How far can the FTSE fall?

The FTSE hit a long-term low at 3,287 at the close of 12 March 2003. If it were to drop to 5,000 now, that would still mean about 8% p.a. compound growth.

Dow and FTSE: making progress towards fair value

Investment, inflation and market collapses

We have had no fewer than three major financial institutions (outside the US) call for an utter collapse of the equity markets in the last two weeks.

... says Karl Denninger. Seems like the pros are sitting around waiting for someone else to panic first. Then it'll be time to get in, right?

I recently looked at what happened to shares when a period of inflation begins. You might think that since inflation will also balloon the underlying tangible assets of companies, shares would do okay. But here's the results:

If you're an active investor, you may start thinking about opportunities. Look at the red zones. Draw a line from a deep points to a high one, and feel the greed; but draw lines from a temporary rally to another low, and feel the disappointment. You do need to get your timing right.

But inflation heavily penalises the passive investor, too. His boat settles onto the harbour mud; while the unlucky speculator dives headfirst off the retaining wall, deep into the goo. Inflation raises the risks for all.

The FTSE - semi-wild guesses about fair value

I suggested on Wednesday that the market may already have lost much of its bubble, considered in real terms, and here below is my simple attempt at chartism.

What I've done is to draw two purple lines, one connecting the lows in the mid-80s/early 90s, and the other the highs in the same period. I've chosen that time-frame because it's before the silliness of the late 90s, and it does also include a period when the UK economy was in the doldrums.

Using these parameters, the late 90s and early 00s were well above trend, whereas last year's highs only just peeped above the upper line and the current value is hovering a little above the centre of the hi-lo wedge.

The implications are that the next low, if it comes soon, shouldn't be worse than around 4,500, and by 2010 (when I'm guessing the tide will turn) the bracket would be in the 4,700 - 7,000 bracket, with a midpoint of c. 5,850.

Taking the market at close yesterday and extrapolating to that 5,850 midpoint, would imply a future return (ignoring dividends) over the next 16 months, of c. 2.5% p.a. - not nearly as good as cash, especially in an ISA. On the same assumptions, to achieve an ex-dividend return of 6% p.a. would require entry into the market at c. 5,400.

On this tentative line of reasoning, we should be looking for a re-entry opportunity somewhere in the 4,500 - 5,400 level, say 5,000. Shall we wait for the next shoe to drop?

How much of the crash is behind us?

The FTSE is closing somewhere around 5,666.10 today. It closed at 5,709.50 on 17 February 1998, which was the first time the market had breached today's level.

So we've spent a little over 10 years to get nowhere in nominal terms, and meanwhile the value of money has dropped by approximately 25%.

Yes, shares pay dividends, but most people buy them as part of some collective arrangement that involves initial and recurring charges and/or fees. After charges (and taxes, remember), it would have taken a net dividend yield of about 3% per year simple, or 2.65% compound, merely to replace the value lost to inflation.

So quite possibly the putative investor in the FTSE has actually fallen behind where he was in 1998.

Are the pessimists lagging behind the news? Has the worst happened already?

Comparisons are odious

Why has the American stockmarket done so much better than us since 1990?

And which way will these lines turn now?

Is inflation negatively correlated with real stock values?

I'm aware that I'm setting myself up to be laughed at by the quants, but I'm playing a hunch. The FTSE graphs I've done over the last couple of days suggested to me that periods of high inflation are bad news for stock prices, as well as for cash.

Obviously, this isn't exactly news - a quick Google leads me to this book by Alicia Haydock Munnell, where she says "The long-run negative correlation between stock prices and the rate of inflation has been confirmed in several statistical studies." Yet another academic study says "The bivariate results for the real stock returns-inflation pair weakly support a negative correlation in the 1970s and 1980s."

But what if we compare real stock prices with changes in the inflation rate? So I've done something childishly simple - perhaps childishly wrong, I await your correction:

First ("L2/J2"), I divided the FTSE index by the RPI index (end December figures in both cases); since the FTSE has grown in real terms by only about 1.6% p.a. since 1970, I think this should reduce some of the statistical noise - in effect, we have the inflation-adjusted value of the FTSE for each year end.

Then I looked at how much the RPI index had changed, year on year, expressed as a percentage.

Then I used Excel to calculate the correlation between the two sets of data. The figure (as you see at the bottom of the sheet) is (0.711). I may be mistaken but I think this shows that there is a strong negative correlation between changes in the inflation rate, and changes in the inflation-adjusted capital value of the FTSE.

(By contrast, the correlation between the annual percentage increase in RPI, and the annual percentage increase/decrease in the FTSE, is only 0.275576.)

FTSE stats from Wren Research, RPI from here and (for the latest 2 years) here.

Thinking about this, it would make sense: when inflation starts roaring away, investors will want better yields on stocks, so (as with bonds) the value of stocks needs to fall. The question is, how long does it take for the dividends to compensate for the capital loss, to someone who held the shares before the major inflationary period began?

Maybe the sales line that stocks are a long-term hedge against inflation, is only half-right: it'd pay even better (when inflation begins smouldering) to switch out of cash, bonds and stocks and into other stores of value (such as commodities and houses), and come back again when the inflationary fire looks as though it's been brought under control. Look at the real capital values of the Dow and FTSE in these graphs, and imagine you had stayed out for a decade or more, then jumped in with your portfolio in the early 80s, or mid 90s.

But speculators have already gotten into commodities, and (thanks to greedy banks and lax governments) houses are massively oversubscribed. Nevertheless, commodities may yet be a better long-term punt than the average investment at this stage, and there are those who will argue the case for good agricultural land. So maybe there's still an opportunity to get on the cruise ship, even if we've missed the speedboat?

It's so difficult when, as Marc Faber says, for the first time we're in a world-wide bubble. This nasty combination of monetary and fiscal crises has us running in all directions.

UPDATE

Yes, I've got my methodology wrong, as my brother has pointed out. So I'm back to the simpler, positive (real, but not so strong) correlation between percentage changes in the FTSE and the RPI: 0.275576. Interestingly, the correlation is very slightly better (about 0.285), if you look at the FTSE 12 months ahead of the RPI.

It's just that, visually, the inflation "mountain" of the 70s and early 80s seems to want to turn upside down and fill the inflation-adjusted "crater" of the FTSE in the same period. But at least there is a definite correlation, over the series as a whole from 1971-2007.

Panic overstated?

40 years on from the Summer of Love. Here's a chart I made to show the capital value of the Dow at the end of each calendar year.

I used Yahoo! for Dow valuations (ex dividends); rebased them so that Dec 1967 = 100; and adjusted for cumulative inflation as per Inflation Data's calculator.

Theoretically, someone investing a sum in the Dow at the end of 1967 would have had to wait 28 years to see it return to its original (inflation-adjusted) value.

But over the whole 40 years, the averaged return is 2.175% per annum compounded, which is very close to the 2.2% p.a. real capital growth on the S&P 500 (1871-2006) illustrated in the previous post.

These long views suggest that the Dow's recent 12-year zoom is merely a kind of rebalancing. In this context, it's interesting to see that as of September 2007, the price-earnings ratio of the S&P 500 is not far off its average over the period since 1871. The fall in stock valuations since then should have brought the p/e ratio even closer to the norm.


By way of comparison, here below is the result of a similar exercise for the FTSE, though I have been unable to go back further than 1970. Again, it's the close at end December each year up to 2007, adjusted in this case for RPI. FTSE stats from Wren Research, RPI from here and (for the latest 2 years) here.

The overall shape looks fairly similar to that of the Dow over the same period. Average capital gain over 37 years is c. 1.6% p.a. compounded.

Back to 2003

Karl Denninger thinks we're on course to lose all the gains of the last 5 years:

I am updating expectations for this Bear Market; I no longer believe 1070 on the SPX will hold, and have now moved to the camp that sees the potential for the S&P to retrace all of the 2003-2007 Bull Market's gains, taking us back to around 800 on the SPX.

In the UK, the FTSE closed at 3,287.00 on 12 March 2003.

Ten years after the stock market bounce

The FTSE is currently at 5,664.60. It stood at 5,782.90 at the end of trading on 6 March 1998. Has your wealth kept pace with inflation?

There's lots of ways to figure inflation. Monetary inflation is like pumping up an air bed (or a Space Hopper): if you squmph one end down, another part will swell, and that makes it hard to estimate the effect in any particular sector. So let's go back to the major source of inflation, and assume M4 (bank lending) has increased by an average 10% p.a. - I don't think that's far off.

According to this article (which also predicts even lower returns in future years) the total return on equities over the last 100 years has averaged 10.1%. That'd be nice. Now let's assume dividends averaged 3% - and let's assume you kept it all, instead of what really happens, which is you pay much of it to intermediaries, stockbrokers, fund managers and the taxman. To get the rest of this monetary-inflation-matching total return, we'd have to see 7% p.a. capital growth.

7% compounded for ten years makes 96.7%. So if you had bought the FTSE ten years ago, it would need to be worth around 11,375 today. After taxes, fees and charges. And then it would have to be worth even more, to make up for the fact that you don't keep all of your dividends, either.

Oh.

The Golden Compass doesn't work

FTSE closed today down at 5,724.10, a point first reached (travelling the other way) in December 1998. The longer-term chart above suggests to me a glass ceiling. Or flogging a dead horse (I can't tell you how some ten-year-olds I know misheard that last saying recently, or how their conversation continued. That generation appears to be developing backwards from middle age.)

Adjusted for inflation, the line would look worse, of course. I think my gut feeling was right ten years ago: essentially, we've been going down since the late nineties.

But what inflation measure to use? Gold seems to go down together with equity sell-offs, rather than seesawing against them. And unlike with the Dow, there doesn't seem to be an easily accessible index of the FTSE priced in gold terms; but GATA last week went very public with their theory that gold is being held down by surreptitious selling - and has been quietly disappearing from central bank vaults. This is something I've touched on a number of times before, and MoneyWeek gives its take on it here. Meanwhile, here's the ad:

Funny line

Traders described the losses on the FTSE 100 Index as "incredible", with the Footsie at one stage plummeting by as much as 330.7 points.

(Press Association release today.)

Less than 6%. Maybe they should raise the minimum age to be a trader.

Oh, and the PA uses the hack line "More than £x billion was wiped off the value of ... shares". Enough experience for cliche, not enough to remember history.

"See what I mean? Kids!"

It can't happen here

The US bemoans its fate, but we in the UK have also had something of a crash in the last three months, too. FTSE on 12 October: 6,730.70; now: 5,578.20 - 17% down.

It can't happen here
It can't happen here
I'm telling you, my dear
That it can't happen here
Because I been checkin' it out, baby
I checked it out a couple a times, hmmmmmmmm

(The Mothers of Invention)

There was a period of hip journalism in the 60s and 70s that thought it clever to quote pop trash as if it were Holy Writ, and I'm afraid I couldn't resist the cheek. Retro, but maybe appropriate for a rerun of the econogrind of those years.

Something Golden This Way Comes

Stock traders' bonuses are calculated on the basis of profits made up to... NOW. And perhaps not entirely by coincidence, the Dow has clambered back up to 13,300 and the FTSE above 6,400.

So the books close, the champagne flows and the rest of us can start doing our own accounts. Where are the customers' yachts?, as the naive investor asked.

Karl Denninger looks at E*Trade's difficulties and reckons the 70% mark-down of their home equity lending portfolio implies a loss of $1.5 trillion on HELOCs (home equity line of credit) alone. The bad news hasn't all come out yet.

Perhaps we entering the period of "dawning realisation".

Red screens

It all looked a bit woeful yesterday, but I stick with my prediction: the market will go up towards the end of the year, so that dealers can suck out a last-chance bonus. For perhaps slightly different reasons, Bloomberg reports a similar forecast.

Dow and FTSE lows

The Dow had its lowest close yesterday since 19 April 2007; the FTSE is currently below 5,950 - the most recent lower closing figure was on 3 October 2006. Why we're suffering more, I have no idea.

Could the Dow drop 50%?

"Two views make a market," goes the adage, so there's no "right" value for the Dow. But as I showed yesterday, the Dow has had an extraordinary rise in the last 20 years, about double what has happened with the FTSE.

It doesn't seem related to average income (American average earnings have grown more slowly than in the UK); if it relates to greater inequality of income, then presumably if the market turns, rich bears will be capable of pushing it down as fast as it rose. And I doubt that American multinationals have exploited subsidiaries in the Far East that much more than British-based multinationals - or have they?

Or is it money invested through the carry trade, borrowing cheaply from Japan? Then maybe it will unwind when Japanese interest rates rise. Is it the benefit of low American interest rates, thanks to huge foreign support for US Treasury securities? That love affair is coming to an end.

Let's do a thought experiment. 1987 seems a reasonable base year for our measurements, since the markets weathered the "Crash" of October and still ended up ahead by the end. From the end of 1986 to close of business this last Wednesday, the FTSE had grown by some 280%. That works out at around 6.7% capital growth compound per annum, for the whole period; add-in dividends and the reasonable investor should be satisfied.

If the Dow had done exactly the same as the FTSE, it would have grown from 1,895.95 to around 7,200. Instead, it closed on Wednesday last at 13,657.86.

Maybe there's still a lot of air in that balloon.

Is the Dow more overvalued than the FTSE?

I've compared the growth of the Dow and the FTSE with the increase in national annual average earnings in each country. As you see, the Dow has advanced much more rapidly.

UK earnings are calculated as 52* weekly wages. UK stats here, USA stats here. Dow and FTSE stats from the Yahoo! finance website - see sidebar.

October 1987 revisited

I'm trying to work out whether making an historical analogy with 20 years ago is valid.

Let's have a look at what has happened to prices. Cliff D'Arcy in The Motley Fool (22 May 2007) does a very informative comparison between houses and the FTSE 100. He reminds us that although the FTSE-100 dropped dramatically on "Black Monday" (19 October 1987), it ended about 2% higher over the year as a whole. If we take his figures for 1987 to 2006, house prices increased 287%, and the FTSE 263%. This would suggest that house prices and stock prices have increased about equally (though houses cost money to run, whereas shares pay dividends).

Are British people over-borrowed? This Bank of England research document from September 2004 says not, in relation to house prices. Yes, debt-to-income has gone up, but interest rates are now low. And despite its name, the latest survey from UK site HousePriceCrash indicates a general belief that house prices will continue to rise in the months ahead. (But recent first-time buyers will be more vulnerable, having little equity and probably a high income multiple for their loan.)

I find the monetarist arguments intuitively persuasive, but I'm puzzled by the disparity between prices and monetary inflation. Using the UK's M4 stats, over the 78 quarters from Dec 1987 to March 2007, the average annualized increase in the money supply is about 10.48%. Compounding that figure, we get about 7 times more borrowed money in the system today than in 1987. Yet houses and shares are only 3-4 times higher.

What does seem clear is that we have borrowed more in relation to income, and this makes it even more important not to lose your job, or be hit by high interest rates. It's worrying when you have to depend on things carrying on as they are, indefinitely.

How far could the Dow (and FTSE) fall?

Some (e.g. a commenter on one of my May 12 posts) think the Dow couldn't possibly fall 50%, but there is no objective support level for a falling market, it's just a balance between buyers and sellers.

The Wall Street Crash started dramatically, but took about 3 years to complete its decline. On September 3, 1929 the Dow reached a peak at 381.17; by July 8, 1932 it stood at 41.22.

Serious, experienced analysts like Michael Panzner and Peter Schiff tell us that in some respects, the systemic financial problems we now face are indeed comparable to those times. Our advantage is that we have that history to warn us.

UPDATE

More recently, the FTSE 100 reached a peak of 6,930 on December 31, 1999 and a low of 3,287 in March 2003, as shown here. That's a drop of over 52%.

At the time of writing (5:42 pm GMT) it stands at 6,649, but you have to see this in the context of massive monetary inflation; compared with the end of 1999 in real terms, it's lost a lot of ground already. That's why I've suggested that we may already be in a bear market that is disguised by inflation. As in Alice in Wonderland, it has to run quite hard just to stay in the same place.