FYI | Jul 31 2007
By Greg Peel
“We shall hear any number of Wall Street analysts tell us that this weakness is to be seen in the context of a global bull market and that it is merely a correction. It is not merely a correction. It is the signal of the end of the global bull market that began several years ago, and before this near bear market is done we are likely to see share prices materially… indeed very materially… lower.”
So said Dennis Gartman, author of The Gartman Letter, following the Dow’s 311 point fall on Thursday. Following Friday’s 208 point fall, Gartman correctly tipped that Monday would bring a rally.
There are common themes found in the bull arguments that proliferate on Wall Street – arguments, the bears don’t mind pointing out, made by those holding long stock positions. The first is the coupling of a strong global economy and strong earnings. The global economy is expected to continue growing at around 4.5% despite any credit crunch. The second quarter earnings reporting season in the US, now reaching its end, shows 14% market cap-weighted profit growth with some two-thirds of reporting companies having beaten consensus estimates. Around a half of those earnings came from offshore sources. Price/earnings multiples based on forward estimates, discounted at the US Treasury rate, are now as low as they were in the nadir of 2003 just before this multi-year bull market began. They are not at 20 times plus levels like they were in 2000 or 1987.
Secondly, the subprime mortgage market is a small percentage of the mortgage market which is a small percentage of overall debt markets and a smaller percentage of total financial markets. Sure, the subprime crisis proved contagious and has spread to all levels of debt – from junk to AAA – but this is a natural reaction in a market that had run away with itself and if credit spreads move back to more realistic levels then this can only be healthy. Junk has only risen about 200 basis points to be around 350 bps spread to Treasuries and yet it was as high as 1000bps at the turn of the century. Private equity firms may need to curb their activity slightly but they are still awash with cash looking for a home. Global liquidity has not dried up and any yen carry trade unwinding will prove temporary.
The bulls have put a positive spin on the recent correction in global stock markets, almost thanking the world for throwing up such valuable buying opportunities (while not mentioning how much they have lost in a week).
Locally, the theme is similar. TD Securities’ global strategist (a recent promotion from local chief economist) Stephen Koukoulas has stated:
“In some respects, the broad based nature of the market ructions has thrown up opportunities for buying the ‘quality’ assets that have been dumped in the flurry to exit the more marginal credit positions.”
Koukoulas believes global monetary policy implications are unlikely to be significant. The situation would have to get worse for the US to consider a cut, while Canada, Australia, the UK and Europe are likely to see more inflation-led hikes. Inflation drivers include commodities – which are the best proxy for global demand, and remain firm despite a slight correction. The global CRB index, for example, is down only 12% from last year’s peak but 70% above 2001. Emerging markets have been “caught in the backwash,” says Koukoulas, and favourable fundamentals suggest buying the dip.
From a technical perspective, the analysts at Barclays Capital note that since this bull market began in 2003, the average correction in the US S&P 500 has been 8%. Hence it is likely the current correction has further to run – it reached 6.4% – before we can return to an upward trend.
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To support the continuing trend view some analysts point to China, which has actually put on about 7% while the rest of the world has been tanking. If China is strong, the global economy is strong. The only problem is that as the Shanghai Composite keeps pushing ever northward, its PE multiples are starting to look stretched (as far as any comparative measures are appropriate). This means that one of two things must happen. Either earnings have to jump significantly to justify share prices, or share prices need to correct and pull back to levels which reflect current earnings. CommSec’s chief economist Craig James worries that the latter is the most likely scenario.
Were China to take a dive (and China rarely mucks around when it takes dives) then it would be a severe blow to already jittery global stock markets.
Nevertheless, even among the bears there is a feeling that we need to suffer perhaps a few months of correction before the credit crunch effects can be shaken out. Thereafter, however, there is no reason why the global bull market cannot recommence with more appropriate levels of risk pricing. But then there are those, such as veteran commentator Dennis Gartman, who are quite happy to suggest it’s all over red rover. This is not because Gartman has been a long time equity bear who has finally been vindicated (just as a stopped clock is right twice a day). Gartman simply calls it as he sees it in the shorter term. And what he sees at the moment are global large-cap, bellwether stocks pulling back up to 50-60%.
“In retrospect,” says Gartman, “we shall look back upon the public offering by Blackstone’s management as the very top of the bull market. They will be seen from the perspective of history as one of the ‘strong hands’ who sold their holdings to the ‘weak.’ They will be seen as the Mary Wells of this bull market, for as the ‘Old Timers’ amongst us shall remember, it was Mary Wells of Wells, Rich & Green who sold her Madison Avenue advertising agency to the public in the frenzy of the bull market several decades ago at the very top and bought the entire company back several years later when the shares of the company fell by nearly 90%.”
(And Australians will remember one Kerry Packer who, despite loving his flagship Nine Network like a child, sold it to Alan Bond for $1.1 billion because “you only get one Alan Bond in a lifetime”, and eventually bought it back at less than half price.)
In the middle of this are those who have simply withdrawn to watch the battle from the sidelines, safe in the knowledge that cash is as good as any a place to be at present and there’s a lot of dust that needs to settle before a victor can be determined.
At the very least, there are few who believe that last night’s 92 point rally in the Dow signalled the end of the scare.