Recipe for a rally: Add two teaspoons of confidence

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By Shaun le Roux

The market is enjoying a decent rally.  At last!  In early March the JSE’s All Share Index found itself languishing below 18 000 and very close to last November’s lows.  Now, it is back above 21 000 and a full 18% up from the lows of a month ago.

On Friday, the Dow ended above 8000, a 24% gain from early March when it was below 6500.

On Friday the rand traded below 9 to the US dollar having been above 10.70 a month previously.

These moves are indicative of a pick-up in global risk appetite.

And, what makes this rally in a bear market all the more impressive is that it is taking place against an extremely gloomy economic backdrop.  The US economy shed another 663 000 jobs in March and four million jobs have been lost since Lehman Brothers went under in September.  The US unemployment rate, at 8.5%, is at a 25 year high and is tipped to breach 10% before the economy recovers.  Last week, US President Obama signaled his willingness to explore bankruptcy plans for General Motors if it couldn’t manufacture a viable turnaround plan soon.

On most measures, it is clear that the globe is enduring its worst economic crisis since the 1930s and that a swift turnaround is extremely unlikely.

On the domestic front, recent manufacturing and export statistics have been dismal and last week we saw the Investec Purchasing Managers Index slump to a new low for March. Our export-facing industries are finding life very tough at the moment and as we are well aware job losses are intensifying.

The key ingredients of the dramatic global slowdown, all of which are inter-linked, are:

  • The de-leveraging of the global financial system
  • The sharp decline in US house prices
  • The collapse in the world’s credit markets
  • Confidence

The de-leveraging process will run for many years on account of the excesses that were built up in the financial system in the preceding decades.  That said, it is fair to say that the process is through its most intensive phase.

It is difficult to get bullish on the US housing market while excess inventories are the order of the day.  This means house prices have further to fall, on top of the 29% that they have fallen to date as per the S&P/Case-Shiller 20 Index, before demand picks up and the market stabilizes.   Some analysts, such as Gary Shilling, are pointing to a further 20% decline in house prices.

Governments have been scrambling for some time to free credit markets. The revised Obama-Geithner Treasury Program to purchase toxic assets from the banks has been well received by the markets.  The reason:  it implies that they are slowly but surely winning the war to unblock the credit system.  The collapse of Lehman was surely the low-point in the credit crisis, from there it can only get better, and credit spreads are off their worst levels.

The wildcard in the performance by financial markets will always be confidence

Consumer confidence in the US had already been in sharp decline for almost two years when the credit markets blew up in the fourth quarter of 2008.  What followed was a complete collapse in business confidence, hence orders from factories and global trade.  This has extended into the first quarter of 2009 with businesses clearing existing inventories while they wait for confidence to return. Japanese industrial production in February was 38% down on the prior year!

Naturally, investor confidence has been exceptionally weak in recent times.  Nothing weighs on investment returns quite like uncertainty.  Particularly when the world is undergoing a painful adjustment that involves massive de-leveraging of financial assets and a return to higher levels of savings in the West.  The full impact of this adjustment on corporate profitability and investor sentiment remains very difficult to predict.

While the future remains very uncertain, it is becoming increasingly clear that the worst is behind us.  This doesn’t mean that the de-leveraging process is through or that US unemployment has peaked.  It means that the perfect storm that was unleashed on credit and financial markets over the past six months has begun and will continue to clear over the months ahead.  Remember, bear markets don’t end when the bad news becomes good, just when it gets less bad.

It is encouraging to see that the market is rallying in the face of very weak economic data.  This implies that such gloom is already priced in.  The market has also enjoyed seeing the G20 presenting a united front at their recent summit where they largely spoke as one in their determination to provide the interventions required to stabilize the financial system. The last thing the market wants to see right now is large disagreements on the way forward and a rise in protectionism.

It is impossible to say whether the market has bottomed or whether a re-test of lows is on the cards.  We would favour the former on the basis of some of the panic having dissipated, the level of government stimulus and the very attractive valuations at the lows.  But, we have a long way to go before we can say this with confidence.

Up until a few weeks ago, investors were concerned about how bad things could get and how to avoid losing capital.  Now, for the first time in a while they are starting to worry whether they might have missed a great buying opportunity and whether sitting on cash at such unattractive interest rates is such a great idea.

Source: Shaun le Roux, Alphen Asset Management, April 6, 2009.


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