Possible Near Term Market Correction?

It is now the second longest period since the DJIA suffered at least a 10% correction. The latest count is 1,022 trading days, just exceeding the 1956 figure of 1,020 days but still second to 1997 which was 1,723 days, the other eight such periods since 1929 ranged from 617 to 960 days. The important words above are “at least” because the awaited, inevitable correction, when it arrives, could be, and probably will be, much bigger than 20%!

Stephen Roach, Chief Economist at Morgan Stanley recently wrote:
“The bursting of two bubbles seven years apart – dot-com and housing - holds the key to the macro outlook. While different in many respects, these sharp swings in asset markets share one thing in common – the initial belief that any spill-overs would be limited and that the rest of the economy and the financial markets would remain unscathed. Just as that view turned out to be wrong in the early 2000s, I fear a similar outcome today…. What’s especially worrisome about the current situation is that real GDP growth has already slowed to just over 2% over the past three quarters - far short of the 3.7% annualized pace of the previous three years. Yet this down-shift is largely an outgrowth of a steep recession in homebuilding activity, together with collateral impacts of a recent downtrend in business capital spending. By contrast, the American consumer has barely flinched, with average gains of 3.2% in real consumption since mid-2006 representing only a modest downshift from the astonishing 3.7% growth trend of the past decade. Should the consumer move into a more meaningful period of consolidation – precisely the risk as equity extraction from residential property now slows in a post-housing bubble climate – then macro contagion could become an increasingly serious problem”.

Has subprime meltdown been contained
It is generally thought that the recent stock market turbulence is now over and although the rally in major markets, particularly in the US and the UK, have failed as yet to exceed the year’s earlier highs, nonetheless it is expected that will happen soon. Should stock markets however fall from current levels, it could all get very ugly, very quickly! Two key levels to watch are the FTSE 100, at 6000 and the DJIA, at 12000. Any near-term weakness that brings prices below those levels would subsequently see selling vigorously accelerate.

I am expecting the worst and that the driver of market deterioration will be a developing credit crunch. The optimists believe that the US sub-prime mortgage market can be contained; however, loose lending practices are everywhere. For the record, I am receiving at least 5 calls a week from telemarketers tasked by the banks to offer me low or no interest-bearing credit. Such destructive lending practices typically happen at asset market peaks.

Q1 2007 saw a record $1,000 billion total of M&A deals with a large percentage of these financed using covenant-lite loans. The IMF consider this situation serious enough to issue an important warning to the private equity industry saying that a large scale collapse in the sector is increasingly possible and that many of the major deals currently being mulled over could prove a disappointment. It also said that the potential problems with the buy-out industry were among the biggest risks facing the global economy.

Prospective Outlook for Corporate profitability
Q4 2006 was the 14th consecutive quarter of double digit profit growth, it is generally agreed that has now ended. For the Q1 2007, the average rise in profits was as low as 3%. But as recent as Jan 07 some estimated the figure was going to be much higher, at 8.7%! Declining profit growth will tend to restrict even further the low current levels of corporate America’s capital expenditure. Capital expenditure to one is revenue to another; so lower profits will generate lower capital expenditure; lowering further profit expectations, etc…. And over the last 2-3 weeks the US service sector, so important for economic growth in the developed world, appears to be slowing.

So, be warned, my friend. Given the likelihood of meaningful consumer spill overs, I would place about a 60% probability of an outright recession scenario in late 2007 and early 2008. Your call.