Thursday, June 15, 2006

6/15 Bernanke Talks Down Risky Assets: Another “Hot Money” Temper Tantrum, or a Major Economic Trend Change?

June 15 (Econotech) – In my last article on June 2 link, I noted the usual “belief by the global hyper-speculators that the central banks and governments don’t have the incentives and/or guts to take them on, a usually safe assumption most of the time.”

Global Market Decline Doing Some of the Central Bankers Tightening for Them

The very next working day, June 5, Bernanke gave his inflation fighting credentials speech, which sent the global markets on the second down leg of its sharp decline since May 10, with key indexes slicing through March-April short-term support levels on their charts, declining to, or below, their 200-day moving averages.

So far Bernanke and his colleagues on the Fed have managed to talk down the most risky asset classes that were threatening to spiral out of control in March-April, especially industrial and precious metals, emerging equity markets and Japan, without having to actually slightly raise rates as of yet.

Through June 14 the GS industrial metals commodity price index, gold price and MSCI emerging market index were all down around -20% since May 10, Japan’s Nikkei fell -19% from its high on April 7.

I.e., skittish global markets have been doing some of the central bankers’ tightening for them. That is not to say that global monetary conditions are tight, especially in Japan, where the BoJ’s ending of its “zero interest rate policy” may be pushed back from July after it has sopped up much excess liquidity after stopping its five-year old “quantitative easing” regime in March.

Bernanke’s Current Inflation Fighting Act a Mirror Image of His "Helicopter" Money Deflation Fighting One

Bernanke’s current inflation fighting act almost seems like the mirror image of the performance Greenspan and Bernanke pulled off in late 2002-early 2003.

Back then, those two conjured up a threat of deflation, even though U.S. real estate prices and consumer spending were rising, unlike in actually deflationary Japan, fear of which was invoked to justify a super-loose 1% interest rate policy. That’s when Bernanke said the Fed could go even further if it had to fight deflation with its printing press and helicopter money. It “worked,” creating a massive reflationary real estate refi bubble to slingshot upward the consumer spending recovery.

Of course monetary/credit inflation is in the DNA of the Fed. Especially in the Greenspan era, the Fed found it much easier, economically and politically, to create multiple bubbles than to achieve a “soft landing” trying to deflate them.

Withdrawing Global Excess Liquidity without Major Problems Easier Said than Done

It’s easier for Bernanke to talk tough when the economy seems to be still doing okay, if slowing. We will see how strong an inflation fighter Bernanke really is if the economy does start to slow more sharply this year and early next below trend growth.

The problem facing the world’s central bankers as they withdraw liquidity was addressed by Mervyn King, the governor of the Bank of England, in a major speech June 12:

“One risk is that during the fastest three-year period of world economic growth for a generation, monetary policy around the world may simply have been too accommodative. In the main industrialised regions – the US, Euro area and Japan – official interest rates were very low for a long period. The liquidity created by low official interest rates around the world has helped to push down long-term real interest rates and compress credit spreads to unusually low levels. That monetary stimulus is now being withdrawn. Since January, long-term interest rates have moved up, and now other asset prices are responding. So far we have seen little more than a modest correction to the prices of a wide range of assets that had risen sharply over the previous two years. The realisation that such levels of asset prices were unlikely to be sustainable, coupled with a tightening of monetary policy in many countries, has injected uncertainty into financial markets. And it is hardly surprising that, as investors searching for yield realised that they might have underestimated the uncertainties, the price of risk moved up. Even though the monetary stimulus around the world is now being withdrawn, its effects are still being felt. There are some signs of inflationary pressures in the main industrial countries.” [bold emphasis added]

King captured the central bankers dilemma. If even minor attempts to rein in years of excess liquidity growth fueling massive asset bubbles has resulted in what he calls a "modest correction to the prices of a wide range of assets," imagine what a more serious effort would do to the global economic/financial system?

Any New Bubbles Left for Global Hot Money?

Global hot money inflates new asset classes while the previous ones deflate. Since last summer, when real estate started peaking, hot money started flowing in earnest into commodities, and equities in emerging markets and Japan. Japan’s stock market was mainly driven up by foreign, not domestic, hot money. Japan corporate profit growth fell to 4.1% in the first quarter from 11% in the fourth.

What if these latest hot money targets have peaked after their huge moves in Mar-Apr 2006? That is not a forecast, just a “what if” question. Are there any asset classes left that the hyper-speculators can now run into that are large enough to accommodate them, following previous global real estate and global equity bubbles.

Emerging markets have long since been “discovered,” as a quick glance at the volume on a three year chart of the EEM ETF shows (it has increased about tenfold).

As noted below, with the Fed having raised its rates and the BoJ at least beginning to get back to a more “normal” policy, liquidity growth in China and India remain extremely high and a concern for its officials. Will they attract even more of the stateless hot money, e.g. into their real estate markets, hindering their officials’ efforts to achieve strong but stable growth?

Market Volatility as an “Asset Class”

According to May 23 FT article titled “Volatility becomes an asset class”:

"Volatility is becoming an asset class in its own right. A range of structured derivative products, particularly those known as variance swaps, are now the preferred route for many hedge fund managers and proprietary traders to make bets on market volatility … among the advantages of the contracts are that they are almost as liquid as S&P 500 listed options, with spreads that are just as tight and with smaller capital requirements … One hedge fund manager, added: ‘As volatility, in the form of options or variance swaps are sold into the market, volatility drops. We invariably take more risk and the price of risky assets goes up. The introduction of these derivatives in the market then creates a situation that when volatility begins to rise, these trades must be rehedged and/or unwound. This makes volatility rise again.’”

Is Fed Now Trying to Subtlely Signal Not to Go Overboard on Inflation Fears?

John Berry’s June 14 Bloomberg column titled “Fed Doesn’t See Inflationary Spiral” may come as a seeming surprise to global financial and commodities markets obsessed with every tweak in U.S. economic data and every statement of concern about inflation by Fed officials. But Berry, along with Greg Ip of the Wall Street Journal, is considered well-connected to the Fed, and his columns are often viewed as a not-too-subtle conduit for conveying Fed thinking to the global markets.

In his lead, Berry says, “financial markets have been spooked by irrational fears of surging inflation. The result: an imagined need for endless interest rate increases to bring prices under control.” He concludes: “with wage increases so subdued, [UC Berkeley economist] DeLong said, the odds are ‘that there will be no significant uptick in inflation and no significant increases in interest rates from now forward to the end of the business cycle.’ Would that the markets could accept that quite reasonable forecast.”

As King of the BoE said June 12: “Pay pressures in the [UK] labour market are muted, reflecting in part the need of employers to adopt a tough stance in wage bargaining when faced by such large increases in other input costs … The rapid rise in input prices and the muted degree of pay pressures are not independent of each other." The same goes for the U.S. and globally.

Family Quarrel Between Central Bankers and Global Hyper-Speculators

I’m not inclined to take sides in family quarrels over inflation between central bankers and global hyper speculators, whom I view as two sides of the same inequitable global financial system. Price indices seem rather inaccurate anyway (“owner’s equivalent rent” being just one of the flaws). Inflation is a lagging indicator, and most importantly the debate almost always ignores the fundamental issues of massive monetary/credit expansion and an unprecedented series of huge asset bubbles.

The howls of derision and rage coming from the speculators directed at the modest efforts of the central bankers to make a small impact on their previously free liquidity largesse provided for the benefit of the former indicates just how out of hand the situation has become in favor of the global hyper speculators the past few years, once again reflected in the continued huge profits reported this week by Goldman Sachs (slightly down from the even larger first quarter record results) and Lehman Brothers.

As I’ve previously dubbed it, this is truly the “Golden Age of Goldman Sachs,” which now makes most of its money speculating, as a symbol for all the global hyper speculators.

Declining Gold Price, Rising Bond Market, and Credit Default Swaps Reflect Concern about Slowing Growth?

Despite the obsessive pre-occupation of some markets with inflation, other markets, specifically gold and bonds, don’t seem overly concerned about it. Since May 10, gold’s price is sharply down while the U.S. 10-year bond has slightly risen in value. Inflation-protected TIPS also don’t indicate a strong concern over inflation. The dollar also has recently strengthened, also hurting gold, again due to favorable yield differentials and a “flight to quality.”

Credit default swaps are beginning to indicate more concern about a slowing economy. From a June 14 Bloomberg article titled “Credit Derivatives Jump, Signaling Decline in Corporate Bonds”:

“The threat that U.S. growth could slow to less than 2 percent from 5.3 percent last quarter raises ‘significant’ risk of defaults, Banc of America Securities LLC said in a June 12 report. ‘It is this concern in turn that likely is contributing to the increase of spreads,’ wrote strategist Jeffrey Rosenberg. Rosenberg said a growth rate of 2 percent would cause defaults to surge to 6 percent … The credit derivatives market has grown to $17 trillion from almost nothing in eight years … ‘Credit spreads are likely to struggle to make any positive headway over the next few weeks if not longer; more likely, they will come under incremental pressure until or unless this period of interest-rate uncertainty ends,’ said Edward Marrinan, head of North American credit strategy at JPMorgan Securities in New York. “

Will Increase in Credit Risk Impact Huge “Cynical Bet” of Private Equity Firms?

From a June 13 WSJ article titled “High-Risk Debt Still Has Allure For Buyout Deals”:

“The resilience of poorly rated corporate debt ... has buoyed private-equity firms. They are plowing ahead with ambitious takeover plans of companies that often involve loading them up with debt … It isn't just banks eager to lend feeding the froth. Demand also comes from new groups of investors, including hedge funds and other money managers … there will be little warning when the turn comes. That is because one of the more popular structures, so-called PIK, or payment-in-kind, loans, allow private-equity firms to load up their portfolio companies with debt that they defer repaying. Such back-ended structures can amount to a cynical bet that, by the time the real burden of repayment comes, the private-equity firms no longer will be the owners … part of the traditional early-warning system of the debt markets comes when ailing companies ask lenders to relax loan conditions. These days, terms have become even more relaxed, or even nonexistent … when defaults come, they will come suddenly. Moreover, recoveries are likely to be lower. That is because there are so many layers of debt, compared with previous cycles. Also, private-equity firms have taken a lot of cash out of their portfolio companies while putting more debt on the balance sheet, leaving less for creditors when these companies finally hit the wall … The smart money is starting to plan for less-robust debt markets.”

Broad Global Equity Market Indexes Uptrend in Question but Seems Still Intact, for Now

As I asked in the title of my last June 2 article link, is the more than 3-year cyclical bull market uptrend definitively broken? Obviously it seems a lot closer after June’s sharp down leg, but it still hasn’t happened just yet, at least judging by the broadest global equity indexes.

Again, stepping back for the “big picture,” it still seems to me that the MSCI, FTSE and DJ world indexes have come down at the moment to right around their rising 200-day moving averages, whose slope was higher in 2006 than 2005. In this longer cyclical bull time frame, there are not lower highs (May 2006 is the last peak) and lower lows (the last one being in Oct 2005) yet on their charts.

Thus, needless to say, the quality of any rally, which may have begun June 14 (starting as a typical mid-week short covering bounce induced during options expiration week) from these short-term deeply oversold market conditions will go quite a way toward indicating whether the long-term trend has changed. Specifically, a failure to take out the previous high in early May would be very significant.

Energy and Broker-Dealer Stocks Are Leaders in Cyclical Bull Market

Energy stocks have been among the best and most consistent performers in this bull market due to their favorable cyclical and secular story. The energy sector has been the story of this cyclical bull market, just as tech was for the previous one. The oil services stock index has come down to right around its rising 200-day ma, which has held as support in its huge uptrend since Nov 2003. Uranium prices for nuclear energy remain strong.

Another strong group, broker-dealer stocks, is now just below its rising 50-day ma, on its uptrend line since its July 2005 lows, and well above its 200-day ma, as Goldman and Lehman sold off after strong quarterly earnings reports this week. Besides its traditional role of indicating the amount of optimism about financial markets, this sector is even more important now then in previous cycles, given the dominance of hyper-speculators in the global economy.

A much less known bank index of global shipping stocks, which should be sensitive to trends in world trade, has been flat since early 2005, after tripling from late 2002 to early 2005.

Homebuilding Stocks Reflect Continued Concern about Real Estate

Less talked about lately by the financial media but a key area of concern for me continues to be the homebuilding stock index and new etf.

However you draw the “neckline” of a topping pattern on the HGX chart from its Jan and April 2005 lows (horizontally or up-sloping), it has clearly been broken on this last leg down in June, with the 50-day ma also now well below the 200-day. Given the critical importance of real estate paper “wealth” to the U.S. economy, this breakdown is a serious warning.

From a June 12 story on titled “More housing markets overvalued”:

“according to a study based on government data released Monday by Global Insight and National City. In the first quarter, 71 housing markets, representing 39% of all U.S. housing, were deemed to be ‘extremely overvalued’ based on median sales prices, median income, population and historic values. That's up from 64 markets accounting for 36% of housing in the fourth quarter. In the first quarter of 2004, just 1% of housing was considered overvalued. To be ‘extremely overvalued,’ homes had to be valued at least 34% more than "normal." When prices do fall from overvalued levels, they typically fall by about half the overvaluation, DeKaser said. The correction usually takes three and a half years … California and Florida accounted for 17 of the top 20 overvalued markets, economists at the two firms said.” (Link for the 27-page report.)

Emerging Markets a Replay of 2004’s Decline in Growth of OECD’s Leading Indicators?

Another large area of concern, the MSCI emerging market index, is currently a couple of percent below its still rising 200-day ma.

The last decline in this index of similar magnitude occurred in April-May 2004 due to concerns about China tightening to slowdown an overheating economy, demand from which helps drive the commodities of emerging markets.

One can see that on the chart on page 1 of the June 9 OECD release link showing the 6-month rate of change of the Composite Leading Indicators (CLI) for the OECD and for China, which lead changes in industrial production growth.

Back in the first half of 2004 both CLI’s growth rates rolled over, which was discounted in the sharp Apr-May decline in the MSCI emerging market index. Currently, the rates of change of both CLI’s are rising through April (which doesn’t factor in the sharp stock market declines since then).

Very Strong Growth in China and India Continues, along with Excess Liquidity

So, the same concerns in emerging markets about a turndown in the CLI’s growth rates could be re-surfacing. Once again China’s growth rate is even higher than expected, indicated in the spate of latest economic statistical releases.

China fixed-asset investment rose 30.3% through May. According to a June 15 Bloomberg story, “Premier Wen Jiabao yesterday told local governments and banks to limit lending to stop excessive investment that the World Bank says could cause the world's fastest-growing major economy to slow abruptly. The central bank, which raised lending rates in April for the first time in 19 months, today announced plans to step up operations to drain funds from the financial system.”

China’s industrial production was up 17.9% in May, the largest since April 2004 after adjustment, beating all 22 economist forecasts surveyed by Bloomberg. To put this is some perspective, China’s steel production is currently nearly four times that of the U.S.

Also in May, China’s exports were up 25.1%, a record $13 billion trade surplus for the month, a surplus for the year to date up 57% from last year. Retail sales are up 14.2%, the highest in 17 months. M2 money supply is up 19.5% through May, the fastest since Dec 2003 and above a 16% target. China’s bank lending in May was almost double that of a year ago.

Similarly, manufacturing in India was up 10.4% in April. I saw India’s finance minister on Bloomberg tv recently defend the central bank’s surprise decision to nudge up its policy interest rate, one of several rate hikes by central banks last week, by saying that credit was growing 30% over the past 24 months and widely available.

In other words, seemingly excess credit growth in these two largest emerging markets has barely begun to be reined in so far.

Real estate speculation remains a key concern of China's central government. According to a June 7 AP story:

“more than 60 percent of recent land acquisitions for construction in China are illegal, with the figure rising to 90 percent in some cities, the government said in a report demanding investigations of such deals. The increase in violations comes despite repeated calls by the central government for local officials to stop selling land use rights for unauthorized construction, often for industrial parks, luxury housing and showcase projects such as convention centers. In a warning posted on its Web site Wednesday, the Ministry of Land and Resources said any land deals lacking its formal approval are invalid. The ministry, which oversees all land use, reported that more than 60 percent of new land deals since September 2004 were illegal, the official Xinhua News Agency and other state media reported Wednesday.”

How Long Will Rest of World Put Up with Global Hot Money?

As officials in emerging markets countries once again try to achieve “soft landings” in this over-heated environment, the increasing volatility of global hot money is not making things easier. One wonders how long the rest of the world will put up with this, since this hot money is not economically critical to emerging markets, unlike foreign direct investment.

There have been major changes since the flight of hot money exacerbated (some say caused) the many major emerging markets crises of the 1990s, which were enormously destructive for their poor populations. The emerging markets in East Asia are now much stronger, with current account surpluses (elsewhere Turkey has a deficit), huge forex reserves, somewhat more flexible currencies, etc. Meanwhile, the U.S, with its massive, unsustainable current account deficit, and Japan, with its mountain of government debt, are arguably financially weaker than they had been.

Increased global market volatility from the flight of hot money seeking to protect its recent gains is causing concern about hedge funds from non-U.S. officials, most recently expressed in the ECB’s latest “Financial Stability Review,” and by Hong Kong’s second highest-ranking official in a June 7 speech to international securities regulators.

One key battleground is the “opening up,” to global hyper speculators, of the financial sectors of China and India. In China, a decision is expected soon on Citigroup’s effort to control Guangdong Development Bank. In India, the issue is currently being fought over how much foreign control of insurance joint ventures.

Geopolitical Efforts to Dampen Energy Inflation from Multilateral “Realist” Elite Faction

Raising interest rates does not seem to be a very effective way of controlling energy and commodity price inflation.

It seems that the “realist” multilateral factions of the U.S. foreign policy elite, i.e. the conservative Bush Sr. crowd (Baker - Scowcroft) and the more liberal wing of Colin Powell - Richard Armitage - Richard Haass (pres of Council on Foreign Relations) may have, finally, had a little more impact on the Bush administration, through Rice, who is an opportunist, not a neocon, with long-standing ties to the Bush Sr crowd.

The multilateral realists increasingly had been clamoring for direct talks between the U.S. and Iran. This was usually couched in foreign policy terms, including the U.S. being overstretched in Iraq.

But it is quite possible that some of the "realist" foreign policy elite finally realized that the global economy was too fragile to take another huge spike up in oil prices during an Iran confrontation, and are attempting to minimize that hit to the global economy (e.g. Haass’ May 15 Newsweek article, “Let’s Not Play the Oil Game").

The outcome of the U.S. recent diplomatic opening to Iran is very unclear, and I remain skeptical until proven otherwise. Even such a staunch ally of the U.S. as Koizumi’s Japan is evidently wary of Iran sanctions, which takes 22% of Iran’s oil exports and “has more at stake in Iran financially than any other potential sanctions partner,”according to a June 13 Washington Post story.

The presidents of Iran and Pakistan have been in China this week as observers at the Shanghai Cooperation Organization meeting, which included Russia's Putin and four central Asian states. India, with which the Bush Administration has been trying to create closer ties through a special nuclear deal, was represented by its Oil, not Prime, Minister.

Rumsfeld earlier expressed his displeasure at Iran’s presence at the SCO meeting. According to a June 13 Bloomberg story, “the U.S. government today froze the assets of four Chinese companies and one American company accused of helping Iran to develop missiles. The Treasury Department said the companies supplied Iran with missile components or with technology that can have military uses.”

Real Solutions to Global Economic Issues Remain as Distant as Ever

The recent volatility in global markets continues to obscure the fact that the key underlying problems are simply not being dealt with.

In the absence of a strong domestic high-tech industrial economy (the growth of China's exports of high-tech items is now outstripping its low-tech goods), best indicated by the huge and unsustainable U.S. current account deficit and the -17% decline in worker average real weekly earnings since 1972, the U.S. economy is now mainly being driven by the impact of bubble psychology on huge speculative asset classes creating so-called paper “wealth.”

This paper wealth is heavily concentrated at the top of the wealth/income pyramid, as most recently indicated by the Fed’s first quarter flow of funds report showing rising U.S. household net worth and the federal government’s stronger than expected tax receipts from capital gains.

Much sooner rather than later, the U.S. needs to wean itself from dependence on bubble economics, or the global financial markets will become overly concerned about its resulting unsustainable current account deficits.

Meanwhile, Everyday Assault on Global Labor Unabated

Real wage growth still seems non-existent though measured productivity is quite high, given the huge success of the unrelenting global assault on labor ushered in long ago by Thatcher and Reagan.

A June 9 article in the S.F. Chronicle titled “Train your replacement, or no severance pay for you” gives an honest, if rare in the mainstream media, look at what goes on everyday throughout corporate America, as anyone who works there knows full well:

“Bank of America has been steadily moving thousands of tech jobs to India. The latest to go are about 100 positions that handle BofA's internal tech support. While many of the bank's Bay Area techies accept the inevitability of their jobs heading abroad, what rankles them is the fact that, in many cases, they're being told they have to first train the Indians who are getting their gigs … a BofA spokeswoman … acknowledged. 'What we ask associates to do as part of getting severance is that they stay on the job until the job is transitioned.' 'It's a common practice when your job is being transferred from one person to another that you train the new person,' she added. 'We expect our people to stay until their jobs are consolidated.' Making workers train someone from India to take their jobs away isn't unique to BofA. Other U.S. companies reportedly have done the same in recent years.”

The comments by the BofA spokewoman are only unusual for their candor, she is simply describing standard operating procedure in corporate America, where “employment at will” is now widespread.

My “Blog” Focuses on Key Trends, Not Trading Advice Per Se

Needless to say sharp declines of the magnitude recently experienced in some markets are usually not fully anticipated, even if they were long overdue after their huge run-up without a major correction, topped off in March and April.

I should make it clear that my intention is not to give direct investment advice, but rather to discuss general trends, in part because I’m not writing a daily blog that addresses rapidly changing market conditions.

In retrospect, the title of my March 24 article, “Potential Tipping Points Could Make Spring Very Interesting” link seems understated. I did mention there that “it perhaps wouldn't take too much to start the mass psychology pendulum downward in the other direction,” that “the U.S. stock market may top out in the next month or so, then decline, perhaps much more sharply then many might currently expect, into an October low.”

I also mentioned in a May 11 article link, just as the global market declines began in earnest, “with hedge funds and other hot money crowding into smaller asset classes such as precious metals, emerging markets and anything else going up, liquidity issues are important, in both directions.”

Friday, June 02, 2006

6/2 Did May's Sharp Global Market Sell-off Signal a Major Trend Change in the Cyclical Bull since Oct 2002?

June 2 (Econotech) -- After the first significant global financial markets correction this year in May, this article will examine some of the major trends in the bull market that began in Oct 2002 by looking at key financial and commodity indexes from a global perspective.

Key Recent Trends in Global Indexes and Economy

With very strong global economic growth in the first quarter of 2006, led by the U.S. (+5%) and China (+10%), inflationary manifestations in various asset classes seemed to threaten to spiral out of control in Mar-Apr, as indicated by the nearly parabolic surge in the price of gold and other metals; in a further acceleration in the big run up in global emerging stock markets; and in the decline in the U.S. bond market and the dollar.

The modest response so far has been rising expectations of continued very small rate hikes by the three largest central banks (Fed, ECB, BoJ); the Bank of Japan’s sopping up huge excess liquidity it had provided this decade; just announced additional measures to curb real estate speculation in China; and vague promises in late April by the G-7 and IMF to try to deal with global economic balances.

Since some of these actions were enough to help throw the financial markets into a tizzy in May, imagine what more significant measures would do. E.g. those that actually began to deflate the extremely over-inflated global real estate bubble, beyond the current flattening out year-to-year of U.S. real estate prices.

Or, conversely, what would happen with the quick renewal of the Mar-Apr belief by the global hyper-speculators that the central banks and governments don’t have the incentives and/or guts to take them on, a usually safe assumption most of the time.

The ECB’s latest “Financial Stability Review” released yesterday for the first time had a section on hedge funds, according to the front-page lead in today's FT, which said, "hedge funds have created a 'major risk' to global financial stability for which there are no obvious remedies, the European Central Bank warned yesterday ... the ECB ranked an 'idiosyncratic collapse of a key hedge fund or a cluster of smaller funds' in the same category as a possible bird flu pandemic as the types of shocks that could trigger fresh disruption in financial markets."

I would replace "idiosyncratic" with "possible systemic." China officials have also mentioned concern in the past about hedge funds. In contrast, Bernanke not surprisingly recently defended them, as has his predecessor, Greenspan.

So Far Key Indexes Support Seems to be Holding, But…

So far, the long-term cyclical bull market up-trends, i.e. since Oct 2002, of key indexes seem to remain intact following the sharp May correction, indicated by the MSCI world equity index; the strongest stock indexes, such as MSCI emerging markets, Japan’s Nikkei, the stock indexes of U.S. broker-dealers, oil services, and small-mid caps; and the prices of industrial and precious metals commodities.

Despite its recent pullback, the MSCI world equity index still seems to be in a strong, if still very over-extended, uptrend from Oct 2002, and until that changes, the global bull market in stocks would seem to reman intact, if perhaps much more volatile.

The strongest stock and commodity indexes seem to be currently holding at important support levels (e.g. the MSCI emerging market index around 750 and the EEM emerging markets ETF around 92, Japan’s Nikkei around 15,500, the Russell 2000 around 710, etc).

Whether the strongest indexes decisively break down through their long-term up-trends, or conversely resume their very sharp pre-May climb, obviously will be an important indicator of whether a major change has occurred in the global liquidity/credit/economic cycle, or whether the so-called “Goldilocks” (not too hot or cold) economic consensus returns.

In the meantime, there is no progress on global economic balances as far as I can see, when that will cause even further problems for the dollar above and beyond the ongoing long-term decline is anyone’s guess, but it always lurks in the background, whether or not acknowledged on Wall Street.

Emerging Markets Bubble Starting to Pop?

Emerging markets is one of the key potential “bubbles” in the global economy, although the jury is still out on that issue, both from a technical (as previously mentioned, the EEM ETF is holding support around 92) and fundamental/valuation view. Pimco’s McCulley said emerging markets was an area he was focusing on just as he was cut off on an interview on Bloomberg tv the other day, and so am I.

According to a May 30 FT article on the World Bank’s latest "Global Development Finance" report, “volatility in emerging markets and fears of a flight of foreign capital have come at a ‘critical’ time for developing countries’ financial markets.” The report's lead author was quoted as saying: “Many developing economies are half in, half out of the global financial system—they’re half open, half closed right now.”

According to one i-bank, portfolio inflows to emerging markets between Oct 2005 and early May 2006 were well ahead of the cumulative total of the prior decade. Thus, not surprisingly the World Bank report's lead author said: “If these foreigners withdraw, then local market rates go up and that’s an area we’re worried about.”

Chart Trends Helpful at Key Inflection Points When Fundamentals Become Unclear

"Technical" chart trend-following can perhaps be helpful for individual and small institutional investors who can react quickly to major trend changes. The current obsessive Wall Street “data dependent”debate over economic "fundamentals" is primarily for large institutional investors who must find some plausible-sounding reasons to tell their clients and superiors for making bets that can’t be readily changed without the risk of significant losses should a major trend change not be detected.

Especially when there is a lack of clarity regarding fundamental factors driving financial markets, often during possible key inflection points, e.g. the ongoing growth vs inflation “data dependent” daily news obsession (will Bernanke or won’t he) and its impact on various asset classes, I have found that it is usually helpful just to step back to try to simply see what key indexes are actually doing from a longer-term perspective.

I.e., the purpose of this article is to try to note key asset trends, not to fundamentally analyze or forecast them.

Throughout this cyclical bull market I have tried to make the ultra-simplistic assumption that the huge monetary/credit expansion and asset price inflation that have characterized it are intact until and unless the key up-trends are decisively broken and then reversed.

Then, in a long March 24 article titled “Potential Tipping Points Could Make Spring Very Interesting” link, I discussed a large number of potential fundamental risks and expressed my guess that the stock market might top out in a month or so from then.

But until that is clear on the charts, that’s simply my guess. Similarly, in follow-up articles, I did long fundamental discussions on the dollar, etc (e.g. May 1 link, May 11 link, May 19 link). This article instead focuses on the charts to simply try to see what's actually happening.

Broker-Dealer Stocks, Japan's Nikkei Turned a Little Early

The current leg up of the strongest indexes began in Oct 2005 and then, especially in the case of industrial and precious metals commodities and emerging market stocks, accelerated so sharply starting in March as to force the issue of global credit excess and asset inflation to the fore of central banker concerns.

The U.S. broker-dealer stock index gave an early indication of both the upturn in Oct 2005 and the sharp May 2006 downturn, having peaked earlier on April 19. Since we now have a global hyper-speculative economy which these stocks directly reflect, this index should also be watched closely to see if it resumes its huge bull market upturn. Failure to do so will be red flag.

Japan’s stock market is up about 20% (I round off in this article as prices are very volatile lately) since Oct 2005, down from over 30% in early April, leading the way down before the MSCI world equity index and the U.S. cyclical stock index, which also are up about 20% over this period (and well above the about 7% gain in the S&P 500), which peaked on or near May 10.

Japan, emerging markets and global equity indexes started taking off around when the U.S. bond market peaked in late June 2005, the latter is down about 7% since then. The U.S. dollar index peaked in mid-Nov 2005 and is down about -9% since then.

Japan’s Nikkei has tracked gold’s price very closely all during this cyclical bull market from Oct 2002 (despite its strong recent performance, the Nikkei has been the weakest since Oct 2002 of the major indexes discussed later in this article, up about 90%)

Rolling Corrections of Cyclical Stocks, Starting with Homebuilders

There have been rolling corrections of some cyclical stock indexes. Whether that continues and gathers steam is another key thing to watch here.

These rolling cyclical stock corrections started with the U.S. homebuilder stock index, which peaked at the end of Jul 2005 and is down more than -20% since then, to its level at the beginning of 2005, at support of a large triple or head-and-shoulders top.

Given the importance to U.S. consumers of real estate “wealth” creation and their home equity ATM, this support level bears watching for signs of further deterioration in the real estate market (which is indicated by forward-looking economic data).

Semiconductors, another cyclical group that reflects the “real” economy, after its typical fourth-quarter reflex rally initially peaked at the end of Jan 2006 and is down about -12% since early March

U.S. Small-Mid vs Large Cap

Btw, for those intrigued by the 2.3% gain yesterday (June 1) in the Nasdaq 100, re the issue of small/mid-cap vs large growth stocks, the Nasdaq 100 is up about 80% since Oct 2002, while the Russell 2000 and S&P 600 small caps (which since mid-2004 perform nearly identically) are up about 115%, with the S&P 400 mid-cap up about 95%.

The Nasdaq 100 got a stronger start out the starting blocks back in Oct 2002 then the small-mid cap stocks, the out-performance in favor of the latter has been much stronger since Mar-Apr 2003 invasion of Iraq, at its peak in May nearly 2 to 1 in favor of the S&P 600 small caps. The same holds true from another bottom in Aug 2004 and even more so since the Oct 2005 bottom, since then small-mid caps are up about 15%, three times that of the Nasdaq 100.

I.e., it would take much more than one strong up day to break the Nasdaq 100 long-term downtrend relative to the small-mid cap indexes, but hope always springs eternal, I suppose.

Digression on the Mainstream Inflation Watch

A brief digression on inflation before getting back to the charts, since it is much in the news nowadays.

I tend to look at inflation as excess monetary/credit growth. Due to “globalization,” that growth is mainly manifest in asset prices (a critical point that the ECB's retiring Issing and the BIS' Borio and White acknowledge, unlike their U.S. counterparts at the Fed), not in the goods (particularly tradeable) and especially labor markets, as was the case in the "good ol days” when the Fed would tighten to head off inflationary pressures in those markets.

E.g., Citibank’s chief global equity strategist was on Bloomberg tv the other day seemingly very pleased in saying that unit labor costs in the world’s four largest economies, the U.S., Japan, Germany and China, were all simultaneously declining (presumably his “compensation” wasn’t, given last year's huge Wall Street bonuses).

As long as key asset classes are in very strong up-trends, then inflation is still very much intact, imho, whether or not it ever “spills over” into the goods and labor markets, regardless of the theoretical, practical or even political implications, which I won’t examine in this article.

The financial markets, officials and mainstream media are obsessed with each little squiggle, literally each tenth of a percent in a low single-digit number in various official price indexes, which aren’t measured accurately anyway.

Yet they choose to generally ignore the larger inflation picture in various key asset classes, most especially gold, which quickly change by literally tens of percentage points, that is plainly the most dominant feature of the global financial landscape.

Key Index Trends During Cyclical Bull since Oct 2002

From Oct 2002 to present, the strongest key index is the Hang Seng China Enterprise Index, the “H” shares, which had been up 320% from Oct 2002 until its recent pullback to around 270%. Its strength is perhaps not surprising given that the annual growth of China’s economy of around 9-10% has been a key feature of the global economy in recent years, not to mention of enormous historical significance.

The second strongest key index over this period is industrial metals commodities prices, which was up over 270% from Oct 2002 until its recent pullback to around 240%. Again, this is not surprising, as this asset class story is intricately linked to the strong growth in China and other emerging markets. E.g. re the ongoing negotiations over iron ore price increases, China produced 38 m tons of steel last month, compared with 10 million tons from U.S. mills.

The third strongest key index over this period is the U.S. broker-dealer stock index, up about 260% from Oct 2002, until pulling back to around 220%. As I dubbed it in my 5/1 article link, this is the “Golden Age of Goldman Sachs” (which firm has just supplied a second Treasury Secretary, one for each mainstream party, and is third top choice of graduates from leading MBA programs, according to a recent Fortune magazine poll).

Of course, I am simply using Goldman, now highly dependent on its speculative trading side (as essentially a huge unregulated hedge fund) from which its new CEO is expected to come, as a symbol of the current hyper speculative version of globalization.

Throughout this cyclical bull market I have focused heavily on the broker-dealer index because the economic health of the global hyper-speculators is so closely tied to that of the global financial markets and the underlying real economy

This perhaps can be viewed as a parasite-host relationship, since the ECB used the bird flu analogy in the report mentioned above (if so, then very well-fed parasites, the 26 top hedge fund managers averaged $363 million in “compensation” last year, according to an article in the May 26 FT).

The fourth strongest key index has been the MSCI emerging markets equity index, which peaked around up 250% from Oct 2002 before its sharp recent pullback to around 190%.

Finally, the fifth strongest key index is oil services stocks, which peaked around 220% before declining to around 180%.

The cyclical/secular bull case for this stock group has remained intact so far, despite the fact that energy price increases have been less robut since the beginning of September 2005. Oil prices are currently up about 13% since then, with geopolitical issues such as Iraq, Iran, Nigeria, Venezuela being a major factor, while the energy commodity index is down about 7% from that peak.

Btw, another much smaller energy asset play, uranium, has been extremely strong throughout this period.

There are two key indexes that are up about 135-145% since Oct 2002. These are oil prices and U.S. homebuilding stocks. They got there on much different paths, which I describe below in the two sections on inflection points.

There are five key indexes clumped together up around 105-115% since Oct 2002. These are MSCI global stocks; U.S. cyclical, Russell 2000 small cap, and semiconductor stock indexes; and the gold price.

Given the recent strength of gold's price and weakness in semiconductor stocks, this perhaps might be surprising to many. These two got to this point in widely divergent ways, also as described below.

Finally, the Nikkei and U.S. bank stock indexes are up 80-90%, the latter has been in an uptrend since Oct 2005 after being flat since Jan 2004.

Major Inflection Point, Nov 2003, Energy Begins Major Outperformance

In the first year of the bull market from Oct 2002, most of the indexes mentioned above sharply rallied, the strongest being China’s H shares and U.S. semiconductor stocks, up more than 200% and 125% by Jan 2004, respectively, with the tech crowd typically trying to relive its past glory from the late 1990s TMT equity bubble.

The H shares have added to its gains recently after being flat from early 2004 through the end of 2005, while the semiconductor stock index has gone nowhere after its strong first year, this being a different cycle for hard-core tech-oriented investors.

The most conspicuous exception to strong gains in the first year of the cyclical bull market was the price of oil and the performance of the oil services stock index. Through late Nov 2003, the former was flat and the latter up less than 10%.

Then something changed in Nov 2003, that being the perception that China and other emerging markets seemingly had almost overnight (increasingly since China’s accession to the WTO in late 2001) developed a strong new thirst for oil, at the same time that excess oil producing and/or refining capacity was much more limited in this cycle than previous ones (which may be related to the “peak oil” hypothesis, but separating out oil’s cyclical supply/demand balance from that secular trend is still not clear).

The price of oil bottomed in mid-Sept 2003, with the oil services stock index following in late-Nov 2003. From that point on, until just recently, these two have been by far the best performing indexes discussed in this article, with industrial metals commodities belatedly catching up with oil services stocks and closing the gap and now slightly passing in their huge run up in Mar-Apr 2006, with both up over 150% since late-Nov 2003.

The rise of oil prices, which had moved in lock-step with oil services stocks from late 2003, has cooled a bit from its earlier torrid pace, as previously mentioned. There has been some divergence with oil sevices stocks starting in Oct 2005, with the oil services stocks zigging straight up while oil prices continued to zag down and then meander until Iran and other geopolitical issues got everyone’s attention, ending up 125% since late 2003.

The two next best performing asset classes over this period since Nov 2003 has been China H shares and the MSCI emerging markets, both up about 85%. Broker-dealers and gold are next around 65-75%; Russell 2000 and homebuilders around 30-35%; and bringing up the rear, semiconductors, down -5-10%.

Major Inflection Point, July 2005, Hot Money Looks Elsewhere as Homebuilders Top

The next key inflection point began in late July 2005, when the homebuilder stock index peaked. It has fallen more than 20% since then. By Nov 2005, it was becoming increasingly clear that homebuilding stocks, and thus much more importantly real estate speculation, were no longer favored asset classes, and speculative hot money started chasing in earnest after something else

This turned out to be industrial and precious metals commodities, emerging markets equities, two closely linked stories, and Japan. The metals, especially industrial, have been by far the best performing asset classes ever since, with industrial metal gains of about 85% since Sep outstripping gold gains of 45%, followed by China H shares, oil services, brokers and emerging markets, all up 20-30% after their recent pullbacks.

Finally, to wrap this up, a brief word on the gold price and the gold stock indexes. Since Oct 2002 the gold price is up a little over 100%. The XAU is up about 140%, and the HUI is up about 200%. Since sharply turning up in mid-May 2005, the performance is over 50%, about 75%, and about 95%, respectively.

(I perhaps will save for another time a June 1 Bloomberg story titled, "China Should Buy Gold With Reserves, Central Bank Adviser Says," plus more on emerging markets.)