wmeubank@ocp.kcmo.com
Fuller Money:
The Global Strategy Investment Letter
Prepared by Chart Analysis Limited
The Short-Term Lead From Bonds Has Turned From
Bullish To Neutral/Bearish For Global Stock Markets
--Prices for most global bond markets have broken their short-term uptrends in regions of historic resistance.
--A yield of 1.75% for 10-year JGBs is ridiculous, short of a depression in Japan, and cannot last.
--The most depressed Asian stock markets are arguably cheap but unlikely to stage significant catch up moves as the global cycle for equities is deteriorating.
--Many European stock markets continue to show at least preliminary evidence of top formation development and will fall sharply when their respective bond markets weaken.
--Alan Greenspan's recent remarks before the U.S. House Budget Committee are a serious warning for Wall Street.
--Currently in-form emerging markets can move higher until Wall Street's main indices fall more than 10% but the risks are increasing in this illiquid sector.
--The U.S. Dollar and its proxies should range higher against the yen in coming months.
--The U.S. Dollar and sterling are in a bottom area against the mark. All three should now range higher against
the Swiss Franc having completed their intermediate-term corrections.
Risks In The Better-Performing Stock Markets Are Increasing
They Broke The Barrier - What do Chuck Yeager, Andy Green and Wall Street have in common? They all broke the sound barrier. Fifty years ago Yeager made his historic flight that broke the sound barrier. Green has just become the first human to achieve this feat in a jet-powered car. Wall Street, not to mention a number of other racy stock markets, has broken the sound-money barrier. With apologies to Australia's splendid Northeast coastline, where I enjoyed snorkeling last Easter, might stock markets be about to founder on The Great Barrier Grief?
Time will tell, as legions of other don't know types have said, honestly if disconcertingly in answer to most of the important questions through human history, but the portents are not favourable if you have time for The Great One. I do, believing that Alan Greenspan is currently the most influential person on earth. In case anyone missed it, he gave new paradigm bulls another wake up call a few days ago. Some of his more salient remarks are quoted in 'The Big Picture' section.
Cutting to the chase, Greenspan doesn't think Wall Street can maintain its record breaking pace. That is an opinion, of course, but more importantly, he operates the monetary policy levers which control liquidity - the life blood of all bull markets. Bond bulls, high on the opiate of self-interest, had spun a seductive tale of deflation and rate cuts. Instead, Greenspan seems more likely to raise short-term rates, possibly before the year's end. Investors have seen other central bankers raise interest rates recently, notably the Bundesbank. Presumably Hike 'em Eddie George at the Bank of England is straining at the leash and can't wait to get back in on the action.
Judging from the all-important charts, investors have begun to notice that the liquidity lake is beginning to dry up. Here's my favourite recent comment from an investment manager, quoted by Bloomberg: 'The train is on the track, the light's in your face.'
Now in being a recent bearish convert, I readily admit to speaking with all the subjectivity of someone who cannot take profits fast enough on shares mostly recommended in these pages over two years ago, and who also now sells stock market futures short every time their rallies tire. In my view the great bull market has already ended for some markets and the others are in injury time. They are obviously not all turning down at once. Instead, the deterioration started in Asia. The bear has now embraced two previous high flyers from that region--Taiwan and Hong Kong--is reaching towards Europe, will perhaps be clearly evident on Wall Street last among the developed countries, and finally drag down the currently in-form emerging markets. I don't know whether the process of topping out will be rapid from here on or spun out over many months. However the charts will tell us, particularly those for bonds. Meanwhile, I like cash.
Interest Rates And Bonds
Worrying About Higher Short-Term Rates--I have long maintained that there was no need for higher short-term rates in the developed economies, given the moderate growth and low inflation, while always acknowledging that a central banker is gonna do what he thinks he's gotta do. Suddenly rates are popping up like uninvited guests at the party. The justification has been growth feared or anticipated. We will see, but meanwhile the fashion for rate hikes is catching on. I believe Canada started the latest round, then the Bundesbank moved, forcing a knee-jerk response in Northern Europe, further cuts are on hold in Australia, Greenspan is issuing warnings once again and we can assume that Eddie George won't want to be left out of the act.
Eurodollars Fall Back From Their 11-Month Highs--Following the August shake out December Eurodollars rebounded for a few days and then gradually ranged sideways to higher. They edged above the August peak earlier this month, although not the December high, before sagging back and recording an upside failure. This latest move suggests that prior support within the overall range is now more likely to be tested than the recent high.
U.S. Treasury Bond Prices Fail To Maintain A Break Above Their August High--The long-dated Treasury bond contract rallied sharply following an upward dynamic off the August/September range lows. However following new contract highs, December T-bonds fell sharply, establishing a potentially important upside failure. While the overall uptrend has not been broken, a peak of at least near-term significance appears to have been established. A decisive up-day, such as we saw in mid September, is required to offset lower scope.
UK Gilt Prices Break Their Short-Term Uptrend--UK 10-year bonds accelerated to a peak at 121-27 on 3rd October before falling back sharply. Here also a peak of at least near-term significance has been established. The December contract price has firmed subsequently but an upward dynamic is needed to indicate more than top extension. A close beneath the recent low at 118-14 would signal an additional retracement of previous gains.
German Bund Prices Fall Back Into Their July-September Range--December bunds also show a failed upward break although they have subsequently steadied along with other contracts. However more decisive upside action is now required to reaffirm underlying support and a close under 102.10 would indicate further pressure on the previous range.
Swedish 10-Year Bond Yields Rebound From A Floor Near 6%--Once December Swedish bond yields broke down out of their July/early-September range they fell steadily reaching a low at 5.98% on 3rd October. Three days of quiet ranging was then followed by an upside gap, indicating that a floor of at least near-term significance had been established. While the rally has paused, a downward dynamic is now required to offset scope for some further retracement of the recent decline.
Japanese Bond Prices Are Losing Upward Momentum--December JGBs had been ranging steadily higher for months and were impervious to the August shake out experienced by other government paper. However, following a slight acceleration the last two weeks have been characterised by some loss of momentum and a slight increase in volatility. While these are only clues, they suggest that a peak is at hand.
Australian Bond Prices Peak--Australian bonds rallied powerfully from their April low before losing upward
momentum and peaking with a key day reversal at 93.965 for the December contract on 7th October. Following a
sharp reaction they have steadied in the early-September range but upward scope now appears limited to top
formation extension.
Conclusion On Bonds
Another strong rally by global bond prices has peaked with clear downward dynamics. While there is no
conclusive evidence that this is more than another temporary correction, many contracts are in areas of historic
resistance, and Japanese bonds are off the map. Despite low inflation, this is dangerous territory at a time when
short-term interest rates have either risen or are no longer falling in most countries, amongst many forecasts of
higher growth.
Global Stock Markets
The Lead From Bonds Is No Longer Bullish. Most Stock Market Indices Continue To Underperform Bonds,
Highlighting The Growing Overall Risk--The Asian markets remain sluggish although, arguably, the most
depressed of these are now very cheap. Continental European markets currently look the most vulnerable overall,
showing many overstretched uptrends and some evidence of top formation development. The U.S. indices do not
yet show any downside deterioration, although cycle laggards are making the running and the large capitalisation
indices have seen an overall loss of upward momentum. Many emerging markets remain in form and can extend
gains until the U.S. market clearly weakens. A firmer tone by global bond prices is necessary to reduce the
growing risk for stock markets generally.
Watch The Charts
I maintain that 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. This is usually done by monitoring a large selection, well in excess of our main interests, for the perspective that it can provide. Watch particularly for sustained breaks of previous rally highs to indicate a firmer tone, or conversely, failed moves over previous highs, not to mention breaches of former reaction lows to signal pattern deterioration. In the reviews here, I aim for an objective assessment of the technical facts--there are plenty of forecasts elsewhere in this issue--and I eschew targets which are pure conjecture.
The Chart Analysis World Market Indicator (currently 1692) has followed its largest fall since February-March 1994 with a lower rally high, adding to the loss of prior uptrend consistency. A move above 1750 is required to offset this deterioration while a push over 1820 is needed to revive the former uptrend. Conversely, further weakness would be signaled at 1640. CAWMI is unweighted and calculated in local currencies every Monday.
MS Capital International's World Index (970) has rallied back to potential resistance near 980 and needs to sustain a break over this level to reaffirm the uptrend. However, a move to 910 would indicate potentially significant deterioration. The MSCIWI is capitalisation weighted and calculated in U.S. Dollars.
The U.S.A.'s Dow Jones Industrial Average (8096) has ranged higher recently and would need to close below 7840 to provide clear evidence of resistance from the August peak. An important downward break would be signaled below 7600. Conversely, a sustained push over 8260 is needed to reaffirm the upward lead from other U.S. indices. The Standard & Poors 500 Index (983) has nudged above its August high, opening the door for some further gains. However, evidence of an upside failure would increase with each point below 960. The NASDAQ Index (1746), which sometimes leads, has forged ahead and would have to fall below 1600 to indicate a substantial loss of momentum.
Canada's Toronto Composite Index (7169) has moved to another new high and now needs to fall back under 6940 to provide the first evidence of a possible upside failure. However, a break beneath 6600 would be necessary to indicate that a major peak had been seen.
Argentina's General Index (24,995) has hesitated near the August high and the important 1994 peak at 25,400. Nevertheless, a break under 23,400 is the minimum needed to reaffirm those former barriers given the overall upward bias.
Mexico's IPC Index (5324) has pushed above its August high and looks somewhat overstretched. While an increasingly important upside failure would be indicated with each additional point below 5200, a fall under 4600 is needed to indicate a completed top.
Brazil's Bovespa Index (12,895) has rebounded following its biggest correction for years. A fall back under 11,700 is needed to reaffirm resistance from the peak area rather than an additional test of the highs.
Japan's Nikkei Stock Average (17,306) is pressuring the year's earlier floor which extends down to 17,019 on an intra-day basis. A break in the progression of lower rally highs, by a move to 17,900, is the minimum required to indicate that support is being found near that former floor.
Taiwan's Weighted Price Index (8429) has fallen steadily since failing to maintain a push over the psychologically significant 10,000 level. While there is some potential support from the March-June trading range lows near 8000, a strong rally would be required to check the overall downward bias.
Hong Kong's Hang Seng Index (13,837) could not maintain its nudge above 15,000 and is eroding prior support once again. A close over 15,200, which remains unlikely, is required to indicate a higher phase of top extension.
Singapore's Straits Times Index (1878) experienced a climactic fall to an intra-day floor of 1735 before establishing a closing low at 1786. While that trough should hold for at least the short to intermediate term, patterns of this type are usually followed by a significant retracement and lengthy base extension phase before a sustainable uptrend occurs.
Malaysia's KLSE Composite Index (823) has a similar pattern to Singapore and has steadied above its low in a potential base extension. A move below 740 is currently required to indicate a further test of the intra-day floor at 675 rather than sideways and eventually higher trading.
Australia's All Ordinaries Index (2662) could not maintain this month's push to a new high but a close at 2580 is needed to indicate more serious pattern deterioration. The All Mining Index (765) is retracing its small rally, and while the overall decline continues to look somewhat overextended, a close below 750 would indicate renewed vulnerability. A move over 875, which continues to look unlikely over the near term is necessary to significantly check the previous downward bias.
New Zealand's Capital 40 Index (2612) remains steady and while some loss of momentum would be evident below 2540, a breach of the January 1994 and January 1997 peaks near 2450 would be needed to indicate major pattern deterioration.
South Africa's Industrial Index (8852) has steadied in the upper region of its large trading band which formed between January 1996 and June 1997. A move under 8540 is required to signal renewed pressure on this area. The JSE Gold Index (1043) did not maintain its fall beneath 900, and given the extent of the prior slump, should now have established a low of at least near-term significance. If it can hold most of the recent gains during a consolidation, a further rebound is likely in coming months.
Belgium's BEL 20 Index (2458) has encountered resistance beneath the July peak area. A move to 2520 is required to indicate a further test of that region while significant deterioration would be apparent below 2300 which would also take out the August/September intra-day reaction lows.
France's CAC 40 Index (3005) has not maintained its move to a new high and the pattern would deteriorate progressively below 2950. Conversely, the top-building hypothesis would be questioned by a move over 3100.
Germany's DAX Index (4202) rallied back into its July/August peak area before encountering resistance. A clear break above the intra-day high of 4460 is needed to question the top building characteristics of this pattern which would deteriorate progressively below 4100.
The Netherlands' AEX Index (935) has encountered some resistance below the August peak near 1010 and would have to clear that level decisively to partially offset top formation characteristics. These gain credence with each point below 900.
Spain's Madrid SE Index (601) rallied sharply but has been unable to maintain last month's move to a new high. While a move to 645 would revive the uptrend, further and potentially important deterioration would be evident at 570.
Italy's BCI Index (1002), a previous laggard, pushed further into new high ground than most other European indices recently before encountering some resistance near the psychological 1000 level. A move under 925 is required to commence a potentially important erosion of support.
Sweden's Affaersvaerlden General Index (3250) pushed steadily back towards its August high before hesitating. While a move to 3320 would suggest somewhat higher scope, the overall pattern would look progressively like a top area under 3140.
Norway's Oslototal Index (1382) has pushed steadily above its August high after a comparatively small correction. A fall back under 1325 would be needed to provide the first evidence of an upside failure.
Denmark's Copenhagen SE Index (659) pushed steadily to a new high before faltering. So far it has not come back sufficiently to look like a significant failure but this would look increasingly likely with each point below 630. A close over 664 is needed to reinstate the uptrend.
Switzerland's Swiss Market Index (5836) has faltered in its July/August peak area. A sustained break above the psychological 6000 level is required to suggest somewhat higher scope. Conversely, the action would look progressively like extended top-formation development below 5600.
Ireland's ISEQ Overall Index (3924) has extended its consistent uptrend and would have to move under 3700 to indicate a potentially significant loss of upward momentum.
The UK's FTSE 100 Index (5299) broke decisively above the psychological 5000 level and the August peak just
under 5100. While other upside breaks have often proved difficult to maintain initially, a move back beneath these
two levels is now required to indicate pattern deterioration.
Conclusion On Stock Markets
In the August shake out most of the previously in-form indices fell from their peaks more slowly than they had risen to those levels. That usually indicates scope for top-testing recoveries, at least. We have now seen these while several indices have pushed to new highs and held those gains to date. Moreover, none of this year's high performing stock markets have retested, let alone exceeded, their late-August/early-September lows. These are points for the bulls. The fact is, there can be no major correction, let alone a bear market, without breaks of the recent lows.
Despite those signs of strength, there are a number of warning signs for global stock markets that we have not previously seen over the bull run which commenced in early 1995. Many of the European indices had accelerated dramatically to their July/August peaks--a trend ending signal. A number of the subsequent shake outs were considerably larger than other corrections seen over the previous two and three-quarter years. Larger trading ranges are forming for a number of indices than we have seen for many months. This indicates that the previous imbalance between supply and demand has narrowed. For that reason large trading ranges following substantial prior moves are notoriously unreliable continuation patterns. The all-important bond lead has turned from bullish at the September lows for stock market indices to neutral at best.
In conclusion, there is still no evidence that the bull market is over for markets outside Asia. However, the trend
inconsistencies suggest waning momentum and we may have seen the penultimate peaks, at least. Further ranging
over the next several weeks could indicate top development. While another bond market rally would probably lead
most stock market indices somewhat higher, weakness in the fixed interest sector could only increase the growing
risks.
Currencies
The U.S. Dollar Has Established A New Floor Against The Swiss Franc And Should Retest Its High, At Least--The dollar ranged downwards from its August high at SF1.5389 much more slowly than it rallied to that level. This is typical of an intermediate consolidation rather than evidence of a primary trend reversal. Recently, the greenback has shown a loss of downward momentum, moved laterally out of the short-term downtrend and broken the previous progression of lower rally highs by edging above SF1.465. This evidence suggests that the U.S.$ has established a new floor against the SF. A clear break under SF1.435 is now required to delay current scope for sideways to higher ranging by the U.S.$, including a successful challenge of the August peak as the overall bull trend is extended.
The U.S. Dollar Is Bottoming Against The Mark Prior To A Successful Challenge Of The August Peak--Here also the dollar's ranging decline is much slower than its rally to the peak at DM1.8905, suggesting that we have seen no more than a multi-month consolidation. The correction has slowed recently near the upper region of the extensive February-June platform which supported the last big rally. Consequently this is a probable bottom area although a push above DM1.78, taking out the last in a sequence of lower rally highs, is required to provide clear technical evidence of recovery. A breach of DM1.73 is needed to delay this prospect and indicate somewhat lower trading for the U.S.$ before it ranges back up to and eventually over the August peak.
The U.S. Dollar Should Range Higher Against The Yen--I maintain that the dollar's primary uptrend against the yen remains intact, although it certainly experienced a significant correction last May. Subsequently, a gradual build-up of support has occurred and this appears capable of sustaining a successful challenge of the earlier high at ¥127.5. A clear break under ¥119 is currently required to question this hypothesis.
The Mark Has Commenced Its Recovery Against The Swiss Franc--The mark checked its slide against the Swiss Franc with a key day reversal at the July low of SF0.8101. Subsequently it had been ranging sideways in a support building phase above its historic lows. The recent break above lateral trading near SF0.83 indicates that a recovery move has commenced. Given the low starting point, the mark could experience a significant rally against the Swiss Franc over the intermediate to longer term.
Sterling Remains Generally Steady Against The U.S. Dollar--This is a difficult call, except at the extremes of the broad band that has kept the dollar and sterling rangebound for a long time. Currently, the pound remains in a recovery phase from the lower side of its overall pattern, although it has been unable to break clear of lateral trading near US$1.62.
Sterling Should Range Higher Against The Swiss Franc--The pound appeared to have reached an important reaction low near SF2.30 in mid-September. This was just above the year's earlier troughs and the downward trend from the August peak has subsequently been broken. Some resistance has been encountered from lateral trading near SF2.38 but underlying trading appears sufficient to clear this before long, reaffirming higher scope.
Sterling Appears To Be Bottoming Against The Mark--Following its July peak sterling fell back steadily against the mark before encountering support above the year's earlier trading band which launched the last big rally. Subsequently it has ranged sideways and out of the prior downtrend. A clear break of DM2.80 is now required to delay recovery scope and indicate an additional test of underlying trading.
Sterling Is Steady Against The Yen And Seems Well Supported--While the pound has not yet been able to break clear of lateral trading near ¥195, it appears well supported by the underlying range that has formed since mid-May. A clear breach of ¥192 is needed to delay sideways to higher ranging.
The Australian Dollar Appears To Be Completing A New Base Against The Yen--After reaching a high just over ¥100, the A$ plunged against the yen along with other currencies in May. Subsequently, it has been tracing out what seems to be another large base formation capable of supporting a possible retest of the year's earlier high. A move under ¥85 is required to delay higher scope over the short to intermediate term.
The U.S. Dollar Remains Generally Steady Against The Singapore Currency--Although the U.S.$ fell back sharply from this month's high at S$1.566, it has subsequently steadied in the upper region of the August/September range against the Singapore currency. A breach of S$1.52 is necessary to indicate a lower phase of ranging before the U.S.$'s overall upward trend is extended.
The U.S. Dollar May Have Reached An Important Reaction Low Near M$3.00 Against The Malaysian Ringgit--The U.S.$ accelerated to a peak at M$3.41 on 1st October. Following that short-term trend ending, it fell back
sharply to M$3.00 where support has been encountered. A decisive break of this low is needed to indicate a further
correction over the near term rather than sideways to higher trading for the U.S.$.
Commodities
Natural Gas Peaks But It May Only Be A Consolidation--Natural gas broke up out of a long range centred on $2.40 for the December contract in early August and rallied steadily before accelerating to a peak at $3.50 on 26th September. While that ending was climactic and the price fell back sharply, it has subsequently rebounded with a clear upward dynamic. Consequently a close under the recent reaction low at $2.94 is needed to reaffirm last month's peak and indicate a further retracement of prior gains. Until or unless that occurs, there is a possibility that natural gas is consolidating before resuming its recent uptrend.
Gasoline Falls Back To Potential Support From The Year's Prior Range--Gasoline prices surged in late September before peaking on 3rd October at 63.35¢ for the December contract. While this move also looks climactic for at least the short term, it will be interesting and important to see how the price behaves near the upper region of the year's prior range. If it encounters good support around the 58¢ level, the overall pattern will have the appearance of a consolidation above a base prior to renewed strength. Conversely, a decline much below that level would look increasingly like an upside failure to establish an important peak.
Gold Follows Oil--The December contract accelerated to a low at $318.5 on 7th August and then ranged sideways before breaking up out of this pattern as oil prices surged. However that rally has not been maintained suggesting that gold is now susceptible to a retest of the low. An upward dynamic is required to reaffirm support from the July-September range floor and a close over $341 is need to indicate additional recovery scope.
Palladium Prices Are Strengthening Once Again--December palladium bottomed at $145 on 10th July and then
accelerated to a peak at $219.6 on 5th August. The subsequent retracement encountered support from the upper
region of the May-June range and the price gapped upwards from this rounding formation recently. A close below
$195 is now required to question near-term scope for additional strength.
Where To Invest--The Big Picture
The Global Investment Scene
Sentiment is often ephemeral in the financial markets as we have certainly seen in recent months. No sooner had the crowd consensus decreed that August's squall for bonds and stocks was nothing more than `healthy profit taking,' U.S. Federal Reserve Chairman, Alan Greenspan, delivered a psychological bombshell. His sobering warning before the House Budget Committee about potential wage inflation and the overvalued stock market was totally unexpected by the markets. I believe that Greenspan's latest remarks are much more significant than his often parodied question about `irrational exuberance,' issued last December when the DJIA was considerably lower.
For the record, here are some of Greenspan's more important remarks: `the performance of the labor markets this year suggest the economy has been on an unsustainable trackfinancial markets seem to have priced in an optimistic outlook characterized by a significant reduction in risk and an increasingly benevolent inflation process.' Consequently stock price-earnings multiples are at levels `not often observed at this stage of economic expansionit would clearly be unrealistic to look for a continuation of stock market gains of anything like the magnitude of those recorded in the past couple of years.' On wages: `to believe that wage pressures will not intensify as the group of people who are not working but who would like to rapidly diminishes strains
credibility. The law of supply and demand has not been repealedrewards sufficient to make jobs attractive could conceivably also engender upward pressures on labor costs that would trigger renewed price pressures undermining the expansion.' On productivity: `this is clearly an evolutionary not a revolutionary process.' Declines in costs have 'led to speculation that we are operating with a new paradigm where price pressures need rarely ever arise because low-cost capacity both here and abroad can be brought on sufficiently rapidly when demand accelerates. Before we go too far in this direction, however, we need to recall that it was just three years ago that we were confronted with bottlenecks in the industrial sector' that were `putting visible upward pressures on prices.'
Obviously not everyone will agree with all of these assessments, particularly regarding inflation. However, rather than allowing ourselves to be side-tracked by the relative merits of Greenspan's opinions, it is far more important to consider what they may reveal about future Federal Reserve policy. This is particularly relevant against the background of a recent consensus view among investors that inflation pressures will not only remain benign, but that deflation is the major threat. Before he spoke many bond bulls were saying that the Fed's next move would be a rate cut! Clearly nothing could be further from Greenspan's mind. Suddenly the possibility of a rate hike before the year end appears very real. Markets have reacted accordingly.
Often when investors are overleveraged and caught unawares by unexpected bad news, `it never rains but it pours.' The day following Greenspan's broadside, Germany's Bundesbank triggered Continental Europe's first significant change in monetary policy for 5 years by raising short-term interest rates. Canada had hiked rates earlier this month and, of course, short-term borrowing costs rose sharply in the UK following the election last May. Only one investment conclusion can be drawn from these changes in monetary policy--the global liquidity that fuels all great bull markets is now shrinking.
Earlier this year, monetary tightening had been confined primarily to so-called Asian 'tiger' economies which had expanded too rapidly on borrowed money. The consequences for their stock markets have been severe. Those were mostly regional problems and there is obviously no prospect of a similar monetary squeeze in the developed world's economies. Nevertheless, a widespread change in liquidity trends, such as we are seeing now, usually produces a significant move in stock and bond markets, if not initially, over the intermediate to longer term.
While Alan Greenspan's pronouncements on labour tightness and U.S. stock market valuations understandably
gathered the most headlines, this month's bluntest statement by a leading monetary official came from Eisuke
Sakakibara, Vice Finance Minister for International Affairs. Speaking at a conference on 4th October, he described
Japanese 10-year government bond yields of 1.74% as 'crazy' and warned that their buyers would 'get hurt.' How
could he not be right? Meanwhile, bond yield convergence theories took a knock when the UK Government
described rumours of a significant shift in favour of EMU as 'pure speculation.' A preview of how smoothly the
pending 'United States of Europe' will function came with the fall of Italy's 17-month coalition government when
the Communist members refused to back additional budget cuts required to meet Maastricht criteria.
Government Bonds
The great bond bull market story for the last two and three-quarter years has been high real yields, a favourable outlook for inflation and strong demand from the yield-starved Japanese public and insurance companies. Arguably some developed country yields still offer value on the basis of historic comparisons. However, recent yield convergence left little room for unsettling news, particularly with third world debt.
FM160's lead article quoted from The Wall Street Journal Europe on 18th September, a report that bond-fund managers are 'buying more high-yield, high-risk junk bonds than at any time in recent memory.' Four days later, Stanley Fischer, Deputy Managing Director of the IMF, said in a Hong Kong speech before the Fund's Annual Meeting: 'The hazard is that the private sector may be too willing to lend because it knows that a country in trouble will go to the Fund rather than default. Investors may already be too indiscriminate,' he stated, as interest rates on some bonds 'are so low as to support this view.' He indicated that investors would have to share in the financial cost of dealing with future crises, such as in Mexico a few years ago and Thailand more recently. According to the International Herald Tribune, Bloomberg News quoted Mr Fischer as having said after his speech that the IMF's goal regarding certain investors was to 'find ways to make them pay.'
We have been warned, and bond markets have seen speculation this year reminiscent of 1993's bubble. Meanwhile 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 have begun to weigh on bond prices. Eisuke Sakakibara, Japan's most high-profile economic spokesman, alias 'Mr Yen,' has stated a basic truth. Japanese bond yields are crazy, and out of line with the rest of the world unless investors in Japan expect across the board deflation of 4% per annum over the next ten years. That stretches credulity.
Bond bulls have overhyped the deflationary risk, unless we get a global stock market collapse, which would almost certainly be triggered in part by bond price weakness. Yes, we have pockets of deflation, a potential problem of overproduction and competitive pressures that keep prices low generally. However, the IMF is forecasting global GDP growth of 4.5% for this year and next. I think they are too optimistic, but even if the outcome is half that, we will still not have global deflation. Instead, what we are seeing is greater competition than ever before in a market place that is larger than ever before. Overall, that is good for global GDP growth.
Meanwhile, the Bundesbank has just instigated Europe's first significant interest rate increase in 5 years. U.S.
Federal Reserve Chairman, Alan Greenspan, is clearly concerned about wage inflation due to labour shortages and
may well raise rates before the year end. The latest U.S. PPI figure for September 'surprised' with a leap to 0.5%
against expectations of 0.2%. Rising prices for petroleum, the world's most important commodity, were the main
factor.
Stock Markets
The abundant liquidity that fuels all the great bull markets for stocks is beginning to dry up as more countries have increased short-term interest rates. While neither inflation or GDP growth rates argue for a squeeze, the significance of any tightening in monetary policy against the background of generally high valuations should not be underestimated. Even when generally anticipated, the actual reality of higher rates can only damage sentiment as investors fear further hikes and analysts lower earnings forecasts.
When demand starts to wane in a mature bull market cycle, as we are certainly witnessing, supply becomes a problem. Sensing that share valuations are too good to last, companies rush to the market with initial and secondary share offerings. Currently there is no shortage of emerging market governments anxious to privatize moribund state industries, led by China.
Finally, management and employee share options, so popular in the U.S. and 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. According to Vickers Stock Research Corporation, insider selling in the U.S. is now higher than at any time since 1993, although still some way below 1987.
Despite these intermediate to longer-term problems, Wall Street is unlikely to lead an overall decline by world stock markets given the vastly superior economic performance in the U.S. over the last few years. During seven years of economic expansion it has been U.S. companies that have most successfully increased their sales in the global market and experienced the more consistent profit growth. Corporate results have been further boosted by share repurchase schemes which also reduces supply.
It has been Asia which has led the way down in the current stock market cycle, or in the case of Japan, failed to participate at all except for the world-class exporters which have mostly enjoyed strong earnings, boosted considerably by a weaker yen. Some strategists now favour Japanese domestic companies, financial and property shares. Purchasers are likely to require patience as many of these companies still sell at higher multiples, for no good reason, than their counterparts in other developed countries.
Asia's depressed 'little tiger' stock markets are arguably cheap and considerably more competitive following this year's sharp devaluations. However, here also patience is likely to be required, at least until interest rates are considerably lower, because there will be more financial skeletons to emerge from closets and justifiable concern over debt default. Asia's two high-flyers up until August - Taiwan and Hong Kong - remain vulnerable. Taipei's stocks in general had soared to considerably higher multiples than any other major market. Hong Kong has developed a property bubble to rival the worst excesses seen in Japan in 1990.
No developed country stock markets had outperformed those of Continental Europe's leaders during the 20 months up until August. However the outlook is considerably less attractive now that the long period of very accommodative monetary policy has ended. The earnings-boosting advantage of devaluation has also been shelved recently, although probably not removed for the intermediate to longer term. However the structural problems of bureaucracy, overtaxation and union intransigence leave the region generally ill-equipped to function effectively in the competitive global economy.
Arguably, these problems have worsened with the election of a Socialist/Communist government in France determined to shorten the work week with no corresponding loss of pay. Taxes have also risen in France and in Germany left-wing opposition has blocked proposed tax reforms. Thinking economist, Anatole Kaletsky, writing in The Times (London), points out that 'much of Germany's export growth is simply a function of the hollowing out of the German economy. German companies are selling machinery to the overseas subsidiaries of other German companies setting up production bases in lower-cost locations.' Finally, EMU has always been a triumph of political will over economic logic.
While the UK has few of Continental Europe's problems, high short-term interest rates have added to borrowing costs and are likely to keep sterling uncomfortably firm for exporters. The UK market is vulnerable to at least a correction as investors look beyond EMU hype and realise that there is no justification for long-dated yield convergence with Germany given Britain's stronger economy and higher inflation.
The in-form emerging markets will continue to take their cue from Wall Street. Given the fashion change in
favour of previously lagging but more speculative smaller capitalization domestic companies and emerging
markets, U.S. investors will continue to diversify for so long as the major U.S. share indices move sideways to
higher. However, when the DJIA next clearly falls more than 10%, which has become the periodic and therefore
acceptable norm, U.S. investors are likely to take fright and repatriate capital. We last saw this in 1994, when
emerging markets, which had been all the rage the year before, became submerging markets.
Currencies
Primary fundamental factors of interest rates, growth inflation/deflation and money supply in the currency markets do not change all that frequently and when they do, it tends to be in small increments over a lengthy period. Therefore the main factors behind FOREX trends today are well known and unlikely to change much. Consequently it is perceptions at the margins of fundamental change that have a disproportionately strong impact in the FOREX markets where many hundreds of $bns are traded every market day. In a global market dominated by leveraged traders, it is the short to intermediate-term trends that shape sentiment, determine how the various players will be positioned and become self fulfilling - for a while. Accordingly, extremes of sentiment are a contrary indicator.
It is worth recalling the extremes of bearishness for the U.S. Dollar and sterling in mid-1995. This year practically everyone was bearish of the yen in May, leaving it susceptible to a sharp contra-trend move when Eisuke Sakakibara made his now famous comment about historic volatility and 20% corrections. The bearish consensus was substantially reversed by the yen's explosive rally that followed, leaving it technically vulnerable to another phase of weakness as the fundamentals of a weak Japanese economy and exceptionally low interest rates reasserted themselves. This month people had probably become a little too bearish of the yen against the dollar, for the short term, judging from sentiment readings.
An equally important change in sentiment has occurred for the U.S. Dollar against the mark within the last three months. In August on the approach to DM1.89, practically everyone was a dollar bull at a time when the Bundesbank was rolling out an official a day to say the move was over and the appropriate rate was DM1.70. With the approach of that level, sentiment has turned against the greenback, evidenced by forecasts of DM1.60. These are a far better indication of people's positions, rather than what the market will do, and therefore a contrary indicator.
With inflation low generally, interest rate differentials are particularly important and perceptions are now changing once again. In July many forecasters looked for an 8% base rate in the UK by the year end as the pound soared to a peak. More recently they pondered a possible cut as the BoE's next move, a view that is likely to change as the pound firms once again. The BBK's hike this month has understandably led to expectations of further short-term rate increases as EMU candidates move towards convergence. However, this need not necessarily influence Switzerland where rates remain low, although SNB president Hans Meyer is talking of a future rise in response to some evidence of economic recovery.
This has been at least partially matched as an influence on currency trends by a reversal of opinion regarding U.S. rates, in favour of another hike this year, following Greenspan's latest comments. Elsewhere, Canada's half-point increase this month has firmed the C$. Australia's unexpected drop in unemployment figures has lowered expectations for another rate cut, strengthening the A$. There seems little reason to expect a rate increase in Japan where investors will have scant incentive to repatriate capital short of a severe correction by global bond markets.
As for economic factors, a stronger U.S. Dollar in coming months would, arguably, do less harm to the American economy than a strong mark and yen would do for Continental Europe and Japan. The latter teeters on the brink of recession once again. Continental European politicians are upbeat about 1998's growth prospects (they need to be) but all of the structural problems remain. Consequently their economies have more in common with Japan than the U.S.
Turning to jawboning, which has certainly been effective this year, there is no reason to expect Robert Rubin or Alan Greenspan to oppose another dollar rally since neither spoke out when it was higher during the summer. The latest BBK comments have indicated satisfaction with the U.S.$/DM rate, which is another way of indicating that they do not seek a further recovery. Hans Meyer has often stated his preference for a weaker Swiss Franc against the mark. Japan has less cause to talk the yen up than a few months ago.
In conclusion, the U.S. Dollar and sterling are likely to be near the bottom of their reactions against the mark and
particularly the Swiss Franc. Significant rallies are likely. The greenback and pound are no longer oversold against
the yen but there is no fundamental reason why the ranging rally towards the May peaks should not continue.
Within Europe, the mark is now a recovery candidate against the Swiss Franc. The Canadian, and possibly the
Australian and New Zealand Dollars should have some catch-up potential against the European currencies and the
yen as U.S. Dollar proxies.
Commodities
Petroleum contracts saw their most explosive rallies for nearly a year recently. While prices are notoriously volatile and often hard to analyse fundamentally, being produced in many countries around the world and, of course consumed by all of them, there is no doubt that the long-term trend of consumption continues to rise remorselessly. This demand will not diminish until prices are considerable higher and/or the world enters another recession.
While there is no shortage of oil reserves in the ground, with more being discovered and becoming recoverable with the march of technology, the world is susceptible to bottlenecks of refined production from time to time. With all the deflation talk, analysts have underestimated the demand for petroleum products, particularly those who work in the financial markets. Unless prices soon fall back as sharply as they rose, there will be an inflation shock. We have seen the first evidence in the U.S.'s higher PPI figures for September, issued on 10th October.
The powerful rebound in petroleum prices pulled gold up off its lows, temporarily shifting sentiment away from
deflation forecasts and justifiable fears of central bank selling. If another oil rally occurred and were to trigger
widespread short covering by producers and speculators, the financial markets would get a totally unexpected
inflation warning shock. Greenspan would not like it. Meanwhile, the main action has been in the other precious
metals. Silver has risen 25% from its depressed July low while palladium and platinum remain particularly firm
due to further shortages from Russia. If these moves are maintained, let alone extended, it can only spark renewed
interest in other commodities, particularly in the agricultural sector where some prices are historically low. These
will also be subject to more speculative interest in coming months because of El Niño.
Portfolio Strategy
Government Bonds
Last month I mentioned that from an investor's perspective, I would want to reduce exposure in the event of any failed breaks above the July/August highs. We have seen price failures for the U.S. and several European contracts, while prices for all others have broken their short-term uptrends. As for new commitments, there are times when one should be bold, like last April, and times when caution is preferable. Today I would focus on safety rather than opportunity and only consider short-dated issues. From a speculative viewpoint, I advocated running with last month's breakouts using trailing stops and treating any clear downward dynamics as a sell signal. This has proved effective in terms of getting out of long positions, as the chart uptrends were very consistent and orderly until broken. The clearest downward dynamics came from Australian and U.S. T-bonds, with the former looking particularly overstretched beforehand. Given all the overhyped deflation talk and historic resistance, I would prefer to play the short side, on a baby steps sell-high-buy-low jobbing basis, until or unless upward dynamics are seen by prices.
Personally, I have done less in bonds recently, feeling that the better short opportunities would be in overextended
stock market futures. However, I am building up a short position in December Japanese bonds. In addition to the
Far East, these are also listed on the UK's LIFFE market.
Stock Markets
I continue to advocate the defensive strategy introduced in FM159 and FM160. Top-testing technical rallies, or more, from September's lows in most of the performing markets provided an excellent opportunity to reduce exposure. This also provided institutional investors with another opportunity to write covered calls and short index futures as the rally uptrends were broken. In the developed markets I would not play musical chairs by joining the search for laggard small capitalization companies that had previously underperformed. Managers are under tremendous performance pressure to do this, and it has certainly worked on Wall Street in recent months, but the strategy will eventually leave them trapped in illiquid markets when they either decide or are forced by redemptions to raise cash.
The same illiquidity argument applies to emerging markets, but the potential may justify the risks while Wall Street avoids a serious correction of more than 10% for the DJIA. Investors have been conditioned to expect these from time to time, but no more. Consequently they may continue to push money into emerging markets until frightened by a larger fall in the U.S. Believing that this risk is now quite high, I would not want to be holding emerging market funds if the DJIA falls anywhere near its last reaction low at 7580. I am not tempted by Asia's bombed out markets, even though they may have bottomed, because a significant recovery over the intermediate term is probably dependent on developed markets avoiding another sell off.
In making another cull of the now much reduced FM share portfolio, I wish that I could claim the prices available when this month's selections were made. However, I will stick to my usual month by month formula, comforted in the belief that savvy subscribers are probably doing better. Incidentally, the only shares that I would not earmark for sale are those that have performed very badly. Since they are very much a minority, what would be the point? Meanwhile, laggards can always stage at least a partial catch-up move during that window before the major indices establish clear downtrends. Gosh! Gold shares have been one of the best performers in recent weeks. Who would have expected that? Looking further ahead, there are no stock markets or shares that I would expect to resist a serious correction on Wall Street.
From a speculator's perspective, I was standing aside last month, looking for further rallies in stock market futures
and awaiting a signal to short from bonds. That signal has been given and I will be baby steps jobbing short
positions on a sell-high-buy-low basis until I see clear evidence of a bond market rally. I think many of the best
opportunities for bear traders are in the overextended European share indices.
Currencies
A year or two ago I was happy to bet the ranch on U.S. Dollar long positions against the yen, mark and Swiss Franc. Today, I am only willing to bet the front porch because the opportunities are not the same. Nevertheless, I remain an active player in these markets. My biggest position, built up in recent months, is short the Swiss Franc. It is costing me a bit against the U.S. Dollar at present and that is partially offset by profits on the sterling position which I timed better. I am looking for a significant rally against the Swissie but would lighten positions on strength, using my baby steps tactic. I like the U.S. Dollar and sterling against the mark near the low DM1.70s and DM2.80s, respectively, but the Swiss Franc trade is better on both interest rate and chart considerations. Accordingly, I like the mark against the Swiss Franc.
I remain short of the yen against the U.S. Dollar, but am generally quick to take some profits when the greenback
rallies, because this club had become more crowded recently. I think there are some good parallel plays in sterling
and the Canadian, Australian and New Zealand Dollars against the yen. I was too soon in standing aside from
those profitable South East Asian currency shorts against the U.S. Dollar last month when the chart trends faltered
briefly. Today, I think that play is mostly over, at least for a while, although the long-term charts show
considerably more upside potential against the Singapore currency at some point.
Commodities
I confess to not paying enough attention to these in recent issues, although the same cannot be said for my colleagues who produce the DTRs each day. They had all the petroleum contracts for the big rally, a great zinc short and some other good trades which more than made up for the whipsaws that are an occupational hazard in these fast-changing thin markets. Personally, I like the petroleum sector most, because it is not dependent on the vagaries of a weather report, the number of related contracts hammers home chart messages and natural gas often leads the other contracts. I am standing aside at present and would wait for evidence of support within underlying trading before considering long positions.
Among precious metals, palladium looks the most promising once again, although I would keep positions small
and protected because this is a very thin market. Also, I would turn from a short-term bull to a bear of gold and
silver if the petroleum contracts fell back to their lows.
Cash
I feel very comfortable with cash right now. The time to be in cash is when interest rates are just beginning to rise.
Generally, one should be moving out of cash and into the safer bond and stock markets when short-term rates are
high but starting to come down. Most people do the opposite. Declines from the summer peaks by the U.S. Dollar
and sterling make them attractive today for safety and yield. I am adding the Canadian Dollar to this list following
the recent rate hike.
October 16, 1997
David Fuller, Chairman
Chart Analysis Limited
7 Swallow Street, London, W1R 7HD, United Kingdom
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