Are Markets About to Correct? A Quick Look at The Big Picture

Economics 2

If you’re reading this, I can almost guarantee at some point in your “investing career” you’ve asked yourself – “Are markets about to drop sharply“?

Fear and greed are the primary emotions that drive the stock market. Unless you’re a total psychopath, devoid of feelings and emotions, you would have experienced these feelings at some stage (if not constantly) in your dealings with the markets.

It’s for this reason that markets often rise and, usually more often, fall rapidly, rather than slowly and methodically along with fundamental changes in the economy.

This is because it’s long been known that fear is a much more powerful emotion than greed, as is highlighted nicely in this NY Times article back in 2008 at the height of the Global financial crisis.

That’s why the saying “markets take the stairs up and take the elevator down“, explains typical market movements nicely – history clearly shows that years, and even decades of investing gains can be wiped out in a few short months.

Most investors know this, which contributes to the powerful “herd mentality” described by countless scholars of financial markets. When the market starts heading south, momentum can take it far lower than the overall market fundamentals suggest it should go.

This brings us to the main question I’ll attempt to answer in this post – where are we currently at in terms of the big macro picture?

The Global Macro Situation – Two Key Concepts to Consider

Firstly, I just want to disclose that I am no macro-economist – I don’t have some fancy PhD from a prestigious Ivy League college. In fact I have never taken a single economics subject in my life.

However, there are some very simple concepts which have become very apparent to me in my short time in the markets – two of which I feel are very important to the current situation.

Probably the most important of those is that markets never go up indefinitely. As discussed in one of my earlier posts, other the past 100 years or so bull markets typically last four to eight years, and are always followed by periods of contraction in market prices.

Many a time throughout history, economists have tried to claim a “new era” in the economy whereby technological advances have resulted in the abnegation of booms and busts.

History has proven these claims of a “new normal” to be false, and I see no reason that this has changed (and will probably never change).

new era

Does this mean that selling all your stocks because it’s “been a while” is a good way to make investment decisions – absolutely not. But it’s useful to keep in mind that we will experience market declines again in the future.

Another important concept to consider is that for the past 50 years at least, and probably the last 100 years, the USA has been the main driving force in the global macro picture.

Note, I didn’t say the only driver – the global economy is an extremely complex system with almost infinite interconnected and co-dependent components.

But there’s a common saying – “when the the USA sneezes, the world catches a cold”. That’s because the US makes up such a massive percentage of global economic activity (over 20% of total global GDP), that in this highly global and interconnected economy, any contraction in US markets is almost certain to affect almost every other market in the world.

It’s therefore very important to keep an eye on Uncle Sam as any slow down in US markets likely represents problems in the broader global economy.

So, lets get to the meaty question – How are global markets looking?

The Global Macro Picture – An Overview Of The Current Situation

For a starters, lets take a look at US markets.

The chart below shows how the Dow Jones Industrial Average Index has performed over the past 12 years. It’s pretty clear that the last five or six years post GFC have been dominated by a very strong upward trend over the past six years.

Dow Jones Industrial Average monthly chart.

Dow Jones Industrial Average monthly chart.

Here’s a second chart of another major US index, the NASDAQ 100.

The NASDAQ is heavily weighted with technology based companies, and the chart clearly shows a similar upward trend to that seen in the chart of the DOW above.

One subtle difference is that price has broken above the long term trend line since about March 2013, highlighting the out-performance of technology companies over the past couple of years. This has been very visible in my trading as tech based companies have done very well for me, but warns that things may be getting a little “frothy”.

NASDAQ Monthly Chart

NASDAQ 100 Index monthly chart

One thing to note on both charts is that the indicator shown, Twiggs Money Flow, has been declining from recent highs, reaching multi year lows. Values above zero typically indicate positive conditions and we are still very much in positive territory, but a negative trend in these indicators does signal that the US markets has been experience a selling over the past few months.

Now lets turn a little closer to (my) home and look at the Australian market. The chart below shows the performance of the Australian All Ordinaries index over the past 14 years. One striking difference to US markets has been the lack of new highs, post GFC – The Aussie market has been a very poor performer, relatively speaking, over the past five or six years.

This can largely be attributed to the commodities bust as the Australian market is heavily weighted with commodity related companies.

XAO Monthly Chart

Australian All Ordinaries Index Monthly Chart

To top things off, the VIX index which charts market volatility has risen a little of late, but is still showing relatively low values, suggestive of bullish market conditions. Indicators always have some degree of lag, but still, we are not yet seeing levels of volatility which precluded major market busts such as those in 2008.

Weekly VIX index

Weekly VIX index

One Thing in Common – Testing of Long Term Support Levels

The one one thing in common with all the charts above (with the except of the NASDAQ) is that markets are seeing short term selling which is resulting in a pretty stern test of long term trend lines and resistance levels.

At the time of writing (Friday afternoon in US), the Dow Jones has declined over 500 points in a single session and is sitting right on the long term trend line at approximately 16,500. This trend has been in place for over six years, and a downwards break of this level is likely to incite a degree of panic selling.

Technical indicators such as Twiggs Money Flow are all showing short to mid term selling, price is dropping below key long term moving averages for the first time in years and market commentators the world over are coming out of the woodwork warning of impending “financial doom”.

This is definitely not a time for complacency, and one should definitely be keeping a close eye on market movements at the moment.

But price movements unto themselves aren’t the “be all” when it comes to trying to figure out what markets are going to do, and I always like to try and take a “peek under the hood” at other indicators which help paint a more complete picture of broader economic conditions.

Looking Under the “Economic Hood”

Again, as mentioned earlier, following what is happening in the US is highly important when it comes to the global economy.

No one index or indicator can paint a complete picture, but there are a few useful things to look at. The positive first:

Total construction spending remains in a healthy uptrend, albeit still below pre global financial crisis (GFC) levels. Increasing construction spending is one of the key contributors to employment growth.

2015-08-18-construction

Housing starts also remain in a long term uptrend, supporting the theory that we are seeing consistent growth in the construction space which was decimated during the GFC.

2015-08-19-housing

Total Retail trade is maintaining a growth rate slightly above CPI (inflation). This is likely supporting employment growth in the retail sector and is a positive sign for corporate profits.

Retail

Light vehicle sales, which are often used as a barometer for consumer and business confidence, remain in a strong up trend and are now at levels seen pre-GFC.

2015-08-18-lightvehicles

All the above paint, at the very least, a picture that things aren’t in terrible shape as far as the US economy is concerned. We haven’t seen an explosion of growth back above pre-GFC levels, but nor has activity remained at depressed levels.

Now for the slightly less positive signs:

The Freight Transportation Serviced Index which, surprise surprise, tracks US freight movement as an indicator of the overall health of the US economy has been declining for most of the year. This gives us a hint that there may be signs of slowing in the overall economy. Transport bellwether stock FedEx has also been in decline, strengthening this theory.

FTSI

One of the major things that concerns me is the current level of margin debt in US markets, which now eclipses pre-GFC levels by almost 20%. The graph below shows how closely margin debt levels and stock valuations correlate.

NYSE-margin-debt-SPX-since-1995

There’s a bit of a debate about correlation and causation regarding the two, i.e. do increases in margin lending cause the markets to increase, or do people increase margin lending based on increasing stock valuations?

I’m of the opinion that both concepts are applicable and we see a sort of feedback loop where rising prices and the ensuing hype cause more people to use margin lending to fund stock purchases. This in turn drives the market higher…which increases speculative fever and margin lending.

One thing is known though, and that is that high levels of margin lending make the markets a far riskier place and can greatly exacerbate volatility and the ferocity of declines when they do occur due to the margin call effect. The fact we are now experience margin levels far above those prior to the GFC is, to put it lightly, a little concerning.

BUT, if the US margin data is a little concerning, it’s Chinese data that really scares the bejesus out of me. Without getting into the intricacies of the China situation, unless you’re deaf, dumb and blind, you’d know that China has become a MAJOR player in the global economy, therefore like the US, one should pay significant attention to what is going on in China.

Thats why the astronomical growth in Chinese margin lending over the past 12 months (over 400% from 0.5 trillion Yuan to a peak of over 2 trillion Yuan), shown in the graph below should not be taken lightly.

chinese margin lending Yup that’s right, Chinese margin lending for stock purchases grew by over 400% in a single year, and margin lending as a percentage of the total market capitalisation reached over 20%!

To put that in perspective, typical levels in US markets don’t rise above 3%…

It doesn’t take a rocket scientist to figure out that the Shanghai Composite Index’s 100%+ gains seen this year have been driven by highly speculative, margin lending driven stock purchases.

The recent 30% drop in that index in just a matter of a few weeks highlights what can happen when speculation, particularly funded by margin debt, gets out of control.

To highlight the situation in the Chinese markets, here’s an excerpt taken from the Economist in April, prior to the Chinese bust :

” many of those rushing to snap up stocks are small-time day traders with little understanding of what they are buying. Chinese investors opened nearly 5m trading accounts in March, a stampede that has continued into April. A survey by China’s Southwestern University of Finance and Economics found that two-thirds of new investors last year did not complete high school

Chinese markets do look incredibly fragile and many think the current rout is just getting started. The problem has gotten so bad that Chinese government had to step in an emplace draconian controls restricting selling of certain companies.

Closely linked with the China story, the final negative factor I’m going to briefly touch on is the rout in global commodity prices (China is by far the biggest contributor to global commodities consumption growth). The price of just about every single commodity on earth, from gold to iron ore, from sugar to milk has been decimated.

We’re not talking about a few percent here are there either…most commodities have seen 25-50% declines and a lot much, much more.

As an example, Oil was trading at nearly $US120 a barrel a little over a year ago. It’s now barely over $40. Iron ore has seen similar declines, as has soft commodities like sugar, wheat and milk solids. There’s a lot of money invested in the commodity space looking very risky right about now…

OIL

The nature and source of these declines deserve a post unto themselves, however it’s a little discerning that commodity prices are declining in such a dramatic fashion.

You’d think, if the global economy was expanding, as too would the demand on resources and we would be experiencing upwards pressure on commodity prices, not the opposite. That’s a gross over simplification of the situation, but the concerns are still valid.

There is one bright side to the commodities rout though, and that is cheaper prices of key commodities for consumers, which should act as a kind of stimulus – everyone likes cheaper gas prices when we fill up at the pump.

Looking Forward – Are We About To See a Major Sell Off?

There’s definitely PLENTY of negative sentiment out there in markets right now, and it’s definitely not the time for complacency. We’ve already seen a reasonably intense sell off, and markets now look to be in short term heavily over sold positions.

There’s also plenty of cause for concern as factors such as all time high levels of margin lending in the US, but particularly in China. This could cause markets to rapidly destabilize should we see a continuation in global market declines.

The collapse in global commodity prices could also cause significant trouble should companies heavily exposed to commodity prices (such as mining/oil & gas companies and agricultural businesses) come into hardship “en masse“.

However, these issues have long been known to the markets and in most cases, haven’t come out of left field. Large scale, global, market panic events almost always are caused by some “black swan” type event that almost no one foresaw.

There are also enough positive indicators to suggest that things aren’t as bad as many of the doomsayers are suggesting, particularly regarding US retail and construction spending. The US consumer is the major driver of global growth, so as long as things remain bouyant in that department, the global outlook should be remain “o.k” at the very least.

I’m no market oracle, but I can’t see this recent period of downwards volatility escalating into a full blown recession circa 2007-8, absent any black swan event.

At the very least, markets are heavily oversold at present and should see some kind of relief rally that should last a few weeks, probably not before we see a little more of a shakeout.

Beyond that is anyone’s guess, but my gut tells me we will either see a period of sideways movement, possibly lasting a year or two, or a break out to new highs and a resumption of the long term up trend. I could be completely wrong, but that’s what I’m seeing based on the data I’ve been able to have a look at.

This could mean it’s a good time for bargain hunting, and buying quality stocks for a long term hold is never a bad idea, regardless of the short term market fluctuations.

I’m probably not going to be buying anything for the time being, but I’m not in a rush to sell everything and move to cash just yet. I will be keeping a close eye on things than usual though, and we are likely to experience a prolonged period of heightened volatility as things sort themselves out.

Happy Investing,

The Nude Investor