Sunday 9 May 2010

ACROPOLIS NOW











In my self-proclaimed role as Cassandra-in-Chief, I've been scanning the horizon these past several months waiting for an economic 'Ride of the Valkyries' - the famous helicopter attack scene from Apocalypse Now in which US helicopters swoop down from across the sea and let rip upon the Cambodian jungle with napalm and flamethrowers to the stirring strains of Wagner.


So with the dramatic collapse in US share prices on Thursday May 6th and wild moves in currencies across the world, with a wobbly new government forming in the UK, with Greece's problems leaking all over Europe and real uncertainty over the future of the European Union itself, what next?  Could it finally be time to cash in what few chips we have left, stock up on gold and beans and start digging? 




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Do not press this button

yet



Back in February, after taking a whiff of the economic excrement the so-called PIGS (Portugal, Ireland, Greece and Spain) were rolling in, I concluded we could be heading for the financial equivalent of the China Syndrome:



"...Put all these factors together and what you have is a dangerous cocktail of risks, opening up the renewed possibility of what markets fear most: contagion - that nuclear-like chain reaction of events which led us from a bunch of failed subprime mortgages all the way through to full-scale global economic meltdown.


"To sum them up:


  • Withdrawal of monetary stimulus leads to interest rate rises - or increased fear of interest rate rises


  • An inability to pay their debts or borrow in bond markets leads PIGS to the very edge of default, leads banks to take another huge loan hit and the UK to the door of the IMF


  • The US dollar surges and the carry trade unwinds, leading to a plunge in any asset prices and currencies bought in that trade


  • The Chinese government tightens stimulus taps for fear of inflation, triggering a collapse in Chinese property values, a halt in construction and a global commodity crash."


All these potential calamities are now in motion.  That is not to say contagion leading to a full-scale meltdown is inevitable - but the symptoms are no longer being discussed as dry theory in nerdy blogs, they are now bursting into worldwide public consciousness.



  • The threat - and in some places the reality - of interest rate rises is hovering over investors and beginning to make them more risk averse. 



A few countries with strong exports to resource-hungry China and Asia have seen a tigger-like rebound from the financial meltdown: Australia, in a typical show of economic virility, was one of the first to proudly tighten the screws; Canada has been heavily hinting at rate rises this summer and Brazil is already busy fighting its inflationary bushfires. 


But rising interest rates rarely translate into soaring stock prices.  While low-interest rate western markets were sailing upwards, our investor friends down under have been having a torrid time of it lately, Canadian investors have been wading through maple syrup in recent weeks and Brazil's market now resembles a rather nice pair of... Sugar Loaf mountains:








  • The PIGS are headed for slaughter.  In the abbatoir of the bond market, Greece has already had the stun gun applied and the others are now lining up behind.



Poor old Greece.  If you're wondering how they got themselves into such a mess, take a look at this sad, yet utterly hilarious, video. 







They are, quite literally, swimming in debt.


This tiny country, which represents a piddling fraction of world GDP and a footnote in the UK and US export market, has sent a massive shockwave through the financial system.  Why?  Well it's not because a few anarchists in balaclavas started carrying on up the Colossus. 


It's because investors are finally waking up to the fact that the crisis which started three years ago is not over: that it is instead moving into a new and potentially even more dangerous phase, a crisis of sovereign debt.




GREECE IS THE WORD


The fact is that a vast interconnected web of increasingly questionable government debts and liabilities - just like the subprime mortgage bonds which kicked off the credit crunch in 2007 - stretches throughout the financial system, reaching deep into the bank vaults of even the world's strongest economies.


Just like subprime, folks, they've all been eating each other's cheese




The bank rescues and stimulus programmes many governments patched together essentially transferred the risk of ruin from private financial institutions onto the supposedly stronger public balance sheet, at vast cost to taxpayers.  Slapped on top of the high levels of debt many governments already had, this put them in an increasingly dubious long term position.


So here's the set-up: if Greece refuses to take its medicine - or if it does and still can't pay its debts, which is more likely - the banks which hold that paper will be forced to start either writing the debt down, or have it restructured (stretching it out over many more years or taking a 'haircut' on the amount they're owed).  


The fear of that prospect - never mind the reality - is enough to start banks selling their holdings of other dodgy countries' sovereign bonds, an action which sends their interest rates higher:  Portugal (already happening), Spain (already happening), Italy, Ireland and yes, eventually even the UK




Few European banks would be spared the debilitating effects of this selling.  According to the Bank of International Settlements, there is half-a-trillion euros of PIGS debt sitting in German banks alone.




As Euro politicians grind through endless meetings, symptoms of major stress are breaking out.  On Thursday last week, Spanish ten year bonds soared to their highest spread (difference in yield) over the benchmark German equivalent since the peak of the credit crisis in 2008. 


As the price of these bonds tumbles (when traders sell off, interest rates rise and prices fall), some institutions will then, inevitably, become insolvent - in other words, they won't have enough capital to cover the losses they've sustained. This is of course what happened to Lehman Brothers.


The coup de grace is delivered when banks, terrified of not getting their money back from institutions which are potentially bust, stop lending to each other and freeze up the entire banking system.  Result: Meltdown 2.0.



Listen to the near-panic evident in the tone of Angel Gurria, Secretary General of the OECD in the first half of this interview last week:







Friends, unless some way is found to short-circuit this accelerating crisis we face the prospect of a rerun of 2008; only this time it is potentially far worse, because precious few governments - most of which are now severely weakened and drained dry of cash by previous bailouts - will have the resources to rescue their stricken banks.




Speaking of which...




HUNG


Into this fevered and clammy market environment stride (don't laugh) our political white knights.  While the great tragedy that is Gordon Brown rolls towards its inevitable denoument...





...new younger fresher-faced heroes step bravely forth.  Or should I say, recline languidly back..? 



Don't worry David, there's no hurry...



By ensuring a hung parliament the unfailingly brutal British voter made sure all the parties lost on Thursday.  And as the hours tick by and markets stew and fret, party leaders tip-toe around the constitutional niceties and the Queen has a lie-in on Friday morning; political greybeards urge caution and call on the parties to take as much time as they need, while a sudden oily discharge of pleasantness leaks from Labour and the Tories in the general direction of the Liberal Democrats. 


Yet, as smoke-filled rooms billow and puff, markets edge towards the abyss...










It's plain that, whatever the outcome of political negotiations this weekend, financial markets are highly unlikely to get the sense of clarity, certainty or direction they need. 


Monstrous public spending cuts and painful tax rises are required to sort out the deficit (just to remind you, our government is currently borrowing around £500million A DAY) and it seems inconceivable that the Liberals will be happy to get into that soiled bed with the Tories without swingeing concessions on electoral reform that David Cameron will find impossible to stomach. 






Also, if they've got any sense, the Liberals will have Bank of England Governor Mervyn King's recent comments ringing in their ears: that "whoever wins this election will have to take such unpopular measures they'll probably be locked out of power for a generation".


So it seems more than likely that something else will happen; and anything that is not a decisive government with a working majority and a serious fiscal plan of action will I'm afraid go down like a flying PIG in the markets. 


If Cameron cannot get his hardball plans through the House of Commons, an eventual British date with the IMF is an odds-on bet.








  • The US dollar is surging and the carry trade is already beginning to unwind


As I detailed back in February, the banks have made billions in profits over the past year using the falling dollar and low interest rates in the depressed West to buy high-yielding assets and currencies across the rest of the world, an olde investing technique called the 'carry trade'.  That little wheeze is now, to all intents and purposes, dead. 



Commodites v US dollar &
Emerging markets v US dollar



Because they've borrowed dollars to leverage their investments many times over, if the dollar suddenly shoots higher these traders have to sell the overseas assets they bought and change back into dollars, fast, in order not to get wiped out.  This mass repurchasing of dollars sends its value skyward, reinforcing the great unwind, leading to an upward spiral in the value of the dollar and a downwards spiral in foreign assets and currencies.   The process is plainly evident in both commodities and emerging market share prices as you can see in these charts.  It was heavily at work in the violent plunge of 2008 and, if the sovereign debt crisis accelerates, it can surely happen again.



  • China has begun to seriously tighten the screws on lending, while an increasing number of shrewd analysts and investors believe their property bubble is doomed to burst



Friends, its time to get ready for the great pall of China.  Prepare for the mother of all property busts, a collapse which will bring down commodity prices across the world and plunge many countries back into recession.   


Think I'm exaggerating?  Never mind London and New York: if you want to know what a real property bubble looks like, folks, check this:




         To skip the preamble start around 1 minute in


A huge waterfall of stimulus funding from Beijing central planning has deluged local authorities in China, a bounty they are compelled to spend in order to meet growth targets.  This has created over-building in residential and commercial real estate on a scale never before seen in human history.  Jim Chanos, famed Wall St hedge fund manager who made his name and fortune predicting the demise of Enron, explained why he's made a huge sell-side bet on China in this recent Bloomberg interview.


He's not alone.  Andy Xie, highly-respected former chief economist at Morgan Stanley, who has warned of previous bubbles and busts from the Asian currency crisis of 1997 through the dot-com bust to the last US property bubble, is certain a calamity in Chinese property is coming even if not quite yet.  Legendary trader George Soros, our nemesis on Black Wednesday 1992, is of a similar opinion.  Individually, these guys are very rarely wrong on such a major call.  If you are invested in China, Asia, or in commodities, you cannot afford to believe all three are wrong today. 




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ACROPOLIS NOW!


I've never been a natural doom-monger.  I am not by nature a gloomy bunny.  I don't get paid a penny for my views so have no need to pander to any bearish followers, and I've carefully avoided issuing blood-curdling cries of doom on too regular a basis, as so many bearish stopped-clocks in this space are wont to do.


In fact from 2002 until two years ago I was publicly, unbearably, full-bloodedly, unapologetically BULLISH.


But I turned to the dark side in early 2008 because it finally became clear to me that the party was over.  Not just for a year, or for two years, but for the foreseeable future.




I've described in previous posts the underlying theory which got me in to stocks in 2002 and out in time to avoid the carnage of 2008.  And it seems to me that avoiding an eventual repeat of that carnage in 2010 or 2011 may, all things considered, simply not be possible.


The debts built up in our government, corporate and household bank accounts over so many years have not been remotely dealt with, but merely shoved under multitudinous corporate and government carpets and sustained by generationally low interest rates.  The debt will not magically go away.  Without unnaturally strong growth these debts will overwhelm our ability to pay in a relatively short period of time.  Along with many esteemed economists and economic historians of far greater brain than mine, I am highly, highly dubious that this level of growth can be achieved. 


Theoretically it is possible to 'inflate' away some of our debts, but blatant government attempts have so far failed miserably; central banks are pumping stupendous amounts of money into the system yet inflation in the developed world (except in stock and commodity prices) is virtually non-existent.  Demand in the economy is extremely weak.  Wages are flat and show no signs of life.  Where is this inflation going to come from?






Modern historians among you will remember that what triggered the final calamitous slide into the Great Depression was not an American institution but a European one.  Austrian bank Credit-Anstalt was Europe's first investment bank and went bust in May 1931, crippling banks around the world in a massive chain reaction.


This kind of event is what may ultimately lead our little European sovereign debt crisis directly to the door of the United States.  It would quickly force a re-evaluation by Americans of their own debt problems, currently swept under a particularly heavy shag-pile.  But truth will out...

 



The true extent of the long term US debt problem is made plain in this investigative TV report



Meanwhile the hideous virus of financial contagion is, as I write, busy worming its way through the guts of the system - banks, bond markets, stock markets, governments and, ultimately, into the minds of the ever more cautious consumers and business leaders who have the power to choke off recovery in the 'real' economy beyond the markets.


Yes, this time really is different.  The 10% market plunge on May 6th was a stark warning to complacent investors, to those who think recovery is certain and that we're heading back to business as usual, that well-founded fears lie just under the surface of this stock market advance.  If these fears are confirmed by real-world events, the fall out for anyone with money at stake is potentially devastating.  As ever, count on me to keep a steady lookout as together we attempt to navigate these seas...




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Join me once again - if you dare! - on Sunday June 6th for another slap with the reality glove, and check out this month's Outlook for some of the implications of all this on your investments. 


Because if there is going to be a meltdown, folks, you might as well make it pay.



Have a great month!









MAY 2010 Investment Outlook






This month's theme, all things considered, is the implication for investors of the developing sovereign debt crisis.  In this context, the central London property bounce-back is looking increasingly absurd, and there are numerous opportunities and warning signs in other departments which are worth getting familiar with as dark clouds gather.  So let's take a look.

 


PROPERTY





  • Meanwhile in the real world, mortgage lending virtually stopped dead in the run-up to the election amidst renewed predictions of a moribund market in 2010




  • ...As data shows that UK house prices remain, in relation to average income, historically unaffordable:



Prices are still 50% above long-run average affordability




Friends, the conclusion is inescapable: over time either average wages must rise to meet house prices or prices must fall to meet wages.  In this environment, which do you think is most likely?




  • Furthermore, Yale professor Robert Shiller called the top in housing four years ago and, amidst calls from others that the bottom is already in, he sounds a note of caution:





 





  • So-called 'strategic defaults' - in which US mortgage-holders simply refuse to make their payments - are spreading and now make up at least 12% of foreclosures according to a Morgan Stanley report, though some experts believe the true figure is closer to 30%




COMMODITIES




  • Commodities feel the heat as the dollar rockets


Copper

Oil


Silver




  • Yet last week for the first time gold (and silver) pushed substantially higher despite a rising dollar on sovereign debt fears, indicating it may ultimately succeed as a safe-haven play; in large part this seems to be European investors dumping the Euro and charging into gold, as evidenced by the substantially higher price of gold in Euros compared to Dollars



  • China's stock market breaks DOWN from the formation I highlighted in last month's Outlook - not a good long-term sign for commodities or other countries dependent on Chinese growth - 






Like ours, the Shanghai stock market is a leading indicator for its own economy and has, logically enough, been an increasingly reliable leading indicator for Western markets since the crisis began



Shanghai's Index (in red) consistently leads our own




STOCKS



ONE TO TWO MONTHS***

My red-light call in last month's Outlook for a correction has indeed materialized, with the US S&P500 index dropping 9% to date and the FTSE100 shedding almost 12%.  A sickening plunge on Thursday 6th May was technically the result of a fat-fingered trading error which sparked a wave of panic selling.  However, neither the knowledge of that mistake nor an excellent jobs report in the US on Friday could spark a bounce-back.  For that reason we should be careful about rushing to buy here, as well as being careful not to assume a crash is underway and going heavily short.


At moments of high uncertainty like this I like to open up the history books and see whether anything similar has happened before.  Almost always, of course, it has.  My favourite technical boffin, Jason Geopfert at SentimenTrader, looked back at 9 similar-sized sudden plunges in the US indices over the past 50 years and the results are consistent and instructive.


Here are two examples of what tends to happen.  































The pattern goes as follows:
  1. The market takes a few days to establish an initial low.
  2. A rally begins lasting a week to a month, retracing some or occasionally all of the losses sustained on the crash day itself
  3. Prices turn and re-test the lows set during the crash 
  4. Stocks survive the re-test and a sustainable rally begins


In all nine previous instances, the panic low of the first few days held or was only breached temporarily, before a new up-leg began.  I see no reason for this to play out differently unless contagion in Europe accelerates.  (See this month's OntheMoney post for details).


If you are still holding stocks at this point I see no imminent need to sell, but any deviation from the above script will set alarm bells ringing.  I will of course post an immediate update if that occurs. 


However, assuming the situation in Europe stabilizes (if only temporarily), the yellow caution light above as of May 9th will turn green once a successful re-test of the current lows has taken place and it will be time to BUY. ***




***UPDATE SUNDAY MAY 23RD



I believe a short-to-medium term low was likely printed on Friday May 21st.  Over the next week or so, after a strong initial bounce, there is a chance we'll see a partial re-test and stocks may fall back to near or slightly below the Friday low.  From that point on I expect to see a multi-week bounce to somewhere approaching the highs set in early April, 10% or so above here.


This is therefore - for short-to-medium term investors only - a great opportunity to BUY.







THREE TO TWELVE MONTHS


For the first time since last Autumn, the medium term outlook is looking doubtful.  In other words, once we have taken advantage of any short-term bounce as markets - hopefully - recover from the current correction, downside risk may soon become more compelling than upside potential.

Investors have now woken up to the dangers of the sovereign debt crisis in Europe.  American commentators are beginning to discuss publicly whether their own debts are sustainable (they aren't) and if they could suffer a similar collapse in confidence (they could).  For now, these worries seem a long way off.  But as we saw in the summer of 2007, they have a way of creeping up and biting off your financial backside if you're not careful.






Again, as I've been saying throughout, using strong rallies as an opportunity to take money gradually off the table and go to cash will continue to be a very sensible strategy.  A return to the recent high on the S&P500 at 1200 - 1220, or on the FTSE100 at just over 5800 will now present another, potentially final, bite of that cherry. 



ONE TO THREE YEARS


If the sovereign debt contagion plays out to its ultimate conclusion and engulfs the United States, and if China's property bubble bursts (which would follow from a serious breakdown in the West), we are looking at a scenario which is truly terrifying.  However, even a turn of events which stops well short of Armaggeddon will present heavy headwinds to stocks over the next few years and other investments - chiefly cash and bonds - will almost certainly outperform.




SAVINGS


  • The outlook for savings rates is becoming more uncertain, as UK gilt yields upon which they depend are buffetted from both headwinds and tailwinds in the sovereign debt crisis

  • Locking in a fixed-rate now may be unwise, as any political deadlock in the UK could see further selling in the gilt market, forcing savings rates higher

  • Any major crisis in the UK bond markets which leads to a spike in yields of the kind seen in the PIGS should be seen as a generational opportunity to lock in savings rates LONG TERM 



BONDS


  • The corporate bond market sold off strongly last week amidst unambiguous signs of waning momentum; lower prices in the medium term look very likely indeed






  • Last week, US 10-year treasury yields fell precipitously as traders rushed to safety in US bonds, breaking the neckline on the bullish 'reverse head and shoulders' pattern I highlighted last month; unless they stabilize here and resume their previous rally, that pattern will be negated and a possible new downtrend will have to be evaluated, something which would have major implications for all our investments...









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That's it for this month.  There may well be more chaos to come, and I'll post an interim update if it seems a potential market calamity is lining up.  But wipeouts permitting, I'll be back in the saddle for another round with the ol' bucking bronco on Sunday June 6th.



Have a great month!









Thursday 6 May 2010

Special Update - May 6th 2010





Click to enlarge




Mid-afternoon Eastern time the US stock market plunged dramatically and with little warning, before recovering a good portion of its losses into the close.  The Dow Jones index lost almost 1000 points - nearly 10% of its value - before a substantial bounce took place in the final hour of trading.  The Dow ended down 3.3%.


News reports are suggesting that this is not a genuinely broad-based sell-off, but is the result of a single fat-fingered trader at Citigroup accidentally putting an extra '0' on the end of one of his trades.  Hmmm.  This, it's said, began something of a chain reaction among the other large institutional trading desks, which have computerized systems making automated buys and sells - and it appears they all screamed sell at exactly the same time.  


Investigations continue as I write this, but I would tread very carefully over the next few days.  There is huge event-risk in terms of news coming out of the US and Europe which will very likely whip the markets up and down and make any knee-jerk decisions - buy or sell - instantly look extremely foolish. 


Events in Greece, the EU, the bond markets, the UK election (exit polls suggest a hung parliament at time of writing), China... all these are working to undermine confidence and create uncertainty, yet traders now believe that this sell-off might have been 'an accident' and, with prices now substantially lower, there is eagerly-awaited US economic news on Friday that could spark a big bounceback.


I'll be watching events carefully and will issue another post immediately if conditions deteriorate into genuine crash territory.


Otherwise, I'll return late Sunday 9th, with an update on the latest dramas, in my scheduled post.


PS.  If you want to know what a real market crash sounds like in the mayhem of the futures exchanges listen to this: it's one of the guys taking orders in the pits as panic strikes.