Inflation-adjusted market returns not so rosy as bear trend continues.
This is the second of a multi-part series from Matt Stiles. Catch up with part I, A look back, published yesterday, before diving in to today’s article.
It is a rare treat when commentators take the effort to go through past picks and predictions to see what they got right – or wrong – and then let their readers know. The courage to own up to mistakes and celebrate wins is the hallmark of a trustworthy market watcher.
Please enjoy part II of Matt Stiles’ analysis below, “World equity markets,” and stay tuned for more in the coming days.
World equity markets
Since my writing last December, most economies and equity markets alike have taken a turn for the worse. As expected, the continued credit tightening by lenders, asset depreciation, and a more frugal consumer have resulted in lower profits for major corporations. Consumer confidence readings are in territories not seen in decades, as are wage growth expectations. Combine this with spiraling higher prices for food and energy and it boggles my mind how there are still economists out there claiming the economy is “robust.”
I used Ben Stein as my whipping boy in December when he claimed the total fallout from the credit crisis would not exceed $280 billion. That number has already been long surpassed. But Stein has now in effect doubled down on his bet with this latest excerpt from a debate with economist Paul Krugman on CNN, where Stein stated, “I think it is largely a media mirage that is depressing people and making them feel terrible.”
It is scum like Stein that has promoted the latter stages of this credit bubble, so it's no wonder he's trying to cover his behind. He better hope he has some good lawyers.
Regardless of what so called “economists” are saying, the U.S., the U.K., Canada, Spain, Italy, and a growing number of other Western states are in a recession that is deepening by the day. The economic numbers used to officially declare a recession in most countries are both falsified and laggy. The issue of inflation in determining these numbers is a hotly contested one and I'll touch on that later. But as can be seen by equity markets worldwide, the only ones believing the numbers are the bureaucrats making them up. From a technical perspective, the markets don't believe them either. Let's take a look:
North American markets
In part five of my year-end writing, I outlined my reasons for being bearish on equity markets with the S&P sitting at 1497. Six months later we are 15% lower and I remain cautiously bearish.
I believe there is a very good probability of the S&P reaching a downside target of 1075 before the end of the year. If that were to happen, it would likely occur in the next few months (a function of seasonality) and would be driven by panic or forced liquidation selling. This is not a prediction; it is a mere statement of probability based upon the technical, fundamental and psychological inputs I take in on a daily basis.
Just as likely is a phase of muddle-through. As presidential races heat up and promises of stimulus are given out by both Obama and McCain, Who knows what the reaction to this could be?
But this is very short-term thinking. Let's expand our horizons a little. I have long questioned the validity of the entire bull market from 2002-2007 on the basis of dollar devaluation. Productivity gains made through technology and globalization through the ‘80s and ‘90s are undeniable. That was a bona fide bull market based on our standards of living increasing through greater economic efficiencies.
The last five years of economic “growth,” however, are due to gains in financial innovation and its ramifications. Unnaturally low costs of credit kick-started a spending spree by consumers that is now known as the housing bubble, but is really just a blow-off of the credit bubble started in the early 70s when Nixon booted the gold standard. Nixon was lucky, in that the aforementioned advances staved off a near hyperinflationary meltdown in ‘79-‘81. The natural deflationary forces of greater efficiency postponed the problems for two decades. But they again began to manifest themselves in the form of a lower rate of exchange. Here is what the U.S. markets look like for a European investor over the last two decades:
This chart looks similar when the S&P is compared with almost any other major currency (other than Yen). What it says to me is that much of the gains from the 2002 lows have been dollar devaluation driven. And this has the fingerprints of “easy” Al Greenspan all over it. So this latest bull market may be a mirage, and is simply a correction of a far longer bear market that started in mid-2000. If so, it is not unreasonable to assume that this time we will surpass the 2002 lows. Just for fun (yes, this is my idea of fun), let's review the entire last 100 years of Dow performance:
1903-1929 – 1200% gain – 26 years
1929-1942 – 70% decline – 14 years (adjust for increased purchasing power, closer to 50%)
1942-1966 – 1100% gain – 24 years
1966-1982 – flat prices – 16 years (adjust for decreased purchasing power, closer to a loss of 50%)
1982-2000 – 1700% gain – 19 years
2000-2015? - Wanna argue for higher prices?
This is, of course, quite a small data sample. Anything is possible. But it is again consistent with generational cyclicality. The Baby Boomer generation who have been the main investment drivers for the last 30 years are retiring and withdrawing their assets from the housing and equity markets to pay for their retirement. The pieces fit together like a giant jigsaw puzzle.
Plenty of discussion is centered around the Canadian small-cap index, the TSX Venture Exchange. And the chart of that index over the last few years shows fantastic growth, but has come to a sort of crossroads. I use the index as a proxy for commodity-related sentiment. Right now that sentiment is extremely negative in relation to the price of commodities.
I'll talk more about commodities and what that means for the Canadian indices more later. First, let's look at some important international markets.
Foreign markets
In December I wrote in Themes for 2008, part five:
“The Chinese stock market continues to defy gravity but is another one of those things that can’t go on forever. The same can be said about the Korean Kospi, Brazilian Bovespa, Indian Sensex and other emerging stock markets. A consumer slowdown in the U.S. and rising input costs means these economies will need to re-tool their manufacturing base to maintain the same levels of profit growth. A synonym for re-tooling the economy is “recession,” and emerging markets aren’t any more immune to the business cycle than we are. This doesn’t mean they go back to living in mud huts. It means capital is redeployed to more efficient uses. This sudden realization of mortality will mean big declines at some point. I think that day will come in 2008.”
That day did come, and the onslaught is continuing. Shanghai stocks were down 56% at their lows; in Seoul investors had lost 27% from the highs; Indian markets are tanking with Bombay shares down 36%. Brazilian markets are relatively unchanged year-to-date, although they are off nearly 12% in the month of June. The same can be said about Russian markets, which are up 6400% from their lows during the Ruble crisis of '98. Too bad we couldn't have been in on that one, eh? (Now we know why Moscow is the most expensive city to live in the world.)
Again, the point of this is not self-congratulatory. If I made huge bets on this happening, I'd have better things to do than write to you! As a rule, I don't bet against parabolic price structures. Valuations of these markets were absurd two years ago, and that didn't stop them. Put it this way: If I were to drink 12 beers in the next few hours I'd be sloppy drunk, would pass out and have a hangover the next day. So what if I were to drink 24? It might take me longer, but the end result is basically the same. [Editor’s note: Lightweight.]
That these fantastic bull markets would end so terribly was no surprise to many, other than those directly involved who thought they had found nirvana. Now consider that this has all occurred while official GDP estimates have not yet slowed. They will. No country grows at 12% y/y without eventually encountering a recession. But that doesn't stop market pundits worldwide from hailing China as the next global superpower by 2020. It didn't stop them from giving Japan the same label in the 80s (Japan was supposed to overtake the U.S. by the turn of the century). And it probably won't stop them from doing it again in another decade.
Don't get me wrong. I fully believe that the rest of the world is trying to catch up to a Western standard of living, and that over centuries, it will. But extrapolating recent trends over the distant future is the dumbest game going.
So if the BRIC countries can't grow at over 10% per year indefinitely, what does that mean for commodity markets that are rising because of the enormous demand from these countries?
That is the single biggest question on my mind. I'll hash out the possibilities in the next installment.
