Will we have a Crash or Correction this Autumn?

market-crash

Dear PGM Capital Blog readers.

In this weekend blog article we’ll elaborate on the approaching inevitable reversal of the capital markets in the West.

The stock markets in the West, specially those of the USA are dangerously stretched in terms of valuation and sentiment, and they do not accurately reflect the country’s economic situation and fundamentals such as earnings and sales growth.

It is important to care if a stock market is overvalued or that it doesn’t correlate with the Economic reality of a country, because those who sell near the top before the market drops preserve not just their initial capital, but their winnings from the over five-year bull market. Those who fail to sell, risk losing not just their gains, but quite possibly a material chunk of their initial capital.

Another reason to care is that those who correctly bet on a market’s reversal will profit handsomely, just as those who bought at the bottom of a decline profit.

That few manage the apparently simple task of making three accurate predictions in a row (and being confident enough in the technique to leave all the chips on the table), is powerful evidence that no such technique works consistently enough to last even three trades.

The following three basic tools can be useful in prognosing of a trend reversal in the capital markets:

  • FUNDAMENTAL ANALYSIS:
    Fundamental analysis involves analyzing the characteristics of a company, such as; earnings, sales, lifecycle of product mix, valuations, financial conditions, in order to estimate the value of its shares.
  • TECHNICAL ANALYSIS:
    Technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity or trend reversals.
  • CYCLES:
    Cycles do not presume to predict the causes of trend reversals; they only reflect that such reversals often follow patterns over time. There are many cycles of varying durations such as:

    • DOW to GOLD cycle:
      The DOW to Gold ratio tells you how many ounces of gold it would take to buy the Dow on any given month. Previous cycle lows have been 1.94 ounces in February of 1933 and 1.29 ounces in January of 1980 as can be seen from below chart.DOW to Gold ratio
    • Housing Market cycle:
      As can be seen from below chart, housing prices seem to move in 18-year cycle.
      UKHOUSE
    • The Exter pyramide,
      developed by John Exter says, that in times of crisis, depending upon the level of crisis, money moves down the triangle. Small business (In today’s world probably derivatives) and real estate are the first to get hit.
      Money flows to commodities then from it to bonds and T-bills. And when bonds and T-bills start to become risky, it finally ends up in Gold.

      Exeter

    • The Kondratieff cycles:
      More than eighty years ago, a prominent Russian economist, Prof. Nikolai D. Kondratiev described and theoretically substantiated the existence of grand
      (45-60 years) cycles of economic development.
      The internal dynamic of the cycles (named K-cycles after him) and the principle of fluctuations is based on the mechanism of accumulation, concentration, dispersion, and devaluation of capital as a key factor of the development of the market (capitalist) economy.

      Kondratieff_Wave

CENTRAL BANKS INTERVENTION:
In the past six years of unprecedented central banks intervention, the belief that we’re in a “New Normal” that’s immune to downturns has taken hold—mostly because every downturn has been reversed by some additional central bank monetary intervention.

Central banks intervention seems to have generated a new cycle: five years of a roaring bull market that reaches bubble heights and then crashes over the following two years.

If the New Normal is truly permanent, then cycles and technical/fundamental analyses have been mooted: they no longer work because the central banks can push stocks higher essentially forever.

PGM CAPITAL COMMENTS:
Below Economic data published last week shows that the USA Economy isn’t in a good shape, as the country’s policy maker wants us to believe:

  • Manufacturing PMI Posts the Biggest Miss on Record:
    Flash Manufacturing PMI posted the biggest estimate miss on record. The index unexpectedly declined to 56.3 in July, down from 57.3 in June (revised down from 57.5), while it had anticipated to rising further to 57.5.The most concerning part of all of this is the fact that new exports have weakened while manufacturing production has fallen as input costs have surged and the employment component has tumbled to a 10-month low.

    See below chart below chart for details.

    PMI USA

  • New Home Sales Collapse by 20% from May to December 2012 Levels:
    New Home Sales plunged by -8.1% to 406K in June while it had anticipated to decline around -5%. What is more interesting here is that May’s figures have been revised down by more than 10%, from 18.6% to 8.3%.
    See below chart for details.
    Home Sales

Two important questions most investors will ask themselves are:

  1. Are these misses in the USA Economic figures due to the tapering of the FED Bond purchasing?
  2. Is there some reason to believe that the stock markets can loft ever higher, other than central bank intervention?

The one fundamental metric that matters is profits. Let’s look at corporate profits and the S&P 500 (SPX):

CP:GDP

It appears the stock market is responding to central bank intervention to the degree that the interventions have enabled corporate profits to soar. How has intervention boosted profits? One easy way is that by lowering the cost of credit to near zero, corporations have booked the savings in interest payments as profits.

The question of the New Normal boils down to: Can corporate profits continue soaring? Or perhaps more to the point: Can central bank intervention keep pushing profits higher? Since interest rates are already near 0%, the answer seems to be that the fruits of Quantitative Easing and Zero Interest Rate Policy have already been picked, and there is little more profit to be gained from these policies.

Below chart shows that corporate profits have rolled over in the first quarter of 2014:

corporate Tax

And there is a number of other reasons to suspect the New Normal market is stretched. As can be seen from below chart, bearish sentiment is low, and bullish sentiment is at multiyear highs, which are both good contrarian indicators.

NVI Bullis

Other conventional metrics of market activity such as corporate buybacks, mergers and acquisitions, issuance of junk bonds, margin debt, etc. are also at extremes.

A continuance of the New Normal requires these extremes to become even more extreme, with no blowback (unintended consequences) or snapback.

Some analysts also see the emerge of inflation as a precursor to a market correction.

Two basic drivers of inflation are the fact that wages are rising and that bank credit since mid 2012, has started to grow again as can be seen from below chart.

wages and salary versus credit

It will be interested to hear the comments of USA policy makers on the above mentioned fundamental Economic data of the country.

Will they try to blame these soft data to the June weather as well?

and

Will the FED Chairlady Mrs. Yellen, label them as noise as well?

The last extreme to consider is volatility, which has slipped to multiyear lows on complacency born of a belief that central banks can enforce the New Normal of ever-rising markets at will.

VIX

The Big Questions are:

  • Is the New Normal enforceable even as markets reach extremes?
    Or
  • Is the faith in the central banks’ power to bend markets to their will just the latest manifestation of hubris?

No one knows at the moment. But there are numerous persuasive reasons to be skeptical of the New Normal and the utmost faith it places in the notion that markets are in a permanent state of low volatility and rising profits and therefore can only loft higher.

Last but not least is the question whether the “New Normal” isn’t enforceable and the rule of physics – that everything that rises artificially will come plunging down – is applicable to the USA Stock Market

History shows us that all market crashes have happened in the months of September and October. Due to this can we expect this great reversal or even massive crash of the markets to happen this fall?

Keep in mind that regarding capital markets past history is no guarantee for future performance and that the market can remain longer irrational than you can remain solvent!

Yours sincerely,

Suriname Times foto

Eric Panneflek

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