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Who Will be the Casualty in a Slowing Economy?

(August 3, 2006)

Dear Subscribers and Readers,

In our last weekend commentary, I discussed the book “The Support Economy” and its thesis – a thesis which claims “that a new kind of capitalism is emerging – a kind of capitalism that is based more on “psychological self-determination” where each one of us want to seek our own individual meanings – which will in turn transform our economy from an economy based on services to that of one which is based on “deep support.””  I also stated that the days of mass consumerism and “managerial capitalism” are over, and with it, the companies that chooses not to listen to this “growing chasm” between today's consumers and corporations.  For readers who claim this may be outrageous: You are right, this concept of “deep support” and “psychological self-determination” for U.S. consumers is definitely outrageous in the context of today's environment, but please keep in mind that the age of mass consumerism didn't really develop until the 1920s to 1930s – when for the first time, the “middle class” had both the discretionary income and the time to “consumer” mass consumer goods and services.  For example, prior to Henry Ford and the Model T, the auto industry was all about the customer first and making sure that each car was built to the customer's needs.  As stated in “The Support Economy”: “The truly profound innovation by Henry Ford was not the moving assembly line, the minute division of labor, or any one of the many production breakthroughs for which his factories became world-renowned.  Ford's single-minded act of brilliance was to take a process that began with the customer and invert it.  His unusually canny insight into the then-changing structure of consumption, combined with his unique imperviousness to the opinions of others, led to this historic invention: a classic Copernican inversion of periphery and center that would form the template for modern industry in the twentieth century.”

Years later – under the leadership of Alfred Sloan, General Motors would beat Ford by shifting the pyramid bit by bit back to the consumer with its different models and annual model changes.  Along the way, however, the General stopped paying attention and was usurped by its Japanese rivals at its own game.  In the 21st century of doing business, businesses will have to continue to “go back to the customer” in order to be successful and to survive.

Some of our subscribers have asked how we could be bullish on the U.S. large caps given the many concerns in the U.S. economy and around the world, including concerns such as the Israeli conflict, the popping of the housing bubble, high oil prices, an inverted yield curve – all amid a Central Bank tightening environment in many parts of the world, including China and India.  The answer is relatively straightforward and simple.  On a relative basis, the U.S. large caps as an asset class is one of the most undervalued asset class in the world – relative to all kinds of bonds, the international equity markets, the small and mid caps, and not to mention commodities and other hard assets such as real estate.  Moreover, many of the U.S. large caps have great business models, strong cash flows, a high cash level, as well as a high propensity to buy back their own shares.

Readers should also keep this in mind: In a declining liquidity environment, the assets that get hard the most are those assets that saw the most speculation during the last bull cycle.  Asset classes that come to mind include commodities (such as crude oil, gold, copper, etc.), real estate, U.S. small and mid caps, and emerging market securities (both equities and fixed income).  In the case of crude oil, the Energy Information Administration (EIA) does not see any new spare capacity effectively coming online until late 2007 at the earliest, but again, please keep in mind that the EIA is not taking into account a U.S. or a global economic slowdown.  Such a slowdown – especially in China – could potentially increase spare oil capacity as early as the beginning of next year.  Moreover, as I have mentioned before in our June 11, 2006 commentary, the chances of an oil or natural gas supply disruption in the U.S. Gulf Coast this hurricane season is next to impossible, given the latest weather forecasts for this hurricane season.

But Henry, what about “peak oil” and what about the establishment of the United States Oil Fund ETF (USO)?  Just like the “new era” of the late 1990s, the concept of peak oil used to be a good structural story until it turns into a cyclical one.  As the price of crude oil surpasses $70 a barrel, what was once classified as non-recoverable is for the first time counted as reserves.  New supply or old supply that was not economical is gradually brought online.  Similar to the amount of new stock offerings that emerged in 1999, the new supply will inevitably overwhelm demand – no matter how great the story is.  As for the USO, readers should know that the establishment of such an ETF goes both ways.  In an oil bull market, the USO will serve to further escalate the price by bringing in more retail investors.  But in a bear market, the USO may actually be a further drag on the oil price, as market makers will have to ultimately short oil futures or buy put options on crude oil should retail investors want to short the USO.  Effectively, the establishment of a USO actually amplifies the boom/bust cycle in oil – and the downside should ultimately be as spectacular as the upside.

Speaking of the crude oil price, we are now seeing many divergences across the board even as the price of crude oil continues to test its highs.  As I have pointed out in earlier commentaries – ever since the cyclical bull market began in October 2002, the Dow Transports, the Oil Service HOLDRS (the OIH), and the price of crude oil have all moved in sync with one another on the upside.  As the following chart shows, however, this is no longer the case – as the Dow Transports and the OIH have both failed to confirm the latest rise in the WTI crude oil spot price since mid-July:

Relative Performance of the Dow Transports vs. Oil Service HOLDRS vs. Crude Oil (October 1, 2002 to August 2, 2006) - 1) Ever since the cyclical bear market bottomed in October 2002, the DJTA, the OIH, and crude oil have all moved in sync with one another. Given the recent downside divergence in both the Dow Transports and the OIH (the former potentially making a double top and the latter stuck in a series or lower lows and highs) there is a good chance that crude oil prices are finally topping out at least for this cycle. 2) Lower highs and lower lows in the OIH?? 3) Double top in the Dow Transports??

Given the continued deterioration of liquidity in many parts of the world including the U.S., China, and India, this author will have to conclude that the price of crude oil is in the midst of topping out – at least for this cycle (although it still remains a great long play in the long-run).  In terms of timing, however, this author will definitely not short the USO just yet.  At the very least, we should wait until the market's reaction to the August 8th Fed meeting and then reevaluate accordingly.

But Henry, don't we have an inverted yield curve today?  Doesn't an inverted yield always led to an economic recession or a significant stock market correction (not to mention a bear market)?  The answer to these questions is “not necessarily.”  Please go back to our December 15, 2005 and December 22, 2005 commentaries for further clarification, but in a nutshell, we concluded that a flattening or inverted yield curve (as signaled when the differential between the yield of the long bond and the Fed Funds rate turns negative) does not necessarily mean the stock market will decline going forward.  Rather, it really depends on where the financial speculation was focused prior to the inversion.  As an example, the January 1975 to December 1990 experience that we drew upon in our December 22, 2005 commentary shows this.  Quoting our December 22, 2005 commentary: Whenever the yield curve has flatten or inverted, the general conclusion is that the propensity to take risks significantly decreases, given that:

  1. Historically, commercial banks have played a significant role in providing liquidity and financing for domestic companies, and since banks traditionally borrow short and lend long - an inverted yield curve would deter them to significantly curtail borrowing and subsequently result in very tight credit conditions.

  2. Since the end of World War II and until recently, the nominal growth of the U.S. economy has had a great correlation with the yield of the long bond.  When overnight interest rates exceed the yield of the long bond, this discourages companies and individuals to invest in stocks or in their own businesses.  As the logic goes: If I can make more returns by putting my money into a savings account, why not do that instead of plowing into stocks or into my own business - when the latter create significant risks as well?

At various points in time, an inverted yield curve (signaling a propensity for risk aversion) will have a significantly adverse impact on the stock market - but the January 1975 to December 1990 experience does not show this was the case.  Rather, what the above chart does show is that whenever the yield curve has inverted, credit conditions have tighten - which meant a severe "clampdown" on speculation in general.  Specifically, this means that the markets that have risen the most quickly and that have attracted the most speculation will suffer the most once the yield curve is in the midst of inversion, such as the commodity markets in the late 1970s, a bank lending crisis in 1982 (accompanied by the worst recession in post World War II history), and the U.S. Savings & Loan Crisis in 1990 (not to mention the bankruptcy of many real estate investors such as Donald Trump).  During all those times, the stock market was no doubt volatile - but please keep in mind that the stock market was affected disproportionately, given that (with the exception of 1987) domestic stock market valuations and speculation were not as high as, say, emerging markets or the real estate market … History has shown that a flattening or an inversion of the yield curve is usually a precursor to a financial crisis somewhere in the world - said target being an area (either geographically or a particular asset class) which has seen the most speculation prior to the inversion. 

In other words, while one should definitely take note of the inverted yield curve, readers should not read into it too much and should only use it as a leading indicator of liquidity – and nothing else.  To conclude that an inverted yield curve would depress stocks is a bit of a stretch, especially since the level of speculation in U.S. stocks (especially in U.S. large caps) never reached a fever pitch in the latest cyclical bull cycle.  On the other hand, one should really be mindful of emerging market securities, U.S. small and mid caps, as well as “hard assets” such as crude oil, copper, and real estate.

So Henry, are all developed countries a fair play when it comes to equities?  What about Japan?

As this author has stated over the last few months, I still do not like Japan, given the huge 60% rally in the Nikkei from October 2004 to earlier this year and given the huge withdrawals of reserves from the Japanese money markets starting in March of this year (which coincided with the topping out of the Nikkei).  Since the most recent top, the Nikkei has pulled back by about 10%, but this author still does not plan to buy any Japanese equities or index funds, given the following:

  1. The Bank of Japan is still withdrawing reserves from the domestic banking system.  For the month of July, the absolute amount of the Japanese monetary base is down six months in a row and the year-over-year change is a negative 17.8% - which marks the greatest decline since monetary records were kept starting in the 1970s.  The following monthly chart shows the historical divergence between the year-over-year change in the Japanese monetary base vs. the year-over-year change in the Nikkei.  Given this divergence and their historical correlations, this author will have to conclude that the Nikkei still has much further room to fall.

    Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to July 2006) - 1) Note that Japanese money growth has been plunging since the end of 2003 - with the latest Y-O-Y increase registering a highly negative reading of -17.77%. Such dismal growth will most likely mean a continuing correction in the Nikkei. 2) Note that the second derivative (the rate of growth of the Japanese monetary base) has plunged since February 2006 - resulting in the lowest reading since January 2001. 3) Momentum of the Nikkei still SIGNIFICANTLY diverging from monetary growth...

  2. The new government-imposed ceiling of 20% for Japanese credit card companies from an earlier ceiling of 29.2%.  The S&P estimates that such a new ceiling would on average lead to a 70% decrease in operating profits in the average Japanese consumer finance companies.  Such a new ceiling will also inevitably hurt consumer spending – given that many credit card companies will no longer extend credit to the most risky borrowers.  Moreover, folks in this later category will also be cut off – and many of these folks will probably end up losing their homes or cars, and so forth.  A portion of these will probably seek loans from loan sharks.  In other words, this new government policy will result in a) lower profits for Japanese finance companies, and b) a more ineffective Japanese economy and more poverty.

  3. After a brief venture into positive territory in 2004 and early 2005, the Chinese economy is again exporting deflation to much of the developed world.  At the same time, many Japanese economies are pouring money into capital spending and expanding capacity in anticipation of a booming export trade and a rise in Japanese consumer spending.  The $64 million question is: What if the Japanese consumer does not show up (household spending actually fell 2.2% on a year-over-year basis in June)?  Even if he or she does show up, there is no guarantee that there will be enough demand for all these goods – especially since the U.S. economy is slowing down at the same time.  Coupled with a potential rise in the Japanese Yen, and one has a recipe for a lot of red ink going forward in 2006 and beyond.

Things are going to get interesting going forward.  I will continue to avoid commodities, emerging market securities, U.S. small and mid caps, real estate, and the Japanese stock market.  At this point, this author still does not intend to go fully long (100%) in our DJIA Timing System just yet, given the current short-term overbought conditions in the stock market, especially in the Dow Industrials.  If the market runs away from us, then we will just have to let it go, as this author is not going to chase performance, especially not in the current environment.

Signing off,

Henry To, CFA

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