Where the Markets Stand; Where They're Headed

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Includes: ERO, EU, EWJ, EWP, FXI, FXY, KBE, PGJ, SPY, XLF
by: Ari and Arun

The Summary:

I expect equities to sell off dramatically over the next 5 months and to retest the lows (at least a 40% sell off) within 2 years. In the shorter term, I think equities will bounce for 2 to 5 weeks before the next wave of selling begins. If the S&P 500 bounces over 1125, sell any equity you own and consider getting very short.

Spain appears to be the next European domino. The Bank of Spain bailed out the large bank CajaSur on Saturday and capital has been fleeing other Spanish banks.

We’ve reached the end of the road for Japan. The whole world is short Yen, so the Yen may rally, but Japanese equities and debt will collapse.

The Senate just passed an aggressive financial reform bill. It will probably be reconciled with the House bill and made law by July 4th. The bill creates ambiguity over handling insolvent banks. It’s widely accepted that we would have had a complete economic collapse back in 2008 if the big banks had not been bailed out and backstopped by the government. This bill means that in a bank run, the banks (and our banking system) may fail because of the political confusion over the bail out process.

After the Great Depression, equities became a dirty word. They were viewed as too risky for the average investor for more than 20 years. I think we may see something similar again. Many retail investors held on through the collapse of 2008/2009. The next collapse is likely to cause them to give up and swear off equities for life.

Detail:

The global problems that have been building up over the last generation are finally unwinding. The world now recognizes that the EU will not exist in present form in 5 years. Radical reforms will be necessary and are being discussed (e.g. kicking out the weaker members, splitting the Euro into two currencies).

Chinese growth is unsustainable at current levels because they are investing heavily in overcapacity. China is consuming 30-40% of the world’s aluminum, copper, and cement to build entire cities of empty office buildings. When their demand falters, these commodities are likely to fall sharply. Many countries, like Australia and Japan, that rely on vigorous Chinese growth will be in trouble. The Chinese credit bubble is massive, and big bubbles don't pop, they explode.

My favorite short bets are Japanese equities and debt. DO NOT short the Yen, because the entire world is short the Yen. It is a very crowded trade. In the event of a global economic panic, the Yen may rally as the carry trade unwinds. If the Yen rallies, many Japanese exporters will be uncompetitive and quickly go bankrupt. Japanese banks are near collapse, although few are acknowledging this yet. Japan is on the verge of a severe debt crisis that will be exacerbated by a slowdown in Chinese growth. Their only hope is for a sharp devaluation of the Yen, but it’s not obvious this will happen for political reasons, as well as due to the fundamental weakness in other currencies. You can short EWJ (Japanese ETF), or Nikkei futures.

Fundamental analysis of stocks is meaningless today. Yes, many US stocks look attractive based on current earnings. However, we have to look at what is likely to happen over the next 5 years. Consumption will fall dramatically as taxes rise. A flurry of financial regulation is about to hit the financial sector and reduce profits and available credit. The government has spent most of the 2008 fiscal stimulus, so all those easy profits to corporations are about to end. Finally, the bulk of the Fed’s quantitative easing is done. The US economy is like a college student that’s been up for 3 days straight on red bull. The sugar and caffeine has done all it can, and the economy will soon be passed out and covered in its own vomit. It’s an ugly analogy, but sanguine compared to the problems the global economy and markets will soon go through.

How low can equities go? Equities bottomed out at 670 back in March of 2009 because at that point they provided enough value to smart investors. Today, those same "bottom feeding" value investors are predicting 0% equity returns over the next 10-12 years. They believe we are in for a fundamental restructuring of the global economy that will include a drop in US consumption, crowding out of private business by government spending, and eventual severe depreciation. They are in no rush to own equities, and will be far less willing to buy based on traditional valuation metrics. Even more importantly, the average retail investor hasn't yet been washed out. Yes, they panicked in 2009, but many held on for the bounce. In another collapse, many will swear off equities for life and become price-insensitive sellers; in other words, they will be liquidating their portfolios for years to come regardless of valuation.

I read the words of a handful of extraordinary investors very carefully. These men have a deeper understanding and a better long-term track record than just about anyone else in the market. They are all bearish the next decade:

Seth Klarman of Baupost Group - here

Jeremy Grantham of GMO - here

John Hussman of Hussman Funds - here

Hugh Hendry of Eclectica - here

Disclosure: None

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