There is one concrete reason why US indices could lose at least another 20-25% from current levels.
The powerful correlation between margin debt usage by member firms of the New York Stock Exchange and the trend of major indexes such as the S&P 500 and the Dow Jones Industrials Average suggests further selling ahead. The considerable leverage accumulated during the last bull market is now forcefully being undone by a powerful combination of margin calls and accelerating market losses, triggering broad ripples of sell orders among large and small investors. HYPERLINK "http://www.ashraflaidi.com/articles/margin-data-suggest-prolonged-bear-market.asp%22" \t "_blank" \o "blocked::http://www.ashraflaidi.com/articles/margin-data-suggest-prolonged-bear-market.asp\""On Jan 25th, two days after global markets plunged on the revelation of mounting losses at Societe Generale, we predicted a decline of 15%-25% in U.S. equity indexes for the first half of 2008 and further losses in the second half. Amid the many signals in the market and the real economy, we focused on the aggregate margin debt used by member firms of the NY Stock Exchange.
The chart below shows that the rapid declines in margin debt from their record highs correctly predicted prolonged losses in the major equity indexes in fall 1987, fall 1998 and spring 2000. After attaining a record high of $381 billion in July, NYSE member firms' margin use continued to tumble into the subsequent four months, reaching a low of $322 billion. The declines in margin debt resulted from the execution of margin calls as client losses escalate to unsustainable levels— a typical characteristic during surging volatility. The top chart also shows that after recovering in May-July near 300 billion, margin debt fell anew in August, reaching 292 billion—the lowest since March 2007. The bottom chart shows the monthly S&P500, and how it closely reflects the shifts in margin accumulation and disposal.
The relationship has already enabled us to predict 12-15% declines in equities in the first quarter of 2008 (announced to clients in December 2007) and in the first half of 2008. Back then, the rationale was: “We expect another 15-25% of declines to come by end of [June] as the macroeconomic deterioration coupled with prolonged losses in U.S. banks and profit warnings (no currency translation effect this time as the dollar stabilized in Q4-Q1) will overwhelm the easing measures of the Fed.”
Today, all major U.S. equity indices are down by more than 30% year-to-date, leading their international counterparts well into bearish territory and ensuring that recession will not only meet its common definition of two consecutive quarterly declines, but also that the slowing economy will feed into weaker valuations and earnings compression. And as U.S. stocks lose in one year what they gained in nearly four years, the corrosion to the wealth effect adds to an already fragile consumer foundation, burdened by negative home equities.
Margin debt accumulation and disposal bolstered our bearish take on the markets in January, allowing us to forecast renewed unwinding in yen carry trades. Looking ahead, we expect USD/JPY to fall under the 100 yen level this month for the first time sine March. As long as the Federal Reserve holds out from cutting rates before Oct. 29, markets are likely to maintain their relentless pressure, especially considering the vacuum of good news on the economic and earnings fronts. Additional deleveraging is also expected to weigh on EUR/USD towards the $1.3350 territory, while dragging GBP/USD towards $1.7050.
Today's Markets The bigger than expected 100-bps rate cut from the Reserve Bank of Australia had a temporary effect in stemming risk aversion and shoring up carry trades in favor of high yielding currencies at the expense of the USD and JPY. But reports on RBS, Barclays and Lloyds each had sought about £15 in capital, brought back sterling from a session high of $1.7650 to a fresh 2.5 year low of $1.7418. As stocks in these banks plummeted by over 30%, risk aversion bounced back, dragging USD/JPY, AUD/JPY, AUD/USD and EUR/USD.
The fundamental data also weighted on sterling after UK industrial production fell 2.3% year on year in August from a 1.9% decline the prior month, bolstering chances of a negative Q3 GDP reading and confirming chances of at least a 25-bp rate cut from the Bank of England this week. Despite the existing dissent from the hawks at the BoE's Monetary Policy Committee, we expect a 50-bp rate cut to 4.50% mainly due to the expected contraction in Q3 GDP following a flat reading in Q2. Also, if the Fed cuts rates by 50 bps later this month, the US-UK rate differential would plunge to a considerable 325 bps.
Fed Chairman Bernanke's crucial speech at 1pm EST on the "Economic Outlook and Financial Markets” is likely to confirm a contraction in economic growth in Q3, and signal a rate cut for the October meeting.
Ashraf Laidi Chief FX Strategist CMC Markets US a.laidi@cmcmarkets.com
