The turn of the year is characterised by two periods, the first is the run-up to the year end, the ‘Santa Claus Rally’. Stock markets usually enjoy an upbeat period as money managers and investors worldwide contemplate the calendar year-end and optimism is high. Then comes the year end when another market expression is dusted down and brought out: “As goes January, so goes the year”, also called the ‘January barometer’. January’s price action has often been predictive of the year to come.
Most of the investment world returned on 2nd January after what was a prolonged break; however, the United States, at the last minute, opted out in order to pay their last respects to the late Gerald Ford, the unelected President who reached his high office as a consequence of Nixon’s disgrace.
How the stock markets began 2007
The FTSE 100 started the year off in a fast and furious way, immediately putting pressure upon our bear fund holdings which we were poised to part-sell on Wednesday subject to market behaviour. In fact, the UK market struggled for upside momentum all day in spite of a strong opening in America, the Dow Jones at one stage was up over 100. Then the latest Fed Minutes were published which included two key items. First was the continued concern about inflation. Second, an unexpected deterioration in the Fed’s housing market view. So in spite of a weak oil price, the stock market turned tail and the Dow Jones Industrial Average closed only eleven points up. We await Thursday’s market with great interest expecting stock markets worldwide to open in negative territory, if so bear fund positions will remain in place.
The UK expects to see a surge in personal insolvencies for the first quarter 2007 as precarious household budgets suffer further pressure from excess Christmas and January sales spending. The Economist, in its most recent issue dated 23rd December, wrote about “The Big Squeeze on UK Living Standards”. Average earnings in real terms, they say, have failed to increase sufficiently to compensate for the rate of inflation and in 2007 they expect for that situation to be exacerbated. Once the January sales have ended, even those British consumers not confronted with an insolvency nightmare might well choose to retrench somewhat. As we have pointed out many times before, consumers are the plankton in our economic food chain.
We expect, in the first quarter, for our four financial Horsemen of the Apocalypse to deliver a signal which, we believe, will provide an enduring indication of what to expect.
Stock market indicators: VIX gives cause for concern
The white horse – false peace – The Volatility Index (VIX)
Lawrence Summers, on the 27th December, wrote a piece in the Financial Times entitled “A lack of fear is a cause for concern”, focusing on the benign behaviour of the Volatility Index. The new year he said will begin with the greatest divergence for a generation between the general view of global risks as reflected by conventional wisdom and the risks as priced in financial markets. While the commentariat has been more alarmed about the state of the world than global markets for some years, the gap increased in 2006 as markets became more serene and everyone else grew more anxious. At RHAM we are amazed and to some extent scared, by the gung-ho disregard of risk which, like an adder sunning itself in a field, might appear innocuous and harmless but can be deadly if disturbed by a clumsy foot. If that clumsy foot belonged to the white horse, its reaction would be alarming to say the least and on fear returning to the market, accompanying market activity might be very dramatic. The VIX Index on Wednesday was aroused. If from here it should move sharply higher, watch out!
Stock market indicators: US housing market still in trouble
The red horse – war and destruction – The Philadelphia House Market Index
As we reported three weeks ago in issue number 535, US house builders’ stocks that this index comprises, enjoyed a decent run up following a very considerable 33.33% sell-off. That rally has stalled and on the back of comments in the latest Fed Minutes it has turned over. This is what the Minutes said “Economic growth had slowed over the course of 2006 partly reflecting a ‘substantial cooling’ of the housing market.” [This description went far beyond previous Fed assessments, suggesting they think the situation is worsening.] “Considerable uncertainty regarding the ultimate extent of the housing market correction meant that spill-over to consumption could become more evident, especially if house prices were to decline significantly.”
2007 is going to be fascinating for US housing which we believe, in spite of a slightly better new house sales figure in November, is in a continuing downward trend.
For those who are interested, we would direct you to the website of the Center for Responsible Lending*, www.responsiblelending.org, to read their 58-page report entitled “Losing Ground”. They say that sub-prime mortgages in the US developed dramatically in recent years and they are set to deliver a huge increase in house repossessions. They are projecting that 2.2 million borrowers will lose their homes, explaining that one in five sub-prime mortgages originated during the past two years will end in foreclosure and that 25% of all new mortgages over that period were sub-prime mortgages. A typical characteristic of a sub-prime loan is that the early rate of interest paid is below the market rate. In 2007 it is reckoned that $1 trillion of such mortgages will be reset to higher current rates.
Back in the late 1980s / early 1990s sub-prime mortgages in the UK were a very big deal. Our experience of the borrowers who resorted to sub-prime mortgages in the UK at that time was that they typically could not afford the mortgage that they applied for. We don’t doubt that situation exists in the US today; if so, some financial institutions and maybe even the system, will be put into considerable danger.
Stock market indicators: a clear signal from the Dow
The black horse – famine and unfair trade – Dow Theory
On Wednesday 3rd January 2007, the oil price dropped quite sharply and not surprisingly, transportation stocks in the US benefited and rose by more than 2%. Nonetheless, non-confirmation remains the order of the day; eventually either both the Industrials and the Transports will rise to new highs together or, in our opinion more likely, the Industrials and the Transports will fall together. The following list bears reading:
• The transport sector of the US economy accounts for 50% of US oil consumption. If the Transportation Index is lower today than in early 2006, which it is, on the back of a falling oil price, then something is wrong.
• During quarter four 2006, many of the companies in the transport sector announced declining shipping volume.
• The “For-Hire Truck Tonnage Index” provided by the American Trucking Association was down 3.6% in November, this followed a 1.6% drop in October. The Index is 8.8% below its level of a year ago, the largest year over-year decline since the last recession.
The continuing failure of the Transports to confirm the new highs for the Industrials is a clear signal that something is wrong.
Stock market indicators: inverted yield curves persist
The pale horse – sickness and death – The Inverted Yield Curve
In the US and in the UK inverted yield curves historically persist, a signal of pending economic slowdown.
We will be watching the January barometer very closely. That, linked to the Four Horsemen, ought to provide us in just a few weeks with some very important clues to what investments are going to do in 2007.
Unusually, there has been a three-week period since the previous issue. The next issue is timed to be three weeks’ hence to bring us back to the usual two-weekly sequence.
* The Center for Responsible Lending is a non-profit, non-partisan research and policy organization dedicated to protecting homeownership and family wealth by working to eliminate abusive financial practices. CRL is affiliated with Self-Help, one of America’s largest community development financial institutions.
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/