Towards the end of April this year most of the world’s major stock markets turned down and the market highs set then, remain untested. For most, of the markets, the all time highs set in 2000 are also yet to be tested.
In spite of the rally from 2003, we are very suspicious of any belief in a return to bull market conditions until values have fallen from being exceedingly ‘too dear’ in 2000 to ‘too cheap’. Such a move will eventually mark the low that will be recognisable by the same characteristics that have held good since financial markets were first invented. Bull markets end with huge euphoria at nose-bleeding valuation levels and bear markets end at times of black despair and at bargain basement valuation levels. It is quite obvious that the investment mindset of black despair has yet to occur, we therefore conclude that the bear market that started in 2000 has yet to end.
The four horsemen of stockmarket Apocalypse
There is plenty of evidence to support an argument that the current top formation will lead to a significant slide. Four of these are the VIX, the deteriorating US house market, the Dow Theory state of non-confirmation and the inverted yield curve. Individually, each of these makes a case for serious concern. Together, as a foursome, they are potentially, in investment terms, the Four Horsemen of the Apocalypse.
If stock market tops are forming, leading to the next important decline and serious wealth erosion, then investment’s ‘Four Horsemen of the Apocalypse’ are galloping towards us!
1. False peace
The first, on a white horse, is ‘false peace’. The Volatility Index (VIX) measures fear or complacency. In April it stirred significantly, only then to settle back. This horseman’s exploding arrival will be confirmed by the VIX moving above the level of twenty-four.
2. War and destruction
The red horse brings war and destruction. The US house market has been driven to excessive (nose bleeding) valuation levels as a result of easy credit and artificially low interest rates. The boom so created is now poised to bust, as it surely must, in so doing, it will ravage the over-spent, over-borrowed US consumer. It has been reported that, in the first quarter of 2006, 320,000 properties were subject to foreclosure action, a 72% increase on the first quarter of 2005. And the serious house market-driven pain is yet to happen. Some experts are predicting it will fall by between 20% and 40%; if so, foreclosure actions will soar.
The option ARM is a variable rate mortgage subject to an agreed practice of underpayment. Over the next year or two, these will be brought into line. For those complacent borrowers it will cause extreme financial distress. George McCarthy, the housing economist at New York’s Ford of Foundation recently said “The option ARM is like the neutron bomb, it’s going to kill all the people but leave the houses standing.” We thank the Daily Reckoning for bringing that quote to our attention.
3. Unfair trade
The black horse brings famine and unfair trade, which is Dow Theory in a state of non-confirmation. The Industrial Average remains firm whilst the Transportation Average continues to be much weaker. For the economy to be in good health, each of these averages should confirm the other moving higher. If the economy is in bad health, each of these averages should confirm the other heading lower. When one average is relatively firm and the other is relatively weak, something is wrong and if, in the final analysis, the confirmation is one of weakness, the worst must be expected.
4. Sickness and death
The fourth and last horseman rides a pale horse, representing sickness and death. The inverted yield curve can be likened to the mistaken symptom of indigestion leading to a fatal heart attack. When long-term interest rates are lower than short-term interest rates and that situation persists, it invariably signifies future declining economic growth and recession.
UK banks get hotter under the collar as the number of Individual Voluntary Arrangements (IVAs) sharply mounts. The Financial Times reported that a surge in bad debts forces lenders to tighten criteria. This is the inevitable process which generally leads to banks bringing the ceiling down onto their own heads. Once the process of lending ever more amounts to ever more sub-standard borrowers reverses; it’s like the tide turning and finding out who’s skinny dipping. There are far more debtors out there financing their ongoing debt with further borrowings than anybody can possibly know. By tightening their criteria, banks ensure that doors are slammed in the face of those borrowers whose subsequent default is then inevitable. Where the loan is unsecured, the bank suffers a loss.
Where next for markets?
The UK house market continues to be vigorous, albeit driven we hear in London by foreign buyers and elsewhere by resurgent, very brave, buy-to-let investors. The danger is that if the Bank of England hikes yet again, lenders will get even more concerned and tighten their criteria even more.
Certain of the emerging markets have benefited these last few months and unquestionably offer tempting opportunities. We suspect these are best patiently awaited because if the major markets are going to have trouble, the emerging markets will be hurt badly. The centre of the world is in the process of moving from the United States to Asia and as a result of that, many of today’s emerging markets will be become tomorrow’s developed economies. We watch for that to happen.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/