2005 reversals

“To be ignorant of what happened before you were born is to be ever a child” - Cicero

With just one week of 2005 behind us it is way too soon to reach strong conclusions about the year as a whole. However, we have already seen a significant reversal in the dollar, and positions and sentiment both in equities and bonds have a clear bias. It may be that the market is showing its hand unusually early this year.

Let’s take the markets one by one and see if we can see a pattern that will give us an edge.  

The dollar

The first place to start is the dollar. Our previous note in early December suggested that further downside was limited. Since then we saw a peak in pessimism towards the dollar and now we can see that not only does the downtrend look complete (at least for the time being) but we have seen a clear reversal in early January, with the trade weighted index taking out the early December high. This profile is usually the clearest signal the market gives us of a key reversal.

This means that our working assumption for the time being is that a medium term low is in for the dollar. This is likely to be supported by higher and rising interest rates in the US relative to both the Euro and the Yen. It is also supported by a key change in rhetoric from the Federal Reserve in the December 2004 FOMC minutes. Having put real interest rates at negative levels for a record period of time the Federal Reserve now seems very disapproving of “current excessive risk taking” and tight credit spreads.

A change in dollar direction, has key ramifications for bonds and equities as it is a major change from recent years. The dollar index has fallen dramatically in the last four years from 127 in July 2001 to the recent December 2004 low at 80.5. This fall in the dollar is why economic perception in the US is so radically different from elsewhere in the world. Gold has rallied substantially in dollar terms but has gone nowhere in terms of Euros or Swiss Francs. Americans worry about inflation but elsewhere in the world it is hard to see this as a major risk. Inflation is being experienced in the US, but mainly in asset prices.

We are still some distance from a general world-wide surge in price inflation, but the enormous move in the dollar has created very different economic perceptions depending on your geographical focus. This is why the reversal in the dollar could result in a dramatic shift in perception about the US economy and assets.

Bonds

The most remarkable factor in the bond market is the overwhelming bearish consensus and the persistence of this view, despite its lack of success. Ownership of government bonds is at record lows. Wall Street analysts are projecting lower prices/higher yields but since 1982 they have been right about the direction of bonds a third of the time, i.e. usually wrong. Furthermore the options market shows excessive bearishness from the volume of put options (downside bets) traded in excess of call options (upside bets) traded. Yet although short term rates have been rising, longer term yields actually fell last year which was the bias from these notes.

Major bear markets rarely happen, if ever, when there is already a bearish  consensus view. A major change in market direction is pretty much defined by the need for most market participants to change their position. Furthermore, this year we may have a rising dollar, higher interest rates and weaker economic and earnings growth. Why should we get a bear market this year if we didn’t last year? The one main reason could be that central bank intervention from Asian central banks might wane. That’s a big call as it would be a major change in their policy. But for now with a turn up in the dollar, demand for US assets is apparently not a problem. We have to continue to watch the dollar carefully but for now it seems that for the most part the bear case for bonds is even weaker this year than it was last year.

Equally, we do not yet have the conditions yet for a major rally. The ISM surveys still suggest strength in the economy and job creation has improved over the last year, even if it is still the weakest job recovery for decades. Also rising short term rates are a major restraint on bond market performance. My central assumption is that we have another year in line with seasonal bond market patterns. Choppy sideways to slightly lower prices in the first half of the year, with the potential for a major rally in the second half of the year as higher rates begin to bite. The amplitude and timing will of course depend on the usual factors and data flow in particular.

Equities

“The first panacea for a mismanaged nation is inflation of currency. The second is a war. Both bring a temporary prosperity. Both bring permanent ruin.”

- Ernest Hemingway

The two year rally in Equities has been very impressive. My own misgivings about the equity market in general have stemmed from the source of this performance. The most aggressive “growth at any cost” policies I have ever seen in a developed economy, along with a dramatic devaluation of the dollar. While going short the dollar, buying real assets, and buying certain individual equities have been very profitable along with trading bonds, I have always regarded the general rally in equities as a temporary phenomenon. A good trade perhaps but not really a good long term investment.

For me it is still the case that given the scale of the stimulus, the results have been underwhelming. The stimulus may well have been politically convenient but is unlikely to provide sustainable growth. Indeed it may create greater problems down the road.

2005 will likely be a watershed year for my perspective. The indicators I value are providing me with the strongest negative bias to the equity market indices that I have seen for some time:

1.     Extreme bullish consensus in equities. A key contrarian indicator.

 

2.     2004 saw the largest corporate insider selling since 2000 which preceded or signalled the 3 year bear market.

 

3.     The 1-2-3 stock market model is in “red light” condition. The condition was signalled in mid-year 2004, but its impact may have been delayed by the continuance of negative short term real interest rates.  This year real interest rates will turn positive.

 

4.     The election policy cycle has entered its most negative phase, with many of the policy stimulus measures fading in their impact on the economy. The first 2 years of an administration are usually the worst for the equity market.

 

5.     The dollar is now rallying, and the dollar bear market has been an enormous source of earnings growth in the last two years.

 

6.     Commodity insiders (who have by far the best track record) have taken a         record short position in equities, the largest by far since 2001, after which the market fell significantly. 

 

7.     Technically the two year rally looks mature even if it has not yet fully “confirmed” a top in place.

 

 To me these are impressive headwinds and enough to suggest that the first half of 2005 will see the beginning of a reversal in equities. Even if we just have a correction to the two year uptrend this would be a significant setback. Investors may need to consider reducing equity holdings and deciding which stocks they will be able to keep if we get a reversal. Value, income and consistent earnings may be the characteristics to look for as well as using clear money management rules to control risk.

Conclusion

As a trader or investor we should not care too much about whether we are “right” or “wrong” about every view we have or position we take. The only certainty is our fallibility. What we care about is finding a low cost methodology to taking positions with a high probability of success. If we do this consistently it is just a matter of time before we make money.

It is still very early in the year to have a plan, unusually so for me, and, of course, I may throw it away tomorrow morning. But for the moment at least we have some clarity.

Investors should be prepared for a series of reversals in 2005. The dollar has already signalled a change in direction, and it may simply be a matter of time before equities do as well. As for bonds, be leery of the consensus, it has a lousy track record and if we are right about the reversals in the dollar and equities the current consensus could be dead wrong once again at some stage this year.

 

 

 

 

 

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