Bulls Go Backwards

By MoneyMorning.com.au

– Welcome to the new world of stock market trading, where no one really knows what is going on. Below is a chart of the S&P500, showing last night’s trading action.

– As you can see the market surged at the open as traders mistakenly thought the German vote to expand the European financial stability fund solves everything. It doesn’t. The S&P then spent the rest of the day in steady decline, falling around three per cent from the peak.

– Then, just after 3 pm, a buyer showed up to ensure the day finished in the black. Just as well too. A one per cent decline on the ‘positive’ German news would not have been a good look.

S&P500 all over the shop

S&P500 all over the shop
Click here to enlarge

Source: Stockcharts

– Such extreme intra-day volatility is a sign markets are trading in an information vacuum. You can trade the bullish outcome – which is to believe the European Central Bank (ECB), helped by the US dollar swap lines the Fed recently put in place, will flood the markets with liquidity. Or you can trade the bearish outcome – which is to bet on the whole bailout/default thing going pear shaped.

– The end result is in the hands of people who really don’t know what they are doing. That doesn’t inspire a lot of confidence, a feeling reflected in an erratic market.

– But the whole Europe thing is becoming a bit of a bore. While everyone sweats on the Greek outcome, the world economy continues to slow. Doctor copper, as shown in the chart below, is struggling. It’s down nearly 30 per cent from the peak reached in February. Adding impetus to the move, strong volume accompanied the recent sell-off.

– But it’s still got another 15 per cent to fall before it reaches the lows of 2010, which, as you’ll remember, was the point where the market began to discount QEII. Will it be the threshold for QEIII?

Copper looking precarious

Copper looking precarious
Click here to enlarge

Source: Stockscharts

– And copper could fall to that level pretty quickly if the slowdown in China gathers pace, which it will. China is at the tail end of an epic credit boom. The tide is now on its way out, exposing many property developers as having precarious finances. This is probably just the start.

– Hong Kong is a good proxy for what is going on in China’s real estate market, so let’s look at what’s happening in Honkers. Below is a three-year chart of the Hang Seng index. It’s not looking pretty. If the China property bubble is only just starting to show some cracks, then this market has much further to fall.

Hong Kong is looking sick too.

Hong Kong is looking sick too
Click here to enlarge

Source: Stockcharts

– Which is not great news for Australia. We’ve been riding the China boom for a while now. China’s credit bubble had a major impact on Australia’s post-2008 recovery, terms of trade, strong dollar and high relative interest rate structure.

– If China continues to slow, it will have flow-on effects for Australia’s nominal income growth, which in turn will see interest rates head lower by the end of the year.

– As far as investment strategies go, it could pay to have a look at beaten-down domestic cyclicals – like building materials companies – in advance of lower official interest rates. Commodity producers and mining services companies aren’t likely to gain much support while a China slowdown is in the news.

– But here’s a reason not to get too excited about growth (in any sector) in Australia. Our household debt levels are amongst the highest in the world. A recent ‘working paper’, called ‘The Real Effects of Debt’ released by the Bank for International Settlements (BIS) suggested there were debt thresholds where, once breached, they become damaging to growth.

– Before seeing what the thresholds are, take a look at the table below. It shows the systematic build-up of debt (combining household, corporate and government debt) across developed nations over the past 30 years.

Household, corporate and government debt
as a percentage of nominal GDP

Household, corporate and government debt as a percentage of nominal GDP


– Australia’s total debt levels are up there, but not as hefty as the G7′s debt burden (the first block of countries in the table). That’s because our non-financial corporate and government debt levels are pretty good, at 80 per cent and 41 per cent of nominal GDP, respectively.

– Household debt is where we stand out as world-beaters. Australia’s household debt is 113 per cent of nominal GDP, a level only exceeded by Denmark and the Netherlands.

– According to the BIS, 85 per cent is the threshold where debt becomes detrimental to growth. Australia is well beyond that point.

– This suggests a few things:

  • When (like now) China slows, the household sector won’t pick up the slack. Without the China boost, Australia could well slip back into recession.
  • Banks are facing a low growth environment, something their share price performance has suggested for a while now. Loans for residential property make up the bulk of household debt and these loans sit on the asset side of banks’ balance sheets. So if households rein in their debt levels, it will affect bank growth rates.
  • The economy is highly sensitive to interest rates. Because the household sector has such a high debt burden, debt-servicing costs soak up a lot of income. If interest rates fall, the interest rate sensitive areas should get a nice short-term boost.

– But any rally based on an interest rate cut will be purely cyclical. The world’s equity markets, Australia’s included, are in a ‘secular’ bear market. We are now suffering the consequences of decades of excessive debt growth. Total debt levels have grown to such an extent that they are damaging economic growth, not assisting it.

– And the refusal by officials to write off the bad debt and strengthen the global banking system is only making things worse. So make sure you have a ‘bear market’ strategy – plenty of cash, gold and good value, income-paying stocks to get through the next few years with your wealth intact. Because if you invest thinking it’s a bull market, you’ll go backwards.

Greg Canavan
Money Morning Australia

Bulls Go Backwards