A rally is overdue

2008-07-24T02:34:00.000-07:00

A bearish air now pervades financial markets as even the secretary has started using the R word (recession). Yet historically it has often been profitable to stick your neck out when everyone else has been hiding. Even in extended bear markets (which we are likely experiencing), it is not unlikely to see markets rally 20% before falling back again. Managers point to three stars that have recently aligned that could make way for rally.

1. Sentiment:
A way to measure capitulation by investors (at least in the short-term) is the VIX index. The understanding is that high (and unexpected) volatility brings about forced sellers – a huge sell-off then would lead to a peak in the index. However forced selling leads to oversold markets. Although the VIX index has yet to reach the heights of 1998 and 2003, where it breached the high 40s, the recent peak suggests another short-term rally is under way.

An interesting graph taken from the Morgan Stanley Fund manager survey shows that most fund managers are overweight cash. Even more so than during the early part of the decade. This firstly shows how much pessimism is already discounted in the market, and secondly it is a vital source of liquidity for a prolonged rally.

2. Valuation
We know that valuation levels are looking very attractive again. Consider the equity dividend yield on the FTSE All Share, which is now yielding close to the 10-year GILT. The last time dividend yields have breached the yield on GILTS was back in early 2003, which we know was just the start of the bear market rally.

3. Catalyst
The only ingredient missing to another rally was for oil prices to come off. The recent fall in oil prices can provide the final catalyst for markets to start rallying from this point.

I think it may be worthwhile to look to the sky for signs, and surely it is telling us that a rally is under way.

Your optimistic about the short-term analyst
Market Puzzle

Japan finally gets what it has been hoping for - Inflation

2008-07-22T07:09:00.000-07:00

As much as moviegoers knew that Arnold Schwarzenegger in the movie Terminator “will be back”, investors knew inflation will eventually return to Japan. Yet unlike the hugely successful sequel which saw Terminator fans celebrating the return of their hero, investors in Japan have been anything but celebratory. Are investors proving to be too pessimistic or is there reason for their pessimism?

We know that the case for a Japanese recovery hinges on one important variable: inflation. So at first glance, investors’ pessimism seems irrational, since the return of inflation will ultimately bring about a virtuous cycle – as goods and services produced by companies increase in prices, underlying earnings increase; this leads to higher wages, which ultimately leads to more spending in the economy and so the virtuous cycle continues. Like the rest of the world, Japan has in fact been experiencing inflation. The Bank of Japan (“BoJ”) increased its annual inflation rate forecast inflation for the year ending March 2009 to 1.8% from 1.1%. Therefore the first part of the equation of the virtuous cycle seems to be met; that is Japan has seen an increase in consumer prices (goods and services) which should lead to higher company profits and wages, and ultimately greater domestic spending in the economy. Yet there is something very disturbing about the current price increases which could mean that Japan’s recovery falters at the first obstacle (again).

Even though Japan has been experiencing inflation, the increase in inflation is mainly imported. Dearer food and energy prices, the source of every country’s malaise at the moment, is the culprit. Since Japan is a net importer of these goods, Japanese companies are not benefitting from this inflationary environment. Yet the prospects for companies are even more bleak than that. Demand from Asia, which constitutes about half of Japanese exports, has fallen this year. Exports to America are declining fast. Now Europe, which has so far proved to be the most stable trading partner is looking like it will join the group. And even though some analysts proclaim that higher inflationary expectations will ultimately lead to higher wages, it is very unlikely that in an environment of declining earnings and greater economic uncertainty, companies will increase their fixed costs by increasing workers wages.

So as promising as at first glance seemed, the return of inflation is not the welcome sequel investors have hoped for.

Your still optimistic investor in Japan analyst
Market Puzzle