OT- something to chew on. geez i don't feel so bad predicting a wicked drop down to 5400(dow) when the hong kong real estate and stock market values plunge another 50-65%.(hong kong's piggy bank used for market intervention, imagine that!)
Saturday, October 3, 1998
Portents of a nasty storm
Rising real interest rates, widening yield spreads and collapsing commodities
all say the same thing: share prices will be swept away
By AMANDA LANG
New York Bureau The Financial Post
Never let it be said investment bankers are humorless. In its most recent market strategy newsletter,
Salomon Smith Barney recommends that "investors accumulate stocks in beaten-down industries
that are expected to beat earnings expectations."
The trouble is Salomon's analysts offer this pearl without irony. In a market and an economy this
volatile, advice of this kind can induce panic in the average investor. And while panic never amounts
to a strong investment strategy, there is reason to be pessimistic about North American equities.
Despite the roughly 20% decline from the Dow Jones industrial average's July high, some analysts
believe the worst is far from over.
North American corporate earnings growth is still slowing and continued weakness in emerging
market economies will provide little respite for the next few quarters.
Analysts are busily revising their estimates of earnings for the Standard & Poor's index of 500 U.S.
companies for the rest of this year and next. Since stocks should be trading on a multiple of future
earnings growth, that is not a good sign.
Vancouver-based market historian Robert Hoye watches indicators, including the stock market and
other economic data. For some time, he has been warning the similarities are growing between
today's conditions and those that heralded previous market crashes.
"In a historical sense, to have it replicate so closely is very satisfying," Hoye admits, "but should
conditions continue to evolve along historical patterns, I find it very daunting."
If history is any kind of guide, we are in a bear market. Previous bears, before they lumbered off,
wiped out about 50% of the gains delivered by the preceding bull.
That could leave the Dow, which hit a high of 9337.97 in July and closed Friday at 7784.69, at
around ***4500***, based on a bull market cycle that began in 1974. "It's as good a measure as any," says
Hoye of the 50% rule.
He adds the stock market and the U.S. economy are following classical patterns. A market crash
and ensuing recession begin with a crash on a "lesser exchange." In 1929, that was New York;
today, that means such exchanges as Toronto and San Francisco.
The data that concern Hoye aren't from September 1929, but from September 1930. So far, he
says, they're a pretty close match with today's trends, despite differences in the structure of the
economy and government policy.
Equities are a coincidental indicator, he says. The truly bearish signs include:
Rising real interest rates, which have crept up on the long end of the curve for more than a year.
"That turning from real rates declining was a warning."
The past year's bear market in base metals, which fell about 40% from the spring of 1997 to its
recent lows.
The real price of gold, the quintessential hedge against bad times. The decline here is ending and
gold's price relative to silver is now rising after bottoming in February. Since the summer of 1997, an
index of representative U.S. commodities has fallen 32% relative to gold. This is almost exactly what
happened in the 15 months after the summer of 1929.
The near-collapse of the junk bond market, another bearish sign, is well under way, Hoye says.
This helps explain the need to bail out Connecticut-based hedge fund, Long-Term Capital
Management LP.
For bonds, the pattern that precedes a market crash begins when spreads widen between yields on
high-quality corporate bonds and their lower-quality junk bond cousins.
That widening of "quality spreads" began a year ago, Hoye says, and was interrupted only by a rally
this spring after lesser stock exchanges tumbled. Those spreads are widening again and this is drying
up liquidity in the bond market. "Typically, quality spreads narrow during a boom and, as part of a
contraction, widen."
Other analysts, while cautious, aren't yet prepared to join Hoye on the leading edge of pessimism.
Jeffrey Hooke, author of Security Analysis on Wall Street, expects the Dow to bottom out around
7200 within six months or so.
For the bear market to turn bullish again, blue chip stocks will first have to trade at lower price to
earning multiples, he says. "At that point, even with the economy slowing, the low interest rate
environment, combined with companies trading at lower multiples, means many companies will either
be takeover bait or candidates for corporate share buybacks." That will help jump-start equities.
Hooke is wary of analysts' earnings forecasts, since many have the tendency "to assume a
continuation of the last three- to five-year trend," even when economic indicators are pointing to a
downturn.
In fact, when Salomon's analysts told investors to look for earnings surprises, what they were really
saying was that investors must read between the lines.
Some market watchers, too, are inclined to keep their own counsel. Richard Bernstein, chief
strategist at Merrill Lynch & Co., declines to forecast a market bottom "I'm no technician." What
he will say is that the general trend will be down until two things coincide: the U.S. Federal Reserve
Board eases interest rates and the yield curve steepens as a result.
The Fed eased rates this week, but yield curves didn't steepen. Bernstein says it is not yet clear
whether the central bank can manage the market out of its downtrend. It is a tricky time for the Fed,
as the rest of the world looks to it to stabilize their economies. But Bernstein says it isn't likely to
take any action that could reintroduce inflation to the U.S. economy, "in order to save Malaysia."
Although many investors feel inflation is a thing of the past, the powerful U.S. Fed can't afford to
make the same assumption. "Who wants to go down in history as the central banker who reinflated
the U.S. economy?" Bernstein says.
Historian Hoye agrees the Fed's role might be overplayed. In fact, he notes no other market top in
history has been so closely linked with central bank policy. If a recession strikes the U.S. and the
stock market loses half its value, there is a danger the role of the Fed could be undermined, he says.
Bernstein thinks that unlikely, but agrees the central bank may be powerless to control the profit
recession now under way. In fact, this is the first post-war period of profit recession that wasn't
preceded by significant Fed tightening of rates. "The question is, if the Fed didn't start it, can they
stop it?"
Most investors, however, are more concerned with what to do now.
Data from August show, for the first time in a long while, investors took more money out of mutual
funds than they put in. Although early indications are this trend reversed itself in September, it is clear
investors are nervous.
In the midst of the stock market "bubble," the best investment was to short gold gamble its price
would fall and to own U.S. treasury bonds with long terms. That strategy, Hoye says, "is about to
become undone."
Now, the best place to be is out of the market and in U.S. treasuries. "Our ideal position is to own
the five-year U.S. treasury bond," a gamble that this medium-term investment will outperform short
and long bonds, as well as equities. He believes many investors are still in long-term bonds. "Our
model suggests investment grade bonds have peaked, as of the end of September."
Bernstein disagrees. He is recommending clients buy at the long end of the yield curve, with 10- to
30-year bonds. Because global profit and economic growth is expected to be weak, it will reduce
the number of quality investments worldwide, he explains. "Most would agree U.S. treasury bills are
among the highest-quality assets."
Either way, Hoye has some chilling advice for investors. The maxim about buying common shares
and stashing them away could fall apart for many. True, the market's tendency is to rise. But if
history is a guide, it could take 20 years for the Dow to reach 9000 again.
Of course, there are still bulls aplenty, including Goldman Sachs & Co.'s much-vaunted strategist
Abby Cohen, who views the present selloff in equities as overblown.
But Hoye suggests those who study what has gone before and follow a wide array of indicators will
have a clearer idea of what is in store. The signs have been there for more than a year. "You could
practically develop a rule that the really seasoned broker or investor gets out a year too early," he
says.
Now "that sound you hear is barn doors all over the world being slammed too late."
|
