Stock market rally last

The situation is that the stock market tops set in February remain secure. However, the markets, having fallen 7% (FTSE 100) and 8% (Dow Jones Industrials), are now enjoying a good rally. They have been helped this week by the latest Fed interest rate decision and the changes in their associated wording which point to a more likely easing than tightening. As the news was announced and the wording digested, so the Dow led markets higher, closing up 159 points on the day.

Why markets are destined for a correction

If stock markets have formed important tops, triggered by the US housing market slump and US sub-prime mortgage market woes, then they are destined to go much lower. In spite of the recent decline, it is still the case that a correction of at least 10% remains long overdue. We can but watch and wait for the market to deliver its decision. Either from below the February high, stock markets will turn over and test their recent lows (which for the Dow is 11940 and for the FTSE is 6000) or the recent rally from those very levels, will take stock markets higher and re-establish the bull trend.

Should markets recover and make new highs, we will consider closing the residual bear fund holdings and look to initiate small positions in one or two Asian markets, where the long-term future unquestionably lies. Alternatively, if, as we expect, stock markets head lower, the bear funds will do well and there will, almost certainly, be a very strong positive move by UK gilts.
The importance of the carry trade

The “carry trade”, which has been so important for stock markets, recently suffered a scary period as the yen rallied and put carry trade holdings under pressure – the carry trade is where investors borrow in a low interest rate currency, such as the yen, to invest in a high yielding currency, such as the New Zealand dollar – if the yen starts to rise, then those deals which are generally heavily geared will have to be sold. The yen, over the last two weeks, has given back some of its recent gains, bringing relief and renewed confidence to carry trade exponents. It is not likely that stock markets will do well if the yen returns to strength; for that reason, we are watching the Japanese yen/New Zealand dollar cross very closely.

Possibly by the time we write the next letter in two weeks, the market will have provided us with a clear message – we wait with baited breath.


What the stock market indicators are telling us now

Our Four Horses of the Financial Apocalypse were recently getting very boisterous but for the moment they feel reassured that the cause of their alarm, the sub-prime mortgage market, may have been overdone.

The white horse - false peace - The Volatility Index (VIX)
The VIX has pulled back to near its recent lows, having not reached the levels of June 2006. This renewed complacency would be shaken very quickly on any bad price action for assets.
The red horse – war and destruction – The Philadelphia House Market Index
No let-up on the grim news, the sub-prime mortgage market is in serious distress.

The resetting of the Adjustable Rate Mortgages that will be taking place this year and next year for mortgages set up last year, hangs over the market like the Sword of Damocles. Many US borrowers are going to face mortgage payments that are unaffordable, with no additional help available to them from the credit market. Large numbers of US sub-prime borrowers are probably financially doomed.

The 9% increase in US house building starts for February was a surprise, although it has to be borne in mind that this followed January’s grim 14% decline and a period of very bad weather. More important was the reported 2.5% decline in permits.

Donald Tomnitz, CEO at luxury house builder D R Horton, recently said “I don’t want to get too sophisticated here, but 2007 is going to suck, all twelve months of the calendar year.” And then Stuart Miller, CEO at Lennar Corp, said that they are writing off deposits and pre-acquisition costs for land it has under option. You don’t dump land if you are an optimistic house builder! Thanks to The Daily Reckoning for both of those recent quotes.

The black horse – famine and unfair trade – Dow Theory
This is the one that is going to carry the big message. The key lows and highs have been arrowed. If the coming price action takes prices below the arrowed lows for the Transports and the Industrials, then expect to see real problems for asset prices. Alternatively, if both arrowed highs are exceeded, markets might head higher quite quickly.

We think the levels we have highlighted are crucial. The good thing is they are quite close to current prices, so we should have a worthwhile signal soon.
The pale horse – sickness and death – The Inverted Yield Curve
This is the bogey-man – whilst the yield curve remains inverted, optimism must be low.

The fact that the Fed have just this week changed their tune and signalled easing rather than tightening is a clear indicator of their concern for the US economy - the danger really does lie to the downside. Lower US interest rates this year will most likely be because asset prices are falling dangerously and the Fed are desperate to put a floor under them. The inverted yield curve is predicting that will happen.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.