Sunday, January 18, 2009

International stock markets markets - where to from here

Many countries around the world are in a recession (one that will most likely get a lot uglier in terms unemployment, poverty and social unrest) and we've had major stock markets busts in every major market. I summarise what past studies and current data tell us about how things are likely to play out in stock markets around the globe. Given economic data and economic theories and forecasts are always flawed (inaccurate, incomplete, irrelevant etc) I find the best way is to take a wide range of perspectives to get an overview and avoid basing my thoughts on one shaking bit of data or one perspective.

A. Let's start by thinking at which equity markets matter and if it's really meaningful to talk about a global equity market, as opposed to a whole lot of country specific equity markets. In recessions most equity markets around the world tend to have much higher correlations with each other than they usually do (i.e especially when there are in sync recessions as is the case at the moment). So at the moment and in the medium term we can meaningfully talk about a global equity market. This means that any question about who a stock market will perform in one market is tied up to the question of how the whole current global crisis will play out. The US is the largest economy in the world and also leading the pack in terms of timing of real impacts on the economy so is probably the most relevant place to study. At the moment it seems the initial crisis stage in the debt markets have passed due to actions by the Federal reserve and others in propping up the debt markets. For relevant indicators see ttp://

However in most vital areas of the USA real economy (e.g. housing markets, retail sales, and unemployment) things are not only getting worse but the rate of deterioration is increasing. Indexes of leading indicators are also pointing down. Before things actually get better in the real economy the chronological steps we have to go through are:
  1. Stop increasing the speed of deterioration
  2. Continue to get worse but at a slower pace
  3. Stabilise
  4. Start to improve.

It's hard to see all these steps occurring within a time frame of less than a year . Indeed to may take it may take a number of years and be an L shaped recession. i.e. a protracted period of economic stagnation like the one experienced by Japan in the 1990s after the bursting of its housing and equity bubble So as far as the real economy in the USA is concerned it's going to be a while before things turn around. Other countries are just now entering in recessions so they may even come out of recessions after the USA.

B. The scope of government action. The decrease in real GDP has occurred despite large stimulus and bank bailout measures and unprecedented monetary policy action. So there is not too so much more the governments can do without causing themselves significant long term problems (i.e. government deficits become to large for markets to believe they will be serviced and the Fed ends up lacking creditworthiness due to holding assists worth less than amounts lent).

OK so that's the real economy but hasn't the stock market already fallen a lot and discounted these problems meaning we might have seen the bottom?

C. When in the economic cycle are equity returns usually strong? Research indicates that returns in stock markets are very high for 6 months starting in the last 6 months of recession or at the end of recession. So given we're very likely more than 6 months away from the end, and possibly years away, this suggests we should be vigilant for a possible stabilisation in the recession (particularly if its' not related to one off government stimulus responses which will have a temporary impact) but we shouldn't be too hopeful about strong equity returns from this point.

D. Are stocks cheap compared to earnings? Aggregation of earnings forecasts suggests that when looking at individual companies USA equity market earnings forecasts are way too optimistic given the bleak macro economic outlook. i.e. analysts forecasts are suggesting earnings will zoom up over the next year when clearly the economy looks tougher this year than last. Earning disappointments will lead to disillusion with the market and create strong downward pressure on prices.

E. Are equity prices cheap compared to the asset values of the companies? Compared to valuation during the last few years yes prices are cheap compared to asset value. But historical standards during recessions equity prices are not cheap. Tobin's Q - The measure of equity prices to prices on assets on the books - is currently around 0.7 this typically bottom's at 0.3 during recessions. This suggests there is a long way to fall. i.e. over 50%.

F. Are longer term technical indicators basing in preparation for a sustained rebound? Primary long term trends in all major stock markets are clearly down.

G. What is driving equity term markets on a daily basis and does this gives us hope? Looking at the past 9 months the pattern in movement in daily stock prices is astoundingly consistent. Equity markets are rebounding based on possible government actions and falling on the reality of earnings and broader economic data. There is no other "story" of substance out there in the market. Given the size of the economic problem, governments cannot have an overwhelming impact. So once the reality of this hits the primarily stimulus in this market of this "Obama bounce" will be gone and traders will be focused on the bleak macro economic data and the bleak earnings data.

H. Will the new administration in the US make a difference? Sure they can take actions that will have positive impacts but they are still politicians in the same political, social, cultural and economic system and political/equity cycles suggest bad times ahead. Basically "on average" equity markets in the US perform well in the third and forth years of a presidential term and poorly in the first and the second years. My understanding of this is that in the third and forth years most presidents (and congress and the senate) worry about being elected next time so they need to get out there and sell a positive picture of the economy. However during the first two years they face the reality of not being able to fund all their promises and the opportunity to talk down things and blame their predecessor. No doubt Obama will "discover" things are a lot worse than he thought and he will not be able to follow through with campaign promises.

I. Buffet is buying so if I'm a long term investor isn't now the time to snap up some bargains? Yes Buffet has been buying (but generally getting a special deal rather than buying at market price as you would be). His interviews suggest he's buying based on his view that this is largely similar recession to the ones he has experienced since he started in 1954. There are two points here. One - this recession looks different in terms of the: possible insolvency of the banking system, the debt levels of the USA consumers and government and the massive bubble in house prices that still has a long way to bust . Two - Buffet doesn't try to time the market, he readily admits he usually buys in too early when the market falls and he buys stocks with very specific characteristics rather than the whole market (often at prices unavailable to others).

So in summary, the all the balance of probabilities is for more downside in stock markets all over the world for at least the next 6 months and possibly considerably longer.

In a word if you're a trader - short . If you're an investor I would dump companies that have a lot of debt (even if prices are fire sale it's better than holding on while they go bust) and stay away from the banks and finance companies, commercial property and builders that are directly exposed to the largest problem areas. Personally I'm short the SP500 index in the US and 85% cash and only 15 % invested in stocks in (this is my primary home market Australia). Most of these stocks are held based on a strategy of buying stocks that are trading at a 30% plus discount to their marked-to-market net asset value (a Buffet type strategy) and have no debt. Generally I try to to be 90% invested in the stock market so here actions speak louder than words.

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