Editor’s Notebook 1 August 2011

The US budget deal announced last night has unsurprisingly prompted a relief rally in the markets this morning, although it won’t be signed into law until tomorrow at the earliest. The assumption is that sufficient members of Congress will be dragooned into supporting it and so avoid the reputational and political disaster which failing to agree a deal would be.

It is worth keeping the numbers in perspective. An agreement to agree to reduce the budget deficit by $3.0 trillion over ten years, while it sounds a big number, is trivial in the context of the overall US budgetary and debt position.  The annual budget deficit is running at $1.5 trillion, so even if the cuts announced in the deal are eventually agreed and implemented (which is no certainty) it will only reduce the annual deficit by around 20% a year on average.

The US in other words will continue to accumulate more debt as each year goes by until or unless more decisive action is taken. If you care to take the unfunded liabilities of Medicare etc into account, the gross debt of the US is already more than five times GDP and some argue probably even higher than that. There is no better illustration of how far American political leaders are removed from the reality required to resolve the fundamental problems which which have been building up in the US economy for more than a decade now.

It seems all too likely therefore that the debt overhang in both the USA and many parts of Europe will continue to restrain economic growth for some time to come. As I have noted before, we do not know yet whether the slowing growth seen in the poor second quarter GDP figures in the US and UK is a sign of midcycle slowdown in the post-crisis recovery, or something much more serious. I still think it is too early to tell, although Tim Bond, the highly regarded strategist now working for hedge fund manager Crispin Odey, is one who is sticking to his argument that the figures are understating the likely scale of recovery in the latter part of this year.

What is clear enough from the charts is that the UK stock market in particular was approaching a critical turning point at the end of last week, when the outcome of the US debt talks was still far from certain. I should emphasise that I do not believe in any of the more elaborate theories of technical analysis, such as Elliott Wave Theory, which assign extraordinary predictive powers to chart patterns and are treated by many as the dominant factor in their investment analysis.

What the charts can do however is show you how the markets are behaving at any point in time and whether that is consistent with the broader hypotheses which are guiding your decision-making. And in that context the UK stock market chart is particular interesting, as it suggests we have been approaching a point where a clear signal of a new bear market might soon be given.

Looking at the FTSE All-Share index you can see that the index’s 50-day moving average has moved below the 200-day moving average for the first time since September last year. If this is followed by the 200-day moving average itself turning down (which failed to happen during the first Greek crisis last summer, and has not so far happened this time round either), that will be a classic warning sign that the bull market which began in March 2009 may finally be about to roll over.

It is not a certainty – there are no such things in markets – but simple technical dynamics of this kind are one of a number of telltale indicators which normally give reliable signals about market direction. A related phenomenon is that ranging markets – those which track sideways without much direction for an extended period of time – tend to make decisive moves one way or another when they finally break out of those ranges. Such a breakout (to the downside) was on the verge of happening in the run up to the US budgetary vote.

If the relief rally persists for any length of time, as I suspect is quite likely, it means we will have avoided the clear signal that was otherwise threatened, but it is worth keeping an eye on this pattern, which has proved a reliable indicator for many years now. The recovery in the equity market which begain in March 2009 has been running for nearly two and a half years now, which is longer than the historical average for cyclical bull markets – though nothing like exceptional in its durability. My friend Ken Fisher, the US money manager, has a thoery that one reason the third and fourth years of a Presidential term are better for stock market investors than the first and second years is precisely because they tend to be associated with legislative gridlock, following midterm elections.

In general, the less legislators are able to do, the better on the while it tends to be for the corporate world and by extension therefore for equity investors. It will be interesting to see, after this extraordinary demonstration of what lengths gridlock in Washington can be taken to, whether the outcome is rewarded by a second half rally in the price of risk assets, as happened last year. It is worth making the point that the US stock market is not yet as close to the bear market signal as the FTSE All-Share has been.

Meanwhile you only have to look at the charts of gold and “safe haven” currencies such as the Swiss franc, Norwegian krone and Singapore dollar to see what damage the fallout from the credit crisis is doing to the value of the dollar and other debt-afflicted currencies, including sterling. For the moment there is nothing I can see in the news that justifies a belief that these trends will not continue for some while. Investors continue to vote with their wallets against the debasement of currencies which the US and others seem intent on.