Stock markets might not bottom out until 2014
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Associate Editor
David Stevenson Dec 11, 2008
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There's still a way to go
Another day, another bull. Yesterday, the strategists at Merrill Lynch joined the ranks of the optimists with an upbeat forecast for European stocks.
To be fair, they're not as gung-ho as some of their rivals. They still see big risks out there.
And looking what's happening in the US, and also at a measure that's been a pretty handy guide to major market tops and bottoms for more than 100 years, they've every right to be worried…
Analysts are upbeat, but economists predict the worst
This week the strategic thinkers at both Credit Suisse and Deutsche Bank have been busy predicting 20%-plus gains for stocks in Europe - including Britain - by the end of next year.
The latest converts, the Merrill Lynch analysts, aren't quite so sanguine. But they still reckon that a mix of even-lower interest rates, government bailouts and high-spending Obamanomics will prompt a double-digit market bounce by December 2009 - unless there's a "severe recession", when share prices could yet drop another 25%.
Trouble is, from where we're standing, a severe recession in the US looks pretty likely. In fact, a full-scale depression plus deflation could be on the cards.
Yesterday's Bloomberg survey of economists' predictions was just about as bad as it could get. US household spending is now expected to fall faster next year than at any time since the attack on Pearl Harbor in 1942.
"That sounds scary enough to me," says Harvard professor Jeffrey Frankel. "Consumers have carried the weight of expanding demand for a long time at the expense of a serious deterioration of their balance sheets".
In non-academic speak, people have spent far too much borrowed money for far too long. Now they've simply run out of cash, so the buck's stopping… literally. Consumer spending – some 70% of the US economy - is falling off a cliff, the jobless rate is heading for its highest level in a quarter of a century, and next year's likely GDP shrinkage is set to create the longest downswing in the American economy since quarterly records began in 1947.
"The big problem is there's no bottom in sight for consumers and businesses," says Moody's Capital Markets' John Lonski. "The negative sentiment makes it difficult to stabilise the situation. It's very worrying."
Obama's new deal is almost bound to make matters worse
Hence Mr Obama's planned New Deal II – a massive public spending programme, supposedly bigger and better than Franklin D. Roosevelt's 1930s original which didn't get the economy going again. Yet this new scheme, long-term, is almost bound to make matters worse.
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Why? Because government schemes always fall well short of their aims. Foe example, do you remember Jimmy Carter's Synthetic Fuels Corporation? It's not surprising if you can't – it failed to find alternative energy sources, but still blew a massive $19bn doing it.
And as John Stossel of Townhall.com points out, the first New Deal didn't fail because it wasn't big enough, but because it messed up the free market's natural regenerative ability.
"By raising taxes, hamstringing producers with arbitrary regulations and creating uncertainly about what the government would do next, business people were unwilling to invest and hire workers", he says. "Uncertainty about taxes, regulation and government policy similarly threaten recovery today. Obama must realize government has no wealth of its own and that commandeering scarce resources from the private sector only stifles the economy".
That's called 'crowding out' of business investment. In other words, Obama's scheme is a short-term fix, and a likely long-term loser.
What does it all mean for stock markets?
Cue Tobin's Q. This is a ratio developed by Nobel Prize-winning economist James Tobin to compare the market value of companies to the cost of their constituent parts, i.e. their real net asset value.
When the gauge is more than 1.0, it indicates that the market is overvaluing company assets, while a reading of less than 1.0 suggests shares are undervalued because it's cheaper to buy quoted companies than build them up.
The Q ratio on US equities has now dropped to 0.7 from a 1999 peak of 2.9. That could indicate shares are now cheap.
But think again. The ratio needs to fall to 0.3 to signal the final stage of a major bear market like this one, says Russell Napier at CLSA. How does he know? Because that's what it did at the end of the four largest US stock price declines in 1921, 1932, 1949 and 1982. That translates into the US S&P 500 index plunging another 55% by 2014.
Ouch.
But between now and then, there's certainly a good chance of a bear market rally – maybe up to two years long, so those strategists may be right about 2009 - as Obama and the US Fed manage to delay the start of deflation with New Deal II. But those efforts will eventually blow up as ballooning government debt devalues the dollar and prompts a massive share sell-off – on both sides of the Atlantic.
"Bear markets always end when they begin 'pricing in' deflation, as the value of assets falls and the value of debt stays up, so equity gets crushed", say Napier. "The results are always horrific, and equities will become incredibly cheap". Albert Edwards at SocGen has christened this period the Ice Age.
Another bull market will start in time. But as Edward's description suggests, it's still a long way away.
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