March 28, 2007
In contrast to 2002, when the uptrends got started in the midst of falling interest rates and global steep yield curves, the current trends are continuing despite global central bank rate hikes and a flat yield curve. Global money supply growth is declining, now only slightly positive on an equal-weighted basis and negative in weighted terms. And the growth rates are also negative when the global money supply is combined with fiscal policy. (Regional differences in money supply growth may help explain differences in market relative strength last year.)
In the credit markets, a drop in liquidity would be indicated by widening spreads, which would be a sign of rising risk aversion. Decisive spread widening would be likely to occur in conjunction with rising stock market volatility, reduced compression among styles and sectors, and reduced M&A activity, which has been a major driver of the market advance. Under those conditions, the global market trend would be on the defensive.
At this point (with emphasis on “at this point”), however, global breadth is still bullish. The recent volatility rise and spread widening have not been great enough to reflect a global market trend endangered by illiquidity. But it would be a stretch to conclude that excessive liquidity will continue to be a strong driver of the global equity uptrend.
As equity markets drifted higher with extremely low volatility, the markets were caught by surprise near the end of February, as the MSCI World Index dropped 6% over a five-day period. Rather than panic at such times and get caught up in the frenzy, it’s essential to take a step back and keep the market move in perspective. In the case of the recent price drop, it has (so far) evidenced itself to be a short-term sell-off in and uptrend that remains intact.
It should be kept in mind that if a global downtrend develops (or even just a large-US downturn develops), it will be hard to find a hiding place in a specific market, since studies have demonstrated that market correlation tends to increase in global (and large US) bear markets. This was evident during the recent sell-off showing that when volatility picks up from low levels, it usually does so on the downside. But putting the recent action into an historical context, volatility has remained low from a long-term perspective. For some investors, the somewhat distant memory of volatility will magnify even the smallest price decline.
In the Autumn of 2002 (see “Past Market Predictions” on the home page) I went from wildly bearish to wildly bullish. Will my next swing of significant U.S. equity exposure (20-50 percentage points) be an increase (like in 2002) or a decrease (also see “Past Market Predictions” for some meaningful asset allocation reductions)?
Consumer confidence is too high for me to think about dramatically adjusting upward U.S. equity allocations. I’m not talking about getting new cash to work or some minor re-balancing – I’m talking about a fundamental change in cyclical investment philosophy.
It’s too soon to tell what the recent pullback will bring, either renewed buying interest or the type of renewed risk aversion that pushes down stock prices. Prior to the recent slide, there were four other, longer corrections of 5-8% since 2003, and each was followed by new highs and the bull’s resumption. But it would be premature to say that the current recovery is headed for a similar resolution, especially given the age of this cyclical bull (the third longest of the 34 bulls since 1900).
My concern is that this recovery is part of a topping process. As such, with a push toward our 2007 reward level of 1,550 points on the S&P 500 I could easily envision a fairly large (if not dramatic) rebalancing – something perhaps bordering on a fundamental change in cyclical investment philosophy.
Ominously, yesterday the Conference Board’s measurement of Consumer Confidence slipped from a level almost identical to the peak confidence level of 2002 – before the tape began to breakdown and losses began to rack up. Yes, levels were higher in the late 1990’s/2000, but that was a bubble. And in the absence of a Fed rate cut, it’s hard to see how confidence will pick up with the housing market depressed, oil prices rising again, sales and productivity slowing, the employment outlook worsening, and the leading, coincident and lagging indicators of the economy reflecting a slowdown. Without the reversal of some of these major trends it is unlikely that consumers of mutual funds will find much reason to become confident enough to start pumping loads of new cash into U.S. stocks.
Modified June 5, 2008