Two-way street

Last week’s column suggested that markets are not the be-all and end-all of the economy, let alone of life. Having said that, and with all due disrespect, let’s talk about the outlook for the markets.

The easiest market to forecast seems to be the equity market. That’s because practitioners of both fundamental and technical analysis are pointing to the same conclusion: the current levels are way too high and prices will fall. That much is pretty much a consensus position, but there is – fortunately – much more disagreement as to how much. Some analysts think that if we revisit the lows of October-November, that will do the trick in terms of reaching what they consider ‘target levels’; others say that the decline could be greater, maybe much greater. In terms of the Dow Jones Industrial Average, numbers as low as 5,000 and even 4,000 – around half current levels – are at the far end of mainstream predictions, although there are much more extreme views out there.

However, davka amongst the biggest bears you will hear or read the expectation that there will be significant rallies along the way down – ‘bear-market rallies’, as they are called in the jargon. These could last for months and see prices go up as much as 30-50% from the previous lows — before plunging again to new lows. Moves of this magnitude are not that surprising, when you consider that the recent bounce from November to early January (which looks to be over, but may not be yet) took the Dow up by 20%, the S&P500 index by nearly 25% and the Nasdaq by more than 25%. Some sectoral indices in the US, as well as some emerging market bourses, saw larger rises still. Eventually, one of these bear-market rallies will turn out not to be a bear-market rally, ie. a rise followed by new lows, but rather will develop as a rise followed by a limited fall followed by a further advance. After that happens, we will know that the bear market has ended, but no-one knows when it will happen – and anyone who claims to is fooling himself and whoever believes him.

The point is that even among those who view the equity market as pointed down, it’s still a two way street. This is even truer of other markets, such as bonds and commodities, whose overall direction is dependent on whether or not the global economy succeeds in avoiding a serious deflation. This critical issue will not be resolved soon, and the answer certainly won’t pop up one morning. More likely, the perception of what is happening will shift several times, as first inflation and then deflation fears become more pronounced. That’s what happened during 2008 and that’s a more typical path for a macro-economic variable to take. But because this one is so important, huge amounts of money will move each time perceptions shift, taking bond markets up and down and potentially causing huge rises and falls in commodity prices such as gold and copper.

Then there are the currency markets. These are far more difficult to negotiate, because not only is there no consensus view with regard to the likely direction of any given currency, there is actually a strong likelihood that whichever view is taken, it should be assumed a priori that it will have to change before long. For example, a bearish view of the equity market can be expected to serve as a long-term position and any swings along the way can be ignored. The currency markets, by contrast, are now an ‘ugly contest’ in which investors are looking for the least bad currency. But it is fairly certain that the relative status of the currencies, and the economies they represent, will change over the next year, whilst to make matters worse, what is considered ugly and beautiful – investors’ tastes – are also fickle. The Japanese yen is a good example of this phenomenon, in that it has gone from most ugly to most beautiful over the last 18 months, but could lose that status in the next few months if any one of several parameters affecting it undergoes a major change – as one surely will, given the fluidity of the global economy. The same is true, in principle, of every major currency.

All this points to the likelihood that 2009 will be a more difficult year than 2008, strange as that may sound. In fact, 2008 was fairly straightforward if you had a clear view of the markets: in equities, if you were out, you were safe, if you were in, you were slaughtered; in bonds and commodities, there was one major inflection point, early in the second half, when the inflation scare ended and the deflation panic began. Even in currencies, the story was one of a weak dollar until July and a strong dollar thereafter. Horrible as most people found 2008, it had its positive aspects. This year will probably be less bad on a full-year basis, but it may not feel that way as it develops.

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