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Monday, November 06, 2006

The Monday Edition- 1986 Like Mid-Cycle Slowdown? Housing & The Fed, Loss Of Interest In Metals & International Equities

By Yaser Anwar, CSC of Equity Investment Ideas

This week I take a look at 1) The biz cycle stage & how it relates to 1986 mid-cycle slowdown, a look at % of stocks trading at or below the 200-day MAs 2) Implications of housing on the Fed 3) Loss of interest in metals & a gold study 4) Increasing flows in International Funds, a look at foreign equities & their risks. Thanks in advance for reading.

Are we headed for a 1986 Like Mid-Cycle Slowdown?

To gauge where we are in the business cycle, I took a look at how cyclical industries have been faring. The economic booms and busts are caused by the huge cyclical swings in goods producers like manufacturing and construction alongside the cyclical parts of wholesale and retail trade.

I believe we are in the midst of a slowdown similar to 1986 mid-cycle one, which was the only case where a decline in goods and trade payrolls did not accompany a US recession. That's where we are today, with the slumping US goods and trade employment. Investors need to ask the question- How long can the economy thrive when over 2/3rds of the job gains in the last six months have come from government, education, health and leisure services?

Taking that into consideration, growth stocks tend to do well in the late stages of an expansion, but are unlikely to outperform as long as the market is unsure whether the United States is in a mid-cycle slowdown or at the end of the current expansion.

The growth in capital spending and net exports is not offsetting fully the effects on the US economy of a weakening housing market. Economists continue to expect GDP to grow at a slightly below trend rate in the second half of this year, which could spil over into 07. That being said, healthy global growth continues to support demand for American products, capital goods in particular. Exports should remain healthy longerterm too, as the expected weakening of the US$ makes American goods relatively cheaper internationally.

When I'm uncertain about market direction, one of the indicators I like to look at is the % of NYSE stocks trading at or below 200-day MA & compare them with previous market overbought levels. If you take a look at the image below, you will see that the % of companies trading at or below their 200-day MAs is nowhere near the overbought, riskier levels seen in 03 or 04, when the % was very low).

Despite the market indexes having hit six-year highs to all-time highs (Dow) this past month, there simply does not seem to be too much enthusiasm in the market.


There has been a rapid increase in the inventory of houses for sale, both new and existing, as a result of the downturn in the pace of sales. This suggests the adjustment might take some time to rebalance the housing sector, perhaps through 07 and into 08.

In the 90s, a similar sort of adjustment took place but that one required a bailout through the Resolution Trust Corporation. While that may not be needed now, it resembles the implications for monetary policy- the Fed eased aggressively back then to cope with the headwinds of the real estate adjustment.

If the housing adjustment intensifies, the likelihood of Fed ease will rise.
Gold & Metals

A study released this week by Belgo-Dutch Fortis Bank forecast that gold supply would fall by 159 tonnes in 2007, but that demand would contract by 303 tonnes, thus putting gold supply in surplus for the coming year. However, with the slowing US economy, the US$ will weaken which could be a positive for gold.

The investment community's interest in metals seems to have been eluded. Large speculators (CTAs and HFMs) in silver & copper are holding only 29% & 18%, respectively, of all long positions, which is their smallest position since 1996.
Anyone for the contrarian bus?

Int. Equities, Fund Flows & Risks

Emerging economies should feel the impact of decelerating US growth and lower commodity prices but these effects will be less severe than in the past. Improvement in their economic fundamentals, such as; flexible FX rates, low political tensions (maybe not Russia) and abundant currency reserves, will likely provide a cushion. Much of the excitement around emerging markets reflects expectations of superior growth outside of developed economies, especially China, India, Russia, and Vietnam.

According to September data just released by the Investment Company Institute, US growth funds have suffered the most, while value funds have witnessed a reversal, posting a modest inflow. The majority of inflows remains international, as $9+ billion made its way into overseas funds, up moderately from August, and also up modestly year over year. According to ICI, nearly 90% of inflows to US equity funds so far this year have been into internationally oriented funds.

At first glance, the outlook for international stocks would appear to be bright. Valuations are not stretched, examples- Germany’s PE is 14 and the UK’s is only 12. And the outlook for earnings has been improving, with every equity market in continental Europe witnessing more companies upward earnings revisions from analysts than downward revisions.
However there are three problems with this picture-

1) Most central banks outside the US are still in a tightening mode. Among the world’s major central banks, the last move was a hike in interest rates by 24 of those banks vs. a cut in rates by only four banks.

In my opinion- The abundant liquidity by central banks was one of the driving catalysts behind the strong international equity market performance over the past few years. The full effects of the withdrawal of liquidity by those central banks have yet to be seen.

2) With economic growth exceeding forecasts in Europe and Japan late last year and in the early part of this year, there are early indications that growth may now be slowing. Upon careful inspection, you will notice that the OECD’s leading economic indicators have decelerated recently in Japan, the Eurozone, and the UK. It is as of yet not clear whether economies abroad will slow down sufficiently to weaken earnings growth.

3) The increasing fund flows in international equities warrants caution given the excessive enthusiasm could be a contrary indicator.

In light of these uncertainties, I think it's best to maintain a market-neutral stance and portfolio allocation to international equities.

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