Monday, April 09, 2007

Epilogue of a boom

As I mentioned last month, the world economy is booming. In many ways, things just couldn't get any better.

If you've been investing in any stock market around the world over the past few years, you've done very nicely indeed.

Of course, if you're a long-run investor or aware that there is a business cycle (or even better, both!) then you've done very nicely over the past few decades and no doubt will continue to do so.

However, you're still only as good as your last investment. After all it can only take a few days or weeks to wipe out an entire year's worth of gains.

Now is one of those times when you really have to wonder if it's the time to sell.

I'm not saying this as an economist or as an investor, but as an observer of three simple facts.

These facts help explain why now is one of the riskiest times to be actively investing in the stock market.


Fact #1: There is a bizarre range of opinions about whether the US Federal Reserve is about to raise or cut interest rates.

Some economists believe a further hike is still a distinct possiblity while others are adamant that the next move will be down either within the next few months or at the latest by year-end.

Of course all of these economists have at some time or another been wrong about the Fed's next move(s), so their opinion (or difference of it) is not something to take too seriously.

What should be taken seriously is the prospect of the Fed actually having to cut interest rates at some point in the near future.

History is not usually the best guide for the future, especially in the stock market.

However, when it comes to the relationship between when the Fed cuts interest rates and the subsequent performance of the stock market, it's all we have.

US interest rates (red) and stock market growth (blue)


... 1996-2007

As both charts show, whenever the Fed has had to cut interest rates (and even when it hasn't) the stock market has fallen sharply.

One thing we often hear about is how interest rates are "historically low". From the first chart it's clear to see how low the red line has fallen and still remains in the second. This is why some economists still believe there is further room for a further hike or two.

At the end of the day, when the Fed does start cutting, it will already be too late if you're exposed to the stock market. As the second chart shows, the stock market (blue line) falls before the Fed starts cutting in anticipation of a slowing economy.

Fact #2: There is an even more bizarre range of opinions about whether the US economy will experience a recession either this year or next.

Most (in)famously, former Fed Chairman Alan Greenspan said recently that he saw a 30% chance of a US recession in 2007. As always, his comments have helped to sharpen the debate among other economists about the probability and timing of the next recession.

Given their poor record at predicting the direction of interest rates, it's not surprising that any forecast of a recession should be treated with more skepticism than respect. If they can't predict the actions of 12 people sitting around a table (deciding the direction of interest rates) it's unlikely they can forecast the consequnces of the actions of millions of people and thousands of businesses.

But again, given the frequency of past recessions in the US (shown by the shaded red areas in the charts above), we're due one soon.

Fact #3: Nobody seems to know if the US housing market will continue to deteriorate.

The consequences of a sharp correction in the US housing market for the rest of the world are extremely severe for one simple reason: if US real estate valuations fall further, US consumers will stop spending and the world economy loses one of its engines of growth.

I say "one of" because these days China and India are also fuelling global growth at an unprecedented rate.

Still, it's US consumers who still remain the biggeset spenders out there and what they do will be as important, if not the most important, determinant of global growth for years to come.


What these three facts all have in common, is that they reflect the fact that the US economic cycle has reached the stage where a sharp slowdown is not only inevitable but likely.

While the timing of such a slowdown remains uncertain, it is likely that any investor who remains heavily exposed to equities for the next 2-3 years is unlikely to see any gains over the period.

There are two choices that remain: sell soon or sell now.

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