The Skeptical Speculator

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2010-03-29T17:07:00.000+08:00

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Bull market threatened by rising inflation and interest rates

2005-10-17T10:42:00.000+08:00

The global bull market in stocks is now between two and a half to three years old. Despite the gloomy prognostications from bears, stock markets have continued to hit new cyclical highs over the past few months, thanks to a global economy that has surprised many with its resilience as well as stubbornly low interest rates. Looking forward, the question is whether the favourable conditions of the past few years will persist and continue to support stocks.

Recent data do not suggest significant weakening on the economic front. Forward-looking indicators continue to hold up well, with many even showing improvements.

Most significant of the latter are the purchasing managers' indices in the manufacturing sector. The global manufacturing PMI compiled by JPMorgan and NTC Research showed a sharp improvement recently, rising from 52.2 in August to 54.7 in September. This improvement was shared by a wide cross-section of economies, as reflected in the following table of national PMIs for the past two months.

	August	September	Change
US	53.6	59.4	+
Eurozone	50.4	51.7	+
Japan	53.8	54.5	+
UK	50.1	51.5	+
China	50.6	50.9	+
Australia	43.3	52.9	+
Singapore	52.2	53.1	+

The PMIs for the services sector were not as good. The ISM's non-manufacturing index, for example, fell to 53.3 in September from 65.0 in August. However, the CIPS/RBS index for the euro-zone rose to 54.7 in September from 53.4 in August. In any case, the indices remained above 50, indicating expansion.

Other indicators have also been positive. The Bank of Japan's quarterly Tankan survey found respondents generally positive on the business outlook in September, while in Germany, the Ifo institute's business confidence index rose in September.

About the only indicators that have tended to be negative are those for consumer sentiment. In the United States, where the consumer has been the engine of US as well as global economic growth, the latest readings from both the University of Michigan's and the Conference Board's measures of consumer confidence have been weak.

So the bears might yet be right. However, the bears might be right even if the economy is not quite on the brink of a downturn. Why? Because there is evidence that a stronger-than-expected economy may be bringing on higher inflation, which in turn may lead to higher interest rates. In the past, higher interest rates have more often than not signalled the end of bull markets, because firstly, they make equity valuations less attractive to investors and secondly, they hurt demand, which ultimately hurts corporate bottom-lines.

What evidence do we have of higher inflation? The US consumer price index for September was up 4.7 percent from the previous year, the biggest jump since 1991. In the euro-zone, the year-on-year inflation rate hit 2.5 percent in September according to a flash estimate, well up from 1.9 percent in January and the highest in over a year. Even deflationary Japan saw its core consumer price index fall just 0.1 percent in August from a year earlier, and land prices in Tokyo in July were actually higher than the previous year, the first rise in prices since 1990.

Of course, high oil prices are the main reason for higher inflation in most economies. And while oil prices had been moving higher for over a year on rising demand, the recent hurricanes in the Gulf of Mexico, which disrupted oil production, adds to the upward pressure on oil prices.

Not everyone is convinced that inflation is a threat, though. Some economists point out that outside of energy-related prices, inflation has been minimal. For example, despite the high headline inflation rate in the US in September, the core inflation rate, which excludes food and energy, was only 2.0 percent.

However, the Federal Reserve does not appear to be among those who are unconcerned with inflation. A number of Federal Reserve officials have come out over the past month or so stressing their concerns over rising inflation risk.

The minutes of the Federal Open Market Committee meeting on 20 September also show that the Federal Reserve appears more concerned about higher inflation than weaker growth. According to the minutes, in deciding to hike the target federal funds rate by 25 basis points to 3.75 percent, the committee was of the view that despite the devastation following the hurricanes in the Gulf, "aggregate demand and output would likely rebound before long". Therefore, "meeting participants were concerned that price pressures, which had been elevated before the storm, could climb further, primarily as a result of additional increases in energy prices".

It also pointed out that even after the latest interest rate hike, "the federal funds rate would likely be below the level that would be necessary to contain inflationary pressures, and further rate increases probably would be required".

The European Central Bank is apparently similarly concerned with inflation. Although it kept interest rates unchanged earlier this month, ECB President Jean-Claude Trichet also said that the bank is showing "strong vigilance" against inflation.

With all this inflation talk, no wonder US 10-year Treasury yields, which had been as low as 3.9 percent in June, are now around 4.5 percent.

However, central banks can be wrong. In fact, many economists doubt that the strength of either inflation or economic growth is enough to justify higher interest rates. As mentioned earlier, indicators such as the core inflation rate and consumer confidence indices could quite plausibly be used to support such views. Betting on higher interest rates is far from a no-brainer.

Then again, if inflation is low because of a weak economy, that might not be good for stocks either. In such a situation, you might still need an uptick in interest rates to tip the stock market over. It is just that you might need less of an uptick.

The current economic expansion has surprised many economists with its strength and resilience in the face of rising consumer debt and global economic imbalances. The strong economy has helped corporate profits rise strongly as well and sustained the bull market in equities.

However, investors should keep in mind that, at this stage of the business cycle, the best part of the economic expansion is over for most economies. On the other hand, inflationary pressures appear to be building up. Under such conditions, a rise in interest rates might just be the straw that breaks the bull's back.

Outlook for stocks in the aftermath of Katrina

2005-09-12T12:58:00.000+08:00

Hurricane Katrina has been described as the worst natural disaster in the history of the United States. Whether the consequences will be disastrous for equity investors in general is another matter.

Katrina hit the shores of the Gulf of Mexico on 29 August, hitting the city of New Orleans particularly hard. The death toll has not been finalised. Earlier fears of a total of 10,000 dead have been scaled back as the official death toll remains in the hundreds. Nevertheless, the amount of destruction is clearly immense. Estimates of total damage caused by the hurricane are now over US$100 billion, while estimates of the impact on the US government budget are approaching US$200 billion.

Such a scale of destruction will obviously have an impact on US GDP growth, especially in the second half of the year. In addition to its generally destructive effects in Louisiana and neighbouring states, the hurricane has hit oil and gasoline production from the Gulf of Mexico. Consumer demand is expected to be crimped by the resulting higher energy prices, not to mention the negative psychology in the wake of the hurricane's destruction.

Last week, Treasury Secretary John Snow told reporters on Tuesday after a meeting with bank and financial regulators that the GDP growth rate could be reduced by "a half a percent or so". The Congressional Budget Office estimates a reduction of between 0.5 and 1 percentage point in GDP growth and a loss of 400,000 jobs.

A recent Bloomberg survey also found economists reducing their GDP growth forecasts and raising inflation forecasts for the second half of the year. The economy is now expected to grow at a 3.6 percent annual rate in the third quarter instead of the 4.1 percent forecasted a month ago, while the consumer price index is forecast to rise at a 3.5 percent rate from a year earlier compared to last month's forecast of 3 percent. For the fourth-quarter, the growth forecast has been reduced to 3.1 percent from the previous forecast of 3.5 percent, while consumer prices are forecast to rise 3.2 percent, up from the earlier estimate of 2.9 percent.

On the other hand, the rebuilding that is planned for the hurricane-hit region is likely to boost the economy in 2006. Whether all this spending would cancel the negative impact to GDP in 2005 is the big question.

Equity investors, however, had another reason to be hopeful in the aftermath of the hurricane -- a possible moderation in the Federal Reserve's tightening campaign. For example, Peter Brimelow, in a MarketWatch article on 5 September, cited Michael Burke of Investor's Intelligence as saying that the slowing economy means that "Fed rate hikes should no longer be needed", and low rates would provide support for the market. Indeed, bond yields fell in the immediate aftermath of the hurricane, the 10-year Treasury yield falling from about 4.2 percent just before the hurricane hit to a low of about 4 percent within a week.

However, recent robust economic data -- and perhaps more importantly, remarks by a couple of Federal Reserve presidents that inflation is a concern -- has diminished such hopes. The 10-year yield has backed up to over 4.1 percent.

As for consumer spending, retail sales data reported in the week following the hurricane have provided no clear indication of any change in trend.

So while among listed companies there are undoubtedly some that are likely to be negatively affected by the disaster and some that may benefit from it, at the moment, for the market as a whole, it may be too early to say whether the fundamentals for equities have changed much -- for better or worse -- as a result of the hurricane.

However, Richard Russell, editor of the Dow Theory Letters and, like Burke, much followed by MarketWatch columnists, recently provided technical reasons for optimism.

In an article on 7 September, Mark Hulbert wrote that Russell has turned "totally neutral on the stock market -- at least as to the secondary trend". The reasons: A new all-time high on the Dow Jones Utility Average and a potential upside breakout for the Standard & Poor's 500. Hulbert quoted Russell on the latter as follows: "The chart shows that if the S&P rises to 1,250, this would be a powerful upside breakout, with a large upside target hundreds of points higher." The S&P 500 closed last week at 1,241.48.

What may also be noteworthy is that Russell -- and Burke for that matter -- are bearish for the longer term. When bears -- especially ones with relatively good track records as Russell and Burke, as claimed by Hulbert and Brimelow -- are prepared to put aside their bearishness and acknowledge significant upside potential, even if only for the short term, I think investors should at least sit up and take notice.

And Hulbert has more to reinforce the short-term bullish case.

In an earlier article, Hulbert pointed out that the Hulbert Stock Newsletter Sentiment Index (HSNSI), an index that he uses to gauge the average recommended stock market exposure among a subset of short-term market timing newsletters, stood at 27.4 percent as of last Monday's close. This seemed unusually low to him; on 10 August, it had been at 52.2 percent.

Furthermore, the Hulbert NASDAQ Newsletter Sentiment Index (HNNSI), a similar measure for the NASDAQ, stood at minus 7.7 percent, which means that the average NASDAQ market timer is now net short the market. On 10 August, it had been in positive territory at 30.8 percent.

To Hulbert, "sentiment moves like the ones we've seen over the last month have more often than not been the precursors to rallies than declines".

On the other hand, investors who focus exclusively on the long term might prefer to ignore such short-term moves. In fact, for such investors, even Katrina may have little relevance. On this fourth anniversary of the 9/11 terrorist strike, it is probably worth remembering that over the long term, one-off disasters seldom have much long-term effects on stock markets as a whole. Hurricane Katrina is likely to be no exception.

Markets not moving interest rates to correct global imbalance

2005-08-22T09:51:00.000+08:00

Low interest rates are increasingly recognised as a worldwide phenomenon. There have been several reasons advanced for the low rates -- global savings glut, weak global economy -- to which another reason has been added: the failure of capital markets.

A recent purveyor of this view is The Economist. On 18 August, it wrote the following in an article on its website:

The world currently displays an alarming number of large economic and financial imbalances. America's current-account deficit is forecast to widen to over $800 billion this year, while Germany, Japan and China look set to run record surpluses. Total government debt in rich economies has risen to a new high as a percentage of GDP, and in many countries households are sliding ever further into debt. Meanwhile, the growth rates of America and other rich economies have diverged to an unusual degree.

Many economists try to explain these trends in terms of underlying structural factors, such as differences in demographic trends or productivity growth. An alternative, more worrying, explanation is that the price signals that are supposed to bring the world economy back into balance have become distorted.

The Economist argued that countries with current account or budget deficits should face higher yields to compensate investors for the higher risk of a currency depreciation. However, using the case of the United States, which suffers from both a current account as well as a budget deficit, this has not happened. The Economist attributed the failure of bond yields to rise to Asian central banks buying US Treasury bonds to prevent their currencies rising and to cheap goods from emerging economies keeping inflation down and resulting in central banks holding interest rates down as well.

The Economist further argued that the liberalisation of international capital flows should have enabled markets to "punish economies where governments or households borrow recklessly with higher bond yields, prompting them to tighten their belts". However, this does not appear to have happened.

This is not really surprising. As I said in my previous article concerning the diminishing US personal saving rate (see "US saving deficit leads to trade deficit"), deficits that appear unsustainable over the long term can still last for a considerable period of time.

While the market will very probably eventually move to a sustainable equilibrium, the timing of such a move is always highly uncertain. Remember that Federal Reserve chairman Alan Greenspan declared that there was "irrational exuberance" in the stock market as early as 1996. The US stock market bubble, however, did not burst until four years later. Even today, US stock market indices remain above their levels in 1996.

Therefore, with ample capital inflows at the moment, countries like the United States can sustain their deficits and maintain low interest rates at the same time for quite a while more.

Certainly, as The Economist pointed out, central banks play an important role in keeping interest rates low. That includes the Federal Reserve. In fact, by keeping the federal funds rate substantially below the inflation rate until recently, the Federal Reserve has played a key role in keeping long-term bond yields low.

There is no secret to this phenomenon. The federal funds rate directly affects the cost of short-term funds, that is, short-term interest rates. The cost of short-term funds obviously affects the cost of long-term funds, that is, long-term interest rates. When short rates fall far below long rates, arbitrageurs swoop in, borrowing at the short rate and lending at the long rate, which tends to close the gap and push the long rate down.

When the Federal Reserve started its interest rate hikes in June last year, the spread between the 10-year Treasury note and the federal funds rate was well over 300 basis points. That is far above its average over the previous 50 years of below 100 basis points. Such a spread might be sustainable in a powerfully-expanding economy, but not at the mature stage of the cycle that the economy is now in where growth is expected to moderate.

The spread has since fallen, partly due to a rise in the federal funds rate, but partly also due to a fall in the 10-year yield as the outlook for economic growth moderated (see "Outlook for stocks and bonds may depend on PMI").

Alan Greenspan has called the fall in long-term rates a "conundrum". But it is partly of his own making. The slow or -- in the Federal Reserve's own words -- measured pace of rate hikes has surely been a factor. A slow rate of Federal Reserve hikes in the presence of a large spread between the 10-year yield and the federal funds rate has historically not been conducive to increases in the former.

The following chart shows how, over each of the 50 years from 1955 to 2004, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread at the beginning of each year (shown on the horizontal axis).

From the above chart, it can be seen that, over the course of a year, when the increase in the federal funds rate has fallen well short of the spread (reflected as a data point well to the left side of the chart), the 10-year yield has often fallen in that year. In other words, if the federal funds rate cannot come up to the 10-year yield, the 10-year yield will come down to it.

Since the start of its rate hikes a little over a year ago, the Federal Reserve has raised the target federal funds rate by 250 basis points, well short of the spread at the beginning of its rate hikes. Little wonder that long-term rates have fallen.

However, with the spread between the 10-year yield and the federal funds rate now at about 70 basis points, a few more rate hikes by the Federal Reserve should see the former finally start to respond in the desired direction -- that is, up. Unless, of course, the economy weakens more than expected.

In any case, the upshot of this is that while the market may not be doing a very good job at moving interest rates in the direction required to correct long-term global imbalances, its behaviour has not, in fact, been very different from its historical pattern.

(Update on 13 February 2006: Corrects error on the spread at the start of interest rate hikes.)

US saving deficit leads to trade deficit

2005-08-15T15:29:00.000+08:00

The US trade deficit in June was near record levels. Considering that oil prices and US consumer spending were at record levels in June, this was not exactly unexpected. Consumer spending's rising share of the US GDP in particular -- and its corollary, a declining personal saving rate -- has been a major driver of the expanding US trade deficit in the past several years.

On 12 August, the US Commerce Department reported that the US trade deficit for June was US$58.8 billion on a seasonally-adjusted basis. That is the second highest monthly deficit in 2005 and the third highest on record.

The record oil prices in June, when NYMEX crude oil futures broke through US$60 a barrel, was a major contributor to the increase in the deficit. Petroleum imports hit a record US$19.9 billion as imported crude oil prices in June averaged US$44.40 a barrel.

However, non-petroleum imports were also very high. The June figure of US$45.0 billion was the second highest on record.

The reality is that US consumer spending is at very high levels, and high overall imports largely reflect this fact.

Earlier, on 2 August, the Commerce Department had possibly given a taste of what was to come in the trade report when it reported that personal consumption expenditures for June had hit a seasonally-adjusted annual rate of US$8,723.5 billion, the highest on record and close to all-time highs even as a percentage of GDP. As a result, the personal saving rate for the month dropped to zero percent.

The fall in the personal saving rate to zero can be considered a milestone event. It is part of a longer decline in the US personal saving rate that began in the 1980s, as the following table illustrates.

	Average personal saving rate %
1961 - 1970	8.5
1971 - 1980	9.6
1981 - 1990	8.7
1991 - 2000	4.7
2001 - 2005 (June)	1.8

There are several reasons given by economists for the fall in the personal saving rate.

One explanation involves the "wealth effect". Rising asset prices -- in stocks for the past two decades or so until arrested in 2000, and in housing more recently -- caused Americans to feel wealthy and feel more able to spend.

Another explanation is the rise in labour productivity since the 1990s. With persistent productivity increases, Americans became more confident of continually rising income, encouraging them to spend more.

A third explanation is that innovations in finance has given Americans increased access to credit, which enables them to increase spending.

A fourth explanation is the fall in interest rates over the past two decades or so. Together with money illusion, it makes people think that they are getting lower returns on saving and incurring lower cost in using credit, thus discouraging them from saving and encouraging them to use credit instead. Lower interest rates also feed into higher asset prices and reinforce the wealth effect.

Whatever the reason, if the saving rate continues to decline into negative territory, consumer spending will very likely take an increasing share of GDP, and that must translate to a rising trade deficit unless other components of the GDP -- investment and government spending -- are sacrificed. As it is, the past years' rise in consumer spending and concomitant fall in the personal saving rate has contributed to a rise in the trade deficit from an average of 1.5 percent of GDP from 1991 to 2000 to 4.5 percent thereafter.

Common sense tells us that the personal saving rate cannot keep falling and the trade deficit cannot keep rising indefinitely. Eventually, Americans will run out of personal wealth and national assets.

How can investors position themselves for the eventual reversal in trends? Here are a few ideas.

A reversal of the falling saving rate implies a reduction in consumer spending and a probable slowdown in growth, even possibly a recession. This suggests a move out of equities.

A reversal of the rising trade deficit implies a weaker US dollar. This suggests a move into foreign assets.

Both might be associated with higher interest rates, at least initially, which suggests a move out of bonds.

The problem is that while common sense tells us that there will eventually be a reversal in the trends, it does not tell us exactly when that will take place. The United States is big and rich enough relative to other countries to be able to afford to run down its wealth for a long time.

A rise in interest rates might be the signal of an impending reversal in consumer spending. In this regard, the Federal Reserve seems willing enough to lend a helping hand. It certainly has been reversing its loose monetary. On 9 August, the Federal Reserve raised its target for the federal funds rate by 25 basis points to 3.5 percent, its tenth such hike since June last year. It also released a statement simultaneously suggesting that it would continue do so for at least a while more.

Having said that, longer term interest rates -- the ones that matter to consumers -- have stayed stubbornly low despite the Federal Reserve's persistent raising of the federal funds rate. Instead, the rate hikes appear to be attracting capital into the US and boosting the US dollar, hardly a recipe for correcting the trade deficit.

So investors who position themselves now for the eventual reversal of the declining saving rate and rising trade deficit might have to be very patient.

Stocks fly in July

2005-08-01T15:22:00.000+08:00

The Singapore stock market had a good July, shaking off not one but two terrorist incidents in London to hit new five-and-a-half-year highs. And there are no compelling reasons why the good run cannot continue in the medium term. The long-term trend, however, suggests a limit to the upside.

The Straits Times Index (STI) gained 6.3 percent in July, closing on the last trading day of the month at 2,352.56, the highest close since January 2000, the month in which the previous bull market peaked. The two bombing incidents in London and the potentially crucial introduction of a new regime for the Chinese renminbi hardly made an impact on the stock market.

The Singapore stock market had good company in its optimism. The following table shows that all major stock markets rose in July. In Asia, the South Korean market, as represented by the KOSPI, did even better than Singapore's, rising 10.2 percent and hitting a decade high in the process.

	30 June close	29 July close	Percent change
S&P 500	1,191.33	1,234.18	3.6
Nikkei 225	11,584.01	11,899.60	2.7
FTSE 100	5,113.20	5,282.30	3.3
DAX	4,586.28	4,886.50	6.5
CAC 40	4,229.35	4,451.74	5.3
Hang Seng	14,201.06	14,880.98	4.8
KOSPI	1,008.16	1,111.29	10.2

Global stock markets have no doubt been supported by the recent spate of good economic news.

The US economy, the engine of world economic growth, grew 3.4 percent in the second quarter. Although this was slower than the 3.8 percent in the first quarter, it was marked by healthy growth in both consumer and business spending. Excess business inventories were drawn down. Price pressures moderated.

Forward-looking indicators have also looked good recently. The Conference Board's US leading index and the Chicago Purchasing Mangers' Index rose in June and July respectively. US home sales and durable goods orders for June also increased. US consumer confidence indicators moderated in July, though.

Perhaps more importantly, the positive news flow has spread to the rest of the world. Last week saw reports of both Japan's NTC Research/Nomura/JMMA Purchasing Managers' Index and Germany's Ifo business climate index rising in July, adding to earlier evidence that these two major world economies may be seeing a significant upturn.

Most importantly from the Singapore stock market's point of view, the Singapore economy has also been looking better recently. On a seasonally-adjusted annualised basis, real GDP expanded by 12.3 per cent in the second quarter, reversing the 5.5 percent contraction in the first quarter. June in particular saw turnarounds in Singapore's manufacturing output and exports, which rose 9.2 percent and 1.3 percent respectively. Non-oil retained imports of intermediate goods, a short term leading indicator of overall manufacturing activities, rose a strong 11.3 percent in June.

An announcement by the Singapore government on 19 July that it was easing rules on property financing and foreign home ownership also boosted market sentiment, especially in property and finance stocks.

Valuation-wise, the Singapore market is probably trading at a price-earnings ratio of about 16 based on 2005 earnings. It is not particularly cheap, but not high enough to suggest that low interest rates and momentum cannot bring it substantially higher.

And yet, it is important to remember that this bull cycle is already more than two years old. At this stage of the cycle, with the market looking at a likely moderation in the economy and corporate earnings growth in 2006, it is prudent to at least have an idea where the market is likely to peak.

As I have mentioned in previous commentaries, when the stock market last peaked in 2000, the STI had initially found support at around 2,000. Rebounds from that level had found resistance at around 2,200. Earlier, I had considered the possibility that the current cycle would peak between these two levels. However, after struggling for much of this year with the 2,200 level, the STI has now broken convincingly above it, so this target is obviously no longer valid.

Beyond 2,200, I see no obvious target for the STI. In last week's issue of The Edge Singapore, Goola Warden suggested a target of 2,400. To which I say: why not 2,583, the level of the last peak? This seems a more natural target to me.

This means that there is potential for the STI to rise over 200 points or almost 10 percent. Mature bull market or not, nimble traders may still fancy their chances in trying to eke out more gains on the long side.

However, if the longer-term trend holds, the STI may have trouble breaking its previous high in this cycle. Because for all its impressive showing over the past two years, over the longer-term, the Singapore stock market has looked more like it is in a secular bear market rather than a secular bull market.

The above chart shows the STI since 1993. In terms of its raw numbers, the STI has looked, at best, as if it has been going sideways. If adjusted for changes in the US$/Sing$ exchange rate or CPI inflation, the trend for the STI, if anything, looks worse. While the raw STI hit its highest level in early 2000, the exchange-rate-adjusted and inflation-adjusted STIs reached their highest levels in 1996 and 1994 respectively, and despite subsequent peaks, have not recovered those highs.

Looked at from these perspectives, one could quite plausibly argue that the Singapore stock market has been in a secular bear market for the last decade or so. The July surge notwithstanding, who is willing to bet that this is about to change?

A new regime for the renminbi

2005-07-25T09:47:00.000+08:00

After so much speculation, China announced a new exchange rate regime on 21 July for the Chinese currency, the renminbi, together with a new exchange rate with the US dollar. However, this move may have less impact than many hope.

As announced by the People's Bank of China (PBoC), the renminbi, or yuan, will be placed under a "managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies" instead of being rigidly pegged to the US dollar as previously the case. The US dollar will be allowed to fluctuate against the RMB within a band of 0.3 percent around a central parity to be published by the PBoC each day, while other currencies will be given their own fluctuation bands.

As part of the move, the exchange rate of the US dollar against the renminbi was adjusted to 8.11 yuan per US dollar, representing a 2.1 percent appreciation of the renminbi compared with the previous exchange rate of 8.28.

As the Chinese authorities no doubt intended, the sudden move came as a surprise to practically everyone. The surprise was important to prevent speculators from exploiting the move.

Not that there was much to exploit. The revaluation by 2.1 percent was minimal, and for those hoping to see a major revaluation to correct global trading imbalances, it would surely have come as a disappointment.

American politicians, who have been pressing China to revalue the renminbi for some time, tried to put a positive spin on the move. "I welcome China's announcement today that it is adopting a more flexible exchange rate regime," Treasury Secretary John Snow said. Senator Charles Schumer, a New York Democrat who had put up a bill to levy a hefty tariff on all Chinese imports, said that "after years of inaction, this step is welcome", but hoped that there would be more to come. Federal Reserve chairman Alan Greenspan said that "it is certainly a good first step".

Those hoping to see more revaluations or a gradual rise in the exchange rate peg -- a crawling peg -- may be disappointed though. The very next day, the China Daily said in an editorial:

Expectation for a bigger appreciation of the yuan's value was, and will be, unrealistic. Exceedingly drastic response to the change could throw China's and many other Asian nation's economy into chaos, which would be bad news for everybody.

It is difficult to say how closely the editorial reflected official views, but it is clear that China has much to fear from a more substantial revaluation. A large revaluation is deflationary, something that China would not want in view of the large number of non-performing loans in the banking system. In addition, China needs fast economic growth to soak up the large number of unemployed and underemployed people that it has, especially in the countryside.

That it moved at all to revalue could possibly partly have been because of the 9.5 percent growth rate reported for the second quarter. That was probably too much for the authorities, especially with fixed asset investment also rising by 25.4 percent in the first half of the year compared to the corresponding period a year earlier, threatening to overheat the Chinese economy.

The attempt to understand Chinese intentions has not been made easier by the fact that the Chinese have not been clear on exactly how they intend to manage the float. This could be a significant fact.

While many have compared the new exchange rate regime with that adopted by Singapore, which is similar, it should also be noted that the latter maintains a separate monetary policy stance whereby it makes a decision on whether to let the exchange rate rise, fall or stay unchanged against the chosen basket of currencies -- a decision that is announced publicly. So far, the PBoC has made no such policy announcement. Some have taken that to mean that it is being opaque. However, it could also mean that it has no intention of changing the overall exchange rate for the foreseeable future.

In fact, the latter would be consistent with statements made earlier by the PBoC -- on 12 July when, in its first quarter monetary policy report, it had said that the "growth of money and credit remained broadly appropriate" -- and on 19 July when the PBoC said: "We will continue to implement a stable and healthy monetary policy and maintain the steady growth of credit." It would also be consistent with what Zhou Xiaochuan, governor of the People's Bank of China, said at a conference of bankers on 23 July: "China's exchange rate reform won't have too much influence on US deficits."

Furthermore, as many have pointed out, a small revaluation by the PBoC may actually tempt speculators to make bets on further revaluation. Assuming that the PBoC has no intention of rewarding speculators, that it actually made only a small revaluation could indicate that it has no intention of making a big one.

In other words, the 2.1 percent revaluation so far could be all there is to it for some time to come. If so, the total economic and financial impact from the PBoC's move on 21 July would be relatively limited.

The action in the financial markets so far indicates that at least some people believe so. On 22 July, the second day of trading after the PBoC announcement, the US dollar rose almost 1 percent against the yen, partially reversing the Japanese currency's rise of more than 2 percent the day before. The US dollar's exchange rates with other Asian currencies like the Singapore dollar also reacted similarly.

Fixed income securities also saw a turnaround. After falling on 21 July on fears that the renminbi revaluation means less buying of US Treasuries by the PBoC, the 10-year note recovered the next day, the yield falling by 6 basis points to 4.22 percent after rising to 4.28 percent the day before.

Perhaps most tellingly, on 22 July, on its first day of trade after the revaluation, the renminbi actually slipped to 8.1111 from its opening of 8.11.

However, even if the total revaluation turns out to be small, the PBoC's move may still be significant. First of all, it may help defuse political tension with the United States -- as the initial reactions from US politicians suggest -- and thus alleviate protectionist pressures. Secondly, with an exchange rate that is managed against a basket of currencies instead of a fixed peg against the US dollar, the renminbi can now move relative to the latter, giving the PBoC more flexibility in managing the exchange rate as well as in conducting monetary policy. Thirdly, the move should be seen as part of a series of moves by China towards the lifting of capital controls and full currency convertibility.

As it is, the PBoC's move has already had an impact on policy beyond China's borders. Immediately after the PBoC's announcement on the new exchange rate regime, Malaysia also announced that it is lifting its peg to the US dollar and moving to a managed float.

US current account deficit may stabilise as economic growth moderates

2005-07-19T14:35:00.000+08:00

The United States current account deficit hit a record US$195 billion in the first quarter of 2005. However, the trade deficit has been falling in recent months, giving hope that the current account deficit may be stabilising as the pace of US economic growth moderates over the next few quarters.

While the average trade deficit in the first quarter had been over US$57 billion a month, April and May saw deficits of US$56.9 billion and US$55.3 billion respectively after seasonal adjustments. With rising oil prices, however, many economists think it is likely that the deficit will rise again in coming months.

The long-term trend for the US current account remains a subject of considerable debate. And the substance of much of that debate has been re-directed to the economic policies of the rest of the world rather than within the US itself after then-Federal Reserve governor Ben Bernanke's speech in March in which he said that a "global saving glut" is a reason for the increase in the US current account deficit.

In his speech, Bernanke said that the federal budget deficit is not a major reason for the current account deficit because the latter expanded even when the federal budget was in surplus between 1996 and 2000. Rather, he said that what changed over the past decade or so was a swing in the current account balance of developing countries from a collective deficit to a surplus.

Bernanke suggested that "a key reason for the change in the current account positions of developing countries is the series of financial crises those countries experienced in the past decade or so". These crises encouraged developing countries to build up their foreign reserves as "a buffer against potential capital outflows". In addition, oil exporters have seen their current account surpluses surge as a result of the sharp rise in oil prices.

Some commentators have conveniently seized on Bernanke's speech to conclude that the United States' current account deficit is not its fault. For example, Robert Samuelson wrote in The Washington Post on 27 April: "Whatever the problems, Americans can't fix them."

I think that is jumping to the wrong conclusion.

First of all, Bernanke did say that "reducing the federal budget deficit is still a good idea", just that the effect on the current account deficit is likely to be "relatively modest". He cited a study that indicated that a one-dollar reduction in the federal budget deficit would cause the current account deficit to decline less than 20 cents.

Also, he pointed out that there are industrialised countries that are not experiencing widening current account deficits, namely Germany and Japan, both of which instead saw substantial increases in their current account balances. He thinks that "countries whose current accounts have moved toward deficit have generally experienced substantial housing appreciation and increases in household wealth".

Then consider that the saving glut is not just a developing-country phenomenon but also is present among corporations. A report by economists at J.P. Morgan published in June concluded that "over the past four years the increase in G6 corporate saving has been about five times greater" than in emerging economies.

What the latter two points suggest is that the root cause of the global saving glut is excessive liquidity arising from expansionary monetary policies, and that is something that government regulators are supposed to be able to do something about.

For evidence that monetary policy is a factor, take a look at the chart below. From it, you can see that the US current account deficit generally rises and falls with various indicators of money supply. And money supply as a proportion of GDP, especially zero maturity money (MZM), has risen considerably since the 1990s.

Money supply in the US is regulated by the Federal Reserve, mainly through the federal funds rate. In fact, the next chart shows that there is a direct correlation between the year-on-year change in the current account deficit as a percentage of GDP and the spread between the 10-year US Treasury yield and the federal funds rate.

So far from being absolutely powerless to do anything about the current account deficit, Americans certainly can do something about it. And indeed the Federal Reserve, by raising the target federal funds rate for the past year, has brought the spread between the 10-year Treasury yield and the federal funds rate down to below 100 basis points, and money supply growth has been somewhat flat in recent months. That may yet have an effect on the current account deficit in the coming quarters, if it has not already.

Of course, a flattening yield curve and slowing money supply growth also probably means weaker economic growth. Note that based on the second chart above, to bring about a reduction in the current account deficit, the spread between the 10-year Treasury yield and the federal funds rate would probably have to be negative, and that is definitely not good for GDP growth.

Don't let anybody say that reducing the current account deficit is going to be painless.

Outlook for stocks and bonds may depend on PMI

2005-07-04T08:52:00.000+08:00

For all the fears about a slowdown in the global economy, stock markets around the world did not fare too badly in the first half of 2005. And against the expectations of many, neither did bond markets.

It turned out that among the major stock markets, the one in the strongest developed economy -- the United States -- performed the most poorly. Markets in the moribund and much-maligned European economies, on the other hand, performed very well.

	Close at end 2004	Close on 1 July	Percent change
S&P 500	1,211.92	1,194.44	-1.4
Nikkei 225	11,488.76	11,630.13	1.2
FTSE 100	4,814.3	5,161.0	7.2
DAX	4,256.08	4,617.07	8.5
CAC 40	3,821.16	4,269.62	11.7
Hang Seng	14,230.14	14,201.06	-0.2
Straits Times	2,066.14	2,209.95	7.0

Then again, divergence between the performance of an economy and its stock market is hardly uncommon. In fact, many fund managers had been expecting European equities to do well -- or at least better than those in the US. That they proved right shows that going contrarian is not always a good idea.

One asset class where the consensus have not been so fortunate is bonds. Fears of accelerating inflation at the beginning of the year had many investors shunning them. Those fears have turned out to be somewhat misplaced. Inflation globally remains relatively muted.

As a result, long-term bond prices have risen as yields have fallen. US 10-year Treasury yields have fallen from over 4.2 percent at the beginning of the year to just over 4 percent on 1 July, while over the same period, German 10-year bund yields have fallen from about 3.7 percent to below 3.2 percent.

The fall in yields have been all the more remarkable when seen in the light of the Federal Reserve raising its target federal funds rate since the middle of last year. Federal Reserve Alan Greenspan calls the declining yields in the face of his rate hikes a "conundrum", especially when, in his view, the US economy remains robust.

Well, maybe the US economy is not as robust as he thinks. While the US economy has been growing at close to a 4 percent rate over the past few quarters, the Conference Board's index of leading economic indicators for the US has been declining over the past year or so, as has the purchasing managers' index (PMI) monitored by the Institute for Supply Management.

Historically, the 10-year Treasury yield does tend to track the PMI. In fact, so does the spread between the 10-year yield and the federal funds rate. What the latter implies is that the 10-year yield can fall in the face of a rising federal funds rate if the PMI falls fast enough.

The chart below shows the 12-month changes in the PMI, the 10-year Treasury yield and the spread between the 10-year Treasury yield and the federal funds rate over the past two decades.

Having said that, the latest PMI number shows a rise in June to 53.8 from 51.4 in May. The improvement was quite comprehensive. Most of the sub-indices showed increases, with the new orders index in particular surging to 57.2 in June from 51.7 in May.

And the improvement is not just confined to the US. The global PMI rose too -- to 52.4 in June from 51.1 in May. And like for the US, the new orders index rose strongly -- to 54.4 in June from 51.6 in May, its highest level so far in 2005. The rise in the global PMI was supported by improvements in the PMIs for Japan (from 53.5 in May to 54.0 in June), the euro zone (from 48.7 to 49.9), the United Kingdom (from 47.0 to 49.6) and Australia (from 50.5 to 55.2).

Other recent indications of an improvement in the global economy include the findings from the Tankan survey in Japan and the Ifo survey in Germany.

If the economic outlook continues to improve and the PMI continues to rise, we may get the rise in long-term yields that many had expected at the beginning of the year. So it may be good for equities but not for bonds.

Of course, it is a big "if" anyway. Especially with NYMEX light sweet crude oil prices hovering around US$60 a barrel and a Federal Reserve seemingly determined to keep raising interest rates, a continued rebound in the PMI cannot be taken for granted.

Investors should probably keep a close watch on it.

(Update on 7 October 2005: Chart revised to correct error in spread data.)

The housing boom

2005-06-20T10:13:00.000+08:00

The surge in house prices in many countries around the world in the recent past is raising concerns in many quarters, with many now considering it a bubble and worried over the impact on the global economy should it deflate.

In a recent article on 16 June, The Economist said the ongoing bull market in house prices is larger than the global stockmarket bubble in the late 1990s and America's stockmarket bubble in the late 1920s -- "it looks like the biggest bubble in history".

The global housing boom is widely acknowledged to be the result of low interest rates around the world. The low rates allow house-buyers to borrow cheaply and hence increase affordability, which in turn increases demand and pushes up prices.

And how prices have run up. According to The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years. And it continues to run up. Of the twenty countries whose house prices are tracked by The Economist, half of them showed gains of 10 percent or more in the most recent quarter.

In some of the countries, prices have started to moderate, or even decline. For example, in the United Kingdom, estate agents have been reporting house price declines recently. Australia appears to be suffering from price declines as well.

Other markets remain strong. France, Spain and the United States all reported double-digit price increases recently.

The housing boom has been a major factor behind the strong US economy. It helps provides jobs, not just in construction but in the financial sector. Home equity financing provides home-owners with cash to stoke consumer demand.

An end to the housing boom is likely to undermine the US economy, and with it, the rest of the global economy which relies on it for growth in end demand. So the question of whether the boom is about to end is one that interests many.

So far, there is little indication that the end is near, at least in the US. Just last week, US housing starts in May was reported to have risen 0.2 percent. While permits for future groundbreaking, an indicator of builder confidence, fell 4.6 percent, the National Association of Home Builders/ Wells Fargo Housing Market Index, another indicator of builder confidence, rose to 71, its highest level since December 2004.

Nevertheless, The Economist is not sanguine about the outlook. It noted that prices are over-valued, with house prices at record levels in relation to rents in the US and many other countries.

Similarly, Paul Kasriel of The Northern Trust Company pointed out in a commentary on 17 June that, in spite of low mortgage rates, high prices mean that housing affordability in April, as measured by the National Association of Realtors' index, fell to its lowest level since October 1991. If interest rates were to spike up, things would get worse for the housing market.

However, in its article, The Economist warned that a big rise in interest rates might not even be necessary to trigger a decline in house prices. "British home prices started to fall in the summer of 2004 after the Bank of England raised rates by a modest one and a quarter percentage points. Since 2002, the Reserve Bank of Australia has raised rates by exactly the same amount and unemployment is at a 30-year low, yet home prices have fallen."

That said, it is not always easy to tell exactly when a bubble will pop, even assuming you correctly recognise a bubble when you see one.

Some have pointed to the fact that real estate is now on the cover of magazines like Time -- a bad omen.

As Caroline Baum wrote in her Bloomberg article on 17 June, "by the time a financial phenomenon hits the cover of a general-interest news weekly, it's all over but the shouting". Baum said that the magazine-cover indicator has an 80 percent or better accuracy rate over eight decades.

And yet, Baum cited Paul McCrae Montgomery, president of Montgomery Capital Management, in warning that caution is needed in interpreting the indicator. Montgomery said that Time's housing cover may serve as a better warning for housing stocks rather than house prices themselves, since such stocks rise and fall "well in advance of real estate activity itself".

Mongtomergy also thinks that Wall Street's participation in the housing boom has been too limited. "Before this bull market is over, Wall Street will try to exploit it significantly more than it has done so far," he said.

Baum also cited Jim Bianco, president of Bianco Research in Chicago, in saying that "bubbles don't burst when everyone is talking about a bubble". A fair point, but don't rely too much on it.

In reality, bubbles are often fairly well-recognised in advance and warnings may be sounded both early as well as late.

The stock market and Internet bubble of the 1990s, for example, was recognised as a bubble among many investors and analysts even while the bubble was inflating, and even -- as we now know -- among those touting the bubble stocks. Federal Reserve chairman Alan Greenspan declared "irrational exuberance" as early as 1996. The stock market, however, continued to be irrational and exuberant for another four more years. When Yale economist Robert Shiller then declared "irrational exuberance" again in a book in 2000, this time, the bubble burst.

So those analysing the housing boom face exactly the same problem. Even if they are able to correctly identify a bubble, it is difficult to identify exactly when the bubble will burst.

It is fun trying, though. And potentially profitable.

Sell in May and be dismayed

2005-06-06T11:12:00.000+08:00

Based on the premise that stock markets often perform poorly during the summer, equity investors are often advised to sell in May and go away. However, those who actually followed this advice earlier last month may be somewhat dismayed by their performance since then.

As it turned out, most major stock markets have risen in the five weeks since the beginning of May.

	At end April	Close on 3 June	Percentage gain
S&P 500	1,156.85	1,196.02	3.4
Nikkei 225	11,008.90	11,300.05	2.6
FTSE 100	4,801.7	4,999.4	4.1
DAX	4,184.84	4,510.39	7.8
CAC 40	3,911.71	4,162.47	6.4
All Ordinaries	3,943.1	4,149.3	5.2
Straits Times	2,125.25	2,192.67	3.2

Stock markets are hardly out of the woods, though. Recent economic indicators show that the global economy has not moved decisively out of the soft patch in the first quarter.

Some indicators have continued to surge strongly, for example, US housing sales and prices. Other indicators have turned around in April after weak figures in March, for example, US durable goods orders and Japanese industrial production.

However, many forward-looking indicators remain weak. For example, the Conference Board's US leading index fell in April, as did the German Ifo index.

And in the manufacturing sector, the JPMorgan global manufacturing purchasing managers' index fell to 51.1 in May from 51.9 in April, indicating a rate of growth that is the lowest since July 2003. All the major sub-indices fell in May.

	April	May	Change
Global PMI	51.9	51.1	-
Output	53.6	52.9	-
New Orders	52.6	51.6	-
Input Prices	64.2	56.4	-
Employment	50.6	49.6	-

Most of the major national PMIs also deteriorated.

	April	May	Change
US	53.3	51.4	-
Eurozone	49.2	48.7	-
Japan	53.3	53.5	+
UK	49.1	47.3	-
China	54.4	53.3	-
Australia	52.9	50.5	-
Singapore	49.7	51.0	+

The services PMIs held up slightly better, with the JPMorgan services index edging up to 57.8 in May from 57.4 in April, although in the US, the Institute for Supply Management's non-manufacturing index fell to 58.5 in May from 61.7 in April.

To top off the recent spate of poor economic indicators, the Labor Department announced last Friday that the US economy added only 78,000 non-farm jobs in May, the lowest gain since August 2003.

No doubt, there remains a great deal of uncertainty as to whether the global economy will be able to sustain its growth. Which is possibly why bonds have done well recently too.

US 10-year Treasury yields fell from about 4.2 percent at the beginning of May to below 4.0 percent last week. Yields have fallen in spite of the Federal Reserve raising the target for the federal funds rate to 3 percent in May, a testimony to the amount of liquidity sloshing around in the global economy.

Economists and investors are getting comfortable with low yields. In his investment outlook in May, Bill Gross of Pacific Investment Management Co wrote that he saw a range of 3-4½ percent for 10-year Treasury yields over the next three to five years. Morgan Stanley's Stephen Roach, a bear on bonds for some time now, wrote in the Global Economic Forum on 31 May that he has done some rethinking and he would not be shocked to see the 10-year Treasury yield test 3.5 percent.

And yet, are these the sign of capitulation by bond bears? If the consensus now is for yields to stay low, is it time to take a contrarian bet that yields will finally start to rise?

The spread between US 10-year and 3-month Treasury yields have dropped from about 200 basis points at the beginning of the year to about 100 basis points now. With the yield curve now practically flat, it is more likely that long-term rates would respond to further rate hikes by the Federal Reserve in the conventional manner. Which means that if the Federal Reserve is really determined to cool the economy and asset markets further and continue to raise the target federal funds rate, bond bulls might yet be in for an unpleasant surprise.

And the consequence is likely to be greeted with dismay by equity investors too, and possibly leaving them wishing that they had taken the advice to sell in May after all.

Economic indicators and stock markets change their minds

2005-05-23T11:28:00.000+08:00

What a difference a month makes. After worrying for much of April and early May that the global economy is headed for a downturn, recent data have pointed to a more benign outlook and stock markets have responded accordingly.

Early April saw US light sweet crude oil prices hitting a record of over US$58 a barrel, triggering fresh concerns of an oil-induced recession. This was followed by the report of unexpectedly weak growth in US retail sales in March, a fall in housing starts in March, higher inflation in March, a decline in the Conference Board's US leading index in March, a decline in consumer confidence index in April, a plunge in new orders for durable goods in March, and culminated with a first quarter GDP report dominated by the revelation of a downwardly revised growth rate of 3.1 percent, rising prices, rising inventories and slowing business investment.

Elsewhere, the data were as bad if not worse. Japan and Europe saw falls in industrial production in March, and leading indicators gave little confidence of improvements in economic outlook.

All these indicators had economists worried that what Federal Reserve chairman Alan Greenspan thought was a "soft patch" in the economy was turning into an outright downturn.

A survey of fund managers by Merrill Lynch in early May found that out of 339 managers questioned, 56 percent expected global growth to weaken slightly or a lot over the next 12 months, while only 23 percent expected a stronger world economy. And whereas in the previous month, fund managers in Asia had been relatively optimistic, they were now more negative.

Towards, the end of April, though, better news was already starting to seep through.

In the US, there was news that sales of new and existing homes and house prices rose in March. What was probably most significant in turning the tide in sentiment, however, was the very healthy increase in non-farm payroll reported for April. Retail sales also improved in April, inflation fears abated as price increases outside energy remained moderate in April and housing starts reversed the fall in March by turning up in April.

Meanwhile, in Japan, unemployment reportedly fell in March and unlike in the US, first quarter GDP turned out unexpectedly strong. And in Europe, inflation, especially core inflation, remained moderate in April.

Of course, the global economy is by no means out of the woods. The Conference Board's US leading index continued to fall in April while in Japan, the index of leading economic indicators was below 50 percent in March for a second month.

Nevertheless, the pessimism exhibited in April seems to have lifted somewhat, and this is probably best reflected in stock markets.

Around the middle of April, stock indices had made what at that time looked like decisive plunges below their 200-day moving averages -- for examples, see the charts below for the S&P 500, the Nasdaq and the Nikkei 225. This led many investors to make sell calls.

However, with the economic data becoming more benign going into May, the S&P 500 and the Nasdaq turned back up above their 200-day moving averages. Only the Nikkei 225 remains below its average.

Interestingly also, despite the weak economic data coming out of Europe in general and the UK in particular, the FTSE 100 has been resilient this year and never dropped below its 200-day moving average.

Historically, the 200-day moving average has had some usefulness in market timing. Buying stocks whenever the Dow Jones Industrial Average rises above its 200-day moving average and selling when it falls below would have enabled an investor to beat the market on a risk-adjusted basis, according to evidence provided in Prof Jeremy Siegel's book Stocks for the Long Run. Its main claim to fame, though -- as related by Siegel -- is that it would have enabled investors to get out of the market just before the 1987 crash.

However, followers who timed the S&P 500 and Nasdaq using the 200-day moving average would have been whiplashed by these markets over the April-May period. In fact, the charts above show that this would have happened quite frequently over the past year. Unfortunately, this is an unavoidable hazard with following this technique -- or at least with following this technique on its own. As Tomi Kilgore wrote in MarketWatch recently, "charts don't lie, but they can certainly change their minds".

So, too, for that matter, can fundamental economic indicators.

US employment growth underlines economy's resilience

2005-05-09T11:05:00.000+08:00

After some poor economic numbers coming out around one to two weeks ago, the latest economic data seem to have allayed some concerns that the economy is heading for a downturn.

Last Friday saw the US Labor Department reporting that non-farm payroll employment for April increased by 274,000. And with upward revisions for February and March to 300,000 and 146,000 respectively, it was a good sign for the economy. The unemployment rate remained unchanged at 5.2 percent.

The previous day, the Labor Department had reported that productivity in the non-farm business sector had increased 2.6 percent in the first quarter, faster than the 2.1 percent in the previous quarter.

Together with the increases in personal income and spending by 0.5 percent and 0.6 percent respectively reported by the US Commerce Department at the end of the previous week and healthy increases in new and existing homes reported earlier in that week, these were the indicators that the US economic expansion remains relatively resilient.

Other data from the US over the past fortnight had not been so positive. Consumer confidence clearly deteriorated in April and if consumer spending falters, business investment may not pick up the slack. The Commerce Department's advance first quarter GDP report shows slowing business investment and rising inventories contributing to overall GDP growth slowing to 3.1 percent from 3.8 percent in the previous quarter.

Manufacturing appears to be wobbly. Although new orders for manufactured goods surprised on the upside by increasing 0.1 percent in March, new orders for manufactured durable goods in March decreased 2.3 percent, with non-defense capital goods orders excluding aircraft -- often used as a measure of business spending -- in particular falling 4.0 percent. The purchasing managers' index compiled by the Institute of Supply Management fell to 53.3 in April from 55.2 in March.

Indeed, manufacturing is slowing on a worldwide basis. The Global Manufacturing PMI -- a composite index produced by JPMorgan and NTC -- fell to 51.9 in April from 52.9 in March. The output sub-index fell to 53.5 in April from 54.2 in March while the new orders sub-index fell to 52.4 in April from 54.1 in March.

The sample of national PMIs below shows only Japan and Australia recording improvements. Europe is clearly slowing -- possibly contracting -- with PMIs falling below 50, as is the case with Singapore. Even China appears to be slowing.

	March	April	Change
US	55.2	53.3	-
Eurozone	50.4	49.2	-
Japan	52.7	53.3	+
UK	51.6	49.5	-
China	55.2	54.4	-
Australia	52.6	52.9	+
Singapore	50.8	49.7	-

Commenting on the survey, David Hensley, director of Global Economics Coordination at JPMorgan, said: "April PMI data indicated that growth of global manufacturing output and new orders downshifted following a period of broad consolidation. The Output PMI is currently consistent with below-trend growth of global IP of around 2.5% saar."

Despite the poor PMI numbers, not all manufacturing-related data from Europe last week were bad; Germany did report a 2.2 percent rise in factory orders in March, after a 2.0 percent decline in February. However, Bloomberg quoted Rainer Guntermann, an economist at Dresdner Kleinwort Wasserstein, as saying that "the leading indicators suggest the second quarter will be very weak again".

Britain has other problems besides manufacturing. The Confederation of British Industry's April survey showed that retail sales fell at their sharpest pace since July 1992, while the Department of Trade and Industry reported that the number of people going bankrupt in England and Wales hit a record high in the first three months of 2005.

Amid these reports, the Federal Reserve continued with its tightening programme, hiking its target federal funds rate by 25 basis points to 3 percent. Other central banks -- specifically the Bank of Japan, the Reserve Bank of Australia and the European Central Bank -- have elected not to make any significant moves on monetary policy, indicating perhaps some ambivalence about the direction of the global economy and inflation.

Some economists, though, remain relatively optimistic. In an interview with SmartMoney reported on 5 May, Lakshman Achuthan, managing director at the Economic Cycle Research Institute (ECRI), said:

We view the weakness in manufacturing, or GDP or employment numbers...as part of a slowdown that has been going on for a year. That's in contrast to those who view it as a new slowdown. We think it's the end of the slowdown... [Leading indicators] seem to have made their lows months ago. Now they're rising, which we translate into a forecast of a firmer economy in the second half of 2005 as opposed to an economy that's below trend or experiences a vicious cycle of downturn.

Achuthan mentioned three indicators that the economy is not headed for a sharp downturn in the near future: interest rates remain relatively low, the housing market remains strong and businesses remain profitable. As for inflation, he thinks that globalisation and the Federal Reserve's interest rate hikes should keep it at bay.

He even has some things to say about the outlook for the stock market:

ECRI does not forecast prices... What I can say is that most, if not all, major bear markets are associated or related to recessions in the economy. And we're not forecasting a recession... The farthest we look is a year. And the stock market typically leads the economy by maybe half of that. So that would suggest that we don't have huge downward risk of a big drop in the market.

Good news for stock investors? Perhaps. But as Achuthan points out, the ECRI is not in the business of forecasting the stock market. Take its stock market prognosis with a pinch of salt.

The elusive consensus

2005-05-02T08:38:00.000+08:00

The past week's economic news can probably be better described as bad rather than good. However, whether this is just a soft patch or whether it is pointing towards further deterioration in the economy remains a matter of much debate among economists, and investors and investment analysts appear to be as divided as economists.

While the past week has seen some sprinkling of positive news on the economic front, it is probably fair to say that the negative news has dominated, even from the usually-resilient United States economy.

The week started off encouragingly, with Monday's report of a rise in existing home sales in the US in March being followed the next day by a report of a surge in new homes sales in March to record levels. Wednesday, however, saw a 2.8 percent plunge in reported durable goods orders in March, the biggest drop since September 2002. This was followed on Thursday by news that first quarter US GDP growth was 3.1 percent, substantially down from 3.8 percent in the fourth quarter. Higher inflation, rising inventories and slowing business investment were the highlights of the GDP report.

Friday did see news of personal income and spending continuing their ascent in March -- by 0.5 percent and 0.6 percent respectively. However, a rise in the personal consumption expenditures price index by 0.5 percent negated much of the increases, while the saving rate continues to fall.

Forward indicators are also worrisome. The Conference Board's consumer confidence index for April fell to 97.7 from 103.0 in March, while the University of Michigan's measure of consumer sentiment in April fell to 87.7 from 92.6 in March. Manufacturing outlook moderated, with the National Association of Purchasing Management-Chicago's index slipping in April to 65.6 from 69.2.

It was little better in the rest of the world.

In Germany, the Ifo business climate index fell to 93.3, the third drop in a row, from 94.0 in March. A consortium of German think-tanks, in a report last week, cut its forecast for German growth this year from 1.5 percent to 0.7 percent, while the German government cut its forecast to 1.0 percent from 1.6 percent previously.

In Japan, household spending and jobs both fell in March compared to February, although the economy saw some reprieve in its often-disappointing core consumer price trend, which rose 0.3 percent in March. Japan's industrial production fell unexpectedly by 0.3 percent in March, but the NTC Research/Nomura/JMMA Purchasing Managers Index (PMI) rose to 53.3 in April, its highest reading in seven months.

Despite the generally deteriorating data, there is no consensus on the outlook. Many economists, including Federal Reserve chairman Alan Greenspan, think that the US economy is experiencing a soft patch, implying a re-acceleration in the near future. Others are less sanguine.

In a Bloomberg commentary on 29 April, Caroline Baum -- citing John Silvia, chief economist at Wachovia Corp, who said that the "soft patch" is "a non-starter as a concept" -- expressed skepticism of a re-acceleration. "The business cycle is maturing," she wrote. "The economy doesn't slow down and re-accelerate on its own... Rather, something exogenous needs to happen to cause the economy to reaccelerate."

Morgan Stanley's Richard Berner is more hopeful. In a commentary on 29 April in the Global Economic Forum, he wrote that falls in gasoline and other energy prices may "unmask pent-up demand for capital spending and hiring again".

Berner is also sanguine about the rise in inventories reported in the GDP report. He wrote: "With our industry analysts reporting that end-market corporate demand for personal computers, machinery, and industrial equipment appears to have strengthened in April, it seems likely that any inventory correction will be extremely short-lived."

However, John Hussman of the Hussman Funds, in a 25 April note, looks at the wider context and warns against expecting too much from capital investment: "There is very little in the way of new large-scale technologies that would pace a capital spending boom... we've observed a number of periods of booming investment and growth-pacing technological innovation over the past century. This isn't one of them by a long-shot."

If the economic news can be characterised as bad, it is probably safe to say that much of it has been anticipated by investors.

In his MarketWatch column on 28 April, Mark Hulbert wrote that the Hulbert Stock Newsletter Sentiment Index (HSNSI), which reflects the average stock market exposure among short-term market timing newsletters tracked by the Hulbert Financial Digest, stood at negative 24.4 percent. This means that the average short-term market timer is short the stock market. According to Hulbert: "There has been only one other period since the bear market began in March 2000 in which the HSNSI was any lower. And that was last week, when it dipped to negative 30.6%."

Hulbert also pointed out that according to Investors Intelligence, 44.0 percent of newsletters they monitor are bullish and 29.7 percent are bearish. This is a relatively small margin between bullish and bearish newsletters, implying a relatively bearish outlook, but Hulbert also adds: "Because the average bearish percentage in rising markets is 35%, [editor Michael] Burke suspects there may still be too much optimism among investment advisors."

And Hulbert points out in his column the next day that among the top five short-term market timing newsletters he monitors, "three...are bullish, one is more or less neutral, and the fifth is bearish. That overall works out to a bullish consensus."

So the lack of consensus among economists is mirrored by investors.

And according to SmartMoney, some of the usually-bearish analysts that it regularly follows have also been ambivalent of late.

Bank of America Securities' Thomas McManus reportedly wrote in an 18 April note that while "we still recommend below-average equity exposure...near-term risks may be overstated". And in a 29 April note, he wrote that it is "past time for us to begin the process of sifting through the carnage to look for bargains".

In a note on 15 April, Merrill Lynch's Richard Bernstein reportedly wrote that "the yield curve has become flatter than normal" but "[i]mportantly, the curve is not inverted", indicating that a recession is not imminent.

This is a highly ambivalent market. Investors with a contrarian instinct will have to dig a little harder to find any misconceived consensus to bet against.

Economies stay hot but investor sentiment turning down

2005-04-21T11:23:00.000+08:00

Recent indicators show that economies are still relatively hot, but not investor sentiment.

For March, the Labor Department reported this week that US producer prices rose 0.7 percent from February while consumer prices rose 0.6 percent. Energy prices were largely responsible for the large increases. Core prices excluding food and energy rose at a slower pace -- core producer prices were up only 0.1 percent in March, although core consumer prices were still up a relatively high 0.4 percent.

The Beige Book report by the Federal Reserve on 20 April alludes to similar inflationary tendencies: "Price pressures have intensified in a number of Districts, and most report that high or rising energy prices are a concern across sectors."

Other parts of the report show that the US economy remains strong. Business activity reportedly "continued to expand from late February through early April". More than half of the Districts reported that retail activity was up. Manufacturing activity was described as "ahead of year-earlier or previously-reported levels". The report also noted that in general, "firms in the service sector enjoyed a moderate increase in activity". In real estate, residential real estate markets was reported to be "strong across most of the country, while commercial real estate conditions varied". It also reported that for most Districts reporting on financial services, "demand for loans increased across a range of categories" and other banking indicators "were holding steady or improving in some cases".

On 18 April, though, the Commerce Department did report a large 17.6 percent fall in housing starts in March. Some analysts, though, point out that this figure is volatile and, in any case, the number of starts remains at a high level.

If the US -- one engine of global economic growth -- remains hot, the other -- China -- is no less so.

On 20 April, the National Bureau of Statistics announced that China's economy grew 9.5 percent in the first quarter of 2005, the same rate as for all of 2004. Fixed asset investment increased 22.8 percent in the first quarter, just slightly slower than the 25.8 percent growth rate for 2004.

These figures add to the likelihood of further tightening in both the US and China. And this is surely on the minds of investors.

In my previous commentary, "Analysts slightly bearish towards equities", I had highlighted a number of bearish views. Here is more.

On 19 April, Bloomberg columnist Chet Currier wrote an article entitled "Weitz, Dodge, FPA -- Scary How Wary Top Funds Are". In it, he wrote: "One striking aspect of the recent decline in stock prices is how many top-performing fund managers saw trouble coming."

Currier quotes Wally Weitz of Weitz Value Fund and Weitz Partners Value Fund as saying: "Almost everything looks expensive." And Dodge & Cox Stock Fund chairman Harry Hagey and president John Gunn was quoted as writing in their annual report: "Looking out over a three- to five-year period, we continue to believe that returns from the broad equity market will be modest and could be punctuated by some unpleasant negative contractions." And FPA Capital Fund manager Bob Rodriguez was quoted as saying: "Both in bonds and equities, we are taking extraordinary measures to protect capital, since we believe we are in a period of diminished investment returns."

Consensus, you say? Contrary action indicated?

Not necessarily. Remember that these are top-performing funds. According to Currier, the Weitz Value Fund returned 16.7 percent a year over the past 10 years, the Weitz Partners Value Fund returned 16.6 percent, the Dodge & Cox Stock Fund returned 15.8 percent and the FPA Capital Fund returned 17 percent. For comparison, the Standard & Poor's 500 Index returned 10.8 percent a year over the same period.

Merill Lynch has found similar pessimism as well. In its recent survey of global fund managers, it found increasing pessimism about economic growth, corporate profits and prospects for equities.

Whereas in March, a net 11 per cent of managers expected the global economy to grow in the next 12 months, the latest survey found a net 20 per cent expect it to slow. 52 per cent of respondents expected the outlook for corporate profits to deteriorate over the next 12 months, compared to 39 percent in March. 30 per cent predicted margins will shrink, compared to 18 percent last month.

59 per cent of managers said they were overweight in equities, down from 68 per cent in March. 65 per cent were underweight in bonds, the same as last month.

Recently, global equity markets have been making relatively large moves, mostly on the downside. Yesterday, for example, the Standard & Poor's 500 fell 1.3 percent.

The on-going global equity bull market has been resilient so far, and fund managers have only gradually trimmed their long exposure to the market. Let us see whether things will change from here on.

Analysts slightly bearish towards equities

2005-04-15T13:02:00.000+08:00

A wide diversity of views on the outlook for equities is normal. However, there seems to have been some convergence of views lately, mostly towards the bearish side. Nothing extreme enough, however, to provide a reliable indicator, contrary or otherwise.

This week's issue of The Edge Singapore illustrates this point. It carries five articles describing the investment outlook from different perspectives. None is particularly bullish, and some are bearish.

The first article is from DBS Bank economist Dr Fong Cheng Hong. In the article, she recommends that investors "stay defensive". She thinks that the outlook is clouded by fears of a sharp rise in oil prices, inflation and interest rate hikes. She recommends being overweight in commodities, neutral in equities and underweight in bonds. Among equities, she is overweight Europe and Japan, underweight the US and neutral on Asia ex-Japan. Within Asia ex-Japan, she likes Indonesia, Singapore and Taiwan.

The second article carries an interview with Mauro Ratto, chief investment officer for Europe, new Europe and Asia at Pioneer Investments. In the article, Ratto is quoted as saying that he sees western developed markets as "entering a phase of low yields and low returns". While he thinks that ""there is not too much scope for top line growth, or further cost cutting", his main concern is rising interest rates. He thinks that investors are likely to be nervous until interest rates peak. Then "things will get more interesting", he says. "But at the moment, we prefer to be cautious."

The third article is by Michael Kahn, who looks at technical indicators to conclude that stocks are likely to head lower. He says that "the half of the year that is historically kind to stocks is now about over, and the half of the year that is not so kind is about here. The tide has turned". In addition, in the four-year cycle, or presidential cycle, the first year after the election -- which we are now in -- tends to be "a rough one". For example, there were major bottoms in 1998, 1994, 1990 and 1982 -- the exception being in the crash in 1987, which came late. Otherwise, this cycle indicates a low "in the latter half of 2006, and to get there from the current highs there is only one direction -- down".

The fourth article is by Edgar Ortega. It looks at the survey results from Investors' Intelligence, and finds that the percentage of bullish newsletter writers fell to 47.9 percent in the last week of March from 51.6 percent. That represents the lowest reading since the week ended 3 September. Bearish writers, on the other hand, rose for a fourth week to 29.2 percent from 28 percent. The gap between bullish and bearish sentiment was 18.7 percentage points, whereas it had been as high as 43.3 percentage points in December. Ortega notes that Investors' Intelligence considers a gap of 10 percentage points "normal". In other words, sentiment among newsletter writers appears to be moving from away from a bullish extreme towards a more "normal" one.

The fifth article is an interview with renowned technical analyst Martin Pring. Alluding to the same four-year cycle that Kahn mentions, he says that "it is possible that we will get one more new high in the Dow before the end of the year. However, 2006 is a low point in a very reliable four-year cycle, and so I see prices lowering over the next 18 months." He adds that the market is in the stage that is "bearish for bonds and stocks and bullish for commodities. About half the time, stocks rally a little in [this stage] and in the other half, they decline".

To sum up, of the five articles, only those involving views by Kahn and Pring could be said to be outright bearish -- although Pring does concede to the possibility of one more new high -- while Ortega's article indicates overall sentiment among newsletter writers as mildly net bullish but deteriorating.

We have looked at opinions expressed in The Edge Singapore. In a commentary on 14 April, Peter Brimelow at MarketWatch provided some more views from other sources.

Dow Theory Letter's veteran Richard Russell was quoted by Brimelow as saying: "Both the Dow and the Transports now well under their 50-day moving averages. They will probably test their 200-day moving averages. The 200-day MA has been a big support for a great many stocks on the decline so far. Let's see if she holds."

So Russell is still waiting for the market to give him the signal. The same is true for Michael Burke of Investor's Intelligence. Brimelow wrote: "[R]ecently he wrote, echoing Russell, that the Dow and the Standard & Poor's 500 Index must hold above their rising 200-day averages. Burke added that his short and medium term indicators were bearish."

Brimelow also quoted Dennis Slothower of On The Money, "one of the more successful newer services", as saying: "One of my concerns has been the breaking point at which an economic contraction begins. I think we might be there. There is just more and more evidence that a slowdown in the economy is occurring. I have been worried that the growth in the money supply over the last quarter was too weak. Investors are starting to see that a contraction could be in the cards near term and that earnings for the last quarter are likely to disappoint overall."

Finally, Brimelow cited a sentiment indicator: "Last night, the Hulbert Stock Newsletter Sentiment Index (HSNSI), which reflects the average stock market exposure among a group of short-term market timing letters, stood at negative 2.4%. On average, these letters were net short the market. This is roughly in the middle of the sentiment range, far from the extremes that might suggest a clear contrary indicator."

So, like the articles in The Edge Singapore, overall, you could say that there is a slight bearish tilt in the views of those that Brimelow polled, which is consistent with what the HSNSI indicates. And, as Brimelow pointed out, that is not enough to provide a clear indication of the market's likely direction.

Electronics stocks still underperforming

2005-03-28T13:40:00.000+08:00

Electronics stocks listed on the Singapore exchange have been weak for the past year or so, far underperforming the overall market. There are some signs that the business outlook for certain segments of the electronics sector may be improving, but whether electronics stocks can take advantage of this improvement is questionable.

The SGX Electronics Index closed at 136.77 last week. So far in 2005, it is down 16 percent. This follows a decline of 7 percent over 2004.

Contrast this with the overall market. The Straits Times Index is up 4 percent so far in 2005, after a rise of 17 percent in 2004.

Clearly, electronics stocks have badly underperformed the overall market. The recent performance of the sector in the real economy probably justifies this underperformance.

In February, Singapore's non-oil domestic exports (NODX) increased 7.9 percent on a month-on-month seasonally-adjusted basis, reversing a 0.6 percent contraction in January. However, overall NODX was pulled up by non-electronic products, especially petrochemicals.

Domestic electronic exports, on the other hand, fell 3.6 percent compared to a year earlier. This follows a 5.9 percent year-on-year growth in January. The decline in electronic exports was mainly due to weakness in exports of disk drives, telecommunications equipment and other peripherals.

Non-oil retained imports of intermediate goods, a short term leading indicator of overall manufacturing activities, posted a 3.9 per cent contraction on a month-on-month seasonally-adjusted basis in February, reversing a 9.0 percent expansion in January. This is not a favourable sign, although it should be pointed out that the indicator is somewhat volatile.

Manufacturing output in February tells a similar story, with overall output falling 9.8 percent from January on a seasonally-adjusted basis, having already fallen 6.9 percent in January. On a year-to-year basis, overall manufacturing output fell 10.2 percent while electronics output fell 2.4 percent.

A recent decision by disk drive maker Maxtor to close one of its two plants in Singapore will exacerbate the weakness in disk drive production. The company has decided to relocate its low-end production to China, following similar moves by rivals such as Seagate and Western Digital.

Companies in Singapore, however, may not be unduly hurt by the decline in the disk drive industry in Singapore. In a recent report on the disk drive industry, The Edge Singapore cited a March 7 note by OCBC Securities analyst Bryan Yeong in saying that some suppliers to disk drive makers have themselves set up plants in China. Therefore, this retrenchment exercise by Maxtor is expected to be "a non-event for the share prices of its suppliers".

The report in general struck an optimistic note for the disk drive-related companies in Singapore. It said that inventories and selling prices have improved and demand looks set to grow. High metal prices, however, could "throw a spanner in the works" for some of the companies.

Standard & Poor's also has an optimistic view of the industry. In addition to citing the improving trend in inventory level and selling prices, its analyst Richard Stice recently wrote that revenue growth will be underpinned by the expanded use of disk-drive products, with demand in high-end systems being supplemented by new avenues of growth in the consumer-device market.

Elsewhere in the electronics sector, the chip industry remains in the doldrums, although there may be light at the end of the tunnel.

Analysts generally expect 2005 to see essentially flat growth in semiconductor sales. For example, Merrill Lynch recently cut its earnings forecast for Micron Technology and Infineon Technologies and cut its ratings for Hynix and Powerchip Semiconductor from "buy" to "neutral" in the fact of weak demand and falling chip prices.

As a result, chip companies are holding back on investment. The Semiconductor Equipment Association of Japan recently reported that Japanese-based manufacturers of semiconductor equipment posted a book-to-bill ratio of 0.83 in February, down from 0.94 in January, while VLSI Research reported that the worldwide semiconductor equipment industry slid to 0.84 in February from 0.88 in January.

North American-based manufacturers of semiconductor equipment posted a book-to-bill ratio of 0.78 in February, according to the Semiconductor Equipment and Materials International (SEMI) trade group. What may be noteworthy, though, is that this is unchanged from the revised figure in January, suggesting a possible bottom for the industry.

Indeed, although orders for North American-based semiconductor equipment makers in February fell 22 percent over the same month last year, it actually improved four percent over January. In particular, backend bookings were up six percent in February over January.

"Keep in mind that the back-end typically leads the industry recovery," Avinash Kant, an analyst with Adams Harkness, was quoted in EETimes as saying. "While we expect the book-to-bill to stay at these levels (or even decline slightly) for another month or two, we do expect the book-to-bill to start to move up after that."

In another encouraging news recently reported by Bloomberg, ISuppli Corp said that it expected global stockpiles of chips to be "completely cleared out" early in the April-to-June period.

Demand for personal computers, however, is expected to decelerate. Last month, market research firm Gartner reported that it thought that business and home PC replacement activity is likely to decelerate over 2005. More recently, IDC reported that it was lowering its projected PC growth rate to 9.7 percent from 10.1 percent earlier, citing delayed economic recovery in Japan and a cautious outlook in the United States.

While the economic outlook is an important consideration for investors, they also need to be aware of another fact regarding electronics stocks: Many of them are quite expensively valued. Despite falling for the past year or so, electronics manufacturers listed in Singapore are trading at average P/E ratios of about 26, whereas the market as a whole is only trading at a P/E ratio of around 12.

This indicates that even where the outlook for electronics companies may be improving, the outlook for their stock prices may be a different matter. Investors apparently never quite gave up on the sector, looking forward to the eventual turnaround. When it comes, stock prices may not react correspondingly.

A strong bull run for the overall stock market over the next few months would probably pull electronics stocks along as well. Investors who do not see such a prospect for the stock market should probably remain wary of investing in the electronics sector.

Singapore stock market flashes warning

2005-03-14T14:03:00.000+08:00

The Singapore stock market, as measured by the Straits Times Index, is up so far this year, continuing the bull run that began in 2003. However, fundamentals do not suggest that this bull run has much further to go, while one particular technical indicator actually seems to be flashing a warning sign for Singapore stock investors.

First let us look at the economic backdrop.

Singapore's manufacturing output fell in January by 7.6 percent from the previous month on a seasonally-adjusted basis. However, the fall was mostly attributed to a fall in output from the volatile biomedical manufacturing cluster, which contracted by 8.6 percent over January last year. The spillover effect on other sectors relevant to the stock market is likely to be minimal.

The purchasing managers' index compiled by the Singapore Institute of Purchasing & Materials Management showed a reading of 51.5 in February, down from 52.4 in January. This indicated that manufacturing growth is likely to continue but at a possibly slower pace.

The dip in the overall PMI was attributed to lower new orders and new export orders, as well as lower levels of production output. The electronics index, however, rose to 53.9 from 52.6 the previous month, with strong growth being registered for new orders and production.

In the US, the PMI monitored by the Institute for Supply Management was 55.3 in February, a fall from January's 56.4. The sub-indices for new orders, production and employment all fell.

The global manufacturing PMI compiled by JPMorgan and NTC Research also registered a fall -- albeit slightly -- to 52.8 in February from 53.0 in January.

Paul Kasriel, director of economic research at The Northern Trust Company, thinks that manufacturing activity may decelerate further. In a commentary on 4 March, he said that the growth rate in global central bank holdings of US securities is relatively highly correlated with the ISM manufacturing index four quarters in the future. With the growth rate in these holdings turning down lately in the face of interest rate hikes by the Federal Reserve, he warned that manufacturing activity, and hence economic growth, is likely to slow down in the US.

Of course, as the US economy goes, so does the Singapore economy. And that bodes ill for the Singapore stock market.

In a weakening economic environment, valuations are not likely to be supportive of the market. In a report on 26 February in The Business Times, Teh Hooi Ling said that dividend yields and price-to-book ratios around current levels have historically been associated with weak market performance over the subsequent year. While the equity risk premium is still high compared to historical levels, she points out that rising interest rates and moderating corporate earnings may actually point to a lower equity risk premium.

Not surprisingly then, perhaps, that in an interview by The Edge Singapore of the managers of the top-performing Singapore funds for 2004 and which it published at the end of last month, none of the managers seemed particularly bullish on the Singapore stock market. And just last week, Merrill Lynch said in a strategy report that "we see the Singapore market trading at about fair value with a six-month target raised to 2,190", which is only 1 percent higher than Friday's close of 2,169.41.

If fundamentals do not look particularly bullish, what do technical indicators tell us?

I mentioned in a previous commentary the divergence between the trends for the large-cap Dow Jones Industrial Average and Standard & Poor's 500 from that for the Nasdaq (see "US stock market bullish but divergence and valuation are concerns"). I said that this divergence could be an indication of an impending market reversal.

The divergence between the large-cap index and small-cap index is even more pronounced in Singapore. In the first half of 2004, the STI gained 4 percent but Sesdaq lost 9 percent. This divergence widened in the second half, with the STI gaining 12 percent while Sesdaq lost 13 percent. In 2005 so far, the STI has gained 5 percent while Sesdaq has lost 3 percent.

Sesdaq had been formed in 1987 as a platform for small companies to raise funds. Over most of its history, Sesdaq tracks the mainboard Straits Times Index quite closely. It participated in the broad bull markets of 1993, 1998-99 and 2003, as well as the broad bear markets of 1997-98 and 2000-03. It did appear to go its own way in 1994-95, when it fell sharply by 58 percent while the STI fell by only 15 percent, but this could be attributed to the naturally greater volatility of small-cap stocks.

And yet, in the two main bear markets that it accompanied the larger market, there had been significant divergences at the start of those declines.

In the 1997-98 bear, the Straits Times Index had begun to fall in January 1997. From the beginning of January to the end of July, the STI fell 11 percent. However, over the same seven months, the UOB Sesdaq index rose a remarkable 37 percent.

In the 2000-03 bear, the STI peaked on the first trading day of January 2000, but Sesdaq had peaked in early July 1999. From the beginning of July 1999 to the end of December 1999, the STI rose 14 percent, but Sesdaq fell 20 percent.

The directions differed in the two examples -- Sesdaq outperforming in one, STI in the other -- but the divergences are clear. Possibly, the 1997-98 case reflected frothy excess, with the small-cap Sesdaq outperforming the STI at the end of the cycle -- remember, this took place just prior to the Asian Financial Crisis. On the other hand, 1999 may have been a case of a chastened and sceptical market giving Sesdaq a miss towards the end of its run-up.

Even the 1994-95 Sesdaq bear might have been a signal of relative weakness in the broader market. Although the STI did not tank until 1997, it mainly traded sideways from 1994 to 1996.

Divergence between the STI and Sesdaq has had a good, albeit short, track record. The current divergence has been unusually long and sustained. Investors should watch it carefully.

US stock market bullish but divergence and valuation are concerns

2005-03-07T13:05:00.000+08:00

On 4 March, the Dow Jones Industrial Average hit 10,940.55, its highest close since June 2001, while the Standard & Poor's 500 index hit 1,222.12, its highest since July 2001. The US bull market in equities lives on.

However, some people are nervous.

In a commentary on 1 March for MarketWatch entitled "Testing three-year highs on narrow leadership", Michael Ashbaugh pointed out that while "the S&P and the Dow challenge three-year highs, the Nasdaq isn't even testing two-week highs".

Ashbaugh went on to point out that "the recent Dow and S&P strength comes not only in the face of a weak Nasdaq, but a weakening Nasdaq. Each test of the S&P's three-year highs has been matched by a successively lower level on the Nasdaq".

And although the Dow and S&P went on to make three-and-a-half-year highs on 4 March, the Nasdaq, which closed at 2,070.61, remains almost 5 percent below its high in December 2004.

Ashbaugh explains that the Dow and S&P have actually been propped up by the energy sector. That is why the Nasdaq has not participated. In other words, the recent strength in the market is actually narrowly-based.

Ashbaugh said that in "a perfect world, you would look for more broad-based participation to drive a sustainable move to multi-year highs". Divergence among indices is often a bearish indicator.

At least that is what the Dow Theory claims. The Dow Theory, though, focuses on the relationship between the Dow industrials (as represented by the Dow Jones Industrial Average) and the Dow transports (as represented by the Dow Jones Transport Average).

According to the theory, a bull market is confirmed when both sectors reach significant new highs, while a bear market is signalled when both averages reach significant new lows. Market turning points occur when the two averages trend in opposite directions or diverge.

In a commentary for MarketWatch on 4 March entitled "Dow Theorists smile after Friday rally", Mark Hulbert makes the observation that "Friday's rally was even stronger for the DJTA than for the DJIA, and now both averages are above their late-December levels". No divergence there.

Does this mean that Dow theorists are bullish? According to Hulbert, yes -- at least for the short term. Hulbert makes one caveat: Richard Russell, editor of the Dow Theory Letters, remains bearish for the longer term.

"That's because," Hulbert explained, "by his reading, the original Dow Theorists placed even more weight on valuations than they did on joint new highs among the primary Dow averages. And because the market remains overvalued according to any of a number of fundamental criteria, Russell believes that any bull market we are seeing now comes within the context of a secular bear market that will eventually take the market down to much lower levels."

And Warren Buffett apparently agrees that the market is overvalued. In his latest annual report for Berkshire Hathaway, the billionaire investor said he ended the year with "$43 billion of cash equivalents, not a happy position".

"My hope was to make several multi-billion dollar acquisitions that would add new and significant streams of earnings to the many we already have," Buffett explained. "But I struck out. Additionally, I found very few attractive securities to buy."

That did not stop Berkshire Hathaway from raising its per-share book value by 10.5 percent, close to the 10.9 percent rise in the S&P 500.

Nevertheless, if the great investor has problems identifying good stocks to buy, more ordinary investors would be well-advised to take another look at their holdings or candidates for purchase.

In any case, getting back to the Dow Theory -- which was formulated long before Nasdaq came into being -- one could reasonably ask whether the DJTA is more relevant than the Nasdaq in today's market. And that would of course throw open again the question of whether there is a divergence within the market that is signalling an impending reversal.

The bull market may still be alive, but for how much longer remains an intriguing question.

Bubbles everywhere -- and about to burst?

2005-03-03T13:05:00.000+08:00

How do you know when interest rates are too low? When bubbles start to appear in asset markets in the form of prices rising above historical norms. And there are signs that bubbles have indeed appeared, and in assets that are not always considered as part of financial markets. When bubbles are so widespread, investors would do well to watch out for their bursting.

The stock market is one area that low interest rates could have created a bubble. In a recent commentary entitled "Poor start to 2005 for US equities", I had highlighted a CBS MarketWatch article by Mark Hulbert that indicates that the US stock market could be as high as 50 percent above historical norms. Hulbert's conclusion: Stocks aren't cheap.

What sustains the high valuation? By all accounts, it is low interest rates. Low interest rates allow investors to discount corporate earnings at lower discount rates, which inflates stock values.

If interest rates rise in a persistent manner, though, the high valuation may fall. And that is a real danger, with the Federal Reserve currently on a campaign to raise interest rates. Even 10-year Treasuries, whose yields had stayed stubbornly around 4 percent for some time in the face of the Fed hikes, have started to rise over the past few weeks.

Global real estate is another area that many consider to be experiencing a bubble. I have discussed this before in an earlier commentary (see "No bubble in housing?"). And in December last year, The Economist warned in an article entitled "Flimsy foundations" that the "ratios of prices to incomes are now above levels that have proved unsustainable in the past. Taking the average ratio of house prices to incomes in 1975-2000 as a baseline, American house prices are now almost 30% overvalued".

And the bubble may be about to stop expanding. The Economist article had pointed out that house prices in Britain and Australia were already falling. The US may be about to follow suit.

Sales of existing homes and condominiums in the US dipped 0.1 percent in January, while sales of new homes fell 9.2 percent, and the median price of a new home fell 13.2 percent to the lowest level since December 2003. It is not certain, though, that these indicate softening demand for homes, since bad weather could have played a part.

Richard Berner of Morgan Stanley, nevertheless, thinks that demand will indeed soften soon. On 28 February, in a commentary in the Global Economic Forum entitled " Housing -- Bubbly?", he wrote:

Housing fundamentals, in my view, are as good as they get, and activity is likely to decline over 2005 and 2006. Among the reasons: Previously favorable demographics are turning less supportive, much pent-up demand seems to have been satisfied, soaring housing prices have made purchase less affordable, interest rates are gradually rising, and starts are slightly out of line with sales.

The effect of cheap money is not necessarily restricted to housing. Andy Xie, also of Morgan Stanley thinks that even oil is a bubble. In a commentary on 1 March in the Global Economic Forum entitled "Oil Is a Bubble", he pointed out that although rising oil prices have been widely attributed to growing Chinese demand, China is actually still "a low-income economy and cannot sustain its rapid growth at current oil prices". According to Xie, in the short term, the pain of higher oil and material costs in general have been offset by expectations of "massive profits from property inventory in a rising market".

The real driver behind the rise in oil prices to current levels, Xie thinks, is liquidity.

Oil is a bubble because the strong demand reflects the global liquidity bubble. At the same time, financial investors have poured into this commodity... Without the demand from financial investors, the current oil price could be US$15/barrel lower, in my view.

The oil and property bubbles are aspects of the global liquidity bubble that has arisen from the combination of a low US Federal funds rate and the willingness of Asian central banks to accumulate foreign exchange reserves. The property bubble is the primary manifestation of this liquidity. The oil bubble is a secondary aspect. Oil, however, could destabilize the equilibrium through its contractionary redistributing effects...

However, Xie thinks that the property bubble in China is likely to deflate first, and pull down demand for oil in China as a result.

China's property bubble could deflate under its own weight. The number of residential properties under construction exceeds 10 million, or about 8% of urban households. The current average price exceeds 10 times urban household income nationwide and is more than 20 times in many cities of the Yangtze Delta region. The probability that all these properties can be sold at current or even higher prices is quite low, in my view. As soon as property prices begin to fall, the pain from high oil prices will be felt by the economy, and the demand for oil will likely decline sharply.

Cheap money sometimes makes its appearance in places not normally associated with the financial world. The latest issue of the New York Magazine features a story entitled "She Can't Be Bought" that, among other things, describes the huge demand for artworks:

People on Wall Street are seeking contemporary-art trophies...everyone wonders when this bubble will burst. Right now "feels like the last days of the Roman Empire," says private-art curator Todd Levin. "Compared to the eighties, it's a much broader group with much more money"...

If bubbles are spilling over into the art world, it is difficult to avoid the feeling that the era of cheap money has advanced to a rather mature stage.

STI approaching level of last major peak

2005-02-21T10:29:00.000+08:00

With the Straits Times Index (STI) closing at 2,168.86 on Friday, the Singapore market is around levels not seen since 2000, the year of the last major peak. Is the Singapore stock market ready to scale new heights? Or are we nearing a new peak?

To have an idea, let us first look at the economic backdrop.

The Singapore economy grew 7.9 percent in the fourth quarter on an annualised quarter-on-quarter basis. Manufacturing was the strong driver of growth in the fourth quarter, rising 14.1 percent over the previous year, with biomedical manufacturing outstanding.

The outlook for 2005, however, is for slower growth. The Ministry of Trade and Industry expects growth of 3-5 percent. Reflecting this slowdown, the composite leading indicator fell 1.9 percent in the fourth quarter over the previous quarter, following a 1.2 percent fall in the previous quarter.

Electronics, is likely to be a major victim of the slowdown. Non-oil domestic exports decreased by 0.6 percent in January on a month-on-month seasonally-adjusted basis, following a revised 0.2 percent rise in December, with electronics in particular rising only 5.9 percent from a year earlier after an 8.3 percent growth in the preceding month. Non-electronic products, though, grew 12.4 percent last month, thanks to strong exports of petrochemicals, electrical machinery and raw chemicals.

An outright downturn appears unlikely at the moment. The trade picture shows that non-oil retained imports of intermediate goods, a short term leading indicator of overall manufacturing activities in the months ahead, rose 8.8 percent on a month-on-month seasonally-adjusted basis in January, reversing the revised 3.7 percent contraction in December 2004.

The trend in the economy has analysts recommending investors move to the domestic sector, for example, property, banking and retail.

The property sector has seen particularly buoyant sentiment. This has often been fed by property companies themselves.

CapitaLand chairman Richard Hu was recently quoted in The Business Times as saying: "The outlook is positive given the growth in real estate markets in Asia, and we are well positioned to take advantage of this growth."

In the same report, the newspaper mentioned that Keppel Land is expanding into the property markets of China, Thailand, Vietnam, Indonesia and India, and also expects to see stronger growth in Singapore's residential and property market this year.

Both CapitaLand and Keppel Land recently reported a good sets of results for 2004.

The main risk for property stocks is the possibility that the good prospects for the sector have been discounted by investors. Remember that the Property Index outperformed the STI in 2004 by one percentage point and has outperformed the STI by about the same margin so far in 2005.

In contrast, the Finance Index underperformed the STI by about 7 percentage points in 2004 and continued to underperform the STI by about 3 percentage points in 2005 so far.

In even greater contrast is the Electronics Index, which underperformed the STI by a whopping 24 percentage points in 2004, reflecting the current malaise of the electronics sector, and continued to underperform the STI by almost 7 pecentage points in 2005 so far.

Indeed, many people think that while the electronics sector may be seeing a slowdown, things may turn up towards the end of the year. If that is the case, it may be about time for electronics stocks to start outperforming the rest of the market.

But what is the outlook for the market as a whole?

Interest rates have been rising and the yield curve has been flattening since around the middle of 2004. This trend is likely to persist. Such a trend is bad for the economy, but more importantly, it is bad for the stock market as well.

Asia-Pacific stock markets are generally perceived to be more resilient than US stocks. However, in a survey by Merrill Lynch recently, fund managers were found to be underweight on Singapore.

I had previously indicated that at the start of the last bear market in early 2000, the STI had found support at around the 2,000 level. I had thought that this provided a technical basis for the bull market to end with the STI below 2,000. With the STI now trading significantly above 2,000, this forecast has to be reviewed.

While the STI had found support at around 2,000 at the start of the last bear market, it had also found resistance at around 2,200. Can this be a target? It is only about 2 percent higher than Friday's close.

If the market breaks this level, then the next likely target is none other than the peak of 2,583 hit on the very first trading day of 2000. Now that's almost 20 percent higher than Friday's close. A mouth-watering prospect.

But is it realistic?

Will investors turn chicken in Year of the Rooster?

2005-02-07T13:26:00.000+08:00

Global stock markets have turned in mixed performances so far in 2005. Bullish investors hoping that early 2005 returns would form the basis for further gains in stocks for the rest of the year may be disappointed. And with bond yields low but short-term interest rates rising, investors may be forgiven for thinking that the investment outlook is poor for the Year of the Rooster. However, expert opinions remain highly divided.

The Chinese Year of the Rooster begins on 9 February. So far, European stock investors have the best reasons to crow.

	Close on 31 Dec 2004	Close on 4 Feb 2005	Percent change
S&P 500	1,213.55	1,203.03	-0.9
Nikkei 225	11,488.76	11,360.40	-1.1
Hang Seng	14,230.14	13,585.17	-4.5
Straits Times	2,066.14	2,113.58	2.3
FTSE 100	4,814.3	4,941.5	2.6
DAX	4,256.08	4,339.28	2.0
CAC 40	3,821.16	3,958.01	3.6

Where are stock markets likely to go from here?

Rising interest rates suggest that markets will go down. The Federal Reserve has been on a tightening cycle since the middle of last year and, just last week, raised the federal funds rate again to 2.5 percent.

And yet, interest rates remain low and the yield curve steep compared to historical norms. In the past, these have often provided good conditions for higher stock valuations.

As for the economy, most economists expect moderation in the coming months. A global all-industry index produced by JP Morgan edged lower to 57.1 in January from 57.2 the previous month. Its global manufacturing PMI was also slightly down based on its latest revised series, from 53.3 in December to 53.0 in January.

"The latest output indexes are consistent with annualized growth of approximately 3.5 percent in global GDP and 2 percent in global industrial production," said David Hensley, director of global economics at JP Morgan, in New York recently.

Such rates of growth should not preclude gains for stocks. But they don't guarantee it either. Columnists at CBS MarketWatch have of late argued for both.

Herb Greenberg, a senior columnist at CBS MarketWatch, wrote in a commentary on 4 February entitled "Investors ignore risk, reach for return" that investors might be too complacent.

"If markets climb a wall of worry, as the old adage goes, they collapse on a crevice of complacency," he wrote. "From my perch, the complacency in a wide variety of names, many of which show up in this column, hasn't been this pronounced since 1999 to 2000. There's simply little in the way of respect for risk, which is why I call this the no-fear phase of this market's cycle."

However, Mark Hulbert, editor of Hulbert Financial Digest and fellow columnist at CBS MarketWatch, thinks otherwise.

In a commentary entitled "The retreat of the bulls" on 2 February, he points out that the Hulbert Stock Newsletter Sentiment Index (HSNSI), which reflects the average stock market exposure among some short-term market-timing newsletters, has dropped from 59.2 percent in late December to 23.5 percent. Other indicators like the Hulbert Nasdaq Newsletter Sentiment Index and the American Association of Individual Investors' member survey also indicate large shifts in sentiment from bullishness towards bearishness.

Interestingly enough, Mark Hulbert appears to be saying the same thing about bonds, the usual alternative to stocks. He wrote in a 1 February commentary that "Bond advisers are too bearish right now". According to him, the Hulbert Bond Newsletter Sentiment Index (HBNSI), which represents the average bond market exposure among some short-term bond-timing newsletters, as of the end of January stood at negative 3.2 percent, which means that the average adviser among this group of bond timers is actually short the bond market.

However, CBS MarketWatch columnist Peter Brimelow and Edwin S Rubenstein, president of ESR Research, are not so sure. The latter two wrote a commentary on 3 February entitled "Bonds in uncharted territory" which said that if bonds do rally, it is likely to be for the short term only.

"The great bond bull market since 1980 is living on borrowed time," they wrote. "Our chart today shows that the post-1980 bond bull market is now already in territory uncharted in the past 100 years... There's room for a lot of play around these very long-term trends. But the end for bonds is nigh -- or the financial world is turning upside down."

However, the authors seem to be ignoring even longer-term trends. Indeed, the article provided data showing that $1 invested in bonds in 1801 would have grown to $122 in 1920 after adjusting for inflation. That's a real rate of return of about 4 percent a year. Since then, the value of the investment would have grown to $1089 in 2004 for a real rate of return of less than 3 percent a year.

No, the data actually show that bonds have some catching up to do. But that doesn't mean that it has to catch up anytime soon.

Contrary to what Brimelow and Rubenstein wrote, bonds might instead fall in the short term but rise thereafter. That is because while Hulbert may be correct in saying that bond traders in the US are short the bond market, the big players of today, the Asian central banks, are long -- very long see my previous
article "Explaining the fall in bond yields").

With the outlook so uncertain, I guess you can't blame investors who turn chicken on stocks or bonds going into the Year of the Rooster. Remember, the rooster may have wings but it cannot fly. Perceived potential for stocks and bonds gains may prove just as deceiving.

Companies react as stock options expensing takes effect

2005-01-17T11:09:00.000+08:00

In the aftermath of accounting scandals in the United States involving companies like Enron and WorldCom several years ago, regulators and financial industry experts initiated a thorough review of regulations that affected corporate transparency and governance. The impact of the scandals were so far-reaching that many other countries and accounting bodies other than those in the US carried out their own reviews.

One of the widely-discussed recommendations was that regarding the change to the accounting rule on the treatment of stock options. It was felt that the issuance of stock options by a company to its management encouraged the latter to hoard cash and, in the absence of proper accounting of its dilutive effect on the holdings of the other shareholders, masks the costs incurred by the latter.

On 16 December 2004, the Financial Accounting Standards Board in the US published a rule that states that, starting June 15, US companies will be required to expense stock options. Some US companies, especially in the technology sector, are reported to be unhappy about this ruling, which they claim hampers their ability to issue stock options to attract talent.

However, opponents of the rule still have time to lobby Congress and the Securities and Exchange Commission, both of which could override it. The Republican victory at the November election last year in particular opens up the possibility that Congress will overturn the rule, as some of the newly-elected Republicans are said to support diluting the expensing rule.

In contrast, a similar ruling is already in effect in Singapore. Not surprisingly, it is creating similar unhappiness in Singapore.

In a report in The Business Times entitled "Options expensing forces rethink on staff rewards" on 12 January, Michelle Quah wrote that "corporate compensation in Singapore is changing with the new year, as a new accounting rule compels companies to expense their stock options".

The new rule that she refers to is called FRS 102, which stipulates that from 1 January this year, listed companies must expense their stock options, measured at fair value.

According to Quah, this new rule "has changed the way the compensation game is played". Some companies are moving away from stock options towards performance-based share plans, she said, "because they realise they will have to account for these options as an expense from this year".

Stock option expensing is, of course, just an accounting change. It does not change the fundamentals of the company. The question is: Why should a mere accounting change affect the way a company compensates employees?

One possible answer is that accounting for stock option expenses is difficult -- there is no standard way of accurately assigning the cost of a stock option. Then again, there are plenty of accounting rules for which there is no standard and accurate way of complying. Companies have always found a way to live with them.

The more sinister interpretation is that the rule is having its intended effect. Managements who had been using stock options to pad profits and present a pretty face to investors can no longer do so. Thus, there is no longer any point in using them.

Determined managements, of course, can still find other creative ways to hide compensation expenses -- or any expenses for that matter. Those who have nothing to hide, though, will see less need to change compensation practices. For examples, according to Quah, Keppel Corp and CapitaLand have both decided to continue with the use of share options.

Ultimately, stock option expensing is just another part of the moves to improve the transparency of management action. A management that acts in the true interests of the company and its investors should have nothing to hide and therefore should have no fear of stock option expensing.

Poor start to 2005 for US equities

2005-01-10T11:48:00.000+08:00

US equities ended the first week of January 2005 in the red. The Standard & Poor's 500 was down 2.1 percent, the Dow Jones Industrial Average was down 1.7 percent and Nasdaq was down 4 percent. However, if there is any reason to worry about US equities for this year, this is not it.

In a commentary for CBS MarketWatch on 4 January titled "What's so special?", Mark Hulbert questioned the significance of the performance of stocks in the first week of January.

He pointed out that over the past 108 years -- since 1896, when the Dow Jones Industrial Average was created -- there have been 72 years in which this market benchmark rose over the first five trading sessions of the year. On average during these years, the Dow rose 6.88 percent from the end of that fifth trading day through Dec. 31.

For the 36 years since 1896 in which the market declined over the first five trading days of the year, the Dow on average rose 6.98 percent thereafter through the end of the year.

Hulbert gave more compelling reasons to be concerned in a commentary titled "Stocks are not cheap" on the following day.

Citing research by Clifford Asness of AQR Capital Management and Anne Casscells, formerly the chief investment officer for Stanford University's endowment and now chief investment officer of Aetos Capital's absolute return business, he points out that the P/E ratio of 16.1 for the S&P 500 based on projected earnings was 46 percent higher than the long-term average. Using trailing earnings, Hulbert said that the S&P 500's P/E ratio of 20.6 was 50 percent higher than what the two money managers reported the median P/E to have been between 1871 and 2003.

As Hulbert puts it: "The S&P 500's current P/E ratio is either 46 percent above historical norms or 50 percent above. Your conclusion in either case should be the same: Stocks aren't cheap."

That does not stop others from issuing bullish forecasts.

A BusinessWeek survey of analysts near the end of last year found that the majority of them see a rise of between zero to 15 percent for stocks. A more limited survey by SmartMoney revealed six bulls and three bears.

In his latest commentary for SmartMoney, Donald Luskin of Trend Macrolytics sees "good things" ahead. He says that "we are in a strong economic expansion that has no reason at this point to lose steam. Orderly rate hikes through the rest of the year will help, not hurt".

Luskin was optimistic for 2004, and rightly so as it turned out. Whether his optimism for 2005 is correct obviously remains to be seen.

The rate hikes that Luskin sees coming is usually bad for stocks. It is possible that "orderly" rate hikes may mean something different, although Luskin does not explain how such hikes differ from normal ones.

Luskin also points out that while "S&P 500 earnings were up 23.6 percent in 2004, stock prices themselves advanced by only 8.9 percent. That means there's a lot of upside still to be captured".

My take on this is different. Stocks anticipate the future. If stock prices did not advance as much as stock earnings in 2004, that is probably because at the beginning of the year, prices had already discounted much of the year-ahead rise in earnings. There may not be much upside -- if any -- to be captured.

In my opinion, we are already advanced in the current economic expansion. While the economy is likely to continue to expand in 2005 and earnings are likely to continue to rise at a healthy pace, the risk of a weaker-than-expected economy while the Federal Reserve is on a tightening bias is real, especially as we approach 2006.

While some may argue that 2006 is still a year away, remember that stocks anticipate the economy by between six to nine months. And if Mark Hulbert is correct in saying that S&P 500 stocks are between 46 to 50 percent overvalued, the ensuing fall in stock prices may be large.

The time to turn defensive -- if not outright bearish -- may be closer than many people think.

Stormy 2004 makes way for challenging 2005

2005-01-03T14:33:00.000+08:00

2004 has ended and, while some forecasts made at the beginning of the year went according to script, as usual, the year had its fair share of surprises for markets. Pundits will, no doubt, be looking forward to the new year with new forecasts in a very challenging environment for market predictions.

Arguably, the most unexpected event of the year came on 26 December, when an earthquake registering 9.0 on the Richter scale hit the Indian Ocean floor off the west coast of the Indonesian island of Sumatra. The earthquake triggered a tsunami that has taken -- as far as is known at the time of writing -- over 140,000 lives. As some commentators have described, it is a disaster of truly biblical proportions.

Those countries directly hit by the earthquake and tsunami -- Indonesia, Sri Lanka, India and Thailand -- will have to bear the cost of reconstruction, which is likely to stretch beyond 2005. Their travel-related industries -- the airlines and tourism -- is also likely to be affected. Insurance companies will also be hit, but for insurers, the hurricanes and typhoons that hit the United States and other parts of the world earlier in the year probably had greater impact.

Compared to this cataclysm, everything else that happened in 2004 seems relatively mild.

There were plenty of elections in 2004. President George Bush was re-elected to the US presidency. A few countries saw changes in leadership, including India and Indonesia.

Stock markets around the world did well, with most major markets ending well into positive territory. In this regard, there was little surprise: stock markets generally do well in the year of a US presidential election.

	Start of 2004	End of 2004	Percent change
S&P 500	1,111.92	1,211.92	9.0
Nikkei 225	10,676.64	11,488.76	7.6
Hang Seng	12,575.94	14,230.14	13.2
Straits Times	1,764.52	2,066.14	17.1
FTSE 100	4,476.9	4,814.3	7.5
DAX	3,965.16	4,256.08	7.3
CAC 40	3,557.9	3,821.16	7.4

Bonds, however, behaved contrary to expectations. At the beginning of the year, most analysts had expected interest rates to rise. The US Federal Reserve obliged by raising the target federal funds rate, but the yield on 10-year Treasuries finished the year at 4.22 percent, down from 4.25 percent at the end of 2003. The difference in yield between the 10-year and two-year Treasuries is 115 basis points, compared with 242 basis points at the start of the year.

One of the reasons for the stubbornly low long-term bond yields was Asian central bank buying. Determined to maintain the competitiveness of their economies through weak currencies, many Asian central banks, notably Japan and China, have been buying US dollars, which are then recycled into US bonds. This persistent buying has helped keep long-term bond yields low.

Despite Asian central bank buying, however, the US dollar fell against the yen and the euro for the third year in a row in 2004. The US currency fell 7.1 percent versus the euro and 4.3 percent against the yen as the US current account deficit ballooned to new records, hitting US$164.7 billion in the third quarter of 2004, 5.6 percent of US gross domestic product.

Commodities rose in 2004, fueled by surging demand from China. Gold rose in tandem with the fall in the US dollar. However, it was oil that stole the show. Crude oil prices rose 34 percent through the year, with Brent crude for February settlement closing at US$40.46 a barrel and NYMEX light sweet crude closing at US$43.45 a barrel after hitting a record US$55.67 in October.

So what will 2005 bring?

Analysts are generally sanguine about equities in 2005. The US stock market is expected to show a small gain. Europe and, especially, Asia are expected to perform better on better valuations. But how equities perform will depend on how the economy and other markets perform.

Interest rates are generally expected to rise in 2005. Of course, that was also what analysts expected in 2004. Nothing can be guaranteed. Indeed, inflation, one of the key drivers for interest rates, was generally below expectations in 2004, despite the surge in oil prices. Some analysts are expecting another surprise on the downside for inflation and long-term bond yields in 2005. A flattening of the yield curve -- a reduction in the difference between long-term and short-term yields -- may be a bad sign for equities.

Interest rates in Europe and Asia especially may be capped if anticipation of further weakness in the US dollar drives capital into these markets. Most economists acknowledge that to reduce the current account deficit, the US dollar needs to fall further, especially if the Bush administration fails to curb the other US deficit, its budget deficit.

Oil is expected to fall in 2005, with both Brent and NYMEX crude oil expected to average below US$40 a barrel. Much will depend, though, on whether China's demand for oil moderates and by how much. 2004 saw the Chinese economy moderate, albeit slightly. If it continues to moderate, or worse, suffer a hard landing, oil prices -- indeed prices for many commodities -- may see significant falls.

Finally, the performance of all of these markets will depend on the performance of the world economy. Most economists see a moderation in economic growth in 2005, but no recession. An increasingly indebted US consumer -- the engine of global growth for the past few years -- will have to curb his spending and rebuild his savings, but an outright collapse in US consumer spending is not expected.

A slowdown in spending by US consumers will have to be made up with spending from other sources. US corporations are relatively cash-rich and many analysts expect to see this cash make its way into the economy, either through corporate investment or by having it returned to investors. Other potential sources of increased demand include Europe and Asia, especially if rising currencies boost consumer spending.

However, it is far from certain that these sources of demand will manifest themselves in 2005. Should the highly-indebted US consumer start cutting back on spending but these alternative sources of demand growth fail to materialise as hoped, the expected moderation in economic growth may yet be turned into an outright recession.

Yes, I think forecasting for 2005 will be very challenging indeed.