When I wrote in late January (see January 28th newsletter – Anatomy of a bear market) that the bottom of the current bear market would be in June, I was reasonably confident of the prediction. The call was based on the average duration of previous downturns. As we head further into the month of June, I’m feeling quietly confident that the prediction will come true – providing the ECB finally decides to wake up.
As far as I can tell, the main issue for equity markets right now is the weakness of the US economy and therefore its banks and currency. Under normal circumstances, a weakening economy should drive price inflation lower as demand for products and services contracts. Even though this weakness will ultimately lower the value of the currency (as the central bank cuts interest rates to stimulate demand), the decline in aggregate demand should offset any increase in inflation caused by the softer currency. However, in the case of the US economy this time round, there are two new factors that are distorting this idealized economic model. First, as the world’s reserve currency, US$ weakness has not been as pronounced in the past as the current weakness of the US dollar. Second, whereas in the past a weak US economy meant slower growth for everyone else, globalization and the rise in economic (and therefore political) significance of a unified Europe, China, India, Brazil and Russia, has altered the landscape. In particular, these new economic blocs, have their own political agenda, and they are not in sync with the US.
Hong Kong is a unique position. Its economy is closely tied to China, but its currency is pegged to the US$. In a sense, it should be benefiting from China’s economic strength and the lowering of US$ interest rates. This is showing up in GDP forecasts, which have been raised recently following a 6% surge in 1Q. Local employment is at record levels, lifting retail sales +20% YoY. But here’s the crux for the direction of local equities, despite the all positives, equities are a global asset class, and right now global investment flows are more concerned with preserving value. They are willing to forego the pitifully-low interest income on their US dollars and are prepared to bet that 1) the European Central Bank (the Bundesbank in disguise) will stick rigorously to its (laissez-faire Austrian school) inflation targeting policy and 2) China will not wish to upset its populace (with its Olympic-sized coming out party due in August) by removing its oil subsidies.
The solution is a political one and is simple enough to implement – lift the US$. United States’ officials have already started talking up the US$. As they say – talk is cheap, so this will continue. But, just when the market least expects it the ECB should cut its interest rates. This would put the Eurozone in rhythm with the US. In a concerted effort, China should partially remove subsidies on oil and its by-products. This will force speculators out of the gold and oil markets, lowering the value of both by 20-30%. Inflation pressures and expectations will immediately ease, and the world’s financial markets/economy can return to some sort of order.
There is an argument that removing oil-based subsidies in China would lift the inflationary pressures that China is currently exporting, but the perception of these inflationary pressures is misleading. Many point to the lifting of minimum wages as the start of the surge in global inflation. But, as many of my factory-owning friends point out, they were already paying above the minimum, so the impact on factory wages was minimal. Although thousands of marginally-profitable factories have closed because of the wage hikes, most closed because of rising widget input costs, not wage increases. Confirming this numerically, it should be noted tat China’s exports have slowed, but not significantly (+24% last month), while China’s export prices have hardly moved. Also, China’s oil-consumers have been protected from the rise in oil prices by subsidies and the rising RMB. If the oil-consuming class, which is considered relatively wealthy, and can afford some sort of price increase, were to understand that their rampant consumption of oil is causing the disruption to the value of their equity portfolios, they would think twice about getting the car out for the window-shopping trip to the mall. Finally, China’s leaders are in a bind, because the nation’s foreign reserves continue to climb and are expected to top US$2,000 billion by year end. Currently, the China’s reserves are losing the equivalent of 5% of GDP every month because they have to buy greenbacks. Helping turning the dollar around, and thus lowering the price of oil, will stem this “lost opportunity” income.
From a political point of view, it’ll be a popular thing to do (except perhaps in China). No one, except some futures traders/momentum hedge dealers and a couple of Middle East sheikhs, is going to cry much if the price of oil falls.
So, how did we end up in this state? European Central Bankers have, for a long time, felt inferior and ego-deficient because of the weak performance of the Euro after its launch. They were also stung badly in the past year because 1) they had no idea that Europe’s banks were so highly exposed to the derivatives that US banks were selling them 2) they had no idea that their banks were borrowing so much from US banks, while the US banks were borrowing from the money markets and 3) the ECB’s response to the initial crisis last summer was horribly disjointed. While the US Federal Reserve won plaudits for offering liquidity to its commercial and investment banks, the ECB stood idly by. Even the Bank of England, so radical and forward-thinking under Gordon Brown in recent years, was found wanting with the Northern Rock debacle.
On the other side of the world, China’s banking regulator had no incentive whatsoever to announce another reserve requirement hike last weekend. They were aware that the Dow Jones Industrial Average had slumped 3% on the Friday. They could have let the impact of the Dow’s downturn ripple through the Shanghai stock market. Making the announcement, regardless of world events, suggests: 1) China has reversed its market supportive stance 2) China is willing to put up with the wrath of stock market investors/oil consumers and 3) China is willing to allow market forces to decide the price of assets. It is therefore perfectly logical to assume that the next step will be to release price caps on “essential items” such as oil.
It is against this background, that we are about to begin the second half of the year. I think it appropriate, therefore, to make some predictions for the Hang Seng Index for the next four-five months.
I find it interesting that, after 11 months of financial markets hell, the Hang Seng Index is still trading 13% above where it was in May of last year ago. This doesn’t seem to jive with the fundamentals (mortgage crisis, global economic slowdown, record oil etc). First, perhaps I need to explain why I’m using 11 months, instead of year on year. I have plotted and followed the Hang Seng Index’s Coppock Indicator for many years. The designer of the index determined that stock markets take 11 months to absorb shocks to the system. We are reaching that point in time.
HS Index’s Coppock Indicator
Using Coppock’s method of viewing the world, on average, the HS Index has recorded a trough 11-month fall of 29% in the past six bear markets. The steepest decline of 43% was in 1998 (of course), while the shallowest move was the 19% secondary slide in 2003 – caused by the SARS outbreak.
Monthly Hang Seng Index 11 months % change at past six troughs
The likeliest timing of the trough, in terms of decline for the current bear market, will be in October this year. Assuming a 30% decline from the 32,000 peak (i.e. not as bad as 1998 or 2001) the index could be trading around 24,500 by October. Bearing in mind that the index is currently trading near this level, the forecast doesn’t sound particularly attractive. However, if June represents the nadir of the current bear market, then the index is heading for the 19-20k area (i.e. another 10% leg down to complete the third wave on the chart). Suddenly, 24,500 by October sounds like a nice return of 20-30%. More importantly, the rise in the index will be bounded within a rising up-pattern, which will be a reverse of the downward spiral investors have had to navigate over the past eight months. However, all of this is predicated by the actions of the world’s leaders to prick the oil bubble. Whereas Greenspan warned in the past that deflating an asset bubble too quickly could have highly-negative economic consequences, the bursting of the current oil bubble will likely be cheered around the globe.
