Markets never do what you expect. Or rarely anyway. Just ask strategist and author Russell Napier. In 2005 he wrote the book Anatomy of the Bear: Lesson’s from Wall Street’s Four Great Bottoms.
In the updated edition of 2009, he predicted a market rally in the US stock market after the 2008 crash. He got that part right. But by 2014, he expected the S&P 500 index to fall to around 400. This would complete the big bear market cycle of 2000-2014. However, the S&P 500 is still around 1,750. He’s got 11 months left to achieve his target. Will the bear come into the gun sight this year?
Perhaps you’re wondering why Napier expected a big bear market bottom in 2014 or before. It’s because last century’s major bear markets took about 14 years for equities on average to go from overvaluation to undervaluation.
The biggest peak of all time for US stocks was in 2000. That’s when Napier dates the beginning of this secular bear market. That includes the two large rallies of 2003-2007 and 2009 until today. But Napier says the bear market will not be over until US equities trade at a 70% discount to the replacement value of their assets. 2008, believe it or not, didn’t drive shares down far enough.
Right now, US stocks are only down about 5-7% from their all-time highs. This is hardly the stuff of epic bear market bottoms. But US stocks did get the shakes early this week. We don’t know if 2014 will join the four major bottoms of 1921, 1932, 1949 and 1982. We doubt it. But we mention his book today because recent news coincides with one aspect of Napier’s research. And that involves watching the US bond market for the signal that will bring down the price of US equities.
The shadow of the bear has been hanging over US Treasuries for a long time now. But the 33 year bull market has chugged on and on without a major decline. In his book, however, Napier looks at the structural headwinds for US Treasures…headwinds that are years, not quarters, in the making.
What are they? Rising consumption in China and other emerging markets, and increasing retirement in the US. Here’s Napier writing in 2009 on the first headwind:
‘While it will take some time to engineer the solution, a move away from export-orientated growth to domestic-consumption-driven growth has been instigated. As this form of growth becomes more dominant, the need to depress exchange rates by buying dollars and US Treasuries will come to an end. This withdrawal of foreign support will be the catalyst for a significant hike in the US Treasuries yield which, after little initial impact, will bring down the price of US equities.’
Now, of course, we have some of the emerging markets in trouble. We say some because the common thread between the crumbling currencies of Turkey, Brazil, India, South Africa and Indonesia (the ‘fragile five’) is that they all run current account deficits. That means they rely on foreign money.
Emerging markets took full advantage of the cheap money flooding the world since 2008. In this week’s Scoops Lane (our subscriber-only publication) Greg Canavan highlighted the ballooning emerging market debt situation (private as well as government). This stood at US$9.1 trillion at the end of 2012, up from US$4.9 trillion in 2008 – an 85% increase in around four years.
As some of that money heads for the exit, the central banks of the fragile five have had to step in and sell their foreign reserves, which are mostly US Treasuries, to defend their own currencies. That puts pressure on US bonds, pushing yields (the interest rate) higher.
Notably absent from the fragile five are the traditional big buyers of US Treasuries, China and Japan. They’ve been able to fill the breach so far as buyers of US debt, effectively funding US government deficits. But how long will this continue?
According to the latest data from the US Treasury, in the year to November 2013, foreign central banks bought just US$11.7 billion in US Treasuries, compared to nearly US$200 billion the year before. Is this Napier’s structural headwind at work?
We don’t know. But a recent paper by the Bank of International Settlements suggests ‘the long period of declining interest rates at the global level is over.‘ Higher interest rates will result in slower economic growth in emerging markets. It’s also bound to pinch company earnings for the US multinationals.
That brings us back to Russell Napier: ‘The long bear market in US equities is unlikely to be truly over until we have a bear market in US Treasuries. So investors have to be beware. The initial rise in Treasury yields will be greeted as a sign of "normalisation" in the US as it was from 2003-07. However, as yields return to 2007 levels and the structural deterioration of the market continues, a terrible realisation will dawn.‘
US stocks haven’t had a 10% drop in more than two and half years. But the bear might not be too far away. Will it be as big as Napier predicts? Who knows. But the bigger it is, the better the eventual buying opportunities. The key is not to ride the bear down. That’s one reason my colleague Greg Canavan over at Sound Money. Sound Investments. is mostly on the sidelines in cash for now, save for two Aussie stocks which he believes offer great value thanks to the decline in the resources market.
Do commodities have anything to tell us about US shares? Russell Napier says they do, actually. We’ll tell you why next week.
for Markets and Money