Equity Bear Markets in Progress and Why
My last article for ADVFN, dated March 22, was entitled, "The importance of holding cash". In April, the FTSE and Japan's Nikkei 225 topped out, and most other equity markets around the world have been falling since May 10. So, events showed my advice to have been timely.
On May 10, the Federal Reserve Bank reported the U.S. economy was slowing and inflation growing. That is a scenario that will cause the US Dollar to fall, and to negatively impact exporters in Europe, the Americas and Asia-Pacific. And that is a good reason to be holding cash, while awaiting the equity market to rebalance potential rewards with the risks involved.
The Fed decision to raise the Federal Funds Rate to 5.00 percent in May had been expected. What was not expected, however, was the Fed's indication that growth and inflation risks were no longer in balance, and that growth would moderate due to higher energy costs and a slowdown in the housing sector.
Everyone now, it seems, is concerned about the plight of the American consumer, the lack of U.S. government fiscal restraint, and prospects for the $USD, and what that means for exports to America.
Global Market Summary :
For the most part, the equity markets of emerging economies and advanced economies peaked May 10, which I believe was the starting point of the 2006-xx Bear Market. Two of the three most important equity markets of the world [FTSE (UK) and Nikkei 225 (Japan)] peaked in April. The final important up leg of the 2002-2006 Bull Market started in October 2005 across the board, and that ended. The current and final upleg, which started this past week, is likely to be relatively muted.
So far this year, the leading Asia-Pacific equity indexes (Nikkei 225 and South Korea's KOSPI) are down, while Canada plus the three leading European equity indexes (FTSE, DAX and CAC) are up and so is the Bombay Sensex Index of India. But except for the FTSE, which peaked a couple weeks earlier, the whole lot of them peaked right at the time of the May 10 FOMC announcement.
In summary, I believe the U.S. equity market passed a peak in its long-run bull cycle on May 10, and has entered a period a declining prices, which following a brief intermediate-term bull cycle that started on the day of the last Fed meeting (June 29), shall not recover to the prior cycle high.
I believe new cycle highs for U.S. equities will not be set in the present rally. It is a rally where stocks will mostly be distributed. From these levels (11,200), the Dow 30 will likely decline by perhaps -21 percent. I forecast a Bear Market low of about Dow = 8800 in 2H06.
U.S. Sector ETFs
Eight of 10 U.S. sector ETF's I track were up over the first six months, but three were trading up less than +1.2 pct YTD (consumer cyclical XLY, utilities XLU and financials XLF), so without last week's rally (Thursday and Friday), it could have been 5 up and 5 down for the ETF's. The two big winners YTD were telco service IYZ (+11.7 pct) and energy XLE (+7.7 pct), while the two losers were semiconductor/tech SMH (-13.2 pct) and healthcare IYH (-5.0 pct). Following a Bear Market, I believe that the semiconductor/tech sector ETF (SMH) will be a leader on the upside.
U.S. Bonds and Interest-Sensitive Equities
Over the first six months, interest rates in the U.S. were continually rising, which meant that bonds and interest- sensitive equities did poorly. In fact the price decline in June was such that I almost issued a "Buy Alert" opinion but for the fact the bonds did not quite drop down to my Accumulation Zone. I think the recent buying of these instruments was short-covering only, and a lower price will soon occur, which will likely generate a 'Buy Alert' for U.S. bonds this summer.
The commodities index ($CRB) started an intermediate-term rally on June 14 after reaching a cycle low of 329.61 on June 13. Except for the current rally, $CRB has been flat on the first half. For the commodities Bull be confirmed, however, $CRB must soon exceed the recent cycle high of May 23 (353.31), which is close at 346.39, and in a rising trend. Interestingly, every time (in the past three years) there was weakness in the commodities index, the technical support levels held up, and there was a confirmed higher low which went on to set a higher high. To sustain a commodities rally at this point (given a period of economic weakness ahead) will require a USD that weakens further, which appears to be the most likely scenario.
Oil & Gas
The U.S. crude oil futures index ($WTIC) jumped +265 pct (a gain of $44.13) from the 3Q03 low of 26.72 to a 3Q05 high of 70.85. But in the nine months since then $WTIC is up just $2.92, and traders are wondering if a global economic slowdown will cause oil prices to peak this year. At this point, it appears that $WTIC will trade close to an inversion of the $USD, i.e., as the USD weakens, $WTIC will strengthen, and vice versa.
The gold futures index ($GOLD) typically lags the oil price cycle, and is typically the last of the commodity group to reach a peak. Over the past three years $WTIC has clearly outperformed $GOLD, but that situation has reversed in the past year. I hold the view that $GOLD, like $WTIC, will trade close to an inversion of the $USD for the balance of this market cycle, except that $GOLD will outperform $WTIC on the upside. I believe that a new cycle high above $750 will be set within six months for $GOLD, which would be a gain of +21 pct or more. I also believe that between now and the next U.S. Presidential election (Nov-2008), the $USD will collapse further, based on U.S. economic and fiscal problems, and that $GOLD will rise to over $850, possibly over $1,000.
For the most part this year, the goldminer shares have performed well. Agnico-Eagle (+5.1 pct), Meridian Gold (+32.2 pct), Lihir (+28.2 pct), Glamis Gold (+27.3 pct) and Goldcorp (+24.9 pct) are among some of the mid-cap and large cap leaders. The small and mid-cap stocks in this sector have outperformed and will continue to do that because they have the best profit:gold price leverage in the latter half of a bull phase for the miners.
Trading in the $USD has been extremely volatile. One year ago, $USD hit an intermediate cycle peak of 90.77, which was followed to an even higher peak in the next cycle (Nov-2005) of 92.63. On May 15, $USD reached a cycle low of 83.60, which was reached again in early June at 83.72. Subsequently the $USD rallied to 87.05 before closing the first half at 85.17, following a two-day plunge after the FOMC announcement on June 29. I believe that what happened that day was that traders perceived a huge jump in the U.S. money supply was needed to keep the bond market yields from rocketing up, which would have been a disaster for the housing industry. With a Fed Funds Rate now at 5.25 pct, it appears to me that any further rate hikes will have a deleterious 'tipping point' effect on the U.S. economy that will send it into a tail spin.
The bottom line to the Administration's strategy for the past few years that increased spending combined with tax reductions was it failed because it caused too much money to be printed, which was invested/spent/wasted abroad, thereby causing the $USD to drop like a stone in a sea of liquidity. In retrospect, I think the Administration's policy would have worked had the Fed under Greenspan opted to start raising the Fed Funds Rate a year earlier, and stopping the hikes about six months ago, with a couple pauses in between. But frankly, Congress has to tighten the reins on spending, and the new Treasury Secretary and Fed Governor need to be successful in organizing an international (G-20) agreement on currencies. Until then, I think the $USD is headed much lower.
It is my belief that price motion in capital markets is caused by mostly natural phenomena that culminate in periods of rising and falling corporate fundamentals and quantitative results, and macro economic scenarios, all of which combine to impact market prices. While a matter of conjecture, how far prices rise and fall in cycles should not be our concern. Our focus should be entirely on the matter of trend, and with respect to equities, the selection of the shares of the best quality companies, with timely acquisition on the basis of technical indicators.
I believe that the long-term bullish trend in equity prices has reversed for reasons related to the U.S. Dollar. Until conditions are right for the $USD to trade in a narrow range for an extended period of time, enabling levels of international trade and capital expenditure to expand naturally to where wealth is created faster in America and also Europe, and at a slower pace in emerging economies (China, India, Brazil), I think the financial world will be in turmoil. It is after all, the health and wealth of consumers in the most advanced economies that put the capital markets on an even keel.
Until these issues are resolved, there could be a protracted period of extreme volatility ahead for financial markets. The forthcoming bear market in equities is likely to be just one small step forward.