Since late April the U.S. stock market has rallied strongly. (The S&P 500 is up by 5.5% but still down 1% year-to date.) In particular, the Nasdaq 100 had a powerful recovery move. From its April 29 intraday low of below 1400, it rose as of this writing [June 15, 2005] by 11.2%. In Europe, several stock markets broke out above their March highs (not the UK market), but strong gains in equities were largely offset by Euro weakness.
Therefore, while the German DAX is up by 5.2% year-to-date, in U.S. dollar terms it is down 3.2%. Similarly, the Swiss Market Index is up year-to-date by 8%, but in dollar terms it is down by 0.4 In Asia, the performance has so far been disappointing. There are several factors that may have contributed to this powerful recovery move.
------------ Strength in the U.S. dollar and diminished worries about consumer price inflation, which propelled bond prices to their February 2005 highs, also contributed to an improvement in sentiment. In this respect, it should be noted that by late April, investors' sentiment had become rather gloomy. There were rumors about problems at several hedge funds and, following the dismal performance of the first quarter and the inability of the stock market to rally in the usually seasonally strong month of April, investors were about to give up on equities.
So, given the perceived problems in the hedge fund industry and the slowdown in global economic growth, investors figured that the Federal Reserve Board would shortly stop raising the Fed Fund rate and, if there was indeed a problem with some financial institution, the Fed would do what it had always done in the past, which is to ease and to print money. Each time the Fed tightened monetary conditions, something "bad" occurred. But equally, each time a crisis occurred, the response was swift and massive easing, followed by rate cuts.
Needless to say, the maestro at repeatedly printing money in the wake of crises - and particularly since 1997 - was none other than Mr. Greenspan. In other words, investors now perceive that an economic slowdown, or a crisis at one or several hedge funds, will induce the Fed to refrain from raising rates further and once again to turn on the money printing press.
After all, MZM has been growing recently at its lowest rate in ten years, indicating currently much tighter monetary policies and, therefore, leaving ample room for renewed easing at the first sign of any problem for the economy or the financial system. And since investors have been conditioned over the last 20 years or so to buy into crises, because following each crisis the market has soared, they are now buying in expectation of a crisis, which would force the Fed to ease. The present investment environment must therefore be described as bizarre!
Investors are ardently longing for a poor economy or a financial accident, under the assumption that such eventualities will be favorable for the already highly inflated asset markets. However, and this should be weighted by investors carefully, the strategy of buying stocks on the basis of slower economic growth or a crisis entails very high risk. For one, we don't know how severe any slowdown may be. Under some conditions, a slowdown could lead to a global slump - especially if the U.S. housing market was to break at the same time that China's economy, plagued by huge overcapacities, imploded.
Whether, in such a situation, easy money would solve any problem is debatable, for two reasons. In the past, whenever there was a crisis, there was a flight to safety. Investors immediately bought U.S. government bonds in the hope that interest rates would come down and knowing that interest and principal on Treasuries were 100% safe.
However, it is far from certain that cutting the Fed Fund rate in future will produce the same reaction. It is possible that investors, seeing the Fed easing once more, will grow apprehensive about future consumer price increases and, instead of buying long-term Treasuries, will sell them, thus increasing long-term interest rates. If eight Fed Fund rate increases haven't yet led to any bond market weakness but, rather, to strength, who is to know whether future cuts in short-term rates might not lead to bonds selling off?
Also, since most of the crises experienced over the last 15 years, beginning with the Persian Gulf crisis of 1990, were related to problems outside the United States, there was a flight of safety into U.S. Treasury bonds not only by domestic investors, but also by international ones. This, in turn, tended to strengthen the U.S. dollar in times of crisis. But, what if the Fed were to embark on a massive money printing operation because of a really nasty economic surprise or financial accident in the United States? Would foreign investors still consider the U.S. dollar and U.S. bonds to be safe? I doubt it.
Under such circumstances a far more likely outcome would be a tsunami of dollar selling and, along with it, selling of U.S. dollar bonds. In the wake of massive selling of dollars and dollar bonds by foreign investors, interest rates would likely rise. In turn, this would force the Fed to monetize even more. A further loss of confidence in the dollar would follow.
The question here is, what would the dollar sell off against, and what would investors perceive as a safe haven in such a situation? The Euro? Not very likely! Asian currencies? Possibly, but if China were to weaken simultaneously with the U.S. economy it's unlikely that Asian currencies would be viewed as a safe haven. I suppose that in a crisis of confidence arising from an economic or financial problem in the United States of a scale that would lead the Fed to print money in massive quantities, only gold, silver, and platinum would be regarded as truly safe currencies notwithstanding their current weakness.
There is, of course, always the possibility that the global economy might weaken or that a crisis might occur while U.S. residential property is still accelerating on the upside.
Under these conditions, the Fed would face a serious dilemma (a dilemma it faces already to some extent). Easy money might alleviate the economic or financial problems (though not solve them), but at the expense of extending the housing inflation further and making it even more dangerous for the economy once the housing bubble bursts at a later stage. I have recently received many emails from investors questioning the view that a bubble had developed in some housing markets around the world. Needless to say, these emails remind me of the emails I received in 1999 concerning my negative views about the Nasdaq.
There is another reason for labeling the current U.S. stock market rally as a high-risk move. Usually, strong stock market moves are led, or at least confirmed, by brokerage shares moving higher. While the world's largest retailer, Wal-Mart (WMT), is no longer declining in price, its recent disappointing market action doesn't suggest a very strong consumption environment.
High-tech shares have recently begun to outperform the market, and this trend could last for another few months as performance-minded fund managers shift out of economic sensitive companies into high-tech companies based on hope and momentum. And while this strategy may work for a while, it is also riddled with risks. Take semiconductors. The Sox Index has risen from its late April low by 15% and looks technically strong - albeit near-term overbought. Worldwide semiconductor sales, which recovered from their 2000/2001 slump, have recovered, but at $220 billion annually are barely higher than in 2000. However, the composition of semiconductor sales has changed markedly since 2000. Whereas in the United States and Europe the recovery in sales has been tenuous at best (in the U.S., semiconductor sales are no higher than in 1995, because of product price declines and sluggish demand), in Asia, sales have been booming until just recently.
Now, if Jim Walker and Simon Hunt are right about a meaningful slowdown in the Chinese economy coming shortly, it is likely that Asian semiconductor sales will fail to rise, or may even decline, at precisely the time when large new production capacities will be coming into production. This is hardly a very favorable fundamental outlook for this still highly valued industry! I also fail to see why semiconductors would be less economic-sensitive than the copper, shipping, or steel industries.
So, once again, by moving into semiconductor and other high-tech companies we are faced with a relatively high-risk trade, which may nevertheless work for a while due to the momentum players.
In sum, we continue to recommend a very cautious posture regarding equity investments. Near term, the United States and most European stock markets seem overbought, whereby following some consolidation further temporary bouts of strength cannot be ruled out. But, as we have indicated, investing in an environment of a global economic slowdown is a high-risk proposition for all asset classes, as the severity of the slowdown or economic slump is unknown.
This is especially the case if one is faced with mostly inflated assets, a disproportionately large and highly leveraged financial sector, and a central planner - the Federal Reserve - that repeatedly intervenes in the free market for money and whose intentions are nebulous!