A summer slide or a correction?

Last Friday's disappointing US non-farm payroll employment numbers for May have highlighted that the US economic recovery remains anaemic. Although these figures are notoriously volatile (and subject to change), stock markets have clearly taken these to heart, adding to a slide that has taken world equities down by more than 5% since May 2nd.

It seems that the "Sell in May, go away adage" is obviously proving correct. It also seems to be doing so for the second year running.

Between the end of April and the beginning of July last year, US indices fell by a total of 16%. In 2010, the reasons for the market's weakness were similar: kicked off by the so-called "flash crash" on May 6th (when the Dow fell nearly 7% in a span of 47 minutes), sentiment was undermined by worries about the US economy and concerns over European debt.

Sound familiar?

Last year, the remedy was government and central bank action which resulted in the announcement of QE2 in August and the first of many rescue packages for indebted Eurozone members (Greece and Ireland). As a consequence, after the early summer bloodletting, US indices rebounded to finish the year up 12.8% overall and by 23% from that mid-summer low point.

So what's different this time?

The US economy is still anaemic, but the Federal Reserve would seem to have less room for manoeuvre than was the case a year ago: a third round of QE would be politically tough with Republican deficit hawks in control of the House of Representatives since last November. These upstanding individuals are already slavering at the prospect of bringing the Fed to heel, and a third round of QE, whether necessary or not, would ensure further support for this.

It is also unclear as to whether or not QE has actually achieved its objective, if that objective is defined as anything other than boosting the stock market. In reality, banks have simply sat on the ‘extra’ cash and, as a consequence, credit growth has continued to struggle. Banks remain more concerned about repairing their balance sheets rather than in making new loans to businesses or homeowners (in the case of the latter, there is no evidence that the housing market is starting to recover). Banks may have received cheap credit from the government but continue to feel that this does not place them under any social or national interest obligation.

In Europe, by contrast, nothing seems to have changed. The Europols still seem in institutional denial about the likelihood of a Greek default - sorry, "reprofiling" - whilst ensuring that enough money is lent to the struggling country to enable the whole thing to be deferred for another 9 months or so. Borrowing more money to repay the principal and interest on the loans you already have is clearly a well thought out, sustainable, long term strategy. It would seem that the 80,000 or so Greek protesters who took to the streets last weekend might have other views.

So - there are plenty reasons for markets to be unsettled. Again.

It is also the case that such concerns are valid enough to continue depressing markets for a little while longer, particularly if the global economic data continues to be sluggish over the next few months (as a result, for instance, of the after effects of the global supply chain shocks from Japan being obviously under-estimated).

For how much longer and by how much more markets could fall, is, quite frankly, anyone's guess.

What seems clear however, is that, like last year, rebounds in markets can be equally dramatic. We have been continually surprised at how markets can lurch around. From depression - where all bad news is viewed as cataclysmic. The bottom is usually heralded by Nouriel Rubini forecasting meltdown on CNBC, and Richard Russell's charts forecasting a 50% market decline. To euphoria - where all bad news is viewed as being "in the price" and with central banks doing "whatever it takes" by flooding the system with more cash.

Most particularly, however, the one major thing that hasn't changed is that a sluggish global economy will result in inflationary pressures tailing off (particularly once the year ago price comparisons are no longer a feature) and interest rates remaining at very low levels.

It's interest rates, we think, that remain the key to market performance: investors won't (and can't) sit on cash for very long since the real returns from holding cash remain negative. The slightest evidence that the global economy is recovering poise will result in that sidelined cash charging back.

So the question is, although it's easy to sell now, can one be sufficiently prescient to spot the appropriate point at which to buy back in? Extensive studies of market sentiment suggest not: the biggest market outflows (selling) by retail investors take place just at the point when markets bottom, whilst the biggest inflows (buying) take place at the top.

For our part, we feel that the summer sell-off looks, at present, like a bout of "healthy profit-taking", and are occurring at a time when volumes are seasonally lower. We like having a bit of cash to play with to pick up cheaper equity ideas, but are not running for the hills and stocking up on canned food.

At least not yet. The world is not scheduled to end until 2012, right?

Steve
e-mail: steve.davies@javelinwealth.com
contact: +65 65577186

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