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Germany Rolling Over?

(October 11, 2007)

Dear Subscribers and Readers,

In last weekend's commentary, we discussed that not only the US economy was slowing down, but that aside from various Asian and Latin American countries, the global economy, especially the Euro Zone and Japan, was slowing down as well.  Moreover, while the US economic slowdown has at least been partially discounted (in the form of a US Dollar – note that the current account deficit is, IMHO, at the very low end of the priority list here), this was not the case in the Euro Zone.  Interestingly, while earnings growth estimates for the DJ Eurostoxx 600 has already been revised down from 16% for the third quarter, it is still at a very high rate of 11%, while earnings growth estimates for the fourth quarter is still at a high 9% or so.  We believe that this will continue to be revised down in the weeks ahead.

More importantly, the following chart (courtesy of Goldman Sachs) shows that earnings momentum does have a positive correlation to year-over-year performance in the DJ Stoxx – suggesting that the performance of the European stock markets will at least be below average going forward, if not actually decline:

Earnings momentum moves with price performance

Moreover, the relative strength of the German DAX Composite (note that this is an index priced in Euros and thus do not take into account currency gains over the last few years) relative to the S&P 500 had been rising relentlessly since late 2004, and may now be in the process of peaking (following weekly chart is courtesy of Decisionpoint.com):

German DAX Composite ($DAX) - Relative strength of the DAX relative to the S&P 500 peaked in late July and is now in the process of rolling over...

While the bears could make a good case that we witnessed the same “rolling over” scenario in early April of last year (only to see the DAX rebound and make new highs on a relative basis), a much better case could now be made for the DAX rolling over, given that:

1) As discussed in our MarketThoughts Global Diffusion Index and the most recent decline of base metal prices last weekend, there is very good evidence that the global economy is slowing down.  Given that Europe (and especially Germany) is still the marginal producer when it comes to manufacturing exports, etc., a slowing global economy will hit German's exports first – especially given the strong Euro.

2) From late 2004 to late June 2007, the DAX has outperformed the S&P 500 by approximately 50%, versus an outperformance of only 30% or so during the previous peak in April 2006.  In other words, on a relative strength basis, the DAX is now much more overbought than it was 18 months ago – and thus the chances of it now peaking and rolling over are now significantly greater than it was 18 months ago.

Finally, the average of German corporate bond yields made a significant trough in late 2005 (3.3%) and has since appreciated more than 50% to 5.09% (it is now at its highest level since December 2002).  In other words, the ECB's hiking program – unlike the most recent hiking cycle within the US – has actually had a wide effect on overall interest rates, including rates on the long-end and corporate side of the curve.  Following is a weekly chart of German corporate bond yields from 1984 to the present, courtesy of Reuters EcoWin:

Germany, Corporate Benchmarks, Composite, Yield, EUR

From an asset allocation standpoint, can shares of German companies compete with an overall corporate bond yield of 5.09%, compared to only 3.3% during late 2005?  More importantly, given the country's relatively high fixed capital costs, what kind of impact will higher interest rates have on corporate balance sheets within Germany?  All these – combined with the strong Euro and weak technicals in the German stock market – along with the popping of the housing bubble in Spain and France as well, will not portend well for both German and general European stock prices going forward.

We will go into more details in this upcoming weekend commentary regarding certain sector or industries that we like, so for now, we will leave you with this following chart (again, courtesy of Goldman Sachs) showing net earnings upgrades/downgrades over the last four weeks broken down by the four major stock markets and sectors:

Earnings sentiment by industry

Again, we will discuss this in more detail in this weekend's commentary, but for now, it is interesting to see the divergence within the energy sector – as analysts have slashed earnings estimates for the US energy sector, while raising it for the energy sectors within the European, UK, and Japanese stock markets.

Signing off,

Henry To, CFA

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