Why the stock market's ready to tumble
By
Associate Editor
David Stevenson Oct 29, 2009
Print this article
Politicians: borrowing too much
Interest rates are going up. And shares look to be heading down.
The world over, politicians have been spending and printing new money like mad. Now, many of the world's central bankers are getting the jitters that all that additional money will stoke up future inflation. So they're starting to increase the cost of cash.
Meanwhile, bond market fears about government borrowing levels are growing, and economic data is getting worse again.
It all adds up to some very nasty shocks in store for stocks – and yesterday's falls suggest that investors are just starting to grasp that...
In August, Israel raised its interest rates. Three weeks ago, Australia did the same. On Tuesday, India's central bank ordered the country's lenders to keep more cash in government bonds, which will reduce the money available for private lending. And yesterday Norway hiked its overnight deposit rate from 1.25% to 1.5%.
There's a definite trend here. What's going on?
The beginning of the end for cheap money
The credit crunch was the logical end result of a credit bubble which was caused by too much money being too easily available. So naturally, politicians have been trying hard to drag the planet out of recession by spending, borrowing and printing even more money via "quantitative easing".
On the surface, that sounds mad. And yes, you're right, it is mad. When in a hole, it's best to stop digging. But the politicians reckon they know best, and their "solution" has been yet more of what caused the problem in the first place.
For a fuller version of how daft this debt obsession is, it's well worth reading Bill Bonner's latest column in this Friday's issue of MoneyWeek magazine (if you're not already a subscriber, you can claim your first three issues free here). But for now, back to those rate hikes.
It seems, at last, that many of the world's central bankers have woken up. They're now getting the jitters that all the additional cash sloshing around will stoke up future inflation. And they've concluded that the simplest way to cap this is to start raising the cost of borrowing money.
It certainly makes sense to try to nip inflationary pressures in the bud. Recent upswings in property prices and soaring commodity costs in particular, are likely to filter into higher consumer prices eventually.
But here's the downside.
The real villain of the piece remains too much government borrowing. Higher interest rates won't prevent politicians from thinking they can save the planet by spending lots of money they don't have. Public spending will continue, even if pseudo-recoveries – such as the current one – which are almost entirely government-inspired, simply can't last.
Governments can get away with that at the moment, because central banks are effectively buying up their debt via that quantitative easing, and there's not much competition for funds because the private sector isn't borrowing right now.
However, as David Roche of investment consultancy Independent Strategy writes in the Financial Times, "quantitative easing programmes will have to end sooner or later, and eventually the private sector will start to borrow again. Then yields on government debt will start to rise, back towards at least the average level of the 1990s and perhaps even higher as inflation expectations gain hold".
And the deeper that governments are in the hole when that happens, the more yields will rise – because the more risky and indebted the borrower, the higher the return a lender will demand for taking the risk of lending to them.
Special FREE report from MoneyWeek magazine: When will house prices bottom out - and how will you know?
- Why UK property prices are going to fall 50%
- When it will be time to get back in and buy up half price property
Why shares prices will fall
That would be very bad news for asset prices in general, and stock markets in particular. As higher and safer returns become available elsewhere, this will push up the return investors demand for taking the risk of investing in shares. That will drive down share prices.
So it's small wonder that hints of global monetary policy tightening are causing shudders in the markets. Of course, if there were signs of genuine growth in the economy, then that could help offset the impact of tighter money conditions. And recently equity bulls have been able to point to company profits "beating expectations" as a reason for prices to keep climbing.
But as John Stepek pointed out in yesterday's Money Morning (What BP's results tell us about the state of the economy), where businesses have appeared to do well, it's been because they chopped their costs super-hard rather than grown their sales. The latter have generally fallen sharply. But there's a limit to how many costs can be cut. If you want growth, then sooner or later, people have to feel better about spending.
And that's not happening. Quite the reverse, in fact, particularly in the States, where consumer confidence is slumping again. Home loan applications for last week fell 12% on top of a 14% slide the week before.
It all means that the 'cash for trash' stock market rally, which has been based on cyclical shares surging in the hope of a sustained economic recovery, looks very much like another bubble about to burst. And yesterday's 2.3% drop in the FTSE 100 could be just the start of a major pullback as investors realise this.
Stick with cash or high yielders
Recently we've avoided cyclicals because we've reckoned them to be too dangerous, and have recommended cheap, higher yielding 'defensive' stocks - such as non-life insurers (Here's where to find the cheapest stocks on the market) - which don't need economic growth to make their money. Take a look at the Bloomberg chart below.
The red line is the FTSE 350 index, the blue line shows the FTSE higher-yield index (which tends to consist of more defensive stocks) divided by the FTSE lower-yield index (which tends to contain more economically sensitive growth stocks).
As you can see by the falling ratio, the market value of high-yielding stocks has declined relative to that of the low-yielders during the recent market rally. If a major pullback is on the way, clearly selling out completely would be the best bet. But if you want to keep some money in the market – and that would be understandable, given that we can't know precisely when a big correction will come - high yielders look the place to be.
Our recommended article for today
Your brain's tendency to focus upon only the most recent information can be disastrous for your investment decisions, says Cris Sholto Heaton. Here's how to get around it.
Published in
Stock markets
| More
articles
by
David Stevenson
Related articles
-
By John Stepek, Nov 12, 2009
-
By Matthew Lynn, Nov 06, 2009
FREE - MoneyWeek's daily investment email
Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.
