Global Liquidation – Part II
(September 11, 2008)
Dear Subscribers and Readers,
Our last discussions (please refer to our July 3, 2008 and July 10, 2008 commentaries) on the continuing “global liquidation” of equities and risky assets centered specifically on financial and consumer discretionary stocks in the developed world. At the time, many commodity-related economies, such as Norway, Brazil, Russia, and Canada were still doing relatively well. Emerging markets, with the exception of China and India, were also doing well in general, as investors believed that global economic growth will remain strong (and thus stayed with the equity markets that had exhibited relative strength) even in the face of difficulties in the global financial system and increasing inflationary pressures in many countries around the world.
Since then, we have seen a continued liquidation in global equities. Ironically, even though the current “dislocation” in the world's financial markets/economy began with the subprime/housing market in the United States, the majority of liquidation and/or “forced selling” have occurred in overseas markets. With the notable exception of the United States (particularly in US financial and consumer discretionary stocks, the sell-offs in the GSEs, Lehman Brothers, and Washington Mutual, notwithstanding), India, Turkey, The Philippines, Columbia, Morocco, and Jordan, all countries in the MSCI All-Country World Index are making new lows (for this year) in US-Dollar denominated terms as I am typing this.
The severely oversold conditions of the global, regional, and country-specific equity markets are evident in the latest readings of our Global Overbought/Oversold model. Under normal circumstances, we usually use our monthly Global Overbought/Oversold Model as cues to either go long in a substantial way or cut back on long positions (overbought indicators are notoriously bad timing indicators), and this is what we are going to do in this instance. This model was first discussed in our August 2, 2007 commentary. As we mentioned in that commentary, the inner workings of this global overbought/oversold “model” are rather simplistic. For each country or region, we first compute the month-end % deviation from its 3, 6, 12, 24, and 36-month averages. Each of these % deviations are than ranked (on a percentile basis) against all the monthly deviations (against itself only, not deviations for other countries or regions) stretching back to December 1998. This way, we are comparing apples to apples and can control for country or region-specific volatility. We also added the CRB Total Return Index since our August 2, 2008 commentary. Following is our Global Overbought/Oversold Model as of the close on September 10, 2008 (note that the September 10th readings are used in place of the September monthly readings):
As we mentioned earlier, the entire world's equity markets have gotten much more oversold (the cells highlighted in yellow represent readings below the 15th percentile, or approximately one standard deviation below the average) since the end-of-month readings in June and July. Both Latin America and Eastern Europe (Russia is a particularly notable mention) are now dealing with liquidation pressures not seen since late 2002/March 2003. China – on the heels of more tightening policies, especially in its property sector – has also gotten more oversold, with no significant “relief rallies” over the last two months. Even Japan, which has strived to maintain a close-to-zero interest rate and market-friendly policies, has seen continued liquidation. For the first time in the current bull cycle, commodities (as exemplified by the CRB Total Return Index) are now oversold on a short-term basis.
With the exception of Eastern Europe and selected countries such as Pakistan, and various economies in Western Europe that are heavily weighted in the financial sector, the fundamentals do not justify either a significant cyclical or secular bear market in international equities. More importantly, the continuing downdraft in Western European financial stocks is salvageable – as long as both the Bank of England and the European Central Bank start to ease rates aggressively before the end of this year. Rather, the continuing liquidation in international and emerging market equities has more to do with increasing risk-aversion – a trend that began with the subprime market in the US and that spread into the rest of the global financial sector – further compounded by tightening central bank policies around the world as a response to rising inflationary pressures. The extreme liquidation in international equities is evident from the most recent mutual fund inflows/outflows numbers, courtesy of AMG Data and Goldman Sachs, in the following exhibit:
Interestingly, outflows out of mutual funds that focus on domestic equities peaked in the fourth quarter of 2007 – and actually took a breather in the second quarter, right in the aftermath the bailout of Bear Stearns. Flows out of international equity mutual funds, meanwhile, did not occur until the fourth quarter of 2007, and have since continued to gain strength. On a quarter-to-date basis, flows out of international equity funds are now at their highest level ever, even though there are still three weeks remaining in the third quarter. More importantly, investors have been much quicker to pull assets from equity mutual funds than in the 2000 to 2003 bear market (not shown), when equity mutual funds actually experienced net inflows in aggregate. It appears that retail investors and 401(k) participants have taken their cues from the 2000 to 2002 bear market – leaving them with very “trigger-happy” fingers on the “sell button.”
Finally, no matter what one thinks of the fundamentals in the international/emerging equity markets, there is no doubt that virtually all countries are now severely oversold. Even countries such as Pakistan and various countries in Emerging Eastern Europe are now due for an oversold bounce. Whether US and global equities can end their bear markets soon will depend on monetary policies in the Euro Zone and the UK, as well as the long-term innovative abilities of entrepreneurs around the world to solve our most pressing problems in our current energy and food supply infrastructure (on a more immediate basis, this will involve looking at whether Congress will allow off-shore drilling in more areas, potential capacity coming online in Iraq, Saudi Arabia, and Brazil, and the potential adoption of genetically-modified seeds despite opposition from many Western European governments). I will end this commentary with four weekly charts showing the action of the Chinese, Russian, Brazilian, and Indian equity markets, along with their 40-week rate of change, courtesy of Decisionpoint.com:
Henry To, CFA