Prepared by Chart Analysis Limited
–Global bond market prices have resumed their upward trends but further gains should prove difficult to maintain in coming months.
–The recent reaction lows for most stock market indices should hold for at least the short term, but upside potential is limited and will be confined to top formation extension in some instances.
–Lagging South East Asian stock markets may have bottomed but are unlikely to experience significant catch up moves in coming months.
–The U.S. Dollar is completing its intermediate-term correction against the mark and Swiss Franc. It should range higher and successfully challenge the August peaks.
–Sterling is now due for a significant technical rally against the Continental European currencies.
–Inflationary pressures will remain low generally, but the risk of global deflation in coming months has been exaggerated.
Bonds Throw Stock Markets A Lifeline–There is a growing feeling on Wall Street, and in some of the other better performing equity markets, that the correction is behind us and another upward leg for the bull market beckons. After all, we still have non-inflationary growth. Well, it has certainly paid to buy the corrections in recent years, most Asian markets excepted. I think the optimists will be right over the short term. I certainly hope they are, because even after last month's massive cull of the FM share portfolio, there are more stocks that I would like to sell on further strength.
The bullish news, which has not been discounted, is another upward lead from global bond prices. I just cannot envisage a sustained sell off for world stock markets, let alone a crash, while bond prices are rising. Yes, deflationary pressures could spread beyond Asia and have hovered over Continental Europe during recent years. However the U.S. economy motors along in its seventh year of expansion and a faster rate of growth is occurring in many developing countries. The IMF is forecasting global GDP growth of 4.5% for this year and next, optimistically in my view, but even if a point or two were shaved off that figure by events, it still would not amount to global deflation.
The developing problem for both bond and stock markets, which I was willing to run with until just over a month ago, is growing speculation against a background of abundant liquidity. Bull markets don't die of speculation but it does leave them very accident prone. Moreover, the competition to outperform among investment managers, coupled with aggression encouraged by past successes, causes many of them to take increasing risks in a rising market. The Wall Street Journal Europe on 18th September contained an article sub headed, “Bond Managers Spice Up Their Funds With Bolder Bets.” It reported that bond-fund managers are “buying more high-yield, high-risk junk bonds than at any time in recent memory.” Many readers will recall them doing the same throughout the Autumn of 1993, setting up the last big bond market slump of 1994, despite no real rise in inflationary pressures. Managers will probably be a little more circumspect this time, but another bubble is forming.
Arguably, investment managers are taking even greater risks with equity funds. On Wall Street everyone is piling into illiquid small capitalization companies, just as they have done during the ending stages of previous bull markets. These managers have also thrown increasingly large amounts of money at emerging markets recently. Remember how they were dubbed submerging markets in 1994?
Rising markets increase supply. As yields fall many more countries and corporations are keen to issue new bonds. With stock markets valuations high these countries also want to privatize more of their duff public sector concerns. China, for instance, has recently announced that virtually every state industry will be sold. Meanwhile, new companies are floated on every booming stock market and secondary offerings increase. Share options as an incentive for corporate management are another source of future supply. And just think of the earnings dilution that will occur when those people decide to exercise their stock options!
These are problems for tomorrow as most stock markets have commenced oversold rallies following the recent correction. This should produce some new highs among indices that fell less than 10% in August but perhaps only top extension where reactions were sharpest. I suspect that the next sell off in bonds, which we could even see before year end, will produce much greater falls in world stock markets.
Still No Strong Case For Changing Short-Term Rates–Of course one can never be sure about central bankers but there is no good reason for higher rates in the developed economies. The U.S. Federal Reserve is certainly under no pressure to make that next 0.25% increase and the case for seeing if the economy can operate at a higher level of growth without igniting prices is strong. The BoE can also relax, judging from recent data. Another rate hike would not only look gratuitous but also risk relaunching sterling. The Bundesbank grumbles and would perhaps like to raise rates, but this would look like a political own goal given EMU sensitivities. There is absolutely no case for higher short-term rates in Japan, which judging from the latest GDP contraction, is in danger of sinking back into deflation.
U.S. Treasury Bonds Establish A New Floor But Some Resistance Is Likely To Be Encountered Near The Early-August Peak–After ranging for a month-and-a-half U.S. Treasury bonds have surged back towards their August 1st peak at 116-20 (December contract). Given the speed with which prices had fallen from that level not long ago, it would be surprising if some resistance were not encountered in this region, especially as that is very near the December 1996 top and there is also additional historic resistance at slightly higher levels dating back to 1993. Nevertheless, Treasury bonds have established a new and higher floor of support, and a close under 113 would now be the minimum required to reaffirm overhead resistance.
UK Gilts Accelerate To A New High–Once again underlying support evident on the historic continuation chart for gilts has cushioned a correction at a higher level prior to further strength. The latest gains appear temporarily overextended following some acceleration and the price is not all that far below the important December 1993 peak at 120. However, a close back below 115 (December) would be necessary to indicate more than a consolidation within the overall upward trend.
Spanish And Italian Bonds Clear Their July Highs–Both contracts fell very sharply in early August before staging ranging recoveries. These have now cleared the July highs, extending what has been a very powerful bull market over the last two and three-quarter years. While the latest gains are beginning to appear somewhat overstretched, closes below 101.50 and 109 for Spanish and Italian bonds (both December), respectively, are required to offset some additional upward scope and rather indicate top formation development.
German Bunds Have Underperformed Recently But Are Testing Their July High–The continuation chart shows that there is a lot of prior resistance near current levels. Nevertheless, the more important characteristic may be the rising floors, with the latest being near 100 for the December contract. Currently, bunds are testing their July high and a fall back under 101 is needed to suggest more than temporary resistance in this region before underlying trading sustains somewhat higher levels.
Australian Bonds Extend Their Overall Upward Trend–Australian bond futures commenced a ranging correction in early August. Six weeks later they pushed to new highs and a close under 93.40 for the expiring September contract, and 93.35 for the December position, are now required to reverse current potential for some additional near-term gains and rather indicate top development.
Japanese Bonds Extend Their Record Run But The Overall Trend Is Gradually Losing Momentum–New highs following another shallow consolidation by JGBs indicate that this record- breaking performance continues. However the overall upward trend does show a gradual loss of momentum. Therefore the next reaction of more than a point may mark the beginning of an important trend change.
Conclusion On Bonds
Despite historic resistance global bond markets have recovered following their August shake out to successfully challenge the former highs in most instances, and extend the powerful bull run which commenced in January 1995. Provided there are no clear downward dynamics to indicate upside failures, I can only assume that bond prices can move somewhat higher over the near term. The best bull point, other than upward trends that continue to hit new highs, is the fact that real yields, JGBs excepted, are still historically reasonable, even if they have fallen a long way. However, obviously risks can only grow with each additional decline by bond yields. A return on Japan's 10-year bonds of less than 2% requires a lot of deflation to make sense.
Firmer Bond Prices May Produce Some Sharp Top Extension Rallies But The Intermediate- To Longer- Term Risks Remain High–The deterioration in stock market sentiment over the last two months is further illustrated by the generally poor performance of share indices relative to bonds recently. Nevertheless, despite deflation fears, which are probably exaggerated, a continued firm tone by bonds should spring some more sharp rallies for stock market indices, even though these will probably be limited to top formation extension in many instances. Conversely, weaker bond prices, let alone breaks of the important August lows, which are not under pressure at this time, would hit stock markets hard. Currently, only a few previously lagging fringe emerging market are still hitting new peaks. A number of previously high-flying indices show considerable trend deterioration, although Wall Street has not been among them.
Watch The Charts–The facts of buying and/or selling pressure evident on the price charts offer the most objective route for us to continually assess which market theories are in fashion or discounted. One normally gains perspective by monitoring a large selection, well in excess of our main interests. Watch particularly for sustained breaks of previous rally highs to indicate a firmer tone, or conversely, breaches of reaction lows to signal pattern deterioration.
The Chart Analysis World Market Indicator (currently 1660) has steadied after its biggest fall since February-March 1994, which certainly broke the uptrend consistency evident since the January 1995 low at 970. Consequently a successful test of last month's peak at 1819 appears unlikely over the short- to intermediate-term and a move to 1690 is needed to indicate top extension. Conversely, further weakness would be signalled at 1640. CAWMI is unweighted and calculated in local currencies every Monday.
MS Capital International's World Index (947) has seen its biggest numerical reaction since 1992, but only just, by falling 5 points further than this year's March-April correction. The move to 945 has checked short-term downtrend consistency. A move to 910 is required to indicate a further setback.
The USA's Dow Jones Industrial Average (7894) fell sharply before steadying above the small June reaction low near 7620. This decline was similar numerically to the March-April correction, and therefore of a smaller percentage. A close over 7900 would break the lower highs and indicate at least a higher phase of top extension. Conversely, renewed weakness would be signalled below 7600. The Standard & Poor's 500 Index (943) shows a similar pattern and the move to 940 has taken out the last two rally highs at 932 and 938, suggesting scope for a further test of the peak, at least. On the downside, lateral trading near 900 looks like a critical level if a breach were to occur for more than a day or two. The small capitalization Russell 2000 Index (446) is a lagging indicator which had underperformed in recent years. However, it has staged a powerful and steady catch-up move since May. While this is beginning to appear overextended, a clear downward dynamic, which should not be difficult to see given the persistence of the advance, is needed to check momentum beyond a temporary consolidation. The NASDAQ Index (1666) which sometimes leads, has seen its advance slow, not surprisingly, but requires a move below 1600 to show pattern deterioration.
Canada's Toronto Composite Index (6898) eroded initial support but, perhaps significantly, has not maintained the break under two previous reaction lows at 6660. A move below 6000 is now needed to reaffirm resistance from the peak near 6940.
Chile's General Index (5529) has been trending lower since its failed upward break in July. A push over 5620 is needed to check the current downtrend consistency.
Venezuela's Capital General Index (10,508) did almost nothing until late 1995 but has powered ahead subsequently. An acceleration to a peak in June was followed by another upward break this month, and a fall beneath 9500 would be required to significantly check upward momentum.
Japan's Nikkei Stock Average (17,683) fell back to test the year's earlier floor which extended down to 17,000. A move to 18,800 is currently needed to reaffirm that prior support. Conversely, a breach of the lower level would open the door to a further challenge of the five and a half year range lows.
Taiwan's Weighted Price Index (9088) has fallen sharply after failing to maintain a break above the psychological 10,000 level, clearly breaking the prior two and three-quarter year's uptrend consistency, including the previous progression of rising lows. A rally back over 9500 is the minimum required to check the downward bias.
Hong Kong's Hang Seng Index (14,411) plummeted before encountering support from the November 1996 to May 1997 range evident below 13,800. The move looks too significant to be just a temporary correction but a rally over 15,000 would suggest a higher phase of top extension.
Singapore's Straits Times Index (1896) had been falling all year and accelerated to an intra-day floor of 1735 before establishing a closing low of 1786. The decline looks climactic for at least the medium term and a move to 1960 would break the progression of lower rally highs. However, the initial recovery for these patterns is usually followed by a significant retracement and lengthy base extension phase before a sustainable uptrend occurs.
Malaysia's KLSE Composite Index (811) also established an important low at 675 (intra-day) against a close near 731.12. While a move over 900 would indicate some further near-term recovery, here also there is a strong possibility that a partial retracement and base extension phase will be seen over the intermediate term.
South Korea's Composite Index (700) has actually been trending lower since June in a probable base extension similar to what I have described. It is likely to remain rangebound between approximately 600 and 800 for a considerable time.
Thailand's Bangkok SET Index's (517) slide back to its June low near 460 shows the base extension risk for other South East Asian markets once the initial rally following a selling climax fades. New lows are even possible during this phase. Meanwhile, Thailand has steadied above the earlier floor but needs to move above 580 to indicate higher ranging.
Australia's All Ordinaries Index (2679) has broken its downward bias and would need 2580 to indicate renewed weakness rather than a test of the July-August highs, at least. The All Mining Index (766) has broken its 1995 low at 800. While the decline is beginning to look overextended, a move to 875, which appears unlikely at this stage, is currently required to break the overall downtrend consistency.
New Zealand's Capital 40 Index (2539) has encountered support just above its January 1994 and January 1997 peaks near 2450. A clear break beneath this level is needed to indicate renewed weakness rather than a test of the peak area, at least.
South Africa's Industrial Index (8786) has fallen sharply towards potential support from its large trading band evident below 8700. However, a strong rebound would be required to reaffirm that level as a new floor area. The JSE Gold Index (921) is drifting back to test its July low and a clear break beneath 900 would indicate renewed vulnerability. Conversely, a move to 1060 is needed to signal further recovery scope.
Belgium's BEL 20 Index (2380) has encountered support near 2300 once again. A move under this level, to also take out intra-day lows, is needed to indicate lower scope. Conversely, a move to 2440 would suggest some further recovery towards probable resistance from the July peak near 2620.
France's CAC 40 Index (2944) has held above its recent reaction low near 2780 and a breach of this level is needed to reverse the likelihood of a further top-testing rally.
Germany's DAX Index (4010) ranged lower following its accelerated peak to nearly 4460 in late July. This slower rate of descent suggests a top extension rally and a clear break of 3800 is needed to delay potential for a partial rebound.
The Netherlands' CBS All Share Index (610) ranged lower before finding some support just above 590. A drop under this level is needed to indicate renewed weakness, while some further top extension would be suggested by a move to 635.
Spain's Madrid SE Index (601) has held near initial support at 575. A clear breach of that level is now necessary to indicate renewed weakness rather than a top-testing rally suggested by the slower rate of descent from July's peak.
Italy's BCI Index (940) also fell back from the July high much more slowly than it rose. Therefore a move under 875 is required to signal lower scope rather than the top-testing rally suggested at present, at least.
Sweden's Affaersvaerlden General Index (3142) requires 3040 to show renewed vulnerability. A clear break above 3300 would be necessary to indicate somewhat higher scope rather than top extension.
Norway's Oslototal Index (1297) has encountered some resistance beneath its August peak and needs 1330 to suggest somewhat higher scope. Further deterioration would be indicated at 1260.
Denmark's Copenhagen SE Index (610) has ranged lower following its accelerated peak in July. This slower rate of descent suggests that a top-extension rally will be seen, indicated by a break in the progression of lower rally highs.
Finland's HEX General Index (3424) requires 3320 to indicate renewed weakness, while some further top-extension rally becomes likely at 3460.
Switzerland's Swiss Market Index (5550) has fallen back from its accelerated peak near 6000 more slowly than it rose, suggesting that a top-extension rally will be seen. A move under 5200 would be needed to offset or delay that prospect.
The UK's FTSE 100 Index (5013) has churned near and mostly below the psychologically significant 5000 level. While this is often a top development characteristic, a clear breach of 4800 remains necessary for decisive evidence of pattern deterioration. Conversely, somewhat higher scope would be suggested above 5100, although the FTSE has not maintained initial upward breaks in recent months.
Russia's ASPGEN Index (1924) has lost upward momentum following its accelerated advance. A further retracement of prior gains would be indicated below 1800, while a clear push over the psychologically significant 2000 level is required to reaffirm the uptrend.
Conclusion On Stock Markets
The balance of stock market technical evidence suggests that we have seen the worst of the declines for the time being. The classic warning of an imminent bear market–weak bond prices–is not being signalled at present. Instead, bonds have shown renewed strength recently. However, share indices are no longer outperforming bonds during the rallies. This reflects growing concern over deflationary forces and may mark the beginning of the end for the global bull market. Meanwhile, even where significant corrections have occurred following the July-August peaks, most indices fell back more slowly than they had risen. That usually suggests at least top-testing rallies because the declines were not sufficiently persistent to completely undermine the previous bullish sentiment. Overall, we will probably see more ranging than trending in coming weeks.
The U.S. Dollar's Decline Looks Overextended Against The Mark And Swiss Franc–The dollar surged to highs at DM1.8905 and SF1.5389 against the mark and Swiss Franc on August 6th, before commencing another of its intermediate-term corrections. Not surprisingly, sentiment has switched from extremely bullish for the dollar to somewhat bearish during this reaction. However the ranging nature of the decline, in which the greenback clearly fell back from its peaks more slowly than it rose to those levels, suggests profit taking rather than the onset of a sustainable fall. The slight acceleration against the Swiss Franc recently looks like an ending. Dense prior trading at current levels against the SF and evident below DM1.74 should ensure that any further weakness, even if it occurs, is not sustained for long. In conclusion, the dollar is probably near a new floor, although an upward dynamic is required to reaffirm support and scope for a retest of the August peaks, at least.
The U.S. Dollar Has Taken Another Upward Step In Its Ranging Recovery Against The Yen–Many people concluded that the dollar had ended its two-year recovery against the yen following the plunge from ¥127.5 in May. However that move continues to look more like a panicky flush out of leveraged positions at a time when the crowd was overwhelmingly bullish of the dollar. Anyway, since the June reaction low the dollar has been ranging gradually higher in a move punctuated by sharp, albeit brief, corrections. While unsettling, this often occurs against a background of uncertainty during the early stages of a new trend. Currently, the most important consistency characteristic is the progression of rising lows. A break under the most recent of these at ¥118 is needed to question the demand-dominated environment and potential for a rechallenge of the May peak, at least.
Sterling Has Steadied Against The U.S. Dollar–The pound accelerated to a low at $1.5673 in early August against the greenback before steadying within its present range. A clear break beneath that level is now required to indicate renewed weakness for sterling rather than a retest of lateral trading near $1.62.
Sterling Should Rebound From Prior Support Against The Mark And Swiss Franc Before Long–The pound has been in retreat against the mark and Swiss Franc since surging to peaks in July. These declines now look somewhat overextended and potential support is at hand, from the April-June band evident below DM1.82 and the January-May troughs near SF2.28. An upward dynamic would reaffirm those levels and scope for what could be a significant technical rebound for sterling.
Sterling Should Eventually Clear Lateral Resistance Near ¥195 Against The Yen–This level offered support for the pound earlier this year until it was decisively broken in May. Subsequently, and as is so often the case, it has checked rallies in recent months. However the chart has shown upward dynamics and rising lows since mid August, suggesting that demand is gradually gaining the upper hand. A break beneath ¥185 is needed to significantly delay further pressure on lateral resistance near ¥195 and a probable upward break before long.
The Mark's Recovery Against The Yen Is Approaching Prior Resistance–The mark established a series of lows near ¥60 against the yen between August 1993 and April 1995. These were approached early last month, after which the mark rebounded strongly. This recovery has now reached the first area of potential resistance at ¥68.40, from the lower region of a large top area established between September 1995 and May 1997. Nevertheless, a move below ¥67 is now required to question uptrend consistency which would be clearly broken in the event of a fall to ¥65.
The U.S. Dollar Shows Some Loss Of Momentum Against The South East Asian Currencies, But There Is No Clear Evidence That Significant Peaks Have Been Reached–The U.S. currency surged up out of its long trading ranges against the Malaysian Ringgit and Singapore Dollar in July. The move shows some loss of consistency over the last three weeks, although the reaction lows are still rising. Consequently breaks back under M$2.88 and S$1.485 are required to indicate somewhat lower scope before the U.S. Dollar eventually trends higher.
The Australian Dollar Extends Its Downtrend Against The U.S. Currency But Is Approaching An Important Previous Low–Following a ranging phase last month the Australian Dollar has extended its downward trend. This is now approaching the important June 1995 reaction low which is just above the psychologically significant U.S.$0.70 level. Nevertheless, a clear upward dynamic is needed to suggest more than temporary support in that region.
Natural Gas Remains A Pocket Of Inflation–With all the talk of deflation, we should keep a wary eye on possible sources of inflation, such as petroleum prices which of course are quoted in U.S. Dollars. While crude oil continues to hover near U.S.$19, natural gas surged in August and early September. The price has encountered resistance near U.S.$2.86 recently (October contract), but a close under U.S.$2.50 is needed to indicate significant resistance in this area.
Copper Is Still Drifting Lower But Approaching The Year End Base–The downward trend remains very orderly for copper so it would take a clear upward dynamic to offset a test of the June to December 1996 base area evident below 92.5¢ (December) and extending down to 83.75¢. At least temporary support is likely to be encountered within that pattern.
Aluminum Shows Some Loss Of Downward Momentum Above This Year's Earlier Troughs–Aluminum's spike to U.S.$1770 (3rd month position) in August was short-lived. However the fall has slowed recently above the year's previous lows down to U.S.$1535. Nevertheless in the absence of an upward dynamic there is no evidence to suggest that the troughs will not be further tested.
Gold Is Drifting Towards Its July Low–Gold accelerated to a low at U.S.$316.8 (October) in early July. Subsequently small rally attempts have been turned back at progressively lower levels and the price has drifted to retest its earlier floor. A clear break above U.S.$332 is required to reverse scope for a downward break and additional test of the historic lows which extend to U.S.$285.
Cocoa's Next Big Move Is Likely To Be Upwards–Cocoa has been ranging for years and most of that activity can be seen on the monthly continuation chart covering trading from January 1990 through August 1997. The overall pattern looks like one of those torturously long base formations that occasionally occur in the commodity markets and eventually spring strong advances. The volatility has increased in recent months, which if nothing else, shows that more people are interested in cocoa. Judging from the daily chart, a close under U.S.$1600 (December) is required to indicate a lower phase of base extension.
The Global Investment Scene
No interested observer will have failed to notice a change of mood among investors in stock markets over the last two months. This was in response to the collapse of share prices for South East Asia's so-called “little tiger” countries, the biggest setback recently for many previously high-flying bourses from South America to Hong Kong via Continental Europe since 1994, and a dramatic increase in volatility on Wall Street.
Naturally people search for reasons and explanations in order to understand these developments and assess future prospects. South East Asia's problems have been thoroughly analysed and are now well understood, but what about the rest? Is this just another healthy correction against the familiar and favourable background of moderate growth and low inflation? Could markets now be signalling a changing economic environment in which cost pressures increase, perhaps due to stronger economic growth and higher wages, driving up interest rates? Conversely, is increased competition due to globalization leading to a surplus of goods and further loss of pricing power, resulting in falling corporate profits and worldwide deflation?
It is usually market trends that beget theories and forecasts, not the other way around. When financial asset prices are rising over a long period people understandably worry more about inflationary pressures. Conversely, a sharp correction by stock markets will lead to forecasts of deflation. Accordingly, more people are worried about economic contraction today than at that the beginning of the year.
My own view remains that we could see more of both inflationary and deflationary pressures, but probably only in isolated pockets of the world economy. However the deflation risk is currently somewhat higher and would increase proportionally with a further and sustained slide in share prices. A bear market would obviously reduce wealth, add to uncertainty and curb demand in the process.
Financial forecasters have been overestimating both the inflation and deflation risk for years. To worry about money is only human, just as we are sometimes alert to the risk of danger on a dark and empty street at night, even though there is usually none there. However it is governments that create the major inflations and deflations, through excessively loose or tight monetary and fiscal policies. Since inflation is still regarded as a great evil today, and the inflationary psychology has been broken, politicians are unlikely to debase their currencies and repeat the mistakes of the 1970's and 1980's, at least not before people have forgotten those lessons.
While no one can predict the long-term future accurately, there are grounds for considerable optimism on the basis of what we know today. More countries than ever before are adopting market-oriented economic systems and democratising, profiting as a result. There are few great ideological conflicts today. The most rapid and far reaching phase of technological progress that the world has ever seen is underway with no end in sight. Of course these great themes are well known and have contributed significantly to the huge share price rise of recent years.
Consequently, the main problem for previously high-flying stock markets is Alan Greenspan's much parodied comment about “irrational exuberance.” Everyone will be familiar with the oft repeated language of excess–`paradigm change,' `new era,' `Goldilocks scenario,' `it doesn't get much better than this' and economic `sweet spot.' These vague banalities have been used to rationalise what only a fool would fail to recognise as a good old-fashioned bout of financial market speculation. There is always a good reason for every great bull market, at least in the beginning. However human nature drives markets to irrational levels that are clearly recognised by all as bubbles, not in the making of course, but once deflated.
Government Bonds
Concern over the risk in stock markets has caused some investors to shift funds into bonds recently. This is understandable as real yields still offer reasonable value, given the outlook for inflation. Additionally, further stock market declines could only increase forecasts of deflationary pressures.
Nevertheless long-dated bond yields have fallen significantly over the last two and three-quarter years. Further declines of consequence would probably require continued buying from Japan, which is quite possible given the exceptionally low rates available in that country. Moreover eventual short-term rate increases in Japan, Europe and the USA would need to remain in abeyance for at least the intermediate term. This would necessitate no pick up of growth, let alone inflationary pressures in those countries. Finally, the script for falling long-dated yields would assume little profit taking and certainly no flight to cash if confidence in financial markets, in general, deteriorates.
While these favourable criteria are theoretically possible, the only certainty is that supply is increasing. Government debt remains high in many countries and they still have substantial budget deficits to fund, particularly Japan. Many developing countries, taking advantage of improved credit ratings, have increased their offerings of bonds. Corporations are now resorting to more debt financing in the belief that interest rates will not stay at current levels indefinitely. These factors could weigh on bond prices over the medium term.
Stock Markets
The current problem for previously well-performing stock markets is not that the favourable fundamentals have changed, although they will at some point, but that they have been overdiscounted by markets which had been rising ever more strongly since early 1995. The high- flying share indices, which included most of Continental Europe, North and South America, Hong Kong, Taiwan and many emerging markets such as Russia and Hungary, showed unmistakable and extensive trend acceleration. This is unsustainable by definition and therefore an ending characteristic. Once momentum wanes, sentiment begins to change, triggering a corrective phase which is often in proportion to the prior speculative excesses.
It is never difficult to explain a sell off if valuations had been pushed to levels of credulity as we saw recently. As with 1987 and to a lesser extent 1994, the problems of overvaluation were by no means confined to Wall Street. Generally speaking, it is U.S. companies that have increased their sales in the global market place and experienced the most consistent profit growth. While many emerging markets have attractive growth prospects, the political risks are obviously much higher than in the U.S. Continental Europe's bull market was due to the potent forces of accommodative monetary conditions and orderly devaluation, but the profit-curbing problems of excessive regulation, intransigent unions, the social wage and other high taxes remain. In fact, the corporate tax burden has greatly increased in France since the Socialist/Communist coalition came to power. In Germany, left-wing opposition has blocked proposed tax reforms. Japan's nascent recovery in domestic consumption has been snuffed out by sales tax increases and tight fiscal policy as the government grapples with its debt, which soared during the country's deflation of the early 1990's.
Observers still looking for bullish stories will note that there have been no significantly adverse changes to interest rates, capable of reducing liquidity, outside of South East Asia. However, expanding liquidity can be thrown into reverse if investors take fright in a falling market and flee to cash. Supply becomes a real problem in that environment. Sensing that share valuations are too good to last, companies rush to the market with initial and secondary share offerings. There is currently no shortage of emerging market governments anxious to privatize moribund state industries, led by China. Finally, management and employee share options, which provided every incentive to boost share prices through earnings growth, including share buyback programmes, will become a double-edged sword in a falling market. An individual has no greater incentive to sell shares than the fear of profit erosion. As more of those who hold long-term share options are tempted to exercise them and sell, the supply of stock in the market will increase.
In conclusion, the supply/demand environment for stock markets has begun to deteriorate. Further and substantial declines by bond yields are probably required to significantly delay additional shake outs. The next phase of weakness for stock markets is likely to be led by Asia and Continental Europe, as we saw recently, since they have the worst fundamentals. Developments on Wall Street will remain critical for the global trend, as always. The U.S. Capital Gains Tax cut, which I have commented on many times, came into effect on August 5th, two days before the DJIA and S&P peaked. This is consistent with the previous CGT cuts in 1978 and 1981 which resulted in declines of 11% and 15%, respectively. While declines in the U.S.'s large capitalization indices have not spread to the NASDAQ, AMEX or Russell 2000, the latter two, at least, are lagging indicators comprising smaller companies.
Currencies
Sentiment in the currency markets has been characterised by uncertainty rather than conviction recently, leading to primarily ranging activity, even where trends are evident, and prices are unusually sensitive to any comments from central bankers. The Bundesbank has stopped rolling out an official a day to talk the U.S. Dollar down, having succeeded with this jawboning. So far no Japanese financial spokesman has objected to the dollar's move back above ¥120, which is not surprising given the slump in 2nd-quarter GDP of —2.9% from the previous three months, the biggest contraction since 1974. From the U.S. government, Treasury Secretary Robert Rubin and Larry Summers have not objected to the dollar/yen rate, at least not directly, but they have stepped up their criticism of Japan's persistent export drive while the domestic economy is allowed to languish.
The one surprise from central bankers, at least for me, was Swiss National Bank President Hans Meyer's volte- face on September 5th in saying that it won't be able to continue the low-rate policy `...for much longer if we are to avoid the building up of new inflationary pressures.' This contradicted the SNB's Vice President, Jean-Pierre Roth, who had said the day before that he saw `no reason for rates to rise.' Switzerland is experiencing higher import prices for U.S. Dollar-priced commodities, particularly petroleum products, but inflation remains negligible at under 1%, and it is too soon to conclude that the recent improvement in GDP is more than a blip. Despite Meyer's comment, a Swiss rate hike this year would seem premature. Similarly, hard-liners in the German Bundesbank are unlikely to nudge rates higher given the latest unemployment figures, Euro- partner sensitivities and a weak domestic economy.
The Bank of England has succeeded in talking sterling lower, which was not difficult since the market had already realised that the next interest rate change would almost certainly be a reduction, although perhaps not for some time. Greenspan is unlikely to raise U.S. rates anytime soon because inflation remains quiescent despite somewhat stronger GDP growth than the Federal Reserve has forecast, the dollar remains strong overall and he is concerned about Wall Street's vulnerability.
Trading ranges and lengthy reactions against primary trends can only increase uncertainty in markets but I still see no convincing technical or fundamental reason why the U.S. Dollar's overall advance against the yen, mark and Swiss Franc should have ended. Staying with the fundamentals in this section, a dollar/yen rate over ¥120 obviously favours those contentious Japanese exports. While this is a restraint on the dollar, largely due to awareness of political sensitivities, there is currently little incentive for Japanese companies to sell their dollars given a domestic 10-year bond yield of less than 2% and a flat stock market. However, the U.S. Dollar remains underpinned against the yen by a massive 500-basis-points yield advantage and a comparatively robust economy in its seventh year of expansion.
While the U.S. has a trade deficit overall, this is due more to relative economic performance than competitiveness, as the American economy continues to grow faster than that of its main trade partners, China excepted. Despite slower growth in Japan and Europe, U.S. exports continue to increase due to success in opening new markets. Moreover, the trade deficit is not what it seems, as I have discussed many times before. U.S. Customs and Excise has said that it does not monitor exports of goods comprehensively, unlike imports, underestimating the former by at least U.S.$70bn. Also, financial services such as merchant banking, a major U.S. export, are even more difficult to report accurately. Finally, overseas branches of U.S. companies manufacture many imports, Nike shoes for instance, arguably a great American success story but recorded as part of the deficit.
In addition to these factors the U.S. Dollar has often moved in lockstep with Wall Street recently. This bizarre development is due to the belief among many currency traders that non-U.S. investors would sell American financial assets in a bear market for equities. Indeed they would, but U.S. investors hold at least an equivalent amount of overseas shares, some of which would obviously be unloaded in a flight to cash. Therefore the U.S.$/DJIA link is tenuous and in the event of a substantial shake out for stock markets, once the dust settled, I believe investors would seek safety in the greenback rather than a low-yielding yen, Swiss Franc or soon to be extinct mark.
In conclusion, I believe that the U.S. Dollar will extend its ranging recovery against the yen, evident since the June reaction low, testing the May peak at ¥127.5 in coming months, at least. Despite Hans Meyer's comment, I do not expect Swiss or other European short-term rates to change much, if at all, for some time. Continental Europe's nascent economic recovery could prove to be as ephemeral as Japan's, given uncertainty and the continuing fiscal policy squeeze which will continue because of Maastricht constraints. Obviously European politicians and central bankers do not want to be embarrassed by currencies in free fall, but any further recovery against the dollar would soon jeopardise exports. Consequently I believe that the U.S. currency is near the low point of a lengthy consolidation against all Continental European currencies prior to a retest and eventual break above the year's earlier highs.
Against its proxies, such as the Australian, New Zealand and Canadian Dollars, the greenback is likely to move somewhat higher due to relative economic performance and interest rate differentials, especially as prices for many commodities are relatively low. However sterling is another matter, appearing somewhat oversold generally, even though very significant peaks were probably established in May against the yen and July versus other reserve currencies. Interest rate differentials of up to 625 basis points are a compelling reason for some explosive technical rallies by the pound from time to time. Against South East Asian currencies the U.S. Dollar's upward momentum has been broken but further gains are likely over the intermediate to longer term, especially when interest rates in the region fall significantly, as they must, to stem the decline in GDP growth.
Commodities
Periodic El Nino excitement aside, there is little reason for speculative interest in commodities at present. Arguably, gold ought to look more like a cheap and acceptable alternative to stocks and even bonds when these investments suffer a substantial setback, but people are even more afraid of further sales by central banks, which are widely forecast. Moreover, a majority are more concerned about deflation than inflation. An infrastructure development slowdown in South East Asia, Japan's continuing economic woes and a sporadic recovery in Europe will do little to increase demand for industrial commodities. Prices are likely to trend somewhat lower, in general, punctuated by periodic rallies as and when supplies are threatened, particularly in the agricultural sector which is always susceptible to weather vagaries.
Government Bonds
Investors who still hold long-dated government bonds should reduce exposure in the event of any failed breaks above the July/August highs. As for new commitments, there are times when one should be bold and times when caution is preferable. Today I would focus on safety rather than opportunity and only consider short-dated issues.
Speculators running with the latest breakouts should use trailing stops and treat any clear downward dynamic as a sell signal.
Stock Markets
I continue to favour last month's defensive policy. Technical rallies are now underway and I would use these to lighten positions across the board. Institutional investors could also hedge by writing covered calls and shorting futures on any clear weakening of the global bond market rally. In a complete change from tactics advocated during the long bull run, I would no longer buy shares previously favoured on setbacks.
Many institutional investors remain almost fully invested, banking on no more than a 10% correction for Wall Street, while rotating positions away from previous market leaders to laggards, including small capitalization shares. This has proved successful, at least in the U.S. market, but it is a higher risk strategy. While smaller companies had lagged generally until a couple of months ago, they are also illiquid. When stock markets next move lower, it will be difficult to raise liquidity in thinly traded shares without pushing prices considerably lower. The same argument weighs against emerging markets which have been speculative favourites for many months.
Speculators who sold stock market index futures for the previously high-flying markets short–my strategy in FM159 and subsequent FMP updates, will have done very well provided that they used the baby steps tactic of sell-high-buy-low as advocated and covered any remaining positions as the bond rallies become apparent.
I am not contemplating any new stock market index futures short positions while bonds remain strong. Instead, I am hoping for strong rallies, in which I will not participate, so that I can reshort at high levels when bonds next weaken.
Currencies
Of my two preferred positions in FM159, U.S. Dollar longs against the yen and Swiss Franc, I felt the latter was the least risky. It has not been so over the last month as my profits against the yen, realised and current, have been offset by losses against the Swiss Franc, unrealised. One certainly never knows for sure, but I expect to recoup the latter and hopefully do somewhat better than first envisaged due to the dollar's big reaction against the Swiss Franc during which I gradually increased the position on a baby steps basis. Incidentally, with baby steps I always make sure that I deal in a size that enables me to continue with the strategy, should I wish to, if the market moves well beyond what I had expected, which it frequently does. Because markets can do literally anything over the short term and are sometimes volatile due to crowd emotions, the hardest thing to guess successfully is the extent of any trend or even reaction.
Anyway, rightly or wrongly, I remain reasonably relaxed having purchased the dollar on recent weakness against the Swiss Franc because of the various technical and fundamental points already discussed. I could be wrong, of course, but I am encouraged by the fact that the dollar fell back from last month's high much more slowly than it rose to that level, until the end which looked climactic. Even if its final peak was reached on August 6th, which I very much doubt, the slower decline argues for at least a top- testing rally.
I suspect that much of what we see with dollar/yen in this cycle is approximately repeated by dollar/mark and dollar/Swiss somewhat later. I do not want to belabour this point, but it is logical and that is what we have seen so far. For instance, the dollar commenced its significant recovery in 1995 against the yen several months before it confirmed a floor against the mark and Swissie. Central bank jawboning commenced first against the yen, breaking the uptrend in late May versus an early- August high against the mark and Swiss Franc. The dollar has subsequently been gradually recouping that fall against the yen and we will see what happens against the other two.
For those who share my view that the U.S. Dollar will retest the year's highs against the mark and yen, but want a chart signal that it has bottomed, watch for an upward dynamic following the recent capitulation selling. Sterling's fall against the mark and Swiss Franc will probably show a similar ending and given its deeper reaction, may actually lead the next rally. I recently bought sterling against the Swiss Franc suspecting that two of the best currency moves in coming months will be sterling and U.S. Dollar rebounds against the Continental European currencies. Elsewhere, the greenback's upward trends against most of the South East Asian currencies show some loss of consistency so I would take profits and stand aside for the time being.
Commodities
I currently have no commodity positions and have no positions to recommend. However, I would expect to see some technical rallies as stock markets steady, causing the deflationary fears to subside.
Cash
Many FMs have increased the cash portion of their portfolios recently, after booking bond and stock market profits. I feel very comfortable with cash right now. Recent setbacks by the U.S. Dollar and sterling make them attractive for safety and yield.
September 19, 1997
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