate planning, retirement and long- term investing and offshore products. Please see www.HugoCapital.com/disclaimer for disclosures,disclaimer and indemnity applicable in respect of those reading or utilising our information, advice or recommendations or that of Intent Marketing (Pty) Ltd t/a Hugo Capital.com. Contact us at analysis@HugoCapital.com or at Tel +27-11-802-7282 Fax: +27-11-802-4586 P.O. Box 87282 Houghton 2041 SOUTH AFRICA.
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