When will this end?

The Australian share market has recorded its ninth successive down week. The second half of the year is beginning in remarkably similar fashion to the first half. Three weeks into the calendar year the ASX200 had fallen by 22% from its most recent high six weeks earlier. Right now, the index has fallen by 19% from its most recent high two months ago.

Last month, I outlined some of the international factors affecting share markets both here and abroad. These included the ongoing mortgage and credit market issues and the state of the US financial sector, the oil price, and the state of the US economy. What have we learned about these in the past month?

The trouble with Fannie and Freddie

Perhaps the biggest development has been the increasing problems at the two 'Government-Sponsored Enterprises' that go by the rather odd names of Fannie Mae and Freddie Mac (the names are formed from the acronyms of their full names, the Federal National Mortgage Association and the Federal Home Mortgage Corporation). 'Government-Sponsored' means that, although they are privately owned, they are backed (and protected financially) by the US Government. To cut a long story short, the government backing allows Fannie and Freddie to borrow at lower rates than otherwise, and hence permits them to fund mortgages at lower rates than otherwise.

The two institutions are far and away the biggest players in the secondary mortgage market in the United States. Like so many other financial institutions, they are heavily leveraged, and their balance sheets have been pummelled in recent months by defaults and the other problems of the US housing sector. Their share prices are down more than 80% in recent months. Importantly, Fannie and Freddie deal only in prime mortgages, so the fact that they are floundering shows just how far the mortgage issue has spread in the US.

To the rescue: US Treasury, oil prices and earnings reports

In mid-July, the US Treasury announced even more government help for Fannie and Freddie; they have in effect been pronounced 'too big to fail'. Two days later, the US share market turned sharply, rising by almost 4% in the next three days. This is remarkably similar to the market reaction after the government-inspired takeover of Bear Stearns, a private investment bank. But on this occasion the market’s turn may have little to do with the latest 'rescue'. Rather, it appears to be due to the fact that earnings reports in the rest of the US financial sector have not been as bad as anticipated, and investors have reassessed their degree of pessimism about the US market.

A dramatic fall in the oil price, of about 12% in a week, also helped the market to do better. Last month I suggested that a fall was more likely than a continued rise and that forecasts of $200 a barrel were, at best, premature. I continue to think that the slowdown in economic growth, both in the US and elsewhere, will mean that the price could fall back to close to $100 per barrel.

We really haven’t learned very much new about the US economy in the past month. The labour market continues to suggest recession, while output continues to grow, albeit sluggishly. I continue to think that the US slowdown/recession will drag on for some time, which means that the US market is unlikely to stage a recovery any time soon, but it doesn’t necessarily have to fall further from here.

History suggests the US market 'should' bottom in July

For some months, I have been telling my audiences that the US fell into recession in January (still my view), that the average recession lasts for ten months, and that the share market generally troughs four months before the recession ends (in six of the last seven recessions it has troughed between three and five months before the end of the recession, a remarkable regularity). A little arithmetic then suggests that the market 'should' bottom in July. I have always described this as 'establishing par for the course' rather than a serious forecast, but it does have a good chance of being a good forecast. The problem is that the market can’t be expected to begin to price in a recovery before it has accepted that a recession is underway!

My suspicion is that the market will wander around for some time now until there is more clarity about the three problems besetting it, but given the current P/E ratio in the US, the market doesn’t necessarily have to go (much) lower.

Meanwhile, back in Oz.

I have dwelt so much on the United States because that’s where most of the market malaise comes from. What about the other factors affecting Australia?

First, it is noteworthy that the sharp US turnaround visible in the chart above in recent days was not mimicked in Australia. One reason may be the increasing realisation that world growth generally is slowing, which doesn’t augur well for commodity prices. Expected world GDP growth in 2009 is now expected to be just 2.7%, compared with the 3.4% expected six months ago. Indeed, the 2009 growth forecast is now less than what is expected (2.9%) this year. In 2007, world growth was 3.8%.

Australian growth prospects have also slipped significantly, and there is widespread speculation that the economy may be slowing quite dramatically at present. Let’s just say that the evidence for 'too much of a slowdown' is by no means conclusive - housing and consumer spending have weakened, it’s true, but business investment plans are still strong. The risk is that, were growth to slow significantly, earnings forecasts would have to be revised down, with negative effects for the market. That said, the market appears already to have priced in a lot of bad news.

Interest rates seem to have peaked

The 'silver lining' to the cloud in Australia is that it now appears likely that interest rates have peaked; the RBA has signalled that it believes the tightening cycle has finished, and it is unlikely the banks will continue to raise rates 'on their own', so to speak.

Bottom line: when markets are as volatile and as weak as they have been in the past year, it’s always best to assume that it’s not yet over. A month ago, I suggested that the second half of this financial year would be better than the first half, and that’s still my view.

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