4/4 When Citibank Chief Exec Talks, Do People Listen: “A market correction is coming, this time for real”
Apr 4 (Econotech FHPN)--“much of the good news has come as a result of extraordinary levels of liquidity pouring into opportunities around the globe. To a large extent this is due to the Federal Reserve's expansionary monetary policies early in the decade and the US administration's fiscal stimulus. The yen carry trade has also facilitated the buoyant expansion of investments and leverage evident everywhere today. The low spreads, the tremendous build-up of liquidity, the reach for yield and the lack of differentiation among borrowers have stimulated both dynamic growth and some real concerns. Pockets of excess are becoming harder to ignore … As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface … I believe that over the next 12 months a market correction will occur and this time it will be a real correction … Market developments in the past few weeks should be seen as a warning … what is clear to me is that in the next year a material correction in the markets will occur … Today, hedge funds, private equity and those involved in credit derivatives play important, and as yet largely untested, roles. The primary worry of many who make or regulate the market is not inflation or growth or interest rates, but instead the coming adjustment and the possible destabilising effect these new players could have on the functioning of international markets as liquidity recedes.” “A market correction is coming, this time for real,” Mar 29, "Financial Times" op-ed, by William Rhodes, senior vice-chairman of Citigroup, and chairman, president and chief executive of Citibank [bold emphasis added]
Is the Global Bull Market Still Intact, or Should I Sell Now?
This is the chief executive of Citibank, one of the world's largest, saying "in the next year a material correction in the markets will occur." Not some blogger, permabear, the IMF, or Morgan Stanley's Stephen Roach. (Just kidding on the last one, I greatly respect Roach's intellectual integrity, honesty, and professional courage.)
Given such authority, Rhodes' article certainly got the attention of those to whom I've shown it, followed by the understandable practical question, so, should I sell now? That’s always a difficult question, especially for longer term investors.
My web site link does not focus on and does NOT intend to give investment advice. Given that constraint, this is how I can reply here.
Throughout this 2002-07 bull market cycle, two simple basic assumptions of mine have been that, first, global market uptrends, though perhaps now increasingly vulnerable, remain still intact until clearly broken (e.g. I made that point in a number of articles in 2006, starting in my June 2 article, "Did May's Sharp Global Market Sell-off Signal a Major Trend Change," link that noted at the time that the uptrend still seemed intact), and second, that usually a major change in trend occurs with a change in market leadership.
The sharp correction last May-June was triggered by concern about rising inflation, currently market concern is about slowing U.S. growth combined with stubborn inflation. In both instances, the rising prices of gold and industrial commodities have been a good inflation concern indicator, so I watch them for clues. For signs of sluggish growth, I focus on such things as the homebuilding, retail and other cyclical stock indexes and etfs. I will discuss a few key charts later in this article.
Shorter term, meaning the next six months or so, based upon a current update of a very accurate recession predictor model developed by a Fed researcher, which I will post here if I can figure out how to cut and paste it (for the original model, see Jonathan Wright, “The Yield Curve and Predicting Recessions,” Feb 2006, pdf link), I believe that global markets are currently underestimating the chances of a U.S. recession. E.g., recently reported weakness in durable goods orders did not bode well for those hoping for U.S. capital spending strength, in case the resilient American consumer should, finally, falter.
The big risk, of course, is that should the economy, and thus job and income growth, perform worse than consensus currently expects, then real estate markets and their fragile psychology will get a much larger shock than the subprime-arm reset forecasts of 1-2 million foreclosures anticipate, and more neighborhoods will start to feel a palpable physical "contagion" of unsold and abandoned homes.
Worse yet, should the economy ever fall into that sinkhole, then it is hard to see another asset class of the same size and importance as real estate that could be massively reflated to pull it out. Off the top of my head, only a huge revamping of the economy for more efficient, cleaner energy production and consumption might do the trick. And/or perhaps an even much larger increase in military production.
Longer term, after of course the all-important preservation of inflation-adjusted capital, an important objective for many U.S. investors is to try to become diversified internationally and stay that way, since most of the growth in the world is in the emerging markets. The difficulty at this time is that emerging markets have already had huge moves, and can be very volatile to the downside, as most recently shown last May-June and this late Feb and early March.
Since this bull market has been led by emerging markets, in line with one of my key assumptions mentioned above, I closely watch EEM, the emerging markets etf, for clues. In the first quarter it became more volatile and range-bound in a consolidation of huge previous gains in the fourth quarter of 2006. Increased volatility without increased returns is always a warning flag that catches my attention very quickly.
EEM has now recovered to its previous high following the “Shanghai” sell-off that started in late Feb link . If it doesn't break out to meaningful new highs soon, then I would guess markets might become more concerned about this key uptrend.
India and some eastern European countries have nascent over-heating inflation and/or current account issues that have typically derailed emerging markets in the past. India is a key growth story, including from a U.S. geopolitical perspective. Its stock index has been lagging recently following the recent correction, and thus bears close watching as a possible negative catalyst for the broad emerging market asset class.
While China doesn't have these same economic issues, its stock market remains very extended, making new highs after a couple of very short declines earlier this year. Investors seem to remain convinced that China’s government won’t take away the proverbial “punch bowl” before the party (pun intended) congress this fall and next year’s Olympics. Despite recent top-level official Chinese policy statements in favor of more balanced, equitable, energy efficient, environmentally sensitive growth, the risks that come with a very strong export-led investment boom continue.
Comparison of Key Global Stock Market Indexes
The following points are based on the 4-year daily chart right below, courtesy of prophet.net (left click once on it to expand), comparing etfs based on five key market indices, three domestic, SPY (black, S&P 500), QQQQ (blue, Nasdaq 100), IWM (red, Russell 2000); and two international, EFA (green, MSCI World ex US, i.e. developed markets) and EEM (purple, MSCI emerging markets).
First, all five etfs are still in uptrends according to the most basic definition of higher highs and higher lows. I've drawn in two straight uptrend lines (in brown) just to help visualize this.
Again, until these indexes seem to flatten out, break their uptrend lines, and turn down, the most basic technical rule of thumb is to give the benefit of the doubt to the ongoing uptrends continuing, as I mentioned above, but with a very large caveat, which I will state shortly.
Second, the two international etfs have greatly outperformed the two large cap domestic ones, with only U.S. small caps being in the same league.
EEM, the emerging market etf, has increased about 260% in the past four years, outperforming both SPY and QQQQ by about 4 times. And that is just the broadest index, many national emerging markets have gone up far more, not to mention the even larger gains in individual international stocks.
Third, each etf has rebounded from the decline that started at the end of Feb and is now nearing or at its previous high.
Should they take out those highs, especially EEM, perhaps in another manic run along with rising commodities like last April, this might then trigger another sharp decline, like last May-June.
Here's the very important caveat re market uptrends. Conversely, failure to signficantly take out these recent highs might lead, at minimum, to continued volatility until the global economic/financial picture hopefully becomes clearer.
Or there is a "real," using Rhodes' term, possibility that this failure would mark the onset of a major market correction that he discusses above in the opening quote. Or even, at maximum, perhaps something currently unthinkable by most but quite worse, given the huge leverage and complacency in the global financial system.
I apologize to those wanting a more definitive answer. I don't have it, I don't believe anyone does when it comes to market timing, and even if I did, I couldn't share it here, sorry.
Basic Fundamental Issues in the Current Market Environment
What are some of the key issues currently in the fundamental economic/financial picture?
Here are five of them, leaving out geopolitical stuff, which daily swings between continued poor news and some slightly encouraging positive progress (see my Feb 28 article, link "Is U.S. Slightly Inching Toward My Oct 'Global Strategic Bargain'"? and my long article last Oct 27, "Global Strategic Bargain," link).
First, the impact of the global real estate boom/bubble. This factor has dominated the U.S. financial media, so I won't dwell on it here, with the surprises continuing to be negative in recent weeks and months.
The S&P homebuilder stock index shown below, a 3-year daily chart courtesy of stockcharts.com (left click once on it to expand), which peaked in July 2005 along with the housing market, is now well below its falling 200-day moving average (red line), testing its previous lows. Needless to say, failure to hold those lows might get the market's attention, I would guess.
Second, emerging market economic growth. Right now this is still a positive factor, once again being revised upward recently in China and developing Asia, to around 7.6% for 2007 (e.g., see Table 1.1.1. on page 8 of the new Asian Development Bank "Outlook 2007", I was not able to cut and paste it, the full 388 page report is here, sometimes a long download link) and one which financial markets have some difficulty accurately assessing because clearly this is now a much different global economy.
E.g., using the IMF's purchasing power parity weights, China accounted for 31% of world economic growth in 2005 (I don't have 2006), India 10%, and East Europe 9%, for a total of 50%, vs U.S. 15%, Eurozone 4% and Japan 4%. That is a dramatically different world than the one most American portfolio managers have spent their careers in.
In the most recent week, U.S. domestic steel production is running at a 100 million ton annual rate. China's is 475 million tons. Leaving aside economic and energy efficiency issues, there is an almost insatiable demand from China and other emerging markets for raw materials, energy, etc. Furthermore, light sweet crude oil has been getting much harder to find for more than four decades now (helping uranium stocks, which have been one of the biggest winners since 2000).
Even Europe is getting in on the act recently. According to the lead story in the Apr 3 FT headlined “European bourses eclipse US markets by value,” “the last time Europe eclipsed the US in market capitalization was likely to have been before the first world war.”
Btw, as a very broad generalization, most American fund managers, especially private equity and hedge, under 50 simply have no practical conception of an industrializing, or even an industrial, global economy, it's completely alien to their professional experience and deeply entrenched personal biases, which not surprisingly tend to view economic wealth creation through the distorted lens of massively unproductive paper asset inflation.
Third, private equity and m&a deals. While I consider these to be, both economically and morally (two sides of the same issue), incredibly wasteful high ROLLL (return on leveraged legal looting, see my previous articles, e.g. Dec 19 "World Needs Better 'Face of American Capitalism' than Private Equity," link), global financial markets view them as a huge positive factor. Global m&a deals reached $1 trillion in the first quarter, a record, and there seems to be no sign of slowing down.
Fourth, ultra-low long-term interest rates and credit spreads continue. This has been the support of everything above, global real estate, private equity and m&a deals, emerging market and all other valuation issues, etc. The failure to come to grips with this has been a major problem for bears.
Fifth, earnings growth. This very important fundamental factor often almost seems a secondary issue in the media compared with some of the others I just mentioned. In the U.S.., consensus earnings growth estimates are now projected in the mid-low single digits in the first and second quarters, after a string of 14 consecutive quarters of double-digit growth. Moreover, recently all S&P 500 earnings growth has been accounted for by the financial sector (again ROLLL, return on leveraged legal looting).
It is the global capital market's focus on ROLLL in this cycle, rather than on anemic real productive spending for global development that has been the big missed opportunity (see my recent Mar 5 article, link, "Potential Larger Implications of Volatile Financial Markets").
U.S.-Centric and Global World Views
Rhodes says in his op-ed quoted in my intro to this article, “During the last big adjustment that started in July 1997 in Thailand and spread to a number of Asian economies including South Korea, followed by Russia in 1998 - and led ultimately to the bail-out of Long Term Capital Management, the US hedge fund - a number of today's large market operators were not yet in the mix.”
This comment may strike many American investors as anomalous, since Rhodes skips over the huge 2000-2002 bear market, in which many lost a great deal of money, with the S&P 500 declining -48% and Nasdaq -78% (it is still more than 50% below the peak).
I don't know why Rhodes omitted this. Regardless, most Americans simply have no idea how devastating the so-called Asian financial crisis that Rhodes alludes to was to those countries, and the sea change in their view of western financial institutions that resulted from it, nor how close the global financial system came to a meltdown in the Sep-Oct 1998 LTCM hedge fund fiasco.
That is mainly because at the time the U.S. mass media was pre-occupied with the GOP impeachment of Pres Clinton over lying about sex during that critical period, all Clinton, all the time, for or against.
Now the roles of the two major parties have been reversed, and the issues discussed often more substantive. Now it's all Bush, all the time, for or against. Nevertheless, for the rest of the world, the key issues seemingly do not revolve predominantly around Iraq, Iran, Israel/Palestine, etc., as important as they may be, almost to the exclusion of everything else, as one might believe from the American mass media news.
For the developing nations, the issues seem to revolve more around the ones discussed in Rhodes’ article. Major financial players intensely focused on where the growth is in the global economy know that.
As a parallel to the current media pre-occupation with Iraq and Iran, as I’ve mentioned before, back in the early 1970s, the American mass media and hence public was pre-occupied with getting out of Vietnam and Watergate. Meanwhile, the “Bretton Woods” monetary system was dramatically changed with huge historic consequences that all but a microscopic handful of financial experts were aware of at the time.
By focusing so exclusively on what is happening in the Middle East, a critical region to be sure, the American mass media is subordinating the story of perhaps the greatest economic transformation, in terms of sheer scale, scope, and speed, in human history going on in China, India and elsewhere. And the American public is missing out on some tremendously uplifting Asian success stories, compared to the steady stream of depressing news coming out of the Middle East.
On "Charlie Rose" on PBS, a show I greatly enjoy, the Israel-Palestine conflict, a century-old tragedy which now directly impacts about 10-15 million people including Palestinian refugees, gets far more coverage than China and India, with a combined 2.4 billion, around 200 times as many.
If the tv show “Are You Smarter Than a Fifth Grader” were simply to ask for the names of the current leaders of China and India, which together soon will comprise almost 40% of the world’s population, out of 100 Americans, excluding Asian Americans, global business people and academics, how many would know? In comparison, how many urban middle-class in China and India, with incomes still far below the U.S average, could name the American leaders?
Again, my point is NOT to minimize issues critical to U.S. national security nor the strategic importance of the Middle East, but rather to place them in the context of the profound historic changes in the global economy. Perhaps looking back a few decades from now, that will be clearer.
A Few Closing Quotes With Ideas that May Be Linked
I will close with a few more recent quotes, with minimal comment, that I may take up in a future article.
“Carlyle Group's bid to buy part of Chongqing City Commercial Bank will be rejected as China stiffens opposition to buyout firms, especially in the $5.6 trillion banking industry, three people familiar with the matter said …The regulator is also mulling plans to make it harder for private equity companies to purchase stakes in banks. It is the latest setback in China for Washington-based Carlyle, which was forced last month to scale back a planned takeover of Xugong Group Construction Machinery Co. The Chinese government is concerned that buyout firms seek short-term profits and don't improve companies they buy enough, the people said.” Bloomberg, April 4.
"They [private equity firm Cerebus Capital Management] have to break the union. The key strategy behind everything they’re doing is to crush the unions. That has to happen … the Goodyear model is the model for Cerebus … Cerebus is a very smart company. The lynchpin of the strategy, I believe, is to break the union … I’m pro-union, I’m against manipulation." Jim Cramer, "Wall Street Confidential" video, Mar 29, my transcription, on Cerebus' strategy in the U.S. auto sector.
“Income inequality grew significantly in 2005, with the top 1 percent of Americans — those with incomes that year of more than $348,000 — receiving their largest share of national income since 1928, analysis of newly released tax data shows … While total reported income in the United States increased almost 9 percent in 2005, the most recent year for which such [tax] data is available, average incomes for those in the bottom 90 percent dipped slightly compared with the year before, dropping $172, or 0.6 percent. The gains went largely to the top 1 percent, whose incomes rose to an average of more than $1.1 million each, an increase of more than $139,000, or about 14 percent. The new data also shows that the top 300,000 Americans collectively enjoyed almost as much income as the bottom 150 million Americans. Per person, the top group received 440 times as much as the average person in the bottom half earned, nearly doubling the gap from 1980 … The disparities may be even greater for another reason. The Internal Revenue Service estimates that it is able to accurately tax 99 percent of wage income but that it captures only about 70 percent of business and investment income, most of which flows to upper-income individuals, because not everybody accurately reports such figures. ” NYT, Mar 29
"Venture capitalists in Silicon Valley have been searching for the next big thing in high-tech for years, but now many have switched to greener pursuits -- finding technology to help cut global warming." Reuters, Apr 3.
A little pet peeve of mine is Wall Street's labelling of "technology" to mean a very narrow, if important, sub-segment, information and communication tech. E.g., if you look at "Full Coverage: Technology," in the widely used Yahoo! News, that's all you see link.
This is not to pick on Yahoo! News, which I use a great deal. And I'm using Google's blogger.com to write this. Rather, it's just to point out a mindset that is endemic on Wall Street. That's why Wall Street and Silicon Valley often think the answers to global development and poverty are cell phones, laptops and entertainment downloading.
“Almost half, or 48 percent, [of Americans in a new Newsweek poll] said they reject the scientific theory of evolution, while 34 percent of college graduates said they accept the Biblical account of creation as fact.” Bloomberg, Mar 31 (Please don't read this as anti-religious, it is NOT intended that way, but rather as pro-science.)
“Sales for a top-selling classical recording in the West number merely in the thousands instead of the tens of thousands 25 years ago. More profoundly, classical music executives say that the art form is being increasingly marginalized in a sea of popular culture and new media. Fewer young American listeners find their way to classical music, largely because of the lack of the music education that was widespread in public schools two generations ago. As a result many orchestras and opera houses struggle to fill halls. China, with an estimated 30 million piano students and 10 million violin students, is on an opposite trajectory. Comprehensive tests to enter the top conservatories now attract nearly 200,000 students a year, compared with a few thousand annually in the 1980s, according to the Chinese Musicians Association.” NYT, Apr 3