Month: August 2009

Grist for the Bears

Doug Short has attracted enormous attention to his website http://www.dshort.com/ with his “Four Bad Bear Market Analysis” (shown below and updated to Friday 28 August by its originator). The natural bears took great satisfaction from the apparently severe regularity of past bear markets, especially that of the crash of 1929. The problem for the bear lovers, as may be seen in the accompanying diagrams is that the relationship, especially with the bad bear of 1929-32, appears to have broken down in the face of the rally in stock markets that began in March 2009. The recent recovery appears by now to have extended for too long and too far to be identified as a bear market rally or a bear trap.

Source: dshort.com

If at first you don’t succeed….

This break in the data led the inventive Doug Short (his real name assuredly) to realign the starting point for the analysis and the apparent regularities from the top of the markets before they collapsed to the following bottom, when the markets began their recovery. This new version of the analysis provided by Mr Short that demonstrates that the bottom after the crash of 1929 “failed” eleven months later, no doubt provided renewed comfort to the bears. However as may also be seen the recent rally has also by now taken the Dow beyond its gains of 1929. A new attempt to find regularities in the stock market patterns may (bulls hope) soon be called for.

Source: dshort.com

Bull and bear markets are only revealed with hindsight

The reality is that bear and bull markets are only identified after the event. Daily share market movements are a random walk and recent events prove no exception to this as we show below. A bear market is one when the random drift proves, well after the events, to have been generally lower and a bull market is identified after the event as a period of time when the drift was mostly higher.

In the figure below we show the pattern of daily percentage movements in the S&P 500 and the JSE All Share Indexes since the lows in the market on 9 March 2009 until the market close of Friday 28 August 2009. In the further figure we show the distribution of these daily moves about its daily average of a positive 0.02% per day with a large standard deviation of as much as 1.6% per day. The equivalent statistics for the S&P 500 are an average move of .03% per day with an even larger standard deviation of 1.7% per day. If we take the period back to the peak of the markets in May 2008 the average daily price move for the S&P 500 since then is a negative .09% per day and -0.06% per day for the JSE.

Daily percentage moves in the S&P 500 and the JSE ALSI since 9 March 2009

Source: I-net Bridge and Investec Private Client Securities

Histogram and Descriptive statistics for daily moves in the JSE ALSI March-August 2009

Source: I-net Bridge and Investec Private Client Securities

Beating the market demands careful judgment about the forces that will drive and surprise the markets

Predicting whether the continuous random drift in market indexes and share prices will be higher or lower calls for fundamental judgments about the information flows that will move the market over the following twelve or more months. The past provides us with our theories about the forces that drive markets – our theories then lead us to anticipate and predict the direction of the economic fundamentals that we believe will surprise market participants and lead the market to drift higher or lower in the course of the next twelve months or so. We have to make these predictions with humility about the difficult nature of the task of beating the well informed market.

Mining past moves in stock market indices for patterns that will repeat themselves in the future is often attempted, but in our judgment such attempts are unlikely to prove reliable in a consistent way.

A stubborn CPI – until you look deeper

Inflation in South Africa (6.7% in July down marginally from 6.9% in June 2009) might well be regarded as stubbornly high given the weakness of the SA economy and especially of aggregate demand. The Consumer Price Index (CPI) actually increased by as much as 1.1% in the month that if sustained would lead to an annual rate of inflation about 14%. However it hopefully will be noticed by the monetary authorities that almost all of the increase in prices in July can be attributed to increases in the charge for electricity to households and the increase in the costs of private transport.

Supply side shocks continue to drive the CPI higher

These are areas of the economy where prices are set by officials and regulators rather than market forces and are therefore not susceptible to monetary policy. These administered or regulated prices, especially electricity and water charges, are playing rapid catch up with the costs of adding to capacity to supply more such essential services. This adjustment has come after years of excess capacity and prices being regulated by reference to historic rather than replacement costs. Hopefully these supply side shocks to prices are temporary ones that end when replacement cost pricing is established. In the market place, if firms cannot realise prices that cover replacement costs – and provide a satisfactory return on capital invested – they go out of business. Publicly owned utilities with monopoly power do not go out of business – they charge higher tariffs and are infused with additional capital supplied by the tax payer.

Higher charges lead to less spending – not more inflation

Households cannot avoid paying these higher charges and this makes them less rather than more capable of spending on other goods and services. This adds to the deflationary pressure currently acting on prices that are market determined. Such forces would normally – absent of inflexible inflation targets – call for lower rather than higher interest rates to encourage more spending so badly needed to lift the economy out of recession. These deflationary forces will be revealed in gory detail when lower prices realised at the farm, factory and port gates come through in the Producer Price Index (PPI) for July, to be updated today. PPI is expected to be more than 4% lower than twelve months ago. The threat to the SA economy as most economies world wide has been and remains deflation and recession not an inflationary boom.

Looking at the CPI in detail

In the calculation of the CPI the largest weight by far (22.7%) is given to the broad category Housing and Utilities. The prices of Food and non-alcoholic beverage that account for 15.68% of the Index actually fell 0.4% in July reducing the year on year change in Food and Beverage prices (Food Inflation) to a still above average 8.3% pa. Yet it has now become clear that lower prices at producer level are feeding into lower prices for consumers. The weight attached to the electricity and other fuels account is but 1.87% and to water and other services 3.31%. However the increases in electricity and water charges in July were extraordinarily high – as much as 21.5% for electricity and 8.8% for water.

Thus the monthly increase in electricity charges contributed 0.4% of the July month increase of 1.1% and higher water charges contributed another 0.29%. The increase in Private transport costs – mostly fuel – contributed 0.20% leaving all other items with an average monthly rate of increase of 0.11% – a very low rate of inflation. Thus almost all of the increase in prices in July can be attributed to prices that are beyond the influence of consumer spending and beyond the direct influence of monetary policy and interest rates.

Whither owners equivalent rent – the key to inflation to come

The largest component in the important housing cost category is Owners Equivalent Rent with a weight of 12.21% of the CPI. This item has replaced mortgage interest in the CPI and takes its cue form average house prices of which implicit rents are some assumed fraction. Owner equivalent rent is the statistician’s equivalent of the accountant’s mark to market adjustments that has no direct impact on cash flow but can be just as confusing in its implications.

Unlike when mortgage interest rates rise or fall and add or reduce measured inflation, as used to be the case in the calculation of headline CPI, households are likely to spend more when their wealth increases with higher house prices and a higher CPI and vice versa: spend less when house prices and owners equivalent rent is falling. The task of dealing with asset price inflation – especially house price inflation – has proved beyond the capabilities of central bankers. Asset prices are now a direct influence on the SA inflation rate and will need especially careful treatment when inflation targets are being aimed at.

Owner equivalent rent did not change in July – presumably because (declining) house prices were not sampled in the month. Actual rentals (weight 3.49%) also recorded a zero change for presumably the same reason. Presumably lower house prices when surveyed will help lower owner equivalent rents and measured CPI inflation.

The problem is recession and deflation – not inflation. Will the Reserve Bank act accordingly?

The direction of prices that have been influenced by monetary policy and interest rates is decidedly downwards and is currently still adding to the recessionary pressures acting on the economy. What is required is a full recognition by the Reserve Bank of these facts of SA economic life. The Reserve Bank needs to take a leaf from the play book of most other central banks that cut interest rates sooner and much more aggressively and eased quantitatively – that is printed more money – because they recognised the immediate deflationary and recessionary dangers to the well being of their economies posed by the global credit crisis. This recognition in SA has been far too long in coming – confused as it should not have been by very different signals emanating from the direction of consumer and producer prices. Hopefully the epiphany is upon us.