Markets since Tohoku: consumer sentiment rules

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During and since the massive Tohoku earthquake that hit Japan on March 11, global financial markets have been characterized by a high degree of volatility. I thought it would be worthwhile to compare how the different markets reacted and what trends I could pick up.

Hard currencies were particularly volatile. The euro was by far the most stable of them all. In the following chart I depicted the yen, US dollar and British pound against the euro. The yen initially strengthened significantly against all currencies, but intervention saw the currency weakening significantly until a day or two ago. The US dollar weakened from the outset, while the British pound was relatively strong. The Eurozone’s debt woes surfaced again at the start of the week, when the euro weakened significantly against other currencies.

Sources: I-Net Bridge; Plexus Asset Management.

In comparing the major stock indices, I decided to do so in terms of euro instead of US dollar, as is normally done, due to the latter’s relative weakness.

It is very interesting that, until the end of last week, the MSCI Emerging Market emerged as the stronger equity market, followed by MSCI Europe. Since then the euro has weakened while European shares have fallen.

Sources: I-Net Bridge; Plexus Asset Management.

The yields on 10-year Government notes initially fell immediately after the earthquake, but rose strongly afterwards on expectations that Japan’s earthquake will have limited impact on the global economy. Japan was the exception where the yield remained relatively steady, though. Over the past week the yields on the respective government bonds turned south again, probably due to the fact that Japan’s recovery from the disaster will be more prolonged than originally anticipated. On Monday two issues came to the fore: Firstly, German bond rates fell as Greece indicated that the country wants to reschedule debt. That refueled worries about the debt situation in the region and the possible impact on regional growth. Secondly, US Government debt was de-rated by Standard & Poor’s, resulting in a rise in the yield on the 10-year US Government note as bond prices fell.

Sources: I-Net Bridge; Plexus Asset Management.

In comparing the commodities, I have also expressed them in terms of euro instead of US dollar in light of the latter’s relative weakness. Silver was by far the best-performing commodity since the day before the Tohoku earthquake. Next was oil, followed by gold. Industrial metals were soft compared to the other commodities.

Sources: I-Net Bridge; Plexus Asset Management.

Is somebody pulling off a Hunt Bros type of cornering of the market as in 1979/1980? I will rather hold gold than silver, but will not short the latter!

Sources: I-Net Bridge; Plexus Asset Management.

But where does it leave the markets?

From a long-term historical point of view the valuation of the S&P 500 index, as measured by Prof. Robert Shiller’s Cyclically Adjusted Price Earnings Ratio (CAPE or PE10), remains at the upper end of the band of the range from 1881 to 1997. The current PE10 is 23.06 compared to the historical average of 16.4 – a massive 40.6% overvaluation should there be a mean reversion!

In previous articles I referred to the historical relationship between the Conference Board Consumer Sentiment index and the PE10 or CAPE of the S&P 500 since 1998. What the relationship is telling me at the moment is that, given the current PE10, the market expects the Conference Board Consumer Sentiment index to rebound to the 75/80 level from the current level of 63.4.

But what if the market is wrong and consumer sentiment remains unchanged? In that case the market will move back to the historical regression line where the PE10 would be 20.46. That means the market will fall back 11.3%.

A similar relationship exists between the Conference Board Consumer Sentiment index and the yield on 10-year Government bonds. Currently the 10-year note at a yield of 3.44% is slightly overvalued given the current level of the Sentiment index that indicates a fair value of 3.60%.

Yes, that’s what it boils down to: Consumer sentiment – if you can read it, you can read the markets!

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