Global Stock Markets Now at Crossroads

(November 29, 2007)

Dear Subscribers and Readers,

Before I go on and discuss the extraordinary rally in the US stock market that we experienced yesterday, I want to devote some ink to the world's stock markets.  Specifically, I want to discuss the concept of “decoupling from the US,” especially from an emerging markets (i.e. mostly China and India) standpoint.  Without further ado, following is a table showing the latest 12-month forward P/E ratios for the various MSCI emerging markets indices, courtesy of Goldman Sachs, MSCI, and Thomson Datastream:

For our sharper-eyed or Chinese subscribers, you may notice that the forward P/E for the MSCI China Index is relatively low, given the astronomically high P/E ratios in the “A shares” that we have often heard from the mainstream media.  The discrepancy comes from the fact that the MSCI China Index represents shares in Chinese companies that are investable for the global investor – and includes other classes of shares, such as B shares, H shares, red chips, and so forth (subscribers who are interested in the different construction of the MSCI China Index versus the other Chinese indices can read about it at the following link on the MSCI website).

Looking at the above chart, it is interesting to see the significant divergences in valuations – especially valuations within China and India versus most other emerging markets, not to mention the American, European, and Japanese stock markets as well.  Clearly, global investors are looking for China and India to continue to “decouple” from a general slowdown in the OECD economies (especially the US, UK, Japan, and most of Western Europe ) – whether it is from a GDP standpoint, or importantly, from an earnings growth standpoint going forward.  We have previously discussed the high probability of not only a significant slowdown in US economic growth (which is now pretty much a given), but also in many other OECD countries as well, as outlined in both the OECD leading indicators and the Conference Board's leading indicators.  This is now also being confirmed by the continuing decline in base metals prices, despite the recent decline in the Fed Funds rate, continuing liquidity injections by the European Central Bank, and an inevitable 25 basis point ease by the Bank of England sometime in the next few months.  As we mentioned before, base metal prices has definitely been a good leading indicator of global economic growth over the last five years, given that much of the growth has been dependent on industrialization and infrastructure construction in countries like China, India, Brazil, Vietnam, United Arab Emirates, as well as real estate bubble in countries like the UK, Spain, France, Australia, and the US.   Following is a daily chart showing the spot prices of selected base metals with a base value of 100 on January 1, 2003:

In light of a significant economic slowdown in the OECD countries, especially the United States, the trade balance of the US has improved dramatically over the last 12 months as well.  Following is a chart showing the 12-month change in the US trade balance, smoothed on a 12-month basis, courtesy of Reuters EcoWin:

Note that we haven't witnessed such a dramatic improvement in the US trade balance in modern history, at least on an absolute scale anyway.  Not only have the growth in imports been declining, but given the relatively low US dollar, US exports have been increasing dramatically as well.  In light of the recent decline in base metals and oil prices, not to mention a continuing slowdown in both residential and commercial construction projects, my guess is that the US trade balance will continue to improve in the coming months, barring a 5 to 10% surge in the US Dollar during that time period.

Given the slowdown in the United States, especially in import growth, can emerging markets such as China and India continue to decouple from the US?  Following is a table, courtesy of Goldman Sachs and IMF, showing the amount of exports as a percentage of GDP for various countries:

Ironically, while a dramatic improvement in the US trade balance will help US GDP growth (just by the nature of the mathematics – and my guess is that because of this, the US will not slip into a recession next year) going forward, this will end up hurting other countries, especially Japan, given the recent rise of the Japanese Yen.  As an aside, if the US Dollar is about 15% to 20% higher than where it is now, there is no doubt that we will see a recession next year (such is the double-sided sword nature of a high currency).  Moreover, while Chinese exports to the US only make up 7.6% of GDP in 2006, it is important to remember that other countries in the OECD are also now slowing down as well.  Not to mention that many multiplier effects such as a decline in infrastructure investments or even domestic consumer spending as their export growth decreases going forward.  Just how much of an impact this will have on Chinese exports is uncertain at this point, but given the dramatic decline of the OECD leading indicators, base metal prices, etc., the market is definitely signaling a headwind for China (and to a lesser extent, India) that is the most severe since the beginning of this global economic and stock market boom in late 2002.  Combined with the relatively high P/Es in both the Chinese and Indian stock markets, my guess is that there is a significant chance of a correction in both China and India going forward.

As for the US stock market – given the dramatic two-day rise (greatest in five years) that we have just witnessed, the market is now significantly overbought in the short-run.  For example, the NYSE ARMS Index hit a level of 0.32 yesterday.  Since January 1940, there has only been 163 such readings (or 2.4 a year on average), and since January 2000, only 8 readings, including yesterday's.  Following is a chart showing the days where the NYSE ARMS Index hit a level below 0.33, versus the Dow Industrials, from January 2000 to the present:

Interestingly, four of these readings have occurred over the last four months, including yesterday's reading.  The first reading occurred on August 29, 2007 – the market would go on to rally for about six weeks or so before embarking on the current correction.  The second reading was on September 18th, and the third November 13th.  Despite the heavy buying power in all those three days, the market would ultimately decline to yet lower levels.  It is interesting to note that the first three readings from January 2000 and onwards occurred during some of the most dramatic moments in the 2000 to 2002 bear market.  In two of those instances, the dramatic “one-day wonder” resulted in a more severe correction going forward.  The third reading – coming on March 17, 2003 – actually came as a bear market reversal signal, but that signal came after three years of one of the most severe selling wave in modern US stock market history.  My guess is that yesterday's buying wave is merely a result of the severe emotional swings of investors and traders alike – and do not yet signal the beginning of a new bull market upswing (after all, we just had three of those over the last four months and they have all resulted in more selling afterwards).

Signing off,

Henry To, CFA