Dear Paul,

In last month’s Global Outlook, you said we would see a “rollercoaster stock market” through the fall of this year.  So far, your predictions look right.  Are we anywhere near the bottom of this correction?  Are there any other places to invest while the U.S. stock market completes its correction?

It is important to always distinguish the stock market from the underlying U.S. economy.  The underlying economy has not changed.  It is still growing at a mediocre annual growth rate of about 3%. 

While unemployment remains stagnant and housing continues to be a problem, other parts of the economy are continuing to recover.  Consumers are starting to spend again and industrial productivity is at a record high.  Profits are expected to be very positive and beat expectations next quarter.

The problem has been that the U.S. stock market went almost straight up from March of 2009 until April of this year, while the underlying U.S. economy was roughly flat, just growing about 3%.

In short, the U.S. stock market was completely out-of-sync with the underlying U.S. economy.

Here is where the S&P 500 Index closed on Thursday, June 24, 2010.  I am reprinting this chart with the permission of Doug Short at dshort.com.

This chart starts in October 2007 when the last bull market peaked.  The S&P 500 Index is now down about 10% below its April 2010 high.  The chart also shows that the stock market would have to go up +31.4% in order to reach the breakeven point of the last bull market high reached on October 9, 2007.

How Far Does The Stock Market Have To Drop To Be “In Sync” With The Economy?

Yale University Professor Robert Shiller has created a method of determining whether the U.S. stock market is over- or under-valued by using long-term corporate Price Earnings ratios.  It has a great past record of market predictions.  The current reading of his Shiller P/E Ratio Valuation is that the U.S. stock market is currently over-valued by about 20%.

Below is a 70-year chart of the Dow Jones Index used with permission from Chris Kimble.  This graph shows that the long-term Dow Jones Index has been out-of-sync with the underlying economy and its own long-term average trend since the Tech Bubble in the late 1990’s.  

According to this analysis the U.S. stock market as measured by the Dow Jones Index is overvalued by 31% as of June 24, 2010.

 On the next page there is another chart from Citi economist, Steven Wieting.  This chart shows that the S&P 500 Index is clearly disconnected from current U.S. Industrial Production.

The laws of statistics state that whenever two trends diverge they must always “regress to the mean” of their underlying fundamentals—which is the basic U.S. economy. 

The bottom line is that no matter how an analyst looks at the current stock market vs. the underlying economy, the S&P 500 Index is still at least 20% overvalued.

I still believe that over the next few months through October, we will see continued turmoil and real volatility in the stock market as both the stock market and economy try to find some equilibrium. 

Until a “stop-loss target” is triggered, Foxhall will primarily manage risk in our client’s portfolios by increasing cash and U.S. treasury bonds while volatility in the market remains high.

The good news is, I continue to believe that once we go through the summer and early fall, we will see a sustainable bull market sometime after October.  But however it plays out, Foxhall’s disciplined approach to managing investment risk and portfolio volatility is firmly in place and provides thoughtful investors with effective global investment exposure.

Are There Any Better Places In The World To Invest Right Now?

Not yet—but maybe soon!

A growing number of analysts now believe that the stock market declines in China, Asia and many emerging markets are finally bottoming out. 

Since the Chinese Shanghai Stock Market Index hit its peak in October of 2009, that market has dropped by over -26%.  It may continue to drop in the near future, but most analysts believe that this stock market is getting close to the Chinese economy’s underlying fundamentals.

Has The Chinese Bubble Burst? 

China has had the enviable problem of trying to slow down the explosive growth in its economy—especially its property markets.

The Chinese Government has moved aggressively to slow down lending and investment in what looked like a “bubble” in residential and commercial real estate.

Most analysts think the government is doing everything mostly right. 

Their problem is not nearly as bad as it was here in the United States or Europe.  First, Chinese banks have lifted buyer’s down payments from 20% to 30% on their primary residence and from 40% to50% down-payments for second home buyers.  Chinese investors are also limited to 3 investment properties and in Beijing, investors are forbidden to buy a third home, even with their own money.

The average Chinese mortgage is less than 50% and the average Chinese spends less that 30% of their income on mortgage repayments.

This is more of a “price bubble” than a “credit crisis” like it became in the U.S.  Chinese home buyers did not get 125% sub-prime mortgages, like we gave away in the U.S.  It is also less likely they will “walk away” from a mortgage when they have invested a 30% to 50% down-payment. 

There is also no chance of bank failures, since most mortgage lending banks are government owned.  So even if the government has to take over some mortgages, they have more than a trillion U.S. dollars in surplus reserves that could be used for those purchases.  China will not have to “print money” in order to bail out their banks.

The Chinese government is also planning to impose property taxes for the first time to discourage investment speculation.

China’s Housing Prices Have Dropped Substantially

A combination of all of these new government policies has caused property prices in Beijing, Shanghai and Shenzhen to drop up to -28% over the past few months.  Real estate excitement and speculation has been most frenetic in these three coastal cities, even though these cities only represent 8% of all Chinese residential construction.  Other real estate in China has, for the most part, had very little movement.

China also benefits from the fact that household debt is rising, but is still minuscule when compared with the United States.  Also Chinese incomes continue to outpace the overall rise in housing prices.

Another factor is that the ratio of housing loans to GDP is only 15.3% in China vs. 79% in the U.S. last year.

Many pessimists compare China to Japan in the 1990’s, when Japan suffered a real estate meltdown that has created stagnant growth ever since.

But China and Japan are very different.  Japan overbuilt its residential real estate during a period when their population was dropping and, at the time, almost every Japanese citizen already had a home. 

This is the same mistake we made here in the U.S.  During our real estate bubble we massively overbuilt houses when most people already lived in an adequate home.  In Japan and in the U.S. we both created more supply than there was demand.

In China, they have the opposite problem, one of the reasons housing prices were going up so fast is that China cannot build houses fast enough.  Right now, China’s homeowners remain stuck in cramped, shoddy flats they received a decade ago by the government.  Many Chinese still live in dormitories provided by their employers.

China now has over 215 million middle class urban households, but only 48 million homes have been built and sold.  There is still enormous pent-up demand for housing in China.

China has gone through investment bubbles before—building too many steel mills, and too many office buildings—only to see the nation’s breakneck growth soak up the excess capacity.  With over 1.2 billion people still clawing to advance beyond peasant status, the government seems to be controlling this new bubble and analysts still expect growth over the next year to exceed 10%.

Other Asian stock markets, like India, Singapore, Malaysia, Indonesia, South Korea and Taiwan also seemed to have bottomed out and are now starting to recover.  Over the next few months, I believe These may be the stock markets that will start the new global bull break out.

In the long-term, almost every investment analyst agrees that China, India, Brazil and other Asian and emerging market countries will produce higher levels of growth than the U.S. over the next five years. 

That is why the Foxhall growth strategy specifically maintains significant allocations to those countries and regions via the Foxhall Pacific Rim/Emerging Markets allocations and the Foxhall Global Hard Assets strategy allocations.

Until then!

—Paul Dietrich

dietrich@foxhallcapital.com

800-416-2053

Disclosures: The opinions and portfolio information provided in the Foxhall Global Outlook are subject to change at any time, and are not to be construed as advice for any individual nor as an offer or solicitation of an offer for purchase or sale of any security. Client accounts may differ from model allocations due to many reasons. All investment strategies offer the potential for loss as well as gain. Individuals should consult with their financial professional to determine an investment strategy appropriate for their objectives, risk level, and time horizon prior to investing.  Past performance is not a guarantee of future performance.