Fuller's Forecast

07/16/2004 12:00 am EST


David Fuller

Global Strategist and Producer, Fullermoney

Based in London, and focusing on a wide range of global investment opportunities, David Fuller offers a refreshing and unbiased view of Wall Street through his Stockcube Research. Here, he looks at the US stock and bond markets, real estate, and inflation.

"Where is Wall Street heading next? Opinions regarding Wall Street's next significant move have been evenly divided for much of this year, judging from the S&P 500 Index's trading range and the often offsetting bullish versus bearish opinions one hears. However, like swing voters, there are many people in the undecided camp, who understandably become more bullish near the upper side of the trading range, and more bearish when the year's lows are tested. The only certainty is that we will eventually see a sustained breakout from this year's trading range. But can we anticipate that move? Some strategists, from both the bullish and bearish camp, will base their forecasts on differing expectations for GDP growth, interest rates, and corporate earnings. They are important. But in addition to the market's trend, I prefer to look at what have historically been leading indicators. I've selected a number of these for discussion and illustration:

"The US ten-year Treasury bond yields have recently pushed to their highest level since July 2002. I regard this as a bearish indicator for the S&P 500 index because rising bond yields can signal inflationary concerns, leading to higher short-term rates. As bond yields become more competitive they eventually siphon cash away from the stock market. Meanwhile, every stock market cycle has its leaders and laggards, often among emerging markets. Moreover, leaders often lead in both directions. Among major US stock market indices, the NASDAQ Composite led last year's rally and is currently underperforming. We’d also note that financial shares usually lead recoveries as we saw with Citigroup and Merrill Lynch in the US. They have lost their uptrend consistency in recent months and are currently underperforming the S&P. There is a similar underperformance from bank shares in other stock markets, such as in Japan and the UK.

"In addition, cyclical shares usually underperform in the early stages of a stock market recovery but outperform late in the cycle, often continuing to appreciate after the main indices have peaked. The US oil giant Exxon demonstrates this as it is currently showing relative strength. Similarly, the UK Oil & Gas Index has only recently broken up out of its base formation. Needless to say, these are only clues, but they have served us well in previous cycles. Meanwhile, the current broadening pattern does not look like a typical consolidation within an ongoing uptrend. While comparatively large trading ranges can be continuation patterns, they are more often top areas or at least penultimate highs. Consequently I maintain that the S&P saw last its penultimate high for this cycle in March and that the S&P 500 index is in a secular bear market, having completed its secular bull trend in 2000. What if I’m wrong? Then abundant liquidity, GDP growth, and rising profits will continue to pump up the stock market, and we will see the S&P 500 Index break above 1200 and not look back. Nothing is impossible, but this would run counter to all the post bubble action that I have seen or read about. On balance, our technical signals suggest that of the three things the S&P can do from current levels move significantly higher, range sideways, or retrace much of the earlier advance, the odds greatly favor sideways to downwards.

"I believe we are in the early years of an inflationary process. The Fed and other developed central banks will attempt to head this off, and the cure for inflation is high interest rates and a liquidity squeeze. This would weigh heavily on the debt-burdened US economy, resulting in a potentially severe recession, rising unemployment, and possibly renewed deflationary pressures. Aware of that risk, this Fed would almost certainly continue to err on the side of inflation. PIMCO 's Bill Gross, manager of the the world’s largest bond fund, recently told the Financial Times that the global economy was more vulnerable to a downturn than at any time in decades. Gross's litany of worries included, among other things: US consumers are too deeply in debt and vulnerable to interest-rate increases, the US government is too deeply in debt, and there's too much debt in Japan, the world's second-largest economy. There's a housing bubble in the United Kingdom. The US dollar is overvalued by 20%, propped up by an inflow of foreign capital that can be reversed at any time. My view? Bill Gross is certainly not a cheerleader and his warnings should not be dismissed lightly. No experienced analyst can look at the global imbalances mentioned by Bill Gross and others, and not recognize that there are potential accidents out there, waiting to happen. I maintain that the Fed is behind the curve on rates, intentionally, as pre-emption has not been considered as a policy this time because the Fed wanted some inflation. Now that it has succeeded, there are two important factors that would prevent Alan Greenspan from lifting the Fed Funds Rate to 3% and 5%. These would be an exogenous shock such as a massive terrorist attack or spike in the oil price, and/or a sharp sell off by US stocks. Both risks are sufficiently high that we cannot afford to ignore them.

"Overall, the tide has turned in the direction of inflation. This is because in recent years central banks have clearly demonstrated their determination to fight deflation, led by the US Federal Reserve and the Bank of Japan. With the understandable blessings of their governments, they seek inflation of least 2% as insurance against the risk of outright deflation. Psychologically, this is an irresistible choice for politicians in the current economic environment because deflation, were it to occur, would be here and now. In contrast, new inflationary cycles usually run for a number of years before the problem fully enters the public consciousness. By that time, some other politician is likely to be in office. However, to achieve the inflation target of at least 2%, against a background of often high debt at government and/or consumer levels, and to simultaneously offset deflationary expectations and pressures from extremely competitive global manufacturing, they will err on the side of too much credit creation (the electronic version of printing money), rather than too little. Consequently, outbreaks of inflation are likely to become increasingly apparent during periods of global economic expansion in a cycle that may last a generation. This will have a profound effect on markets. Long-dated government bond markets are likely to see the worst overall performance during the next decade or more.

"An inflationary cycle will be most bullish for the supply inelasticity investments and speculations, such as metals, although these will remain very volatile. Gold bulls will require patience because bullion is likely to underperform relative to other metals, albeit within an overall uptrend, until an inflationary psychology is firmly established. Silver remains my biggest position at present. In the last two months, silver has seen a lateral range forming. From the weekly chart we gather that this range has stabilized more or less above the upper side of the long bottoming pattern which lasted for ten years. The point and figure shows us that within the most recent ranging pattern we have rising lows and almost equal highs, telling us that demand is beginning to overstretch supply at the bottoms. This is quite bullish. Of course this is not going to be a smooth ride not least because of the attitude toward silver in the market. However the balance of probability is that this will rise more than it falls.

"Relative performance within individual countries will be determined by expectations concerning inflation, the underlying currency and the supply of bonds. Currency trends usually move in shorter trends of two to seven years, relative to stocks, bonds and commodities, because no economy can withstand a persistently strong currency against its main trade partners. These trends will be influenced mainly by short-term interest rate differentials and expectations concerning supply, inflation, and GDP growth. A little bit of inflation can be bullish for stocks because many corporations are likely to have more pricing power. However strong inflation is bearish in real, if not nominal terms. However, Wall Street's secular bear trend since the bubble burst in 2000 has ushered in a generation of p/e contraction. Consequently, Western markets are likely to range broadly sideways, at best. Japan should do better because it was out of sync with Wall Street during the 1990s. Emerging markets should do best during the rally phases."

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