Is a Stock Market Correction Imminent?
(March 25, 2010)
Dear Subscribers and Readers,
Just when one thought it was safe to get back into global risky assets, Fitch downgraded Portugal's sovereign debt one notch to AA- yesterday morning – citing a weaker-than-expected recovery and a higher-than-expected fiscal deficit in 2009 (9.3% vs. a prediction of 6.5% of GDP as recent as September). Depending on how generous Germany/France are with the Greek bailout (after all, it is politically impossible to sell any kind of generous bailout when German voters can't retire until 67), Fitch and other rating agencies could downgrade Portugal's debt again in the coming months, especially if various “knock-on” effects occur with a severe tightening in the Greek budget and Greek consumer spending.
I continue to believe that a systemic collapse (such as those experienced in Brazil in 1998 or Argentina in 2002) in Greece and other “peripheral” countries in the Euro Zone is out of the question. During past emerging market debt crises, there was an excessive reliance on hard currency funding (especially short-term U.S. Dollar funding). Crises typically occurred during times of economic stress, resulting in liquidity problems stemming from a combination of high debt servicing costs, as well as a general “buyer's strike” from developed countries (e.g. LTCM). On the contrary – despite Greece's and Portugal's high debt servicing obligations today – there exists “automatic stabilizers” which would prevent a systemic collapse in these countries. Firstly, while those in the Euro system do not have the luxury to print money, the European Central Bank had already taken over this role by providing short-term funding for as long as necessary. In addition, all of the government bonds in the Euro Zone are currently eligible for the European Central Bank's main refinancing operations (with no penalty or discrimination) – which means that banks holding Greek and Portuguese debts, for example, could use this facility to essentially remain liquid and solvent. This facility also indirectly provides the Greek and Portuguese governments with “a buyer of last resort” for their debts.
Nonetheless, while any further troubles in Greece of Portugal should not pose a systemic risk to the broader financial system, there is no doubt that more austerity measures will be needed in the government budgets of Greece, Portugal, and Spain. In other words, the “bond vigilantes” are back – and they are striking at the European peripheral countries with a vengeance! This will act as long-term drag on the economies of the European peripheral countries, resulting in lower living standards, less consumer spending, and less profits for companies whose sales are tied to economic growth in these countries (i.e., the European peripheral countries could very well experience a “lost decade” similar to Japan's).
While a Portuguese downgrade was not a surprise, the timing of the downgrade – coming in the face of a Greek “workout” – definitely was. Despite a relatively benign decline in the major stock market indices yesterday, the VIX actually spiked by a whopping 7.3% - rising from a bull market low of 16.35 on Tuesday to 17.55 yesterday. At the same time, there is still a lack of fear in the markets, despite the fact that the bull market is already over a year old and despite the overbought conditions in many of the technical and sentiment indicators that we track daily. My intuition is that a two to three-week correction is coming, if not inevitable. At this point, we still remain 100% long in our DJIA Timing System (as we believe the cyclical bull market remains intact), but we would also not hesitate paring back our long position (probably to just 50% long) should the market rally further over the next 3 to 5 trading days (if so, we will send you a real-time “Special Alert” email informing you of our shift). The overbought condition in the U.S. stock market could be exemplified by the following indicators, starting with the equity put/call ratio:
As shown on the above chart (courtesy of Decisionpoint.com), the 10-day moving average of the equity put/call ratio recently spiked to its highest levels since the current bull market started. From a contrarian standpoint, this is bearish for the U.S. stock market. Moreover, the equity put/call ratio is now reversing from this highly overbought level – which usually coincides with a reversal (if only temporary) in the stock market.
Similarly, both the 21-day and the 55-day moving averages of the NYSE ARMS Index are at highly overbought levels, as shown on the following chart courtesy of Decisionpoint.com:
In fact, taking both the 21-day and 55-day moving averages together, there's no doubt that the U.S. stock market is now at its most overbought level since the cyclical bull market started in early March 2009. In addition – given the lack of a serious correction since the bull market started (both in terms of duration and in magnitude), I believe the probability for a two to three-week correction is now highly likely (although any correction may be delayed by the inevitable “window dressing” as we near the end of the quarter).
I now want to digress a little bit and discuss the trend of deleveraging U.S. household that we last discussed in our March 14, 2010 commentary (“2009 4Q Flow of Funds Update”). As mentioned, I am still looking for US households' balance sheets to continue its deleveraging process (as consumers adept to a more frugal lifestyle, and as banks and credit card companies restrict lending). I personally do not buy PIMCO's “New Normal” view of a ten-year deleveraging process, although US economic growth should remain below trend for the next few years. Sometime in the 2012 to 2013 timeframe, I expect US economic growth to accelerate again – once US households have paid down a significant portion of their debts and as the next generation of energy, biotech, and nanotech comes online that will drive the next secular bull market in US stocks and Schumpeterian growth. While we did see some deleveraging in the 4Q 2009 Flow of Funds data, the more obvious evidence showing that U.S. households are indeed saving and paying down their debts is the most recent trend in US households' financial obligation ratios (ratios of debt payments to disposable incomes), as illustrated in the following chart:
While the above chart signals that the deleveraging in the broader US economy should continue for the next couple of years, it also suggests that we may be getting close to the end of that process in terms of the most painful adjustments. Going forward, I expect U.S. households to deleverage through a combination of higher disposable incomes (the unemployment rate has most probably peaked), higher savings, and as lenders work through its backlogs of foreclosures and loan defaults. Furthermore, as U.S. households continue to pay down their debts and as they become more productive through technological innovation, “workforce re-education” and starting new businesses, we should experience an improvement in the long-term health of the US economy and society.
Henry To, CFA