Kasriel: How does an excess supply get remedied?

Thursday, June 18th, 2009

This post is a guest contribution by Paul Kasriel* of The Northern Trust Company.

How does an excess supply get remedied? By allowing prices to fall and by cutting production. This remedy applies to everything from hogs to houses. It is well documented that the prices of houses have plummeted. What may be less well known is that newly-started production of single-family homes has come back into equilibrium with the sales of new single-family homes - at least through April. Chart 1 documents that starts of single-family homes ran at a seasonally-adjusted annual rate of 368,000 in April, a touch above sales of new single-family homes at a seasonally-adjusted annual rate of 352,000.

Chart 2 shows that in recent months the ratio of single-family house starts to sales of new single family home sales is at it lowest level in 47 years. This is not to gloss over the fact that there still is a large supply overhang of new homes for sale that either have been completed or are under construction (see Chart 3).

But again, markets work. The housing market is moving toward a new equilibrium with production being curtailed and prices falling.

Source: Paul Kasriel, Northern Trust - Daily Global Commentary, June 15, 2009.

*Paul Kasriel is Senior Vice President and Director of Economic Research at The Northern Trust Company. The accuracy of the Economic Research Department’s forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul’s 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst.

Tags: Economic Forecast, Economic Research Department, Equilibrium, Excess Supply, Forecasters, Global Commentary, Hogs, Housing Bubble, Housing Market, Journal Survey, Lawrence R Klein, New Single Family, Northern Trust Company, Overhang, Paul Kasriel, Senior Vice President, Single Family Home Sales, Survey Panel, Survey Participants, Wall Street Journal
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Hugh Hendry: June 2009 Letter

Thursday, June 18th, 2009

Here, below, in its entirety is Hugh Hendry’s latest letter to investors. Its both enlightening, and highly educational, as the outspoken and brash Hendry has a great handle on market history as well as the English language.

Hendry, founder of Eclectica Asset Management, is one of the hedge fund industry’s true luminaries, and often goes out of his way to argue his convictions as well as make his bets publicly known, and while his theses often get tested, as does his durability, he has yet to be proven wrong.

Hendry has made for some of the most incredible intellectual arguments as well as hilarious direct-attack moments regarding the markets and the ongoing inflation vs. deflation debate during European Squawk Box and Power Lunch gatherings. Here, here, and here (whaling moment of the year).

We got our hands on his hard-to-get letter thanks to Tyler Durden at Zero Hedge.

THE ECLECTICA FUND
Hugh Hendry, JUNE 2009

Warning, I am about to repeat myself.

I have been keeping a low profile and have reduced the length of my reports. There has been little to note: my favourite asset class is long duration bonds; not index linkers. These have performed poorly so far this year. I have not fought this trend aggressively. By March I had rebuilt a modest sized position owing to the severity of the weak economic data. However this was mostly eliminated by the first week of April out of respect for the formidable price correction that was ongoing. As a result the Fund is down modestly on the year to date following last year’s surge. However, with the long bond yield in America now not far off 5pc, it is my contention that the trend may be approaching another extreme. I therefore thought it appropriate to once more outline my thoughts: what if the trend in the charts below continues; what if this year is a re-run of last year?

The decision to reduce the book in April reflected an unpleasant seasonality in our preferred trade. The second quarter in four out of the last five years has simply not been kind to risk aversion. Furthermore, markets continue to swing from the binary outcomes of inflation and deflation. At this point last year inflation was in the ascendancy. Backwards, forwards, since July of last year the same investors had to adjust to profound deflationary forces as all risk asset classes fell precipitously. Can we be any more confident that the market has it right now?

Let’s swallow a frog

I do not have the requisite level of confidence to make such a commitment. Better I would contend to always have a vivid image of the worst that might happen in our uncertain future and have this shape our behaviour today. So let’s consider the “bad things” which might initiate another dramatic rotation towards deflation.

My greatest angst is reserved for the four-fold rise in private sector, non-financial, leverage in America. In just 60 years, the private sector increased its debt from 43pc of GDP to 175pc. To put this into perspective, the UK is on the verge of having its formidable tax raising franchise downgraded because its debt may reach 100pc in two years time. And yet, until last year, there was little hand wringing about the private sector having borrowed more than 4x the public sector’s then debt.

Don’t get me wrong, I am sympathetic to the plight of America’s debtors. I understand why they came to believe that they were invincible. In truth, something without precedent occurred earlier this decade. Fearing the fall out from the tech bubble, businesses across all sectors of the economy set about cutting costs and laying staff off to prepare for the impending deep recession. Unemployed workers should have cut back on spending and rebuilt their savings. Instead they leveraged themselves against appreciating home prices to maintain their spending habits. Corporate revenues should have fallen. Instead, with disposable income boosted by home equity extraction, sales rose and profits boomed like no time before.

Today, by comparison, the corporate sector is threatened not so much by its own debt but rather by the loss of spending in the economy from the debt laden workers it has fired. Businesses are slashing costs and letting staff go. American unemployment is at a 26 year high of 9.4pc and total nominal wage payments have fallen for the first time in at least 50 years. This time around the economic orthodoxy is reasserting itself. Companies are discovering that in their quest to contain costs (by firing the economy’s consumers), they are suffering from a loss of revenue in future quarters; because of this I am wary of most prospective profit forecasts and not tempted by trailing 10 year earnings multiples.

My second concern relates to the willingness of governments to use their own leverage as a remedy for asset deflation. Policy makers seem to believe that the only way to reverse the tide in asset prices is to issue vast sums of ‘money-like pieces of paper’, aka government bonds. In doing so they are mimicking the previous decade when investment banks were able to boost the housing market by issuing trillions of dollars of mortgage backed paper, or the 1990s when it was new internet share issuance which drove the TMT bubble and so on back to John Law and his endless printing of Banque Générale certificates which financed the Mississippi stock bubble.

However there is a glaring flaw. Government debt is very visible; certainly more so than the paper previously issued by investment banks. Increase the issuance of mortgage backed securities, from $0.5trn in 1996 to $3.2trn in 2003, and no one bats an eyelid; house prices boom. Suggest issuing a corresponding amount of Treasuries and the bond market quickly fears inflation and frets over who will possibly buy all these bonds. Today bond prices are falling and there is the possibility that economic activity may be subdued by the rising cost of money. US mortgages are now dearer than at the end of last year.

Stimulus, what stimulus?

So prices are falling on the high street, total nominal wages are in retreat and yet the sovereign debt markets are in open revolt on the premise that “inflation is always and everywhere a monetary phenomenon”. Panic has taken over. Marc Faber is asserting that the US will definitely have hyper-inflation, one investment manager recommends an 89pc balanced fund allocation to inflation-proof Treasuries and CLSA’s Christopher Wood is recommending that US pension funds hold 40pc of their portfolio in gold. In other words people are convinced that inflation is the future.

What is less certain is when rising government bond yields begin to remove credit from the mortgage market and so close the door on the exit route of cheaper refinancing; today this is still seen as a distant prospect. The other pertinent question is whether “deficit nations” like the US and UK will be forced to moderate their ambitious spending targets. No one likes criticism and the reprobation of the German Chancellor and the Governor of the Bank of China must produce some soul searching; after all, central bankers are not renowned for their non consensual habits.

I keep thinking that it would be ironic if history were to show that US policy makers were right to fear the prospects of a $54 trillion debt deflation and that they should have been more ambitious in their monetary expansion. The bond vigilantes believe that the double dip deflation of the 1930s will ensure that the Fed will be slow to raise interest rates this time around. But what if the economy stalls because the credit markets are premature in tightening monetary policy for them?

I am beginning to sense another paradoxical twist. What if the Fed is right and Angela Merkel, Zhou Xiaochuan, Warren Buffet and James Grant are wrong? And that contrary to their inclinations the American authorities are forced to moderate their monetary expansion in order not to undermine the confidence of the international community. Whilst at the same time the bond market pushes long rates higher.

Under such a scenario the debt reduction efforts of the private sector would usurp the government’s attempts at stimulus; the economy would falter once more. Back in 1931 the same thing happened. Bond prices dropped and yields rose to the level that had prevailed for the previous ten years; a feeble economy lapsed back into a deflationary spiral. Perhaps if this were to happen again, and we were once more confronted by a truly dire economic outcome, then it is conceivable that the authorities could gain the vital legitimacy necessary to engage in an unquestionably large monetary response which finally purges the system of deflation. That is when I would choose to let rip on buying commodities and cheap equities.

The key is the economy’s sensitivity to bond yields. Russell Napier argues that it would require ten-year yields of 6pc (vs. 4pc today) to knock the economy and stock market from their perch and reassert the deflationary trend. But he bases his assertion on observations taken since the early 1960s. My quibble is that today’s leverage is unprecedented and prices are falling. May’s American CPI is forecast to contract by 0.9pc YoY; they fell in April. We never had falling prices in the 1960s, 70s, 80s or 90s. I therefore maintain that it is feasible that some unquantifiable but certainly lower nominal rate could choke the economy.

Regardless, it is my contention that many are investing in risk once more almost oblivious to the notion that a heavily indebted economy is confronted by a very real tightening of monetary policy. It is not inconceivable that the macro compass could swing violently towards deflation and wrong foot them again.

Will it happen? As I suggested at the beginning, it really comes down to whether we are trading in a groundhog version of last year. By last summer, oil had been bid up to $147 per barrel and markets were anticipating that central bankers like the Bank of England would be forced to raise (not cut!) rates by 200 basis points. The pressure was intense. I recall philosophical conversations regarding short sterling; what did it really represent? And with oil spiking I was taking my gross long position down but replacing it with $200 call option premium; not $50 put strikes. As Robert Prechter reminds his readers, “the news at turning points is just too strong for most people to act contrarily to it…fundamentals so intensely support the continuation of a trend just when it is ready to reverse”; mea culpa.

I have had cause to think long and hard about what caused the turnaround last July in the commodity spectrum. I believe the persistent and government approved appreciation of the Yuan played a prominent role. Forget quantitative easing, I believe this was the printing press that propelled risk asset prices higher. Chinese speculators could borrow in dollars knowing that their loans could be repaid for less in their local currency. And when the US entered the global recession first, and began cutting rates, the Chinese were emboldened to ramp up their overseas borrowing further; they had to buy something and as we know oil went parabolic. But then the Yuan stopped appreciating. Perhaps the central planners didn’t like spending so much on commodities? I suspect it was more that they became fearful of their competitive position vis-à-vis the Koreans and other mercantilist trading countries. Whatever the reason, it is clear that since last July their currency stopped appreciating vs. the dollar. This provoked an immediate response: speculators rushed to reverse their trade and we immediately went from inflation to deflation.

Since early March the price of risk assets has again risen considerably; the Yuan has gone sideways. Perhaps the Chinese don’t want to re-price their scarce exports amidst the economic weakness? I see this as a non-confirmation of the move in equities and commodities and it reinforces my bearish slant on the year. However, I happily contend that should the Yuan begin to appreciate once more and establish a new high vs. the dollar then I am just plain wrong with risk aversion and I will change the Fund’s posture; but so far it has been almost a year and nothing.

Rapidly Decreasing Pessimism?

I have been very fearful of fighting this stock market rally, taking the view that we could see something vigorous enough to convince the majority that we were in a new bull market. I did not expect anything like new absolute highs; more like 1930 when the Dow Jones rallied 52pc from its 1929 bottom. I was therefore heartened to hear, “History says fill your boots, sell your wife, dive in…” from David Schwartz, the self styled stock market historian, in an article from The London Times on the 9th of May, one day after the European stock futures had completed a 50pc rally from their intra day lows back in March. Furthermore, it was taken from a piece entitled, “Investors bet that worst of recession is over and predict new bull market”. These are early days but clearly the process of social herding and higher prices is succeeding in tempting many investors to risk their capital again.

I have written previously of life imitating art and continue to take inspiration from Will Self’s collection of short stories, “The Quantity Theory of Insanity”. In one tale a plucky undergraduate succeeds in locating his missing college professor by determining a pattern from a collection of integers copied from homosexual graffiti lifted from the cubicles of London lavatories. But it’s just a lucky coincidence. This got me thinking about Soros and Paul Tudor Jones plotting where the Dow might trade in 1987 from the entrails of the Dow in 1929. They thought the “great crash” of 2008 was due in 1987. They were wrong. But their pattern of integers, by coincidence, matched perfectly and Tudor Jones made 50pc in October 1987. In this business it doesn’t matter if you get lucky; just stay lucky.

Investment Strategy

So here I am in June 2009. My favourite asset class is down over 20pc on the year and is popularly derided. But I am feeling lucky. My gut feeling is that this year could follow last year. If I am right then it is time to re-engage tentatively with deflationary trades. Remember, I am fearful that the next few months could still contain further euphoric moments. My preference is therefore to start modestly and go for low delta but big pay-off option trades.

Such opportunities are rare today. However, over the last couple of weeks we began purchasing out of the money call options on the current 30 year US Treasury bond. Do not be too concerned, we have only used about 20 basis points of the Fund’s NAV on such option premium so far. However it is our intention to add to this amount should the elevated levels of fixed income volatility subside. Given the capacity of this market to thrash around from extremes, it is not unrealistic to imagine that yields could match their lows of just six months ago. Should this happen before the year end, our options would payout 14 times our investment.

Similar asymmetric payouts are achievable in the short sterling interest rate market where investors are pricing in a 2pc hike in Bank of England base rate by the end of 2010. This is eerily like this time last year when they were expecting a 2pc hike for the second half of the year. If this time around the market again reverses its opinion by December, and takes the view that this is unlikely to happen, then our option package could payout over 10 times our money.

I also like German sovereign CDS at this level: an annual fee, paid quarterly, of just $30k (a total outlay of $150k if held for 5 years) to insure $10m of notional debt should something truly calamitous happen to the finances of the German Republic. Could it happen? No. However, those who underwrite credit default swaps today can only see Germany’s formidable strengths and laud it for its high savings, fiscal prudence and large trade surplus. But as I wrote to you previously, I fear the “surplus” nations of China, Japan and Germany have been duped by the West’s borrowing binge.

I fear they have over-estimated the global economy’s demand and are confronted with huge pools of surplus marginal capacity. A prolonged and feeble recovery in America’s nominal GDP would have especially dire consequences for such economies; Germany is already on course to contract by 5pc this year. It could be that with a moribund export market (traditionally two-thirds of economic growth) and the likelihood that politicians change the constitution to ban state and local deficit spending, investors might prove willing to pay more for their German bond insurance. Remember it only has to trade at the highs of earlier this year and I would double our money.

Sovereign defaults are today priced as black swan events despite the fact that more than half of all governments defaulted on their external debt back in the 1930s. Already in this decade we have seen both Argentina and Ecuador default. In both cases the recovery rate was 25pc. This is low; historically 40pc is more typical. Perhaps 25 is the new 40? Today it seems likely that Latvia will join them. Their sovereign CDSs trade at €750k per €10m of notional protection. What this means is that should Latvia default tomorrow, or within the next 12 months, you would receive €10m minus the assumption of recovery (25pc) and minus any CDS payments incurred; or 10x your money. I own Hungarian protection which is priced at €340k per €10m of equivalent sovereign protection. Again, assuming a 25pc recovery, a default this year would return us 22x our money, 11x if it is next year, 7x in 3 years and so on.

Lastly, in an effort to help fund the cost of carrying these risk-averse trades, I have been selectively buying corporate bonds in the tobacco, agriculture, and utility pipeline industries. This portfolio has an average yield of 8pc and I would be happy to take you through its finer details on request.

Here is hoping that I get lucky.

(Legal)

This document is being issued by Eclectica Asset Management LLP (”EAM”), which is authorised and regulated by the Financial Services Authority. The information contained in this document relates to the promotion of shares in one or more collective investment schemes managed by EAM (the “Funds”). The promotion of the Funds and the distribution of this document in the United Kingdom is restricted by law. This document is being issued by EAM to and/or is directed at persons of a kind to whom the Funds may lawfully be promoted. No recipient of this document may distribute it to any other person. No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of, and no liability is accepted for, the information or opinions contained in this document by any of EAM, any of the funds managed by EAM or their respective directors. This does not exclude or restrict any duty or liability that EAM has to its customers under the UK regulatory system. This document does not constitute or form part of any offer to issue or sell, or any solicitation of any offer to subscribe or purchase, any securities mentioned herein nor shall it or the fact of its distribution form the basis of, or be relied on in connection with, any contract therefor. Recipients of this document who intend to apply for securities are reminded that any such application may be made solely on the basis of the information and opinions contained in the relevant prospectus which may be different from the information and opinions contained in this document. The value of all investments and the income derived therefrom can decrease as well as increase. This may be partly due to exchange rate fluctuations in investments that have an exposure to currencies other than the base currency of the relevant fund. Historic performance is not a guide to future performance. All charts are sourced from Eclectica Asset Management LLP. Net Asset Values are as at the date of the document. © 2005-09 Eclectica Asset Management LLP; Registration No. OC312442; registered office at 6 Salem Road, London, W2 4BU.

Tags: Ascendancy, asset class, Asset Classes, Asset Management, Aversion, Bond Yield, Contention, Deflationary Forces, Durability, Eclectica, Economic Data, Hedge Fund, Hugh Hendry, Inflation And Deflation, Letter Thanks, Low Profile, Luminaries, Lunch Gatherings, Market History, oil, Power Lunch, Preferred Trade, Seasonality, Severity, Squawk Box, Theses, Tyler Durden, Whaling
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The Recession in Historical Context

Thursday, June 18th, 2009

How does the current economic and financial downturn match up to past contractions?

In an attempt to present matters in historical context, Paul Swartz of the Council on Foreign Relations recently published a chart book showing that the current economic environment has been more severe than a typical recession. He specifically highlights the following four conclusions:

• Financial markets have dramatically improved, but from an extremely low base. Rather than pricing in disaster, they anticipate tough times ahead. For example, the charts on the spread for AAA and BAA bonds show the credit market moving from unprecedented panic to a level of fear that is merely in keeping with the worst experiences since 1945.

• Real economy indicators show signs of stabilization. See in particular the charts on manufacturing sentiment, non-farm payrolls, oil prices, and car sales. Nonetheless, many of these indicators remain worse than anything hitherto experienced in the postwar period.

• The collapse in the federal government’s finances is unprecedented, raising questions about how the government deficit will be brought under control.

• By most measures, the current recession is far milder than the Great Depression. But the appendix shows that house prices have fallen much more sharply than in the 1930s.

The charts below plot current indicators (in red) against the average of all post-World War II recessions (blue). To facilitate comparison, the data are centered on the beginning of the recession (marked by “0″). The dotted lines represent the most severe and the mildest experiences in past cycles. The last few charts specifically compare the current downturn with the Great Depression.

The year-over-year fall in real gross domestic product (GDP) is now competing to be the worst in the postwar period.

The federal budget has deteriorated far more rapidly than in any past recession, in part due to the first economic stimulus and bank bailouts. The current stimulus implies an even larger and more prolonged deficit in the future.

Global trade collapsed in the fourth quarter of 2008 and first quarter of 2009 in a way never seen in the postwar era.

Unemployment initially increased at a rate consistent with past recessions. However, the latest data show the worst labor market in the postwar period.

The fall in nonfarm payroll shows rapid deterioration in the labor market. The deterioration has slowed, but will this improvement be enough to slow knock-on effects?

Industrial production (IP) held up well when the recession began but collapsed in the second half of 2008. The current collapse is creating a new postwar record.

A rise in oil prices is typical before the start of a recession, and a fall is typical as a recession proceeds. This time oil prices initially continued to rise after the onset of the recession. Conversely the recent fall has been larger than usual, even allowing for the rebound in the spring. The recent fall has dramatically changed the geopolitical position of oil exporters.

The ISM survey offers a forward-looking indicator of industrial production. A number above 50 in the ISM survey implies manufacturing growth whereas a number below 50 implies contraction.

Auto sales typically fall by 20% in a recession. This time around they have fallen by over 40%.

Consumer sentiment typically starts falling before the recession begins, but turns around soon after. However, pessimism seems particularly strong this time.

Most post-World War II recessions were preceded by a tightening of monetary policy. This one was not. Easing started sooner and happened faster than is typical. Although the Fed’s ammunition in nominal target rate cuts is gone, it has continued to ease in other ways.

The spread of investment-grade debt - a measure of the risk that high-quality corporate bonds will default - typically rises during a recession. The rise during the current cycle is unprecedented. The credit markets’ recent improvement still leaves spreads at historic highs.

The spread on BAA debt (the lowest investment grade rating) is an indicator of the risk that lower quality companies will default. The recent rise in the BAA spread is unprecedented. As the financial system has stabilized, the credit markets have improved, but the current implied default rates suggest a rough period for corporations.

Equity markets start to fall nearly eight months before a recession begins.
In this cycle, a fall in equity markets preceded the recession. However, the subsequent fall has been larger than normal, and the markets have not recovered on schedule.

The last few charts compare the current recession with the prewar average and the Great Depression.

The thick red line represents the current recession; the thin blue line, the postwar average; the thick green line, the Great Depression; the thin orange line, the prewar average.

Due to financial system deleveraging, the economy is enduring uncomfortably low inflation. The current recession looks more like a prewar recession than a postwar recession or the Great Depression.

Production in this cycle has collapsed relative to the postwar average, but is in line with the prewar average. The current collapse does not compare to that of the Great Depression.

Although the labor market has deteriorated more than at any time since World War II, it is much healthier than during the Great Depression.

US trade - the sum of exports and imports - has collapsed dramatically. But it will have to deteriorate further to compare to the Great Depression.

Government intervention is much less controversial than prior to World War II. Thus government stimulus occurred faster than was the case during the Great Depression. Government net financial investment (bank bailouts) has contributed a substantial portion of expenditures.

So far, equity market performance has lined up with the Great Depression.

One area in which this downturn has been far worse than the Great Depression has been in home prices.

Source: Paul Swartz, Quarterly Update: The Recession in Historical Context, Council on Foreign Relations, June 5, 2009.

Tags: Contractions, Council On Foreign Relations, Dotted Lines, Downturn, Economic Environment, Economic Stimulus, Economy Indicators, Federal Budget, Government Deficit, Great Depression, Gross Domestic Product, Historical Context, House Prices, Non Farm Payrolls, oil, Oil Prices, Paul Swartz, Postwar Period, Recession, Recessions, World War Ii
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Stock Markets: Retreat in Store?

Thursday, June 18th, 2009

It seems as if the spring rally has probably exhausted itself. And it is about time given the extent and rapidity of the move. The MSCI World Index increased by 45.2% from its March lows until the early June high and the MSCI Emerging Markets Index by a staggering 68.9%. Both these indices have only had one down-week since the advance commenced in early March.

Leading markets such as Russia (+137.0%), India (+89.5%), China (+54.7%) and Brazil (+50.4%) significantly outperformed laggards such as the Dow Jones Industrial Index (+27.5%) and the S&P 500 Index (+39.9%), although all markets recorded very respectable returns. The major US indices have gained for 12 out of the past 14 weeks.

Click here or on the table for a larger image.

Source: Plexus Asset Management (based on data from I-Net Bridge)

Focusing on the US, the S&P 500 Index (911) has backed off resistance at its January high (935) and is less than five points away from breaking down through the key 200-day moving average (906) - broken to the upside only two weeks ago.

Importantly, short-term oscillators such as the rate-of-change (momentum) indicator is on a knife’s edge of giving a selling signal, i.e. crossing through the zero line in the bottom section of the chart below. Also note the negative divergence between the Index and the ROC line - typically be a warning sign that a near-term trend change will take place.

Source: StockCharts.com

The venerable Richard Russell of Dow Theory Letters fame said: “In order for a counter-trend rally in a bear market to be sustained, it requires steady or rising buying power plus short covering. Lowry’s Buying Power Index has been declining steadily since May 8. At yesterday’s market close, this Index (demand) was only 24 points higher than it was at the March 9 lows. Furthermore, volume is drying up.

“This is extremely negative action. Whenever buying power contracts during a rally in a bear market, the prevailing primary bear market forces immediately take over. For that reason, unless the trend of declining buying power soon halts and reverses, I believe that the March 9 lows will be attacked and violated.”

For more about key levels and the most likely short-term direction of the S&P 500, Adam Hewison of INO.com prepared another of his popular technical analyses. Click here to access the short presentation.

What about valuations? In order not to work with notoriously unreliable forward-looking earnings estimates, I prefer using Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), or normalised earnings as they average ten years of earnings. This measure provides a good picture of the market’s value regardless of where we are in the business cycle. On this basis, the multiple increased to 15.8 during the rally compared with a long-term average of 16.3. This represents “average” value at best.

I have argued in my post of two days ago ,”Have stock markets run away from valuations?“, that based on the historical relationship between the Purchasing Managers Index (PMI) and stock market movements, the S&P 500 seems overpriced under all scenarios over the next few months and only reaches positive territory again in August under the “very optimistic” scenario and in November under the “optimistic” scenario”.

It is difficult to envisage how much of a pullback we might see. I would be surprised if the retreat is not at least 10%, but do not exclude a bigger and longer correction than what many pundits are expecting. As this juncture my advice will be to assume a defensive position in your investment portfolio.

Tags: Bear Market, Bottom Section, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Index, Dow Theory Letters, Emerging Markets, India, Laggards, Momentum Indicator, Msci Emerging Markets, Msci Emerging Markets Index, Msci World Index, Negative Divergence, Power Contracts, Power Index, Richard Russell, S Market, Spring Rally, Term Trend, Warning Sign, Zero Line
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