Correction, or resumption of a major downtrend?
Dr Faber believes equity markets may be forming a significant top between now and April. Tops tend to coincide with very high bullish sentiment and that is where we are today, with even Dr Faber's wife buying stocks! Inflation due partly to high oil prices is going to burst this bubble.
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According to the Yale School of Management's opinion poll, currently 95% of individuals and close to 92% of financial institutions believe that the US stock market will rise over the next 12 months.
The bull to bear ratio has recently also reached extremely high levels, which are usually associated with major tops, while low readings such as we had in October 2002 occur near market lows
Incidentally, I encounter the same type of optimism everywhere around the world. The consensus believes that a small correction will unfold in the near term but that thereafter equity markets will resume their strong up-trend.
Always being skeptical of the consensus, I am afraid that the equity markets may be forming a more significant top between now and April, which may not easily be exceeded for quite some time.
First of all, more than 90% of all stocks listed on the NYSE are trading above their 200 days moving average, which usually is indicative of a market that is very overbought. Then, the Dow Jones Industrial Average at 10,500 is encountering significant overhead supply, which comes from the Dow's trading range of between 10,500 and 11,500 from the middle of 1999 to the middle of 2001.
Also, as I have pointed out before, stocks tend to reach bargain levels amid very negative news, whereas tops coincide with very high bullish sentiment and favorable economic news. Then, it is of some concern that despite all the 'good economic news' that the government publishes, the economically extremely sensitive airline shares have recently taken a beating and that the Dow Jones Transportation Average has broken down.
Particularly hard hit were the no-frills airlines such as Jetblue Airways (down 70% from its October 2003 high) and Ryanair (down almost 50% since mid-January of this year). Add to the weakness of airlines the recent decline of the economically equally sensitive semiconductor stocks, which are now (including Intel) no higher than they were in October 2003 and one begins to wonder whether the market isn't beginning to discount some renewed weakness in the economy later this year.
Another possibility is that the stock market doesn't entirely trust the glowing economic statistics published by the government, which don't seem to tally with the economic reality of most households, as discussed above.
In this respect, the recent strength in bond prices is interesting. Seemingly, the bond market isn't entirely convinced by the 'strong economy' statements by the US policy makers nor by the published glowing economic statistics. Still, what might unsettle the bond market is US dollar strength and rising inflation rates due to soaring energy prices.
Moreover, our readers should consider whether BBB corporate bond spreads over treasuries have collapsed because of a significant improvement in the quality of corporate debt or whether they have collapsed because of a significant deterioration in the quality of US government bonds. Could, as is frequently the case in the emerging markets, corporate debt have a lower yield than US government debt?
With respect to the strength in the bond market, I suspect that declining interest rates are an indication that the consumer has very little spending power left. Employment gains are minimal and real incomes are declining as prices are rising far more than what the government's statistician are publishing.
In this regards it is interesting to look at a recently article published by the Vancouver Sun in which the author, Chad Skelton, compares some prices of goods and services between 2002 and 2003. And while Vancouver is not in the US, I am sure - based on personal observations - that the price increases quoted - even if in some case atypical of consumer price increases - do suggest that the cost of living is presently rising at a far higher rate than incomes.
Bill King, the author of the excellent and highly recommended daily 'King Report' (kingreport@ramkingsec.com) recently also took the CPI figures published by the Bureau of Labor Statistics apart and concluded that they grossly understate the rise in prices in the US.
Among others, he cites a Henry J. Kaiser Family Foundation study, which shows that health-care costs premiums have surged 42% over the last three years for employees and families. Hewitt Associates is projecting a further 15% hike for 2004. But the government's Bureau of Labor Statistics shows that health care costs only increased by 3.6% in 2003.
King believes that this is the way the government makes 'CPI behavior and inflation disappear, which overstates GDP'. In other words, it would seem that US households have difficulties to make ends meet and have only been able to support their consumption because of real estate asset inflation, which allowed them to take out additional borrowings.
Based on the asset inflation in Japan in the late 1980s and in Hong Kong prior to 1997, we know, however, how consumption driven purely by asset inflation ends when the asset inflation eventually turns into a bust – which in every case is sooner or later inevitable.
At the same time, not all is well in Asia, either. Whereas, so far, the bird flu outbreak has had a very limited economic impact, it nevertheless gave investors a reason to sell and led to a sharp correction in a large number of stocks.
In addition, we should be well aware that it is likely that the bird flu will one day mutate and will then be able to jump from human to human, which could lead to a pandemic of major proportions and have a devastating impact on the Asian and world economies.
With respect to the Thai stock market, I recently received the strongest sell signal I have ever experienced: my wife, who in the 25 years that I have known her has never shown any interest in buying stocks, wanted just recently to buy some Thai shares. Some friends had told her that you could buy in the morning and sell in the afternoon and make a profit!
Moreover, as is the case in the US, some stocks that are sensitive to Chinese economic growth have sold off quite sharply in recent weeks, confirming our suspicion that the Chinese economy is slowing down and may disappoint investors who are positioned in the various 'reflation trades'.
Among the sectors that have run into a serious bout of selling (down around 20% from their peak) we find Chinese oil companies as well as a number of resource stocks around the world, which investors bought on the back of the rising demand by China for commodities.
On a recent visit to Japan, I wasn't surprised to hear from several totally unrelated individual investors that they were buying steel stocks 'due to the strong demand for steel from China'.
Japanese investors, who have repeatedly shown an uncanny ability to buy near tops of a sector's popularity and price, are another warning flag that the 'reflation trade' is a very crowded trade.
We continue, however, to recommend that our readers increase their exposure to oil companies with significant reserves (Chinese oil companies don't have large reserves) and to oil servicing companies, as the fundamentals of the oil industry are compelling.
Asia, with 3.6 billion people or 56% of the world's population consumes less oil than the US with 285 million people. Based on recent trends in oil demand in Asia and given the positive growth prospects for Asia, I would expect Asian daily oil consumption to double from about 20 million barrels to anywhere between 35 million to 50 million barrels in the next ten years or so.
Since current oil production is running at 78 million barrels per day and can due to declining reserves in non-OPEC countries unlikely be increased much, I would expect prices to harden significantly.
In fact, I would not rule out another oil crisis should as a result of some political upheaval in the Middle East supplies be interrupted. Moreover, whereas the NASDAQ seems pricey, to put it mildly, oil companies command very undemanding valuations.
In sum, rising energy prices will lead to higher inflation and higher interest rates. A stronger dollar may hurt some big players who are short dollars and lead to less buying of US treasuries by Asian central banks and so depress the bond market. |
