The Dow took a 358 point hit on Thursday. Jitters about China, oil and interest rates are apparently behind the nervousness.
The reality is the US share market, based on a number of historical valuation measures, is seriously overvalued. Therefore it’s vulnerable to any bad news that may jump out of the economic shadows.
Is this the long awaited beginning of the end? I don’t know. Those crafty little academics in the Eccles Building (the Fed’s offices in Washington) may have another trick or two up their sleeve.
Perhaps the illusion of the Fed having divine powers over the market will continue for a little while longer. Perhaps not.
It really doesn’t matter what the Fed does in the longer run. The market always has the last say. Always, without exception. Only a fool or someone who has a death wish for their capital would bet against the market ultimately giving the Fed a serious towel up.
In last Wednesday’s Daily Reckoning I warned about the unfinished job of the Secular Bear Market that started in the US in 2000. A Secular Bear takes a market from being overvalued (high P/E territory) to undervalued (a single digit P/E).
The graph in that article related to the US Secular Bear markets since 1875.
In response to that article, I received the following email from a reader:
‘I have just completed a two and a half hour webinar on technical trading. It was a full-on immersion in technical analysis of many different markets. Then I read your brilliant essay, illustrated with that excellent little graph.
‘Vern, you’re brilliant! So simple, so clear, so inescapable! But what are the implications for Australian shares? Is our market also overheated? That’s the really pertinent question!’
— Adrian W
Firstly, thank you for the email. And secondly, if the webinar was your first foray into technical trading, then my advice is stop now. Trading is, for the vast majority, a mug’s game. Yes there are those who do very well out of trading. But I can tell you they have well and truly paid their dues. Every single successful (and I stress, successful) trader I know has been to hell and back in trying to finesse their trading model. Most people do not have the experience, temperament or capital to persevere with trading.
The market that I think we are on the cusp of entering will most definitely not be for the inexperienced or the faint hearted or starry-eyed novice thinking of promised riches. Even experienced traders are going to be tested. We have never seen a market in full panic mode.
The GFC gave us an insight into what rattled investors are capable of. However, the Fed managed to steady the ship.
But next time the Fed may not have enough rabbits in the hat. Then we are in unchartered waters. The volatility resulting from the ‘buy-the-dip’ mentality followed by another round of dire deflationary news, will be enough to give you whiplash.
What are the implications for Australian shares? Not good.
Is our market overheated? Not really.
Whether our market is overheated or not is of little consequence in the world. Australia represents around 2% of global financial markets. We are a flyspeck. When international institutions are chasing liquidity, they’ll sell their Aussie shares in a heartbeat. We’ll be caught in the downdraft.
A quick look back through history shows how the Aussie market plays follow the leader.
During that last 25-year period, there was the 1987 crash. The Dow fell around 38% and the All Ords dropped 42%. I remember it well.
The Dow sneezes and we catch cold. We are the dutiful little brother always following one or two steps behind our dominant big brother. Mimicking their every move.
When 9/11 occurred, Wall Street closed for a few days. Global markets came to a standstill. I distinctly remember managed funds would not publish unit prices during this period, citing a lack of guidance from the US markets.
Let’s reverse this situation. If the Sydney Stock Exchange was closed for a few days, do you think the rest of the world would go into a pricing freeze? Not likely. The world would go on regardless.
On the assumption the Secular Bear market is far from finished in the US and also, the extent various valuation metrics (Tobin Q, the Buffett Indicator etc.) have deviated from their long term averages, the US share market has the potential to repeat its 1929 to 1932 performance of NEGATIVE 89%.
In the investing world we have become accustomed to — one that operates with a Fed safety net — mentioning this sort of downside could be grounds for having me committed.
Therefore to avoid that fate, let’s say the US market has a very high probability of repeating its efforts of 2000/03 and 2008/09 and drop 50% or more.
With a downside ranging from 50% to 89%, do you think the Australian market would be able to win against this tide? No way.
We may not fall as hard, but we will fall.
The other thing to remember is why the market went into a death spiral.
Obviously things are not well in the world…specifically China. What are the ramifications for Australia if China enters a prolonged recession?
What does that do to our property market? What impact will that have on the share price of banks with balance sheets loaded up with residential mortgages?
These are just some of the dominoes that start to fall when the Secular Bear applies its razor sharp claws to the US share market.
The really pertinent question is not in fact whether our market is overheated or not. The really pertinent question is whether investors will heed the warnings from history and take steps to secure their capital now before the Secular Bear unleashes its fury against a hapless Fed.
While we may wish our market was subject to a Secular Bear equivalent to a koala, unfortunately history shows us the US grizzly is coming to our shores.
Editor, Gowdie Family Wealths