A recurring theme of recent issues of this report has been that asset markets will remain extremely volatile. There is a tug-of-war between U.S. economic policy makers – notably, the Fed – who wish to support asset markets in order to stimulate consumption, and the private sector, which is tightening lending standards and bringing about slower credit growth and an economic downturn. The outcome of these opposing forces – both very powerful – will not be known for some time; hence the increased volatility.
In fact, I hesitate to make any forecast because I am faced with the following dilemma: Yes, as Ed Yardeni argues, we are in a recession; and yes, as Ian Scott of Lehman Brothers thinks, corporate profits could conceivably decline by as much as 45% if the United States were to slip into recession. But equally, as these economists and strategists argue, the stock market could move up despite poor economic growth and declining corporate profits. This scenario is particularly likely if the Fed pushes the Fed fund rate towards zero and if “extraordinary” monetary measures are implemented with increasing intensity – and also by non-U.S. central banks, which is now increasingly likely.
After all, anything is possible in a land of plenty (at least of dollars, deficits, and unfunded liabilities) in a country where one out of every 100 adults is behind bars (a total of 2.32 million); where the fear of its legal system is such that – according to a survey of 180 in-house counsel working in five European countries – lawyers working for European businesses would prefer to face a major dispute in Russia or China than in the U.S.; where stock car auto racing is the most popular spectator sport (the National Association for Stock Car Auto Racing holds 17 of the top 20 attended sporting events in the United States); where the movie 10,000 BC, described by critics as a “bombastic bore” and “sublimely dunderheaded”, opened in early March at No. 1 with box office earnings of US$35.7 million, ahead of College Road Trip with US$14 million (to be fair, it was also No. 1 in Mexico); and where almost three years into an economic recovery (June 2004), the Fed fund rate was still at 1%!
Yet, I have my doubts about forecasts of the S&P 500 going above 1600 by year end, and of the Dow Jones being at between 18,000 and 20,000 within a year (see above) because, in my opinion, the credit cycle has turned down for good – and when this happens, all asset prices and the economy tend to perform poorly. It would also be extremely surprising if the financial problems that we are now confronted with, which have been fermenting for at least 15 years, were to be solved almost overnight by Mr. Bernanke & Co.! Equally, it would be the first time in my experience that the stock market had made a major low with so many commentators assuring us that a “low” is in place. Not to mention above-average valuations!
Lastly, if money moves out of money market funds into riskier asset markets such as equities, it is likely that interest rates will increase and contain a sharp stock market advance. I therefore maintain my very negative stance towards long-term Treasury bonds.
While I concede that sentiment data is very negative for the near term and so, from a contrary point of view, is supportive of an intermediate low, investors seem to be very complacent and far too optimistic about future corporate profits. A recent Merrill Lynch Fund Manager Survey found that 53% of U.S. fund managers thought a recession in the next 12 months to be “unlikely”, up from 35% in February!
For now, I still think that a likely outcome is a “water torture” bear market α la 1973-1974, during which the downtrend was continuously interrupted by sharp countertrend rallies. A rally towards 1450 on the S&P is possible. In mid-March, commodities began to sell off sharply. This is an ominous sign, as it indicates either that the credit crisis is spilling over into asset classes other than equities or that global economic growth will disappoint, or a combination thereof. Last month, I suggested that some “preventive selling of industrial commodities, steel, and iron ore companies might be advisable”.
I would like to reiterate here that in an environment of relative tightening of monetary conditions, commodities (including oil and art prices) should also correct meaningfully. This doesn’t change my long-term favourable view about the performance of commodities relative to U.S. financial assets. Should oil prices decline, the prime beneficiaries will be airlines. AMR, Thai International, Singapore Airlines, and Lufthansa could be bought for a short-term trade.
The trend over the past few years has been a relative underperformance of U.S. assets versus foreign stock markets – especially emerging stock markets, a weak U.S. dollar, and strongly rising prices for precious metals and other commodities. This broad trend could change for the intermediate term (three to six months). As indicated in last month’s report, U.S. equities have begun to outperform the MSCI World Index and I expect this outperformance to last for a few months. This doesn’t necessarily imply that U.S. equities will rise, but should they decline further then it will probably be by less than we would expect to see in foreign markets.
Gold remains my favourite asset class, but I wouldn’t rule out a decline in prices to below US$800 before the next upward leg gets under way. As Ron Griess observes, the gold price has tended to bounce off the 300-day moving average – currently at US$741. The U.S. dollar may have reached a selling climax in mid-March and I expect a rally, which may have some legs as dollar shorts will be quick to cover their positions.
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