Tags: US | Europe | markets | correction

Nothing Has Made Me Change My Expectation of Equity Market Correction

Tuesday, 21 May 2013 10:53 AM

By Hans Parisis

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Nobody can deny that we have seen broad-based optimism at extreme levels in many financial markets. Equity markets in United States and Europe have continuously been showing very good performances because their economies have remained weak or are weakening once again.

To me this raises serious questions when we see U.S. and European equity markets at historical heights while aggregate corporate earnings aren't rising, but are instead stagnating or shrinking.

Editor's Note: 5 Signs Stock Market Will Collapse in 2013

Nevertheless, it must also be said that we don't see the same kind of price performances everywhere. For example, in China the Shanghai Composite Index is not higher now (2,305) than was it was at the end of the first quarter of 2009 (2,373). In Brazil, the Bovespa Index is also not higher now (55,532) than it was at the end of 2011 (56,794).

Globally we see a clear "divergence" among important equity market performances, while at the same time broad-based consensus still expects a better global economy in the second half of this year.

That view has now been somewhat tempered by the latest global gross domestic product (GDP) forecast from The Economist Intelligence Unit, which expects global GDP to grow at 2.1 percent (at market exchange rates) — exactly the same growth rate as in 2012.

In my opinion, it's certainly not an overstatement to say it has become a real challenge to long-term investors that have funds to invest to not get distracted by the carloads of "optimistic" details provided by many investment "promoters" who try to convince investors that the equity markets still have solid legs to go higher.

I certainly don't share that view because of the simple question: "Investing now is based on what?"

Maybe it's somewhat old fashioned, hence when I have to consider long-term investing, which is absolutely not the same as "trading," I always try to follow, among other things of course, rule #9 of Robert Farrell's "10 Market Rules to Remember," which reads: "When all the experts and forecasts agree, something else is going to happen."

So, today, a reasonable question should be "what else could happen" in the next couple of years.

So far, very few market players seem to be concerned about what's going on in China, where we see a continuously increasing credit bubble even though the investment "boom" is virtually coming to its end and the economy is bound to slow further. Last week, the China Securities Journal quoted Premier Li Keqiang stated: "If there is an over-reliance on government-led and policy-driven measures to stimulate growth, not only is this unsustainable, it would even create new problems and risks."

When we combine the Chinese situation with what is going in Japan, where we see a continued targeted yen devaluation that now has lost a stunning more than 30 percent against the U.S. dollar since Oct. 1. With the yen rising from 78 to 102 per dollar (higher means weaker) over that period, any serious long-term investor should take into account what the combination of what's happening in these two very important Asian countries could mean for many economies in the world in the foreseeable future.

The actual Japanese government aims with whatever it takes to provoke a 2 percent inflation rate within the next two years through, among other things, devaluing its currency. To put this in context, the latest inflation rate that is available showed a still negative -0.9 percent year-over-year inflation rate in March.

Experts agree that for Japan to achieve a 2 percent inflation rate within the next couple of years, it will have to continue devaluing its currency by about 20 percent per year. Believe me, this is no small matter when we take into account that Japan is the third-largest global economic powerhouse ($5.9 trillion) in the world after the United States ($15.5 trillion) and China ($8.2 trillion).

The danger of Japan devaluing excessively its currency could cause severe collateral damage in many other big export-oriented economies, as it would put in danger the competitiveness of many of these economically important economies in the world like Germany, China, South Korea, but also the United States, etc, which in turn, could cause a contraction of returns, with some even going to negative, on recent investments made in these economies. Such a scenario should have deflationary consequences whereby profits also undergo severe cuts and such a situation could even tip the concerned economies back into a recession.

Believe me, the central banks' printing presses or monetary easing policies shouldn't be of great use if we have to face such a situation.

So it all depends on "Will Japan be able, or be allowed, to devalue massively its currency further during the next couple of years? If you ask me, the answer is yes, as I see we are only at the beginning of a cyclical and structural decline of the yen that could easily last for several years.

Unfortunately, the problem doesn't end there.

We should ask ourselves on how do we think equity markets would react once they realize that further money printing/monetary easing policies have lost their broadly believed ability to create growth in the real economy. What would happen once these markets realize "the emperor has no clothes?"

No doubt that confidence in equity market prices would plummet to depths rarely seen in history. No, even if central banks should start buying equities directly, which is highly improbable but you never know, it wouldn't probably help either.

Of course, I don't know for sure if such a scenario will take place within, let's say, the next couple of years. What I do know is that if such a scenario should take place it will surely encapsulate very unpleasant questions to which our economies, as well as most of us, will have to find solid answers for, as will be the case during the next downturn, which could be much closer than many consider as probable today.

Finally, nothing has occurred that has made me change my expectation of a correction in the equity markets.

The United States, as well as the U.S. dollar "cash equivalent" investment instruments, remains my preferred investment locations.
 
Editor's Note: 5 Signs Stock Market Will Collapse in 2013

Of course, the Norwegian krone remains one of my preferred currencies. Norway runs a budget surplus of 10 percent, GDP is expected to grow 2 percent and the unemployment rate stands at 3 percent. With elections coming up in September, I expect the Norwegian krone to strengthen somewhat.

As for gold, I'd like to say I only expect a real resumption of the secular gold bull market once the world economy faces its next crisis, which in my opinion should be sometime within the next couple of years. The good news is the next crisis will offer many interesting long-term investment opportunities.

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