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Have stock markets run away from reality?

19 June 2009 Dr Prieur du Plessis, chairman of the Plexus group
Dr Prieur du Plessis, chairman of the Plexus group

Dr Prieur du Plessis, chairman of the Plexus group

It seems as if the spring rally in international equities has exhausted itself, “And it is about time, given the extent and rapidity of the move,” says Dr Prieur du Plessis, chairman of the Plexus group.

The MSCI World Index has increased by 45,2% and the MSCI Emerging Markets Index has risen by a staggering 68,9% from their March lows until the early June high. Both indices have only experienced one down-week since early March.

A panel of investment experts who are members of the Barron’s (an international financial publication) mid-year Roundtable discussions agreed this past weekend that the March lows of the stock market would not be broken. “Although this is heartening news it rings alarm bells,” says Du Plessis. “This is a reminder of rule #9 of the famous ‘Investment Rules’ of Bob Farrell, legendary former chief stock market analyst at Merrill Lynch. According to Farrell, ‘when all the experts and forecasts agree, something else will happen’.”

Many stock markets registered their worst single-session percentage losses in a month two days later on 16 June. Commodities also faced heavy profit-taking, but safe-haven US government bonds rallied and the dollar strengthened against a basket of currencies. “This could be an about-turn in short-term trends,” says Du Plessis.

Richard Russell, renowned US investment guru and veteran writer of the daily Dow Theory Letters, commented on 15 June: “This bear market rally is in the process of topping out. When a counter-trend rally tops out within an ongoing primary bear market, the odds are that the stock market will break to new lows during the period ahead. This means the stock market will break below its 9 March lows in coming weeks. A violation of the 9 March lows would be a shocker to most investors, and it would forecast an even worse economy coming up.”

According to Du Plessis, the S&P 500 has been mapping out a trading range between 925 and 950. “The 16 June close of 924 took the index below the bottom of the range. As stock markets have started to show exhaustion – also seen in the low volume characterising the last few days’ increases – this could be more than a ‘false alarm’,” says Du Plessis.

The moving averages of the major US indices show all the indices still trading above their respective 50-day moving averages (a short-term trend indicator). The Dow Jones Industrial Index, a longer-term trend indicator, has again fallen below the key 200-day line, rejoining the Dow Jones Transport Index. Excluding the Nasdaq Composite Index, all the indices are below the early January peaks. “Importantly, the levels from where the rally commenced on 9 March should hold in order for base formations to remain in force,” says Du Plessis.

According to Du Plessis, the “less-bad-than-expected” school of thought is largely focused on survey data such as the Purchasing Managers Indices (PMIs). “It makes for interesting reading to revisit the historical relationship between the PMI and stock market movements,” says Du Plessis.

“Based on pronouncements at the 13 June meeting of the Group of Eight finance ministers, ‘green shoots’ seem to be wilting somewhat, leaving investors asking whether the recent reflation trade has not been getting ahead of itself,” says Du Plessis.

Du Plessis’s study went further to apply a regression analysis between the two series of data. “By applying the regression results to a range of PMI assumptions, we could calculate the expected changes in the S&P 500,” says Du Plessis.

The figures show that a “pessimistic” scenario of a stagnant PMI would result in a decline of 23,4% in the S&P 500, that is an index level of about 700. Even a “realistic” scenario of gradually increasing the PMI by 1% per month between now and November would still result in the S&P 500 being 8,7% lower by the end of November. “Interestingly, the US stock market seems overpriced under all scenarios over the next few months and only reaches positive territory again in August under the ‘very optimistic’ scenario and in November under the ‘optimistic’ scenario,” says Du Plessis.

He believes the US market is in need of more corrective action or consolidation before it can move substantially higher. “V bottoms such as we have seen since the beginning of March are extremely rare. W bottoms are a lot more common,” says Du Plessis. “It is difficult to envisage how much of a pullback there may be. I would be surprised if the retreat is not at least 10%, but do not exclude a bigger and longer correction than what many pundits are expecting. At this juncture my advice will be to assume a defensive position in your investment portfolio. “

The rally in the domestic equity market has been somewhat more subdued than that in other emerging markets, with the FTSE/JSE All Share Indeximproving by 30,6% from its 3 March low to a high of 23662 on 2 June.

Although the economic situation in South Africa may not be as dire as that of most First World economies, experience has taught that the local stock market is by no means immune to the international trend. “While the JSE offers better value than most First World stock markets and investors in the domestic market will still be rewarded for buying at current levels over the medium to long term, our advice to investors who are underweight equities is to phase money into the stock market over the next three to four months,” says Du Plessis.

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