Month: April 2013

INTRODUCTION

Wattyl was a paint and coatings company that was taken over sometime in recent memory. One of their products was ‘Estapol’ which was a coating product for timber flooring. Correct surface preparation and then application of the product was important for optimum results. Consequently, the lid of the tin said "When all else fails read the instructions."

Ecinya is ever-mindful of the necessity of not losing touch with the basics and through a combination of our investment rules under the ‘Market Wisdom’ tab, The Ecinya Market Barometer’, our Insight articles and performance evaluation of our two modest portfolios we attempt to ‘practice what we preach’. However, over the years, despite a more than adequate performance in our own activities, our expressed views on the future, and our Ecinya Recommendations derived from our own modelling, we still manage to make mistakes. Our experience is that we have called bottoms well, and tops not as well. Tops can often be driven to a level that constitutes ‘irrational exuberance’.

Analysis, review and introspection more often than not leads us to the conclusion that timing is where most of us get it wrong. Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria. Bull markets are driven by liquidity, and falling interest rates can be trusted to begin a new bull market. However, the current bull market looks and feels artificial as it has been fueled by ‘money printing’ around the globe and over-exuberant debt fueled government spending, particularly in the healthcare and social services sectors.

Earnings momentum in the context of economic growth is not in evidence.The economic growth that has occurred has been muted and company earnings driven more by currency devaluations and corporate cost cutting. When markets are elevated we tend to look for fundamental reasons as to why they should fall and when markets are down we believe that cyclical factors operate for them to rise from the ashes. Very often early signals at both the top and the bottom are recognisable using quantitative and technical analysis plus anecdotal evidence from business associates. Technical analysis in our view has limited forecasting attributes, but can assist to identify potential turning points and support levels. Technical observations seem to indicate that markets trends are testing upper trend limits. Our market quant model uses algorithms derived from All Ordinaries and SP500 data and the current 103 day upwave appears to be coming to an end. Refer Ecinya Market Barometer.

 

MACRO CONCERNS

Our major concerns were outlined as part of our Strategy Essay of 25 January and our ‘Delightful and daring dance with Sir Percy’ Insight essay on 8 March and were –

1. Australian fiscal management during and since the GFC – the chickens are coming home to roost and unemployment, slow growth and higher taxes are on the horizon in a massive landscape of poor policy development and execution. Mid term we remain bullish on hard and soft commodities. Australia needs a Federal election as soon as possible.

2. Europe needs to address creeping imbalances all over the place.

3. China may have a massive credit and property bubble which has not yet popped.

4. The normal menu of global unrest has a new entree in that China and Japan are in dispute in and around the China seas.

5. Dr Ben Bernanke is treating a disabled patient with massive doses of monetary stimulus when the real medical disorder is fiscal profligacy and waste. This is our major major concern as fiscal and monetary policy are natural dance partners.

 

Commentary on the above –

1. The Hawke-Keating and the Howard-Costello governments were very good over about 80-90% of their respective terms in office with both of them being fairly described as ‘centrist’ governments with well above average communications skills. Re-election pressures towards the end of extended terms of government caused each of them to embrace policy that pandered to perceptions of ‘appeasing the base’. The Rudd-Gillard-Greens government has been a sad indictment of misallocation of scarce resources.Cash hand-outs were squandered on imported flat screen televisions and overseas holidays, flimsy climate change policy, broadband without cost-benefit analysis, and education building revolutions have been dismal failures. Realisation of these failures ushered in the carbon tax and a mining resources tax just as a cyclical peak was occurring in the global economy. The result in our view will mean that an incoming government will inherit an extremely poor fiscal position, worse than will be disclosed by the departing government in the forthcoming May budget update.

 

2. Europe still messy with France and Germany soon likely to add to growing uncertainties.

 

3.. China is attempting to rein in its growth trajectory and aiming for a ‘soft landing’. ‘Soft landings’ are difficult to achieve, but with real GDP growth around 7% and large current account surpluses such a landing seems reasonably plausible.

 

4. Add in the North Korean situation and things look volatile. Given America’s traditional allies are South Korea and Japan, history suggests that America will support its allies and that patience is wearing thin with North Korea.

 

5. Fiscal and monetary policy has become wrapped in the summer and winter coat of politics. Unfortunately all around the world winter is in evidence. In a host of countries including Great Britain, Ireland, Iceland, Italy, Spain, Greece, Cyprus, the USA, political springs and summers seem far away. It appears that economic uncertainty in France and Germany is on the horizon. Apart from Australia’s Reserve Bank which acts independently other major central bankers have decided to become a submissive arm of government rather than fulfilling their normal ‘check and balance’ role. The quotes below highlight this –

However, the task of putting private and public finances on sustainable paths in several major countries is far from complete. Accordingly, financial markets remain vulnerable.

Reserve Bank of Australia 3/4/2013

 

The unfortunate reality is that it is normal for forecasts to be wide of the mark.

Deputy RBA Governor Philip Lowe 10/1/2013

 

No central bank will admit it is keeping interest rates low to help governments out of their debt crises. But in fact they are bending over backwards to help governments to finance their deficits….. With high debt to GDP ratios it is difficult for a central banker to raise interest rates. I believe the shift towards less independence of monetary policy is not just a temporary change.

Carmen Reinhart of Harvard University 10/4/2013. Note Ms Reinhardt was the co-author of "This Time is Different" with Kenneth Rogoff.

 

The greatest flaw in the Fed’s unprecedented gambit could well be an emphasis on short-term tactics over longer-term strategy. Blindsided by the crisis of 2007-2008, the Fed has compounded its original misdiagnosis of the problem by repeatedly doubling down on tactical responses, with two rounds of QE preceding the current, open-ended iteration. The FOMC, drawing a false sense of comfort from the success of QE1 – a massive liquidity injection in the depths of a horrific crisis – mistakenly came to believe that it had found the right template for subsequent policy actions.

Stephen Roach ex Morgan Stanley Chief Economist, now Senior Fellow at Yale University’s Jackson Institute of Global Affairs 27/2/2013.

 

We may say that we are aiming for nominal growth of, say, 5 percent. Who thinks you can really do that? It doesn’t correspond to the real world. When have economists been able to predict how much will be inflation and how much real economic activity? Monetary policy has little or no control over the real economy and issues, and yet we persist in using it as a tool for generating growth.

Paul Volcker , former Chairman of the US Federal Reserve in an April interview ‘Dangerous Economic Territory’.

 

The problem with central banking is that there are no longer any bankers in central banking. Too many economists, particularly of the interventionist kind. The latter spend their time and taxpayers earnings in trying to alter economic history, rather than understanding it. The most glaring error is the notion of a "national" economy. When it comes to credit markets, they have been international since at least Roman Times. They insist that because two things occur at the same time they are causally related. Yes, credit does increase with a business expansion and vice versa. But credit expansion does not cause the business boom. Actually, in the final stages of a boom speculators leverage up against soaring prices. In which times, credit expansion depends upon the boom. How could so many for so long be so wrong? Central bankers get wages and glory for their attempt to provide unlimited funding for another sordid experiment in unlimited government. The problem is that even with electronic printing presses and endless buying of lower grade bonds market forces eventually overwhelm arbitrary ambition. As for "wages and glory", the former should be viewed as rent-seeking and the latter as ephemeral.

Bob Hoy, American commentator 12/4/2013

 

CONCLUSIONS

Markets have raced away from their 2010 and 2011 lows, but there are enough balls in the air to indicate a retracement of current gains is overdue. Dr Bernanke has led an orgy of money printing that seems to indicate that past mistakes are in the process of being repeated. The American economy is improving but savers are being asked to suffer low interest rates on mainstreet while Wall Street continues to behave recklessly. In the USA, the world’s dominant economy, housing and employment is picking up but national, domestic, municipal and state deficits persist. Company profits around the globe appear to be driven more by cost cutting than revenue expansion. Our Australian company models suggest that valuations are stretched. Exercise caution.

 

Introduction

Very little has changed over the last four weeks. Markets have NOT rolled over, as I have feared they would for many months now, but this does not reduce my level of anxiety, rather it heightens it. Now is not the time for comfortable complacency about the prospect for ever better returns, but that is what we are seeing to an ever increasing degree with each day that passes. It is vital that all investors recognise just how far attitudes and expectations have changed over the last four years.

This month’s Strategy Thoughts may turn out a little different than normal (if there indeed is a ‘normal’ for Strategy Thoughts), partly because of the need to explore the degree to which attitudes have developed but also due to my imminent departure to the US for the month of April to promote my first book, ‘Bulls, Birdies, Bogeys and Bears’. I have also spent ample time over the last two months outlining both my longer term (secular) views, which by their nature should change only rarely, and also my shorter term view that the cyclical bull market that began four years ago for most markets is either already over or in its final stages. This remains firmly intact so it is therefore unnecessary to revisit those previous rationalisations.

In addition to reviewing the attitudinal shift among investors that is so important I will also comment, possibly slightly tongue in cheek, on the latest headlines created by the former ‘Maestro’ Alan Greenspan and also the headline grabbing story from Australia about the plans for ‘Australia 108’ the proposed tallest building in the southern hemisphere.

Attitudes and complacency

I do spend a lot of time watching the financial media, particularly CNBC, and reading the financial and investment press. This probably does not surprise readers, but I have been particularly struck over the last few weeks, as the ‘countdown’ to new highs took place in America and each subsequent new high was celebrated with almost breathlessly excitement, with the degree to which the ‘bulls’ have grown in confidence. This is understandable, they have been correct, however, it can become dangerous when ones confidence grows too fast and goes too far.

On a smaller scale (although not that small) this behaviour and danger was seen last year in Apple. Then bullish analysts were seemingly battling to leap frog each other to be the most bullish and I suppose feel the most right. With hindsight we can now see that the crescendo of the fervour, and targets in the thousand plus dollar area, occurred immediately prior to the stocks 40% collapse in less than six months.

Recently I have been amazed how commentator after commentator has been wheeled out to proclaim that a new secular bull market has just begun. This confuses me, firstly because surely that new bull market, of whatever degree, must have begun more than four years ago and at levels 50% or more lower. Secondly, I wondered what these fervent long term bulls were saying back in March 2009 when it would have been particularly useful to have called a new long term bull market, even if it only turned out to last four years.

I started to note down the names of each rampant bull and then began Googling their comments from early 2009. You probably won’t be surprised with what I found!

Before going through some of those individuals’ transformations, from scared to super bullish, I thought it only reasonable that I look back at what I was writing in early 2009.

March 2009 revisited

In early March of 2009 I titled that month’s Strategy Conclusions “A reversal in everything (again), the bottom of the ‘slope of hope’”and raised the strong possibility that, given the extreme gloom that was by then dominating all forms of media, an important turning point may well have been seen. Later that month, on the 24^th March, I wrote the April edition of Strategy Thoughts and titled it;

 Has a cyclical low been seen?

I concluded that month’s Strategy Thoughts with the following;

Strategy Conclusions last month concluded with the belief that the bottom of ‘the slope of hope’ was close at hand and may even have been seen and that as a result we were now as optimistic about equity markets globally as we had been for at least four years. We stated that this was not a trading move but equally this was not the start of a once in a generation or more buying opportunity at the end of a secular bear market and so the beginning of a secular bull market. This continues to be my view for a whole host of reasons, some of which hopefully I have illustrated in this month’s Strategy Thoughts, and it will continue to be my view even if, as expected, the so called fundamentals continue to deteriorate. In fact if the markets can hold their own, or continue to advance, in the face of seemingly poor news it would only serve to increase my confidence in the prospects for a meaningful cyclical bull market.

I believed that a new bull market was beginning, but that it was only a cyclical bull market, comparable to that enjoyed from 2003 to 2007 not to the secular bull market from 1982 to 2000. Nonetheless, I anticipated that it would be a rewarding bull market and that one should be invested to take part in what would be another climb up a ‘wall of worry’.

Within that edition I also raised the question of how a new cyclical bull market, if that was what had indeed begun, might end. I wrote;  

This question is obviously incredibly premature given that the current rally is not even the largest of those seen during the bear market to date. Nonetheless, it is still worth thinking about as it helps to crystallise the distinction between the longer term, secular, positioning of world markets and the intermediate, cyclical, position.

If a cyclical bull market has indeed begun then it is starting amid a bleak global economic environment, as described above, just as all bull markets of any degree tend to and the love of risk two years ago has been transformed into an outright fear. The issues that are creating that sense of fear and foreboding all relate to the longer term, secular, unwinding that is still required both economically in the form of global deleveraging and within equity markets by them becoming historically very cheap (not just a little below fair value). This will all take time and is unlikely to occur in a neat orderly fashion with the ultimate destination, in both time and price, being clear to everyone. Rather the path to a secular bottom is made up of a series of cyclical bull and bear markets. So far during this still relatively young global secular bear market we have suffered two cyclical bear markets and one cyclical bull market. It is likely that we will enjoy and suffer at least one more cyclical bull and bear phase before it ends.

As every cyclical bull market in a longer term secular bear market progresses eventually the belief grows that the worst has been seen and the recession / bear market are over and it’s off to the races again. One only has to think about the psychological progression that markets went through from disbelieve in a ‘jobless’ global recovery in 2003 and deep scepticism about any recovery in investment markets to the broad belief two years ago that the ‘ocean of liquidity’ would ensure that all markets for everything would continue to rise. Obviously we now know it didn’t. 

Without intending to be disrespectful to the IMF, it is likely that any new cyclical bull market will end amid similar beliefs to those witnessed at the end of the last cyclical bull market two years ago. With equity markets substantially higher and the fear of risk once again having, at least partially, evaporated it is probable that forecasts for economic growth will be being revised higher and a general belief that the ‘Great Depression II’ has passed and been survived. Credit will undoubtedly be given to the various central bank and treasury officials globally who will appear to have engineered the recovery and all the long term concerns and fears that are so near the surface currently will be forgotten. A ‘wall of worry’ will have been climbed and so another slide down the ‘slope of hope’ will be about to begin.

All of this is getting somewhat into the realm of fantasy, clearly it is far from certain that a new cyclical bull market has begun, but if it has it will be useful to keep some of these perspectives in the back of one’s mind as the bull market runs its course, however far it goes and long it runs.

I have reproduced so much of that section that I wrote almost exactly four years ago because it described the shift in attitudes, and importantly investor time frames, that occurs as a bull market matures. The problems that were so obvious to everyone back in early 2009 have not been fixed; they are still there and are very long term in nature. They are a secular problem. Within secular bear markets the cyclical inflection points are not brought about by valuation or any fundamental drivers, rather they are brought about by extremes of mood, or sentiment. At a cyclical trough, like that in early 2009, or in early 2003, the very long term problems become all-encompassing, and dominate virtually all investors’ outlooks. That is the bottom of the ‘slope of hope’ and so the start of the climb up the ‘wall of worry’. At cyclical peaks the reverse is true, the long term problems are easily overlooked amid rising prices and attitudes reflect an expectation of a continuation of the bull market that by then has become accepted as ‘normal’. Investor appreciation of time frames concertinas in and out with each bear then bull market. At troughs no one can think about long term opportunities the problems are too obvious, at peaks no one worries about short term corrections, the long term opportunity is all that matters.

Perhaps the most important sentence in the section that I wrote four years ago was the final one regarding the value of aiming to keeping some perspective as the bull market runs its course. Unfortunately the majority now appear to have lost that perspective and are only focussed on the long term opportunity.

Then and now!

What follows is just a selection of the many one hundred and eighty degree reversals that have been seen over the last four years, but what was also interesting in reviewing the bulls of today with their attitudes of four years ago was that many of the current spokespeople weren’t in their current jobs back then and some may not even have been in the investment business.

Morgan Stanley now: Adam Parker, Morgan Stanley’s chief U.S. equity strategist, has adopted a positive view of stocks for the first time since he started his job in 2010. (21^st March 2013)

Morgan Stanley then:Investors should sell into the recent stock market rally, Morgan Stanley’s strategist said Monday, arguing that it can’t last as corporate earnings deteriorate further.
“We simply do not believe that the market has completely priced in the prospect of further earnings weakness or that it will, without interruption, look through this weakness to recovery,” Morgan Stanley strategist Jason Todd wrote. (late March 2009 after the first 25% rise)

Michael Hartnett now: “Relative U.S. economic outperformance on the back of the housing market’s ongoing improvement and the energy independence story will lead a secular uptrend in the dollar," said Michael Hartnett, chief investment strategist at BofA Merrill Lynch, a unit of Bank of America Corp. (BAC). Meanwhile U.S. equities’ leadership in the shift "suggests developed market equities are the likeliest winner in this scenario." (19^th March 2013)

Michael Hartnett then: In the survey, America still comes up as a popular stock market, but not because of bullish prospects. "It’s really seen as a safe haven in troubled times," says Michael Hartnett, co-head of international investing strategy at the Wall Street firm. That’s not the kind of optimistic perception that powers a sustained bull run. (March 19 2009)

Rich Bernstein now: We have thought for some time that the current bull market might be one of the strongest of our careers, and could potentially rival the 1980s bull market (March 7^th 2013)

Rich Bernstein then: Just Monday, he advised selling bank stocks after their recent rally, saying the government’s latest plan to get rotting assets off banks’ balance sheets would just delay an inevitable further industry consolidation. (LA Times March 24th 2009)

Nouriel Roubini now:  ROUBINI: ‘Short-Term Bullish, Long-Term Catastrophe’

Nouriel Roubini then: ‘Dr Doom’ predicts further shocks in the market (The Independent April 21^st 2009)

Warren Buffett now:  “Always be bullish on America” Warren Buffett (4^th March 2013)

Warren Buffett then: “the economy will be in shambles, throughout 2009, and, for that matter, probably well beyond.” ( NYT 1st March 2009)

The mood in early 2009 was certainly not optimistic and was a world apart from what so many seem to see now. Businessweek summed up the mood very well in their edition on the 4^th March 2009. The headline read;

When Will the Bull Return?

The article began;

While 17 months may feel like an eternity, it could turn out merely to be a prequel. The questions on the minds of investors, money managers, and corporate executives are threefold: How much longer will the bear market last? How low will the averages go? And when might investors get their money back? As Warren E. Buffett has said: "Beware of geeks bearing formulas." It’s especially difficult to predict the direction of the markets these days because the most popular gauges, from price-earnings ratios to measures of investor "capitulation," have stopped working. The peculiar nature of this bear market limits the kit of useful tools to just a handful of bond market and business confidence indicators. Those signals, along with interviews with financial historians, market strategists, and economists, point mostly to painful scenarios. Stocks don’t seem likely to fall much more from here—but market turmoil could continue for months or even years. Worse, by the time the market revisits its highs, so many years are likely to have passed that many older people will have gotten out of stocks, missing out on the rebound. The flip side is that new money put into the stock market now will likely do comparatively well over the long term. That’s welcome news for twentysomethings and executive compensation consultants, but perhaps not for soon-to-be retirees.

The consensus at the time was very bleak indeed and bullish voices were generally decried as not understanding the true severity of the situation. When the rally continued to surge higher the doubters continued to dominate the media headlines. In late April of 2009 I wrote the May 2009 edition of Strategy Thoughts I included the following selection of headlines put together by Investec research;

Rally, Yes; Bottom, No

Forbes.com – 3/10/09

No Way You’re Getting Me Back in This Market

Yahoo! Finance – 4/8/09

Is this a sustainable bull market?

The March run likely will lead to weakness

MarketWatch – 4/1/09

Warning: The bear isn’t hibernating yet

CNNMoney.com – 4/1/09

Goldilocks rally meets the bears

March was good, but a downturn is inevitable

MarketWatch – 4/1/09

Don’t Buy the Chirpy Forecasts

The history of banking crises indicates

this one may be far from over.

Newsweek – 3/30/09

Bear Rallies Turn Market Into a Circus

Wall Street Journal – 3/23/09

Enjoy the Sucker’s Rally, Says Merrill’s Rosenburg

Yahoo! Finance – 3/19/09

Roubini Says Rally is a “Dead Cat Bounce”

The Business Insider – 3/16/09

Is This A Real Rally Or Dead Cat Bounce?

Investors Business Daily – 3/16/09

The Forbes story included a quote from Art Hogan;

“You’ll know the current hard times are over when the government tells you, by way of improved economic data.The bad news would need to decrease in magnitude” said Art Hogan, chief market analyst at Jefferies”. That same Art Hogan was quoted in a recent CNBC.com article: “We’re certainly in an environment where good news is great and bad news is just okay. The market has just found the path of least resistance to the upside in the near term and it’s hard to find something to knock it off there.”

The CNN money articlequoted John Lynch and Bill Stone with reasons why the market would soon retest the March lows and that it was too soon to get back into the market;

“Bill Stone, Chief Investment Strategist with PNC Wealth Management in Philadelphia, said it’s looking like the economy probably shrunk by at least 5% in the first quarter, following a more than 6% drop in the fourth quarter of 2008. He added that the job market is still in bad shape as well. So with that in mind, Stone agreed with Lynch that it would not be a major surprise if stocks retreated back toward this year’s lows. "It’s never safe to say we’ve hit bottom," he said.

Four years later the same Bill Stone was interviewed by The Wall Street Journal and explained why the new high in the Dow was a reason for confidence (I think he may have got that around the wrong way!)

The Marketwatch column subtitled ‘the March run will likely lead to weakness’ was written by Drew Kanaly of Kanaly Trust. That same firm’s first quarter outlook for 2013 was far more optimistic, including the key points, Major global event risks have faded, the majority of global equity markets in a bullish trend, economic recession risk is low and raising the prospect of a new secular bull market.

It is important that investors recognise just how dramatic an attitudinal shift has occurred over the last four years. Something long term and secularly good is not starting now and it didn’t start in 2009 either.

Finally, just to illustrate how far things have come, I was amused by the headline in Barron’s regarding the US budget impasse and the automatic cuts, or sequester, that kicked in;

The Sequester: More Opportunity Than Danger

At the start of a new bull market such a thing would be universally recognised as being bad for the economy and so bad for the market. That is the kind of back drop that is found when a ‘wall of worry’ is being climbed. By the time the top of that wall is reached it is not that there is no longer anything to worry about, rather the majority choose not to worry about it or even dresses it up as a positive. I was also amused by the following headline on Bloomberg;

Short Sales Decline 53% as Bull Market Enters Fifth Year Bloomberg 4^th March

The article pointed out that short sales, or bets on stocks going down, had fallen dramatically now that the bull market was over four years old. The irony of them being the lowest since 2007 seemed to be lost on the author. Likening anything in the markets now to 2007 should not be seen in anyway as a positive.

Active share revisited, again!

Some readers may remember comments I made over the last few months regarding ‘active share’. It is a measure of how active fund managers actually are and is increasingly raising questions as to why an investor should pay for active management when all they are getting is ‘closet indexing’. This tendency towards indexing, that is attempting to ensure that one’s fund is not too different to the index, is, it seems, deeply embedded in the fund management industry. It is better to be wrong with everyone else than to do what you believe to be right and risk being wrong alone. This sentiment was brilliantly captured in a recent ALEX cartoon sent to me by ever observant reader Neil Beattie.

The scene has Alex lunching with his client Jeremy:

A: You’ve been bearish on stocks for the last year Jeremy, but now you are piling in

J: I still believe the fundamentals are all wrong Alex, but I manage money on behalf of my investors…markets are booming and if my fund doesn’t own equities I miss out on making a profit. At the end of the day I’ve got to remember where my obligations lie and whose money it is I’m investing.

A: Someone else’s??

J: Quite…so what have I got to lose?

A: Well your job if you continued to do nothing…

J: Exactly. It focusses the mind wonderfully.

Active share will likely get more and more coverage if markets once again become challenging. It will be important for all investors to know just which risks their fund managers worry the most about, their clients or their own.

Irrational exuberance or not?

Alan Greenspan made his famous ‘irrational exuberance’ statement in December 1996 as the Dotcom boom was getting into full swing. Now, with the benefit of hindsight we all know that the exuberance had far further to run and that it had to become far more irrational before the bubble would burst, unfortunately for Mr Greenspan he changed his mind as to whether the markets were irrational just when we now know they were irrational. Like so many investors he got whipsawed. He later stated that economists couldn’t detect a bubble until after it has burst, a sentiment that his successor seems to share. Perhaps these ‘misses’ should alert investors as to the value or otherwise of Mr Greenspan’s assessments of markets, but still the media appears to hang on every word of the former ‘Maestro’.

On the 15^th of March this year Greenspan told CNBC that irrational exuberance is the last term he would use to describe today’s market. He went on to say that stocks by historical standards are ‘significantly undervalued’.

These comments no doubt will have boosted the confidence of the growing herd of stock market bulls discussed earlier, however, history clearly shows that investors should place very little confidence on Mr Greenspan’s observations, no matter how well intentioned they may be.

In the past I have frequently questioned the value of employing economic views (not just Mr Greenspan’s) as the basis for an investment view. History repeatedly shows that it is of minimal value, the markets forecast the economy far better than the other way around and markets are virtually uncorrelated to GDP. These comments don’t sit comfortably with a lot of investors who intuitively feel that the economy should be reflected in the market. In prior editions of Strategy Thoughts I have explained at some length why I don’t believe this to be the case so when I saw the chart above in the Economist magazine from the 9^th March I thought it was worth sharing.

The chart looked at all the bull markets in the US since the late forties, how much they rose and how strong the economy was throughout the rise. The following comments accompanied the chart;

It is tempting to attribute the strength of the Dow to optimism about the American economy. Tempting, but wrong. Studies have shown almost no correlation between GDP growth and equity returns. Indeed, the Shanghai stockmarket trades at less than half its 2007 peak, even though the Chinese economy has performed much more strongly than that of America since then. As the chart shows, this rally in the Dow has been accompanied by the weakest GDP growth of all the bull markets since the second world war the economist magazine

The important phrase is ‘Studies have shown almost no correlation between GDP growth and equity returns’ but still the majority seek the comfort offered by an economic rationalisation. Unfortunately these rationalisations will all be optimistic when markets are peaking and miserable when investment opportunities are highest.

Look Out Australia (Pride comes before a fall!)

Back in late 2008 and in mid 2006 I wrote two articles under the title ‘Pride comes before a fall’. The first was prompted by Dubai’s stock market weakness after the construction of the tallest building in the world began and the second was after Kuwait announced they were aiming to build something taller. The gist of both articles was that by the time any country, city or state becomes so confident that they want to build the tallest building in the world then hubris may have replaced mere confidence. History is littered with examples of the next tallest building in the world being planned and announced at the crest of a boom only for that boom to have turned to bust by the time the building is opened. Obviously it is not the case that such an announcement causes economies and markets to retreat, rather it is the case that the desire to build such a tower is a symptom of the excessive confidence that is found at an important peak. It was therefore with some alarm, but not total surprise, that I received  an email from long time reader Matt Hol after the announcement of the approval to build Australia 108 in Melbourne. CNN ran the headline;

Going up Down Under: Southern Hemisphere’s tallest building

The 388-meter futuristic Australia 108 in Melbourne will become a record holder, for a short while at least

21 March, 2013

 

Naturally none of this means that the ‘lucky country’ is about to collapse, but it does indicate that internally at least confidence is at a very high level. Investors would do well to remember that ‘pride really does come before a fall’.

Conclusion

For many months now I have not changed my view, now is a time for caution amid the increasingly optimistic media.. Preservation of capital will be most important through the next cyclical downturn and the current environment is not unlike those seen at prior cyclical peaks. It was no surprise that the recent very brief sell off was seen as another opportunity to ‘buy the dips’. Don’t be surprised if a more serious sell off occurs and it is dismissed as just a ‘healthy correction’, all bear markets in their early stages are seen as this ‘oxymoron’.

This months Strategy Thoughts aimed to illustrated just how far attitudes have changed. Seeking the comfort of a bullish concensus may provide the comfort of the herd and this may feel good for a moment but it will become very  uncomfortable when the ‘healthiness’ of any correction eventually becomes less obvious.

Kevin Armstrong

26^th March 2013

More thoughts on Apple

Bloomberg anchor, and an older user of an iPhone, Tom Keene, asked a simple question of a technology expert recently;

"What I see is a generational divide, is that true? Older people use iPhones, younger people use Samsungs."

I don’t know the answer, although I do probably fall into the ‘older’ category, and I do use an iPhone. I have been commenting for many months now that the market has been telling us something about Apple that the majority, until perhaps now, after a 40%+ fall, didn’t want to face up to.

Waiting for the reasons as to why any bear market has happened does nothing to protect an investment. Most bear markets occur not because the underlying fundamentals deteriorate; rather they happen because expectations were far too optimistic at the peak. A minor disappointment to highly exaggerated expectations can trigger a meaningful bear market.

Final note

This morning chief investment strategist at Standard and Poor’s, Sam Stovall  was on CNBC forecasting 1680 for the S&P500 by the end of the year, a wonderful extrapolation of the bull market to date. I just checked what Sam was saying four years ago. This from Businessweek in early March 2009;

An analysis by Sam Stovall of Standard & Poor’s is discouraging for those who hope the declines just can’t reasonably get any worse—or last much longer—than this. The 15 bear markets since 1929 have lasted an average of more than 18 months and lost investors a median of 34%. However, for "mega-meltdowns"—where indexes fell more than 40%—the average drop was 51% and the bear market lasted more than two years. Between 1929 and 1932, the S&P 500 fell 86%. The 1938 to 1942 bear market lasted 42 months. When this bear market is finally over, nothing says it couldn’t have experienced the worst of all levels," Stovall wrote in a Mar. 2 note. (emphasis added)