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Correction Time is Here!

One month ago, I pointed out that investors were euphoric about buying everything. The same still applies as of today. Equity investors, commodity traders, property investors, art buyers and even bond fund managers are all bullish about the one or the other asset class. From figure 1, we can see that mutual fund cash positions in the US have declined to a record low and that such low readings have, in the past, preceded serious market corrections or bear markets.

Figure 1: US Equity Mutual Fund Cash Positions, 1960 - 2005

Source: www.elliottwave.com

Moreover, from the figure below we can also see that the US stock market has become technically over-bought and that such over-bought conditions have usually been followed by meaningful stock market corrections (see figure 2).

Figure 2: Overbought - Oversold Index 2005-2006

Source: www.thechartstore.com

Another indicator, which is negative for the US stock market, is that foreigners are once again buying US equities at an almost record clip (see figure 3)

Figure 3: Foreign Buying of US Equities

Source: www.elliottwave.com

As is the case for every stock market around the world, heavy buying by foreigners occurs usually near market tops, while foreign selling has always occurred very close to market lows such as we had in late 1998, in October 2002, and March 2003 (see figure 2). So, if we combine the over-bought condition of the stock market, investors' sentiment high optimism, equity mutual funds' low cash positions, and also heavy foreign buying, we have all the ingredients for a stock market correction in the US getting underway very shortly.

There are two questions that preoccupy investors. What might the catalyst for such a correction be and when such a correction comes, which assets will decline the most and which ones will show resilience. In particular, investors in emerging stock markets are concerned that if the US stock market sold off, emerging stock markets would decline even more, as has always been the case in the past. I concede that some emerging markets look extended ( Lebanon is up 45% so far in 2006 and Russia has already climbed by almost 20%). However, there is a fundamental difference between the past and the current environment because today, it is not the US or Europe, which are financing economic development in emerging economies. Quite on the contrary! In an ironic twist of economic history, today, the poor countries - largely the ones in Asia - are the economies which are financing the US with their large current account surpluses (see figure 4).

Figure 4: Emerging Economies Reliance on Foreign Capital, 1970 - 2005

Source: Bridgewater Associates

As we can see from figure 4, emerging economies were highly dependent on foreign capital in the late seventies and just prior to the Asian Crisis in 1997, but currently they are accumulating monetary reserves with their current account surpluses amounting to more than 3% of their GDP. As a result, my bet would be that emerging markets as an asset class may be less vulnerable than the US market should a sharp stock market correction unfold. I concede, however, that some emerging markets, which have experienced vertical price increases recently, are so over-extended that they could easily drop more than the US market, which has been an under-performer over the last 18 months. But, should such a sharp correction unfold, I would feel more comfortable to add to positions in emerging economies than in the US as I still maintain that over the next five to ten years emerging stock markets will outperform the US. As to the catalyst that will trigger the correction, I suppose that inflationary pressures may necessitate more additional interest rate increases than the market now expects. Therefore, rising interest rates and declining bond prices could at some point weight on all asset markets. But it does not really matter what the catalyst will be. When all asset markets are as extended as they are now it does not take much for a vicious sell-off to get underway. Still, I maintain that gold and other precious metals will continue to out-perform financial assets. Wherever, you may think the Dow will rise or decline my view is that we shall, eventually, be able to buy one Dow Jones Industrial Average with between just one and five ounces of gold (see figure 5).

Figure 5: Dow/Gold Ratio, 1900 - 2005

Source: www.sharelynx.com

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