Editor’s Notebook 6 July 2011

[private]A Short And Sharp Recovery

The recovery in global equities over the last ten days has been quick and comprehensive – and, as always these days, a global pattern. I am grateful to my friends at Investors Intelligence for the following useful summary of how the markets moved across the globe last week. As you can see the recovery has been consistent around the leading developed markets of the world, though weakest in the Asia Pacific region.

Europe Weekly Index Summary

Global Weekly Index Summary

UK Weekly Index Summary

In the UK the FTSE 100 has already returned to the top of its recent trading range. This is entirely consistent with the view that the markets are marking time while we wait for clearer evidence whether or not the current pause in economic growth is a temporary mid-cycle phenomenon, or rather the prelude to another serious bear market (as the pessimists would have it) or even a faster recovery than the consensus expects. My view is that it is impossible to be sure; the range of outcomes is still genuinely wide, as Gus Sauter of Vanguard pointed out the other day.

For all the focus that has been paid to the Eurozone crisis in the last few weeks, the market reaction to the ongoing uncertainty about the outcome of the Greek sovereign debt negotiations is a classic example of how market participants like to attribute movements in the stock market indices exclusively to recent current events, to the point where the negative sentiment (on this occasion) becomes so extreme that it starts to drive the market independently of what is going on.

The reality is often more prosaic. As I noted last month, there is nothing out of the way about the scale or speed of the market decline since April; it is the kind of reaction you tend to get after such a strong first quarter. It could have happened with or without the Eurozone crisis – and it could have been something else that triggered the state of alarm. If the market had fallen decisively through the 5700 level, it might have been different – but the rebound to over 6000 on the FTSE 100 (and 1300 plus on the S&P 500 index) has taken that immediate threat away. Not All Rosy In The Garden But are suddenly now to believe that everything is now rosy in the garden again? Obviously not, even though the eurozone crisis does appear to be on the way to a messy resolution for now. It will certainly flare up again as the solutions reached do nothing, as many observers have already commented, to solve the underlying problem faced by Greece and the other peripheral countries – which is that their economies are uncompetitive and their debt burdens impossible to meet so long as they are denied the currency devaluation that they badly need, and which of course is impossible within the current Eurozone framework. It would be difficult, in my view, to improve on the cogent analysis of the situation provided to the Financial Times this week by a very wise old bird, Sir Martin Jacomb, a former banker with Kleinwort Benson, who can certainly truthfully claim to be one of those who “told you so” when the Eurozone was launched at the turn of the century. To quote a couple of paragraphs:

Economic distress in Europe’s periphery is real and will continue. The worst manifestation of this is unemployment, particularly among young people, inevitably bringing with it misery and the danger of unrest. This is the human cost of bad policy governing the management of the euro, combined with bad lending. This seems to have been forgotten or pushed to one side. Greece cannot earn its way out of this mess. Its adoption of the euro made it uncompetitive and, so long as the euro remains its currency, this state of affairs will go on. This outcome was predictable – and was predicted as inevitable by some of us a dozen years ago when the euro was first introduced. These warnings were ignored. The euro gave the peripheral countries a standard of living above their earning power and, at the same time, took away their ability to correct this by devaluation. It is the same process which led to the permanent impoverishment of southern Italy, when the lira became the national currency after Italy was united under the Risorgimento 150 years ago.

He also says:

The Greek parliament has voted, but the crisis goes on. The European Union’s current policy has been driven by the political imperatives of preserving the euro and avoiding another banking crisis – but it will not yield an enduring solution. The EU’s future depends on enabling its poorest member countries to regain their competitiveness – and this requires a very different approach. Everyone knows that lending more money to someone who is already heavily indebted, and has few realisable assets and woefully inadequate income or earning power, creates problems. Putting the repayment date off for 30 years simply ensures that no one in authority today will be around when the time comes.

All of which is very true, and means that the spectre of sovereign default (even assuming that the patched up Greek solution survives its final tests in the next few days, as seems probable), will remain with investors for some time. The policy of “kicking the can down the road” will therefore continue to remain vulnerable to external shocks and political unrest in the countries most at risk. What this implies, unfortunately, is pretty much what analysts such as Bill Gross, the founder of bond specialists Pimco, and the historians Ken Rogoff and Carmen Rinehart warned as soon as the worst of the credit crisis was over. Future economic growth is likely to remain relatively subdued and the risk of policy errors will continue to hang over the markets for some time – hence continued volatility and “financial repression”.

Next on the markets’ worry list will be the intensifying political standoff in the United States about raising the US Federal Government’s debt ceiling, which needs to be resolved by the start of August if the US government is not to run out of money. With Republicans and Democrats both refusing to climb down, a last minute deal remains the most likely outcome, but it could go right up to the wire, in which case it would be prudent to expect some further volatility in the performance of Government bonds and the US dollar.

It is fair to say however that volatility, at least as measured by the VIX index, remains relatively subdued, though it spiked up sharply during the recent unfolding of the Greek scare. Perspective On Trading Opportunities Alert readers will have noticed how the depth of pessimism ten days ago about the outcome of the Greek debt crisis created a useful trading opportunity. The simplest of charts can be helpful in finding these opportunities. My preferred method of tracking the main market indices is to keep an eye on how the market is moving against its 200 day moving average, taking into account also its momentum (as recorded in the RSI graphic below the main chart above). This is how graphs in Independent Investor are typically shown. You can quite clearly how the RSI measure, which is essentially an overbought/oversold indicator, has identified several of the shorter term cyclical turning points in the market over the past few years. Readings of 40 or less typically indicate an oversold market, and those above 60 indicate the need for caution. This kind of analysis tells you little about where the markets are heading in the longer term, and is far from being 100% reliable (be very wary of any market pundits who claim that their technical analysis methods are such a thing).

They can be very helpful however, when combined with other measures of sentiment, to pick up some of the shorter term market dynamics, which the confident can – if they so choose – trade through spread bets or passive instruments such as ETFs. That is what I do with my own personal portfolios, though it is not something I recommend to any but the most experienced investors.

Here is one example of a useful sentiment indicator. The survey of bullishness amongst investment advisers in the United States has been running for years and typically provides a useful contrarian indicator. When the proportion of bullish advisers is low (as it was in August last year), it is often a sign that a market rally is coming. When bullishness is significantly more common than bearishness, as it was in the first quarter of the year (something noted by Richard Oldfield in his Q and A earlier this year), it can provide confirmation that the market has been overbought and is due a correction.

The points to remember, I have found, are that (1) by definition the best trading opportunities come when the markets are experiencing extremes in sentiment, so such moves always feel brave at the time; and (2) you have to be quick to capture the moves – otherwise the markets can move against you very quickly when they do reverse (as has happened over the last ten days). The same approach can work equally well with currencies and proto-currencies such as gold. See for example the chart for the dollar, as measured by its trade-weighted index shown earlier. Some of the turning points, including the most recent one, were well captured by the overbought/oversold indicator. [/private]