Sunday, 9 May 2010

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.



  • 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 feel the heat as the dollar rockets




  • 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



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. ***


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.


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. 


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.


  • 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 


  • 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...


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!