The task of today’s Daily Reckoning is to figure out if asset prices can rise a world of reduced leverage where investor attitudes to debt have changed from indifference to revulsion. Also up for discussion is the psychological effect of the last 18 months on Baby Boomers and their willingness to stay in invested in both stocks and houses now that they’re closer to retiring.
Now, to the markets. You may remember that yesterday we asked chartist Gabriel Andre to confirm or deny the claim by Chart Partners Group that the S&P ASX/200 could rise by another one percent-and then fall by 19%. It turns out Lord Swarm had published his own forecast yesterday in our sister letter, Money Morning.
“What is the target then for this current rally,” he asked. ” Well, as we anticipated a few months ago (see Money Morning dated May 14), it is likely that the next significant objective will be around 4,550 points. That is 300 points ahead, or 7% higher [than yesterday’s open]. The Bollinger bands are widening, the volatility is up. The target could be reached soon.
“Two key points argue for an exhaust at this level of 4,550 points. First, the Relative Strength Index (RSI) clearly shows that the index is already overbought. You may know that a stock or index or any other asset can remain overbought (or oversold) for some time. However a high valued RSI usually means that the countdown has started for the trend in place. Here the RSI is valued at 74, above the overbought level of 70.
“Second, the level of 4,550 points corresponds to the 38.2% Fibonacci retracement ratio of the decline occurred between November 2007 (point A) and March 2009 (point D). It is likely to be a resistance area where investors and traders will take profits.”
There you have it. Expect a rally to 4,550 then profit taking. You heard it here first. Or second, if you read Money Morning yesterday.
Sometimes technical analysis sounds like a foreign language. In many ways, it IS a foreign language. It makes the claim that the best way to understand and trade the market is to be fluent in the vocabulary of technical variables and chart patterns. It’s a big claim.
Your editor does not pick up foreign languages easily. But just for grins, we asked Gabriel to try his technical speak on the CRB commodities index. It’s been up, then way down, then back up. We wondered-all the fundamentals of supply, demand, growth, and recession aside – what the index looks like to trader with an eye for patterns and mind full of oscillators. We showed him the chart below, on to which he put the lines you now see.
His commentary was to the point: “23.6% Fibo (the very first retracement level) hit on last June 11 (point C), is likely to be the immediate target, around 265 points. A correction had followed then a rebound on a support level (green horizontal line) valid since last March. I expect the resistance at 265 points to trigger profit-taking. It should hold, as many commodities are a bit overbought on short-term basis.”
Speaking of commodity prices, the RBA published its commodity price index yesterday. It was, in the spirit of the season, less bad than expected. The RBA said the index was flat in July after being down 3.8% in June. Coal and wheat were down, but beef, veal, and iron ore were up.
Like all other investable asset classes, commodities are trying to find a natural price floor. That floor would be based on the long-term demand in the real economy for tangible assets. And with commodities, you at least get predictable cycles where overcapacity in production leads to falling prices. Or, as we saw in 1999, years of underinvestment in productive capacity coincided with a surge in demand, creating a huge gap that led to spiking prices.
Now things are levelling off at a higher equilibrium. But what about other asset classes? Specifically, returning to the question we began today’s letter with, can asset prices make new highs without new leverage in the system? And exactly who is willing to take on leverage now anyway?
This is the question that we think the markets are working through right now. You get the sense that people feel better about the economy. And they feel like the worse of the financial crisis is over. At the very least, investors feel that systemic risk-the chance of a total meltdown-has been averted. There are still risks, but perhaps not as grave as the risks faced once Lehman Brothers collapsed in September of last year.
One reason investors feel better is that governments have now stepped in and made clear they won’t let any systemically important firms collapse. That’s been a messy process. But it seems to have reassured people that the worst case scenario is impossible.
We’re not so sure. If anyone has learned anything in the last two years, it’s that the improbable is still possible. It only has to happen once, and it only has to happen to you for an event to derail a lifetime of planning. We reckon investors will bear the lessons of the last two years in mind as they approach markets today.
But it sure doesn’t look like that’s happening now, does it? So what, really, is happening? We reckon one explanation is that the financial system has simply doubled down on itself. Banks and institutions have partly shored up their balance sheets by selling new shares or, increasingly in Australia, bonds. They’ve taken the rest and made financial bets which generated paper profits and the false dawn of an earnings recovery, which has been priced into stocks.
You wonder though, how much of the liquidity made possible by central bank policies and government fiscal stimulus has simply found its way right back into speculating on higher asset prices. Is this a recovery in asset prices that simply duplicates the speculative excesses of the credit bubble peak last year? Hmmn.
If the entire financial world-institutions and retail investors alike – reverts back to the bubble era thinking, then you can almost guarantee further losses. This is the debt-deflation scenario. But it’s a scenario where the losses are taking grudgingly, drip by drip, in the face of furious attempts to releverage the system.
We were going to say that recommitting to the bubble could guarantee a retesting of the 2003 lows on stock markets. But this time, it may be a bit different. Because the monetary authorities will not allow a large firm (or sovereign state?) to fail-and because people believe there are no firms whose failure is big enough to take down the system-you’ll get a very different kind of crisis in phase two.
The credit bubble cannot be reflated. But the rate at which asset markets grind lower (in real terms) can be drawn out if there are no catalysts to cause a panic and if liquidity efforts by central banks remain in place. For example, we reckon that Aussie banks and fund are carrying hundreds of billions of dollars in unlisted assets on the balance sheet that are probably worth a lot less. But those assets don’t have to be re-valued continuously (marked to market). We reckon there are serious problems with those assets.
For one, there is the composition of them. Are they infrastructure funds? Listed property trusts? Commercial real estate loans? And then, don’t forget, there are the listed assets, which also include commercial and residential property.
Our main point is that asset values are probably much lower than investors would like to admit. But because of changes to accounting rules, no one has to realise any losses on these assets which would require more capital or, in some cases, force a firm into solvency once the value of the asset was written down.
So the zombie assets slumber on the corporate balance sheets in the hopes that everything recovers, the bubble is reflated, or excess bank reserves make their way into the economy to inflate asset prices (although in real terms, investors will lose ground).
In any event, you can be sure the “authorities” would like you to believe that a gradual reflation of housing and stock prices means there is nothing to fear any longer. But they may be underestimating one major change in investor psychology over the last two years: fear.
It is all well and good for the financial industry to turn Fed credit into asset price speculation. But at the household level, how are investors going to behave? We reckon most investors who expect to retire in the next ten years cannot afford to have another year like last year. The entire investor class that has seen stock and house prices rise for most of their adult life is counting on those assets to live off of in retirement.
Now they have a choice: stay in the game to make back some of what you lost and benefit from government reflation policies. Or cash out, hope you have enough to get by with, and adjust your expectations for a less lavish retirement than you had hoped for.
No one likes downsizing his expectations, of course. But as was discussed last Friday at our Debt Summit, attitudes towards wealth and debt may also move in cycles. Those cycles are informed by the unique experience of each generation. If you’ve experienced nothing but prosperity and rising stock and house prices, you’re happy to take on debt and you tend to discount risk.
But one good wealth-destroying recession is the kind of thing to temper both your expectations and your attitudes toward risk. We would not be surprised at all to see investors begin with holding liquidity from the stock and property markets. They are eighteen months closer to needing that money than they were when the crisis began. We suspect this will modify some behaviour.
Maybe it’s not all that complicated. We’ll see. But it could be that a permanent feature of this recession-and of globalisation for that matter-is lower real wages and income for Western workers. For Western workers to become retirees, then asset prices will have to bridge the income gap. However, as Glenn Stevens himself admitted a few weeks ago, the credit bubble created an exaggerated expectation about the rate of return you can expect from stocks and houses.
We reckon those investors who are first to realise this new reality of expectations will profit best. That is, they will modify their asset allocation plans accordingly. They won’t liquidate entirely. But they will probably (and prudently) risk much less of their capital, while putting the rest to work buying tangible assets at a good valuation. More on this subject tomorrow!
for The Daily Reckoning Australia