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.)