Is The Market Topping Out?

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Recently, many stock market bulls have come out to sneer, mock and dismiss the bears. And with some justification given the significant market upswing since 2009. Sure enough though, just as the bulls started to dominate the airwaves, the market may have reached an important top. Asia Confidential isn’t sure this is the top as a correction is well overdue. But we’re more confident that the market upturn is a cyclical rally within an ongoing bear market. To believe otherwise would be to ignore +100 years of bear market action in the developed world.

If we’re right, upside for the S&P 500 is capped at around 1,600 or broadly flat with the market highs of 2000 (1,555) and 2007 (1,575). That means there might be one more rally left before a more significant correction takes place. For Asia, another rally should mean laggards such as China start to outperform. That hasn’t happened so far this year though as last year’s winners, Thailand and the Philippines, continue to lead the way.

Dancing on the Bears Graves

Until this week, the bulls have been ascendant and the bears in hiding. And boy, have the bulls been having some fun at the bears’ expense.

Josh Brown, a U.S. investment advisor and author of well-known blog The Reformed Broker, typifies the bull argument:

“…while the risks are real and will certainly provide opportunity throughout the course of the year, they are also well-known and represent the core of consensus thinking right now…Against such an awful and seemingly inevitable backdrop of tears and fears, the risk is to the upside. Pray for pullbacks; anticipate them like the cool, restorative rainstorms they are.”

Brown cites the potential for a true U.S. economic recovery this year, led by a resurgent manufacturing sector and the real wealth effect from people’s homes growing in value. Not to mention that the so-called animal spirits are back, referring to favourable attitudes toward risk and the markets.

Stockbrokers have joined the fray, falling over themselves to justify the recent market rise and why it will continue. A common argument has been the “great rotation trade”, meaning that there’s been the first signs of investors switching from bonds back into stocks. No matter that this rotation is a myth, as highlighted by Fund Manager, John Hussman

At the same time, newspapers have started to report on the comeback of stock markets. The New York Times featured a front page declaring: “Americans seem to be falling in love with stocks again”.

Predictably, all of this commentary has perhaps marked a market top in the near-term. The trigger for declines came with news that U.S. GDP shrank by 0.1% in the fourth quarter of last year. Most analysts have dismissed the report, suggesting it’s distorted by a massive swing in defence expenditure, resulting in a -1.33% GDP contribution from the government sector. Strip this out, they say, and consensus GDP forecasts of 1.1% would have been achieved.

I say: not so fast. Remember, the negative number has come before the fiscal cliff, sequester and government spending cuts. In other words, don’t expect the contribution from government to GDP to normalise this year. Particularly as defence spending will suffer as the war in Afghanistan winds down and there’ll be continued budget pressures on non-defence spending at all levels of government.

government contribution gdp growth 2009 to 2012

Hat tip: Ed Dolan.

Also, no-one has questioned the ongoing strength in U.S. consumer spending. Surely this can’t continue with real personal incomes at generational lows and savings rates at just 3%, but everyone’s assuming that it will.

A Temporary Pullback

I have a confession to make: I’ve never been a good short-term trader. Notwithstanding that, I suspect any market correction right now will prove temporary before a further rally. The view is based on a longer term outlook for the markets, particularly the world’s most important market, the U.S.. The chart from broker Stifel Nicolaus below is one of the most important to understanding the possible future direction of markets.

dow jones industrial average 1896 to 2012

The chart shows the four bear markets which have happened in the U.S. over the past century, including the current one. The three bear markets of the 20th century were 14-20 years in length.

Of more importance are the peaks and troughs of the various bear markets. You can see that the market often gets back to peak levels on several occasions during a secular bear market. From 1966-1982, the market got back to 1966 peak levels on four different occasions.

You can also see that after a bear market low is reached, the bear market often ends at levels higher than that low. As a general rule, it’s about half way between the peak and trough of the bear market, when a new bull market begins.

Consequently, if history is a guide, the U.S. bear market started in 2000 and is now in its 13th year. It’s highly unlikely that the bear market ended in 2009. If it did, it would be the shortest bear market in modern U.S. history.

If I’m right, we’re witnessing another one of the peaks in a secular bear market. It means the S&P can rise further from here but upside is capped at probably 1,600 or so. And if history is correct, this bear market has a few years left and will end at around 1,100, or half-way between the peak and trough of 666.

For simplicity’s sake, I’ve ignored other critical indicators such as valuation in the discussion above. Suffice to say, key valuation metrics, such as the Shiller PE suggest the S&P is about 38% overvalued.

If that’s the long-term view, then what will drive a short-term rally towards 1,600 and then a more serious correction to potentially a bear market bottom? That’s difficult to say but it’s worth keeping in mind that inflation normally crimps price-to-earnings multiples while deflation crimps earnings.

I’m in the deflation camp but the market is suggesting otherwise at the moment, particularly the U.S. bond market (there’s been a steep rise in government yields). If the market’s right, inflation is on the way, which would mean stocks rally initially and then fall as the U.S. raises rates to keep a lid inflation.

Asia: Laggards to Come Back?

If I’m correct and we get a temporary pullback before one more rally, Asia should also drive hard towards 2007 highs. And stock market laggards such as China should start to play catch-up, particularly against outperforming South-East Asian countries.

shanghai se composite

Asia’s perennial laggard, Japan, has already started playing catch-up, with the Nikkei 225 up 38% in local currency terms after reaching lows a year ago. China has also rebounded, up 24% from November lows.

Being a laggard isn’t the only reason for China to outperform from here. Valuations are reasonably cheap at 10.1x price to earnings ratio (PER), a discount to Asia ex-Japan’s 11.7x PER. Also, there are clear catalysts in the form of possible structural reforms from the new government. China markets tend to move on policy direction and there should be more clarity on this in the first half of this year.

To be clear though, I view China as a trade rather than a long-term investment. As I’ve mentioned previously, the infrastructure-led, debt-financed stimulus in the fourth quarter of last year may have provided a short-term boost but is detrimental to an already distorted economy.

To that end, the latest report from ex-Morgan Stanley economist Stephen Roach is of interest. Roach has high-level Chinese contacts and is a well-known China bull. To his credit, he’s been right more than most.

In this report though, he expresses clear and imminent concerns for the Chinese economy:

“The Chinese economy has come through two major global crises in the past four years. On the surface, its resilience has been impressive – the first to recover, as Chinese leaders always want to remind the rest of the world. But, beneath the surface, an unbalanced, unstable, uncoordinated, and unsustainable economy risks losing its capacity for resilience. Without balancing and reforms, the days of the automatic Chinese soft landing may be over.”

These are strong words from an establishment figure and are very different from his previous commentary. As if to demonstrate Roach’s concerns, news appeared around the same time that the Chinese government had rolled over 3 trillion yuan in loans owed by local governments at the end of 2012. Recall that local governments borrowed heavily from banks to fuel the massive 2009 stimulus program.

It seems kicking the can down the road is not only a western world phenomenon. The Chinese may be refining and expanding the concept!

In short, play a China rally but don’t fall in love with the trade.

Last Year’s Winners Led January

If the laggards are due to play catch-up, it hasn’t gone according to script so far this year. In Asia, last year’s winners were leaders again in January, with Thailand and the Philippines up 8.5% and 7.5% in US dollar terms, compared with Asia ex-Japan’s rise of just 1.6%.

performance january usd

There’s little doubt that economies in South-East Asia are continuing to prosper, as witnessed by figures out this week showing the Philippines’ GDP growing 6.6% in 2012. Even celebrity economist Nouriel Roubini is lauding the Philippines’ economy (a little late on the bandwagon aren’t we, Nouriel?).

The superior economic performance is arguably reflected in stock market valuations though. The Philippines is the most expensive market in Asia, at 17.9x forward PER. Thailand is not as expensive at 13.5x but still above the Asia ex-Japan PER of 11.7x.

Finally, take note of the “Japanese effect’: the dramatic under-performance of South Korean and Taiwanese markets in January. The weak yen’s first victims…

Source: Asia Conf.

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About James Gruber