Looking For Answers
MCLEAN, Va.–Global markets continue to sell off while investors and talking heads–including me–are trying to find out the underlying cause. I stand by my initial assessment (see SRI, 1 March 2006, The Butterfly Effect):
To put the current selloff into perspective, this is the fourth time that a correction of more than 5 percent has taken place since the beginning of the current bull market in global markets in the spring of 2003. As the following chart shows, we saw similar corrections in 2004 and 2005.
Source: Bloomberg
There’s no denying that the current selloff has been quite pronounced and fast-paced. Emerging markets in particular have been significantly damaged, with net redemptions from emerging-market equity funds surpassing $5 billion. Given that many funds are fully invested, if the heavy flow of invester redemptions continues, fund managers could be forced to sell more stocks.
Investors remain quite confused for reasons such as the disproportional weight market participants have placed on the actions and communiqués of the central banks. It seems the global economy has reached a point where not even central bankers are sure what’s happening.
Inflation worries, growth scares, housing markets and myriad other potential problems have made the picture less clear. For example, the Bank of England’s Monetary Policy Committee had a three-way split at its latest meeting regarding the future direction of rates. And from what the Federal Reserve Board governors have been saying individually, it seems the US central bank is mired in similar confusion.
Such discrepancies have made market participants nervous–they’ve begun to realize that central bankers may not be so omniscient after all.
In situations like these, investors must remember the words of former Morgan Stanley strategist Byron Wein: “Bear markets follow the three Cs–complacency, caution and capitulation.” Although complacency has been a feature of the current market environment for some time, capitulation is not yet in the cards. The market is entering a cautious phase that will be characterized by some buying opportunities in the context of erratic market movements.
The Japanese market is a case in point. “One of the markets most likely to correct,“ I wrote in March, “is our long-term favorite, Japan. The unrealized gains investors have in this market are huge, and some booking should be expected. As the chart below depicts, a move down to the 1,500 level in the TOPIX (TPX) can’t be ruled out.”
Source: Bloomberg
When The Butterfly Effect was published March 1, the TOPIX was trading near 1,600. Although the market defied the call for a while, it’s come back down with a vengeance. Many investors are now questioning whether 1,500 will hold; I believe it will.
I’ve made the case for Japan’s long-term potential on numerous occasions. The main idea is that the current economic cycle in Japan will be stronger and last longer than most market observers anticipate. This view is based on the structural changes taking place in the Japanese economy, the end of deflation and the fact that, as many years of depression come to an end, the Japanese are now much more optimistic about the future than they’ve been for a long time.
To follow up on our long-term theme of strong domestic consumption, the Tokyo-based department store operator Marui Ltd. (OTC: MAURY) is added to the Portfolio. It’s thinly traded, so you should avoid paying more than 36 right now. Given the current market action, consider scaling into the position.
Source: Bloomberg
I also believe Europe’s economic recovery will surprise investors this year. The continent continues to perform well, and the economic recovery continues to be driven by domestic demand because global trade continues to grow at least at trend level. After all, Europe is the world’s second-largest importer.
A look at a few leading European indicators confirms the trend. Specifically, the OECD leading indicator for Belgium, which generally leads the rest of Europe, has been rising at a healthy pace, while the German IFO business survey is at a 15-year high.
Source: Bloomberg
Source: Bloomberg
As the market continues to weaken, the fear is that negative wealth will affect domestic demand in Europe, potentially choking the recovery. This is doubtful, as Europeans traditionally do not have a big part of their wealth invested in equities. However, a big market correction in Europe (30 percent or more) would affect people negatively and thus jeopardize economic growth.
Turning to the markets, it should be obvious by now that investors with exposure to European equities should be making some adjustments to their portfolios.
For starters, cutting positions in small capitalization companies is a must as these companies will underperform, especially as volatility rises. (The chart below depicts small cap companies in the UK.) Consequently, big capitalization stocks are preferred.
Source: Bloomberg
In the context of a growing European economy, energy needs remain on top of the agenda; Europe is the second-largest consumer of natural gas in the world after the US.
Europe represents 20 percent of global gas demand, but produces only 12 percent. And its consumption should increase going forward. Russia is Europe’s biggest supplier of gas, and stands at one end of a relationship that could be marked by periodic quarrels.
In 2004, global gas demand was 2.7 trillion cubic meters and has been growing faster than oil at 2.5 percent per year since 1995, compared with oil’s 1.7 percent growth rate. Almost three-quarters of the world’s remaining gas resources are located in two regions: the Middle East and the FSU (mainly Russia). Iran and Qatar are the main Middle Eastern players.
The largest reserves in the Asia Pacific Region are held by Australia, China, Indonesia and Malaysia. In Africa, Nigeria and Algeria have the lion’s share, while Venezuela and Bolivia have the largest reserves in Latin America. Europe’s biggest players are Norway and Holland, while the US and Canada hold substantial amounts of gas in North America.
Given my view that energy is in a multi-year bull market and that Russia will play a pivotal role in the future as it develops its position as a global energy supplier, the current selloff offers an opportunity to buy in the Russian market. OAO Gazprom (OTC: OGZPY) is therefore added to the portfolio.
Gazprom is the largest natural gas company in the world by reserves and production. The company’s vast resources are 4.5 times more than ExxonMobil’s, the next-largest resource holder. Given that Gazprom is still in the process of developing its expertise, in terms of project and resource management, I expect it to gradually trade at valuation parity with the rest of the major resource companies of the world. Buy Gazprom below 45.
Source: Bloomberg
I sent a Flash Alert on May 15 that suggested reopening two short positions: BHP Billiton (NYSE: BHP) and iShares MSCI Brazil ETF (NYSE: EWZ). It appears these trades will work out. Therefore, I recommend setting stop losses at breakeven, which should be around $46 and $42 for BHP Billiton and the iShares, respectively.
Source: Bloomberg
[L]leveraged trades remain one of the main potential problems global markets face. In addition, many profits have been made, meaning you should expect corrections in many markets at the first sign of persistent weakness.
To put the current selloff into perspective, this is the fourth time that a correction of more than 5 percent has taken place since the beginning of the current bull market in global markets in the spring of 2003. As the following chart shows, we saw similar corrections in 2004 and 2005.
Source: Bloomberg
There’s no denying that the current selloff has been quite pronounced and fast-paced. Emerging markets in particular have been significantly damaged, with net redemptions from emerging-market equity funds surpassing $5 billion. Given that many funds are fully invested, if the heavy flow of invester redemptions continues, fund managers could be forced to sell more stocks.
Investors remain quite confused for reasons such as the disproportional weight market participants have placed on the actions and communiqués of the central banks. It seems the global economy has reached a point where not even central bankers are sure what’s happening.
Inflation worries, growth scares, housing markets and myriad other potential problems have made the picture less clear. For example, the Bank of England’s Monetary Policy Committee had a three-way split at its latest meeting regarding the future direction of rates. And from what the Federal Reserve Board governors have been saying individually, it seems the US central bank is mired in similar confusion.
Such discrepancies have made market participants nervous–they’ve begun to realize that central bankers may not be so omniscient after all.
In situations like these, investors must remember the words of former Morgan Stanley strategist Byron Wein: “Bear markets follow the three Cs–complacency, caution and capitulation.” Although complacency has been a feature of the current market environment for some time, capitulation is not yet in the cards. The market is entering a cautious phase that will be characterized by some buying opportunities in the context of erratic market movements.
The Japanese market is a case in point. “One of the markets most likely to correct,“ I wrote in March, “is our long-term favorite, Japan. The unrealized gains investors have in this market are huge, and some booking should be expected. As the chart below depicts, a move down to the 1,500 level in the TOPIX (TPX) can’t be ruled out.”
Source: Bloomberg
When The Butterfly Effect was published March 1, the TOPIX was trading near 1,600. Although the market defied the call for a while, it’s come back down with a vengeance. Many investors are now questioning whether 1,500 will hold; I believe it will.
I’ve made the case for Japan’s long-term potential on numerous occasions. The main idea is that the current economic cycle in Japan will be stronger and last longer than most market observers anticipate. This view is based on the structural changes taking place in the Japanese economy, the end of deflation and the fact that, as many years of depression come to an end, the Japanese are now much more optimistic about the future than they’ve been for a long time.
To follow up on our long-term theme of strong domestic consumption, the Tokyo-based department store operator Marui Ltd. (OTC: MAURY) is added to the Portfolio. It’s thinly traded, so you should avoid paying more than 36 right now. Given the current market action, consider scaling into the position.
Source: Bloomberg
I also believe Europe’s economic recovery will surprise investors this year. The continent continues to perform well, and the economic recovery continues to be driven by domestic demand because global trade continues to grow at least at trend level. After all, Europe is the world’s second-largest importer.
A look at a few leading European indicators confirms the trend. Specifically, the OECD leading indicator for Belgium, which generally leads the rest of Europe, has been rising at a healthy pace, while the German IFO business survey is at a 15-year high.
Source: Bloomberg
Source: Bloomberg
As the market continues to weaken, the fear is that negative wealth will affect domestic demand in Europe, potentially choking the recovery. This is doubtful, as Europeans traditionally do not have a big part of their wealth invested in equities. However, a big market correction in Europe (30 percent or more) would affect people negatively and thus jeopardize economic growth.
Turning to the markets, it should be obvious by now that investors with exposure to European equities should be making some adjustments to their portfolios.
For starters, cutting positions in small capitalization companies is a must as these companies will underperform, especially as volatility rises. (The chart below depicts small cap companies in the UK.) Consequently, big capitalization stocks are preferred.
Source: Bloomberg
In the context of a growing European economy, energy needs remain on top of the agenda; Europe is the second-largest consumer of natural gas in the world after the US.
Europe represents 20 percent of global gas demand, but produces only 12 percent. And its consumption should increase going forward. Russia is Europe’s biggest supplier of gas, and stands at one end of a relationship that could be marked by periodic quarrels.
In 2004, global gas demand was 2.7 trillion cubic meters and has been growing faster than oil at 2.5 percent per year since 1995, compared with oil’s 1.7 percent growth rate. Almost three-quarters of the world’s remaining gas resources are located in two regions: the Middle East and the FSU (mainly Russia). Iran and Qatar are the main Middle Eastern players.
The largest reserves in the Asia Pacific Region are held by Australia, China, Indonesia and Malaysia. In Africa, Nigeria and Algeria have the lion’s share, while Venezuela and Bolivia have the largest reserves in Latin America. Europe’s biggest players are Norway and Holland, while the US and Canada hold substantial amounts of gas in North America.
Given my view that energy is in a multi-year bull market and that Russia will play a pivotal role in the future as it develops its position as a global energy supplier, the current selloff offers an opportunity to buy in the Russian market. OAO Gazprom (OTC: OGZPY) is therefore added to the portfolio.
Gazprom is the largest natural gas company in the world by reserves and production. The company’s vast resources are 4.5 times more than ExxonMobil’s, the next-largest resource holder. Given that Gazprom is still in the process of developing its expertise, in terms of project and resource management, I expect it to gradually trade at valuation parity with the rest of the major resource companies of the world. Buy Gazprom below 45.
Source: Bloomberg
I sent a Flash Alert on May 15 that suggested reopening two short positions: BHP Billiton (NYSE: BHP) and iShares MSCI Brazil ETF (NYSE: EWZ). It appears these trades will work out. Therefore, I recommend setting stop losses at breakeven, which should be around $46 and $42 for BHP Billiton and the iShares, respectively.
Source: Bloomberg