Andy Xie
July 17, 2009
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作者：謝國忠 | 评论(0) | 标签:谢国忠, 股市, 熊市, 通货膨胀
The summer dip isn't over
Andy Xie
July 17, 2009
There is a saying in the stock market: sell in May and go away. Fund managers tend to go on holidays during the summer. Before they go away, they tend to shift their portfolios into a conservative position. In the statistics jargon it means decreasing the portfolio beta. When all the fund managers do this, it amounts to a significant reduction of risk appetite in the market and can push the market down. What is occurring now seems to affirm this saying. Stock markets around the world (except China's A share market) have been trending down since mid-June. The US's S&P 500 index bottomed in early March at 676, peaked at 946 in mid June, and declined to 901 by July 13. Similarly, Hang Seng Index bottomed at 11,345 in early March, peaked at 18,888 on June first, and declined to 17,663 on July 13. Other stock markets have shown similar trends.
In the past few days stock markets have regained most of their losses due to better earnings from some financial institutions and better predictions of future sales by some technology companies. The financial sector earnings, in my view, are a distribution story and don't predict the earnings for other companies. The IT sector, as I wrote in my previous article, is experiencing creative destruction. Its pie is shrinking. But there are winners too. Hence, good predictions from some companies don't suggest that the whole industry has turned around. When the second quarter earnings from all companies are reported, markets will be concerned again. The odds are that the declining trend will continue into August.
At the end of 2008 I predicted a big bear market bounce in spring, 2009. The bounce would fizzle out in the fourth quarter of 2009 as inflation concerns trigger the expectation of interest rate increase. I modified this view two months ago to add a correction in the middle of the bear market rally, i.e., the market would be M shaped in 2009. The reason for the change was that economic data couldn't improve as fast as the market was hoping. The disappointment would cause a mid-year dip. The market was excited by improving production data in the second quarter. I thought that it was mainly due to inventory cycle and final demand data would disappoint. The economic data so far affirm my expectation. I think that final demand would only improve marginally in the third quarter due to the delayed effect of fiscal stimulus, which would improve market sentiment again. The expectation for interest rate increase will weigh on the market in the fourth quarter and bring an end to the bear market bounce.
All asset prices seem to be correlated to risk appetite. The most important is the dollar's inverse correlation with stock market performance. The dollar index ('DXY') peaked in early March at 89 and has been fluctuating around 80 since. Even though the dollar has been on a downtrend since 2002, declining about one third in value, it has staged numerous bounces along the way. These bounces reflect risk appetite in financial markets. The dollar remains a safe haven asset. When risk appetite drops, the dollar tends to rise. Rising risk aversion drives such dollar bounces.
Oil price also shows high correlation with the dollar. It doubled to $70/bbl from the March low but has tumbled to $60/bbl since the dollar began to bounce in early June. I think that the relationship between oil price and dollar is mostly correlation and some causality. In theory, if the dollar decline by one third and everything else remains the same, it roughly justifies 50% increase in oil price. However, the correlation between oil price and the dollar is far more sensitive than that. For example, 11% decline in the dollar index in the spring was accompanied about a doubling in oil price. Merely 3% bounce in the dollar since has been accompanied by 14% decline in the oil price. Liquidity, driven by risk appetite, drives both the dollar and oil price in the short term.
Risk appetite is determined by the push factor-interest rate and the pull factor-economic growth. When growth is high and interest rate is high, risk appetite is moderate. When growth rate is low and interest rate is high, risk appetite is low. When growth is strong and interest rate is low, risk appetite is high. This scenario fits the situation between 2003-07. When economic growth rate is low and interest rate is also low, as the world is in now, risk appetite fluctuates with economic data and policy actions.
I think that the global economy bottomed in the second quarter and would start to show some growth in the second half due to the delayed effect of fiscal stimulus. With a broken financial system, monetary stimulus doesn't work well. The market thinks that the global economy bottomed in the second quarter also but expects more growth in the second half. I think that the developed economies may show 1-1.5% growth in the second half after 6% decline in the previous four quarters. The market was hoping for much more. The anemic data into the summer have brought some reality to the market. The expectation is adjusting accordingly.
However, when the economic data improve significantly, probably in September, financial markets may become enthusiastic about growth prospect again. At that time, inflation risk would still appear low. Markets could conjure up the scenario of strong growth and low interest rate. The enthusiasm could bring the second wave in this bear market rally. Stock markets and commodities could regain or surpass their spring highs.
Neither assumption-low interest rate nor strong growth is realistic. Instead, the world is moving towards high interest rate and low growth rate, i.e., stagflation. Before the financial crisis, the global economy experienced nearly 4% growth rate and half as much inflation. In the coming five years, I believe the best scenario would be half the growth and twice the inflation. The lower growth rate is due to (1) lack of rising leverage as a driver for demand and (2) lower productivity growth rate as the beneficial effects of globalization and IT have been absorbed. The higher inflation is due to the surge in monetary supply in coping with the financial crisis. The excess supply of money will become inflation overtime.
Financial markets are discussing exit strategies for central banks-when and how to retrieve the excess money supplies before they become inflationary. Central banks are reluctant to discuss it because they fear that it would lead to the expectation of rising interest rate, which would dampen economic recovery. This willingness to err on the 'loose' side could boost long term inflation rate. Central banks still don't recognize the nature of the current downturn. It is not just cyclical. Schumpeterian creative destruction is a big part of the current downturn. As outdated businesses shut, it takes time for the laid-off workers to find alternative employment. This is why the global economic recovery will be anemic and a 'jobless' one. When central banks see high unemployment rates, they see economic 'slack', i.e., stimulus could lead to more growth without causing inflation. If central banks want to fight Schumpeterian creative destruction with easy money, it could lead to high inflation and even hyperinflation in some cases.
In the same context financial markets are speculating about a second round of fiscal stimulus, especially by China and the US. The purpose of the speculation is to alleviate the growth fear among investors, i.e., more stimuli could always be applied to cope with low growth and, hence, you can invest without fear. A second round of stimulus is quite unlikely, in my view. The huge budget deficits in Japan, Europe, and the US could make more stimuli backfire. Bond markets may decide that governments would all go burst and refuse to buy more fiscal bonds. Political backlash against high budget deficits is just beginning and making another round of fiscal stimulus difficult to win support.
China has low budget deficit and could afford a second round of stimulus if it wants. However, China's budget deficit is not as simple as it appears. The massive increase in bank lending, for example, increases budget deficit indirectly as the loose lending could lead to bank losses that the government is ultimately liable. The increased debts at local government-owned companies should be part of the fiscal deficit. Still, it is fair to say that Chinese government's overall financial situation is good enough to support another round of stimulus. But, it still wouldn't bring back sustainable growth. The current lending boom has led to increased economic activities relating to government or SoE-led investments. There are few signs that the growth is spreading sufficiently to private investment and consumption to create a self-sustaining growth cycle. The current round of stimulus has improved economic growth but has also increased imbalance in the economy. A second round may add more to the negative side then the positive.
Even though the second round of stimulus is quite unlikely for the foreseeable future, financial markets will continue to speculate on its coming, especially when economic data are weak. Investors need stories like this to work up their courage to take the speculative plunge. When enough investors believe a story like this, it impacts markets and rewards its believers in the short term. This is why there is an infinite demand and supply for story making. When the second round stimulus becomes too old to be believable, there will be another story to catch investors' imagination.
Imagination is important when interest rate is low. Low interest rate by definition subsidizes borrowing. Ceteris paribus, low interest rate increases demand for speculation. Such speculation is rewarded if low interest rate simultaneously leads to economic recovery. In the past two decades it was almost always the case. Consumers in the west would respond to it and borrow more to spend. Hence, low interest rate could quickly lead to a broad based recovery. It paid to speculate when interest rate was low.
The difference now is that the consumer leverage in the west is too high. Even at zero interest rate western consumers couldn't borrow to spend. Hence, the transmission mechanism between low interest rate and demand creation is broken. On the other hand the transmission mechanism between low interest rate and financial speculation is alive and never better. Here lies the danger for speculators: the broad economic recovery wouldn't come this time.
Speculation on short-term market movement is mostly futile. Most market folklores, if not all, are coincidences. The statistical evidences are too few to make the correlation meaningful. The 'sell in May and go away' folklore isn't more meaningful than others, even though the fund managers' vacation phenomenon in the summer makes it sound more plausible. There are just enough exceptions to make the relationship not reliable.
Herd psychology and structural bias are the only significant factors for making predictions. Stock market has a bullish bias. Most of its participants invest with other people's money ('OPM'). As the bonus in a rising market far exceeds the punishment in a falling market, the structural asymmetry gives the market the bullish bias. This factor is especially important when interest rate is low. Savers are incentivized to look for alternative investments to bank deposits when interest rate is low. Bullish fund managers are more likely to attract flow from savers. When market is rising, savers could be caught in the momentum and shift more to stock market from bank deposits. The combination of this herd behavior and fund managers' structural bullish bias leads to market spiking up from time to time in a low interest rate environment.
Such market spikes can reverse on their own. Any spike will attract profit takers. Companies want to take advantage of such opportunities to raise funds. The outflow can bring down the market. The correction that we are seeing now falls into this category. As interest rate remains low, the correction will attract new inflow that leads to a new spike. This is why I expect a second leg to this bear market rally in the autumn.
So far improving economic data are mostly on the production side due to inventory cycle. Final demand data are yet to improve significantly. They could show improvement in the autumn, which lends more support to bullish sentiment. Hence, the second leg in this bear market rally could be quite vigorous also.
The bear market rally ends when interest rate rises due to inflation expectation. As I have argued many times in this page, the global economy is more inflation prone in the future than in the past. Low growth doesn't mean no inflation. The excess money supply released during the financial crisis will become inflation first through high commodity prices. The pressure for cost-of-living adjustment in the labor spreads the cost push to wage increase. This spiral turns all the excess money supply into inflation. When this prospect becomes apparent, probably in early 2010, market expectation will shift to big interest rate hikes. I think that the Fed will raise interest rate by 300 bps over the next 18 months. Other central banks will also raise interest rates, probably less. High interest rate kills the power of imagination in the stock market and brings the end to this bear market rally.
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