Investment Environment

'''This pages is not investment advice. The authors are not responsible for any losses arising from following any strategies described on this page. All investment advice must take into account the personal circumstances of the investor. The authors of this page do not know the circumstances of any person reading this page so are not in a position to offer advice, even if licenced to do so, which they do not claim to be.'''

There are many macro considerations to investment. This article notes and overviews some of them. Each is worthy of separate page.

Six great resources:

Business Cycle Monitor slideshows

D Short - Great historical charts and context

Mark J Lundeen articles

Yahoo International indexes with technical analysis

Incredible Charts ASX Share Prices

'''Consider changing your buy/sell/hold position when any of the following happen. If you expect a major decline the main countercyclical investments are long term government bonds (because interest rates are lowered in recessions) and sometimes physical gold (and sometimes gold futures). Also consider currency exposures - in a recession the US is often a strong safe haven and the AUD (Australian Dollar) weak as it is significantly weakened by falling commodity prices:'''

NB. Annual earnings are not necessarily a great indicator. In the early 30's markets rose as earnings fell. This affects annual PE's too, which is why Shiller uses 10 years earnings for a PE10 based on 10 years earnings. If earnings and PE seem out of kilter (too low compared to stock prices) they can come back into line from either rising earnings or a falling market. If the market is at historical highs it might be more likely the market will fall, if the market and earnings have had a very large fall, it might be more likely that the earnings might rise.

Valuation

A quote from John Hussman of Hussman Funds:

(START QUOTE)

Consider the following conditions: 1) market valuations above their historical norm by any amount at all - for example, a dividend yield on the S&P 500 anything less than 3.7%, and; 2) The 10-year Treasury bond yield and the year-over-year CPI inflation rate higher than their levels of 6 months earlier (regardless of whether their absolute levels have been high or low).

If you look at market history since 1940, this condition has been in effect nearly 20% of the time. Yet this set of factors alone has made an enormous difference in the returns achieved by the market. When the above conditions have been in effect at the same time, the S&P 500 has actually lost ground on a price basis, and has delivered an annualized return of just 0.28%. In contrast, when those conditions have not been in effect, the market has advanced at an average annualized rate of 14.94%. Of course, these averages mask a lot of volatility, but it is clear that even the most basic combination of low stock yields and rising yield pressures is hostile to total returns.

To the above conditions, if Treasury bill yields are also higher than 6 months earlier (again, regardless of the absolute level of yields), the annualized return drops to -0.83%. Add a discount rate higher than 6 months earlier, and the annualized return drops to -2.22%.

Now add overbought conditions (say, a 12-month advance in the S&P 500 of greater than 30%), and the annualized return turns sharply negative, to -39.17%. Overvalued, overbought, conditions with rising yield pressures are trouble. Given those conditions, excessive bullishness only worsens the situation. Now, this combination of conditions has never persisted for an entire year, so the actual loss sustained by the market is not so extreme, but suffice it to say that the typical loss has been in excess of 10%. Based on the current overbought status of the market, there are only three similar periods that we can identify in post-war data: August-October 1999 (which was followed by an abrupt air pocket of greater than 10%), September-October 1987 (no comment required), and September-December 1955 (which was followed by a 10% correction, a brief recovery, and a secondary decline to re-test the initial low). (END QUOTE)

Introduction
As at 6 March 2009 we were in week 73 of a bear or super bear market. Falls in stockmarkets of over 50% since the peak are very common. The MSCI performance tables show every developed country has a fall in its stock market ranging from 40 to 77%. This was preceded by a boom in asset values for stocks, shares and commodities which was fueled by an explosion in private debt as evidenced by the growth in private debt and increasing ratios of debt to GDP and private debt to GDP for most developed countries. In Australia for example, the household debt binge, which began in 1991 in the depths of Keating’ recession, took the household debt to GDP ratio from 30% to a peak of 99%.

The outlook in the real economyis well summarised by Jim Welsh of Welsh Money Management quoted in John Maudlin's Outside the Box issue of 4 May 2009.

Some Economic Indicators
See the article by Eichengreen & O'Rourke originally entitled 'A Tale of Two Depressions" at:

http://www.voxeu.org/index.php?q=node/3421

Stock prices - many leading indicator series include the stock market as a leading indicator of economic conditions, but that's not much help if you are looking for a leading indicator of the stock market. When looking at aseries which claims to be a leading indicator it is important to know whether the rate of growth of stock prices is included in deriving the valuation of the indicator.

Composite Recession Indicators
John Hussman used the following 4 indicators in 2007 as predictors of recession:

1) The "credit spread" between corporate securities and default-free Treasury securities becomes wider than it was 6 months earlier. This spread is measured by the difference between 10-year corporate bond yields and 10-year U.S. Treasury bond yields (or alternatively, by 6-month commercial paper minus 6- month U.S. Treasury bill yields). This spread is primarily an indication of market perceptions regarding earnings risk and default risk, which generally rises during recessions.

2) The "maturity spread" between long-term and short-term interest rates falls to less than 2.5%, as measured by the difference between the 10-year Treasury bond yield and the 3-month Treasury bill yield. A narrow difference between these interest rates indicates that the financial markets expect slower economic growth ahead. If the other indicators are unfavorable, anything less than a very wide maturity spread indicates serious trouble, regardless of unemployment, inflation, or other data.

3) The stock market falls below where it was 6 months earlier, as measured by the S&P 500 Index. Stock prices are another important indicator of market perceptions toward credit risk and earnings expectations. While the economy does not always slow after a market decline, major economic downturns have tended to follow on the heels of a market drop. Stock markets tend to reach their highs when the economy "cannot get any better" -- unemployment is low and factories are operating at full capacity. The problem is that when things cannot get any better, they may be about to get worse.

4) The ISM Purchasing Managers Index declines below 50, indicating a contraction in manufacturing activity. This index is strongly related to GDP growth, and when combined with the previous three indicators, has signaled every recession in the past 40 years. (In July 2010 John looked at the ECRI Weekly Leading indicator as a possible substitute for the PMI)

Individual Indicators
http://www.businesscycle.com/resources/ ECRI Weekly Leading Index rarely if ever goes below about -5 without a recession occurring within a few months

Purchasing Managers Index (PMI)

Credit growth

Money supply Growth

M1 M2 M3 Velocity (a private M3 guesstimate as the US Government no longer publishes M3)

http://www.consumerindexes.com/ from Consumer Metrics

Baltic Dry Index of shipping rates for bulk dry goods (changes in effective capacity, mothballing old, or commissioning new, ships can also affect rates, not just underlying trade figures)

International trade

Shipping container movements through major ports

Changes in Job Adverts or employment

Retail sales (but when stores and chains are closing it inflates same store sales, so look at state sales taxes and adjust for changes in tax rates.)

Housing finance approvals, Housing approvals, Housing starts, Housing prices, Housing affordability

Office vacancies

Retail space vacancies

Housing vacancies

Interest rates

Inflation

Copper prices, Oil prices, Coal prices, Irron ore prices

Motor vehicles sales, particularly of domestically manufactured models

Change in growth or direction in fiscal budget

Hours worked

Average Weekly Earnings, Hourly rates, Overtime worked

http://www.businesscycle.com/resources/ ECRI Weekly Leading Index rarely if ever goes below about -5 without a recession occurring within a few months

Purchasing Managers Index (PMI)

Credit growth

Money supply growth: M1, M2, M3, Velocity, (M3 is a private guesstimate as the US Government no longer publishes M3)

http://www.consumerindexes.com/ from Consumer Metrics

Baltic Dry Index of shipping rates for bulk dry goods (changes in effective capacity, mothballing old, or commissioning new, ships can also affect rates, not just underlying trade figures)

International trade

Shipping container movements through major ports

Changes in Job Adverts or employment

Retail sales (but when stores and chains are closing it inflates same store sales, so look at state sales taxes and adjust for changes in tax rates.)

Housing finance approvals, Housing approvals, Housing starts, Housing prices, Housing affordability

Office vacancies

Retail space vacancies

Housing vacancies

Interest rates

Inflation

Copper prices, Oil prices, Coal prices, Irron ore prices

Motor vehicles sales, particularly of domestically manufactured models

Change in growth or direction in fiscal budget

Hours worked

Average Weekly Earnings, Hourly rates, Overtime worked

Basic Economic equations (identities)
'''The thing to remember is that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances). (G – T) = (S - I) + (M - X)'''

That means that, by definition, if imports and exports stay at the same level, all private saving (incl debt repayment) must be equlised by the government sector deficit. The balances are derived as follows. The basic income-expenditure model in macroeconomics can be viewed in (at least) two ways: (a) from the perspective of the sources of spending; and (b) from the perspective of the uses of the income produced. Bringing these two perspectives (of the same thing) together generates the sectoral balances.

From the sources perspective:

GDP = C + I + G + (X – M)

which says that total national income (GDP) is the sum of total final consumption spending (C), total private investment (I), total government spending (G) and net exports (X – M).

From the uses perspective, national income (GDP) can be used for:

GDP = C + S + T

which says that GDP (income) ultimately comes back to households who consume (C), save (S) or pay taxes (T) with it once all the distributions are made.

Equating these two perspectives we get:

C + S + T = GDP = C + I + G + (X – M)

So after simplification (but obeying the equation) we get the sectoral balances view of the national accounts.

(I – S) + (G – T) + (X – M) = 0

That is the three balances have to sum to zero. The sectoral balances derived are:


 * The private domestic balance (I – S) – positive if in deficit, negative if in surplus.


 * The Budget Deficit (G – T) – negative if in surplus, positive if in deficit.


 * The Current Account balance (X – M) – positive if in surplus, negative if in deficit.

These balances are usually expressed as a per cent of GDP but that doesn’t alter the accounting rules that they sum to zero, it just means the balance to GDP ratios sum to zero.

This is also a basic rule derived from the national accounts and has to apply at all times.

A recent Goldman Sachs pPaper says that:

Since the three sectors constitute a closed system, one sector’s borrowing must always be another sector’s lending. Hence, the three sectoral balances must sum to zero … private balance + public balance = CA balance.

So they wrote the identity as:

(S – I) + (T – G) = (X – M).

It doesn’t matter how you express it as long as you know what a deficit or surplus balance means.

From Bill Mitchell's derivation, we can also simplify the balances by adding (I – S) + (X – M) to get the non-government sector balance. Then you get the basic result that the government balance equals exactly $-for-$ (absolutely or as a per cent of GDP) the non-government balance (the sum of the private domestic and external balances).

(S - I) + (M - X) = (G – T)

If imports and exports stay the same, private saving must equal government deficits.

Acknowledgement: Bill Mitchell: http://bilbo.economicoutlook.net/blog/?p=10670#more-10670

Context of relative size of debt to GDP by sector of some major economies

 * Australian figures from Prof Steve Keen (Debtwatch Blog: http://www.debtdeflation.com/blogs/) do not have breakdown between finance and non-finance business. The figure for Non-finance is therefore the figure for Business. Australian growth in total debt is not known but is an estimate pending final research.

Investing at the top is a disaster
There is virtually no point investing at the top of a bull market. Even the best performing sectors, economies and stocks fall during any significant global bear market. Even if some were not to fall, is there any reason to believe that you are the person who can pick them against the 10s or even 100s of thousands of professional economists and analysts?

Analyst buy and hold recommendations are highly unlikely to perform positively in a bear market. There are few examples of analysts correctly issuing a buy or hold recommendation during a bear market. Commentators like Jim Cramer on Money talk shows like CNBC can be very wrong in Bear Markets

Crestmont's generation returns chart shows that even 20year rolling returns can be very small. Crestmont's secular bull and bear market profile chart allows you to see the PE ratios at the start and end of bull and bear markets.

Prieur du Plessis’s international investment blog has an article that provides further analysis and graphics support the idea that starting PE is important.

Grantham came to the conclusion that “the best case for caution and bearishness is value, which is a weak predictor of one-year returns, but a dynamic predictor of longer-term returns”.

Consider increased exposure when the PE is 10, 11 or 12, consider reduced exposure when the PE is 20 or over.

It is up to you alone
Even after dramatic bull and bear markets, so called conservative managed funds do not generally dramatically rebalance their portfolios from aggressive to defensive assets or vice versa, although they may rebalance their portfolios as described much further below. They maintain their declared stance quite consistently. You can't rely on the fund manager to save you. (Actively managed hedge funds and black box funds may be an exception to this but they have their own risks which are beyond the current scope of this article)

'''When the shape of the yield curve inverts (short term rates higher than long term) or moving averages cross (eg 30 crosses to below 90), or when the NY Fed predictor indicates a recession, you need to decide whether to change asset allocation by switching between funds or between options with a fund. If a downturn is signaled, think of moving from stocks to long term bonds. When rates have been dramatically cut and recovery looks likely, think of a move from long term bonds to cash, when the bottom seems assured, central banks have started "printing money" (increasing base money supply dramatically) and the moving averages (eg 30 and 90) have crossed again, think of the move from cash to stocks. Or just stay in bonds until it is time to move to stocks. Check how currencies have moved during the bear market and consider investing in stocks in the 2 or 3 economies that have suffered the largest fall in currency as well as stocks. As an example, sell Australian stocks at the top and invest in USD bonds, at the bottom come back into AUD stocks. This would have greatly enhanced returns in the 2007 to 2010 period.'''

Long term moving averages crossing
Once a short term moving average (eg 10 to 30 days) crosses below a longer term moving average (eg 60 to 100 days) (try Incredible Charts as a way of seeing such averages) from above there is a about a one in two probability that a major bear market has started, based on examination of past trends. It is a good time to consider dramatically reducing exposure to shares or buying some form of protection against widespread falls in value. While there is about a one in two chance of being whipsawn (the averages soon cross back indicating a possible major bull period and requiring you to buy back in at prices higher than those at which you sold) the loss of opportunity from being whipsawn using such long moving averages is only about 10 to 20% of the loss that can occur in a major bear market. Unfortunately nothing is fool proof every time and the falls in 1974 were so fast and short lived that you probably would have got out at the bottom when the 20 went below the 100 and then missed the rebound until it was about half over and the 20 went above the 100.

Yield curve inversion
The NY Fed has a recession predicting model based on yield curve inversion which has been quite a reliable predictor of recessions since 1960. See an animated yield curve for 2001 to Feb 2009 and Yield curve, below.

Monitoring you must do
Every person with an investment portfolio exposed to shares whether directly, through managed funds, superannuation or other retirement savings products (eg 401k) should spend an hour a week
 * 1) looking at the shape of the yield curve compared to a month ago - is it moving toward or has it become inverse (moving towards inverse is a warning of possible future falls in the price of shares and a housing slow down). If it is becoming more steeply normal (normal is the opposite of inverse) as a result of interest rate cuts during a downturn it is an indicator that there might be a major buying opportunity within a 1 to 20 months and it is time to consider when you should start pursuing a dollar cost average investment strategy. It warns it is nearly time to unwind any short positions.
 * 2) checking charts with short and long term moving averages of major country and sector indices. You need two sets of moving averages, one set to warn you to move to checking every second day, the other set as your pre-determined action point

If the shape of the yield curve has changed from normal to inverse of vice versa or your "warning" averages cross you need to spend half an hour at least every second day watching for your pre-determined action signals. This could have to be done over a period of many months. If you have a large portfolio it is likely to be well worth while. If your portfolio is only a few thousand but likely to grow because you are young with a good income, you should do it anyway for practice and discipline that you will need later.

You need to then consider whether there are signs for a need to change asset allocation between aggressive (share) and defensive investments (short term cash at AAA or AA+ rated government regulated banks and short term government securities). More sophisticated and active investors should consider entering into other defensive arrangements (eg buy put options, short the major index). Aggressive active investors with an appetite for high risk could consider going short on a net basis, but with protection against a dramatic rise in markets.

The great 1995 to 2007 asset price bubble
The great asset price bubble of the period 1995 to 2007 is well shown by a series of charts in the article [http://www.fnarena.com/index2.cfm?type=dsp_newsitem&n=7827D1BE-1871-E587-E1FD5FCB5C217E7F A Rise Too Far? in FNArena News dated March 04 2008 By Greg Peel].

The great debt explosion
The great debt explosion from 1995 to 2007 is well explained by a series of charts in the article The RBA doesn’t get it Published on March 3rd, 2009 by Steve Keen in Debtwatch. The Chairman of the Federal Reserve (US) during virtually all that time was Alan Greenspan. The Chancellor of the Exchequer (UK) during virtually all that time was Gordon Brown of the Labor Party. The Treasurer (Australia) during virtually all that time was Peter Costello of the Liberal Party.

Bear Market comparisons
There is a helpful series of charts of major bear markets compiled by Mark J Lundeen at The 1929 & 2007 Bear Market Race To The Bottom Week 54 of 149 and at The 1929 & 2007 Bear Market Race to The Bottom Week 72 of 149. See the index of articles by Mark J Lundeen Lundeen following the 07-09 bear market.

Falls and rises
A super bear is upon us

At March 09, at 17 months (53% fall) of this bear market, we are in the 11th longest and 2nd deepest of 20 bear markets in 110 years. In 6 more months (a total of 23 months) this will be 17th longest bear market out of the 20. Only the Great Depression (89% fall, deepest) and 2000-2002 (39% fall, 12th deepest out of 20) will have been longer at 34 and 33 months respectively.

Ranking bear markets
This table is as at 5 March 2009 when DJI closed at 6594.44, down from a high daily close of 14164.53 on 9 October 2007. This is now the third deepest market fall out of 9 in over 110 years. If 1937 to 42 is treated as two crashes as it is in the table above, then we are now in the second deepest crash in 100 years. The market (DJIA) has to fall only 8.1% from present levels to be the second worst crash in 110 years. It has to fall a further 76% to become the worst crash in 110 years.

Earnings rates in major cycles
Table from data at Secular Bull and Bear Markets by Doug Short.

The real fall in the current secular bear market since 2000 is the third biggest after the Great Depression and the 14 year 1968 to 82 secular bear market. However at 9 years this is still a relatively short secular bear cycle with only 1 (1929-32) shorter.

Currency movements in bull and bear markets
The USD is the world's reserve currency. At times of economic and finanncial stress it generally strengthens against most other world currencies in a flight to safety. At the start of an upturn in markets after a global bear market, some other currencies are likely to rise at a much faster rate against the USD. For example at the peak of the 2007 Markets in late October 2007 1 AUD bought 0.93 USD. At the bottom of the bear market in March 2009 1 AUD only bought 0.60 USD. In USD terms the Australian stock market had fallen about 80%, as opposed to only 53% in AUD terms. Conversely at 14 April 2010 the AUD again bought 0.93 USD. so while the rise in the Australian stock market to 14 April 2010 was 61% in AUD terms, it was up over 130%.

An Australian investor who switched from the All Ords to USD cash deposit on 30 October and then switched back to the All Ords on 9 March 2009 and then switched back to USD cash on 14 April would have :

At end October 2007 for AUD100 he would have got USD 93 At 9 March 2009 for USD93 he would have got AUD 1.56 for each USD or AUD145 As at April 14 2010 that AUD145 in the Australian Stock market since 9 March 2009 would be worth AUD229 On 14 April that AUD 229 would buy USD212 at 0.93 Today the USD212 is worth AUD256

An investor with AUD 100 in the All Ords on 30 October 2007 who has just held his investment now has AUD65

The perfect switching strategy to USD cash and back twice would give you 3.9 times as much AUD now as a mere buy and hold strategy!

House prices too
Around 81% of countries recorded falls in the value of property in the final quarter of last year, compared with just 27% in 2007, according to estate agents Knight Frank. Latvia saw the steepest price slides on both an annual and quarterly basis, with homes dropping by 16% in the final three months of the year and plummeting by 33.5% during the whole of 2008. The Royal Institution of Chartered Surveyors said the Baltic States had seen the sharpest falls during 2008, with Estonia recording a 23% slide, closely followed by the UK with drops of 16% and Ireland with falls of 9%. The Institute said even countries which did not experience a house price boom, such as Germany and Austria, had been hit by the credit crunch. Some countries such as Spain whihc did not fall so much in 2008 are expected to have bigger falls in 2009. .

The picture is worse when one looks at the fall from peak to trough as shown by some markets in the US.

According to the S&P/Shiller House Price Index there has been an average price fall for houses of 26.7% across 20 cities (as at December 2008)

The Composite 20 city index of house prices has fallen for 30 consecutive months and are back to their September 2003 level. S&P/Case-Shiller Home Price Indices Jan 2009

The cost of getting out of the mess
The amount of funds to be raised by Governments to get us out of the 2007-9 recession is astounding.

The IMF estimates the increase in public debt by the G12 nations as USD 10.32 Billion. Rogoff and Rheinhardt estimate the increase in public debt in the 3 years after a banking crisis as 86%. The IMF estimates that the cost of the current crisis to the United States will eventually reach 34% of GDP or close to $5 trillion. However, the Obama administration, through its various implicit and explicit guarantees, is already using a number close to $9 trillion4. And Reinhart and Rogoff's historical average of 86% of GDP implies an ultimate cost of over $12 trillion! However, if you believe that IMF underestimates the true cost of this crisis, Reinhart and Rogoff offer a more realistic approach (see chart 8). Using their least costly case study (Malaysia 1997) as our best case scenario, the true cost comes to $15 trillion. If one uses the average of 86% instead, the cost jumps to a whopping USD 33 trillion. The total global assets under managment is estimated at USD 121 Trillion according to Wikipedia

The $64,000 question is: how can this be financed and by whom? Particularly when this is a global problem, not merely a single country, region or bloc with problems.

Will the yield requirements of investors be such that interest rates rise, thus limiting any recovery as shares and real estate have to compete with bond issuance for money flows. "Quantitative easing" or "printing money" seems a more likely route to liquidity to avoid the yield requirements of investors causing a requirement for higher yields/lower prices from alternative investments such as equities, real estate etc.

Charts graphs and tables of share market history
Yahoo has good financial pages with major indices and charts

MSCI Barra has data and charts for major developed and developing markets

Crestmont Research has a series of charts with historical data.

dshort.com has some charts that highlight the real Dow (deflated for inflation) which are really scary. They indicate the possibility that we could only have come back to the long term real growth trend line and that there are long periods where the market was substantially below that line.

Gurus
Before following the the gurus, check and see if any of them are on the Forbes Rich list!!

Warren Buffet is, but see how much he has lost in the 2007-09 bear market!

No one is right all the time.

Commentators like Jim Cramer on Money talk shows like CNBC can be very wrong in Bear Markets

Robert Shiller - Irrational Exuberance

McClellan Oscillator

10Greatest Stock Market Gurus

Public company earnings
Lagging

Mark Lundeen states: "The amazing event of the Great Depression's stock market was the 12 month period from July 1932-33. What follows is fascinating market history! On 08-July-1933, the DJIA had bottomed at 41.22, for a total loss of -89.18% from its high of 381.17 on 03-Sept-1929. Look at what happened between July 1932 and July 1933 in the above chart within the box. The DJIA had its best year in history rising from 41.22 on 08-July-32 to 105.04 on 07-July-33 for a 12 month gain of 154.82%! And what were the DJIA's earnings doing during the Dow's best year ever? The Dow's earnings were either crashing or mired in negative territory. Any investor who waited until the Dow's earnings became positive missed the entire move, as the market went flat for two years when positive DJIA earnings were finally reported."

Unemployment and jobless rates
Lagging

The unemployment rate normally only measures those who have registered and a re actively looking for work. Many middle class people are not eligible for unemployment benefits and so do not register. The jobless rate — in the US the percentage of males 25 to 54 years of age who, for whatever reason, do not have a job is often much higher. In the US as at 10 March 2009 the unemployment rate is nudging 9% but the jobless rate is nudging 11%. Unemployment and joblessness are lagging indicators. People are laid off as the recession really bites as firms typically try to keep employees on in case a downturn in sales is a short term aberration. Only once it is clear that a downturn will be longer lasting does retrenchment start and unemployment and joblessness rise.

Yield curve
Leading

A yield curve is a plot of the interest rates for loan securities issued by the same person for different maturities eg 3 months, 6 months, 1 year, 3 years, 5, 10, 20 and 30 years. Normally longer term interest rates are higher than short term interest rates. When short term rates are higher than long term rates the yield curve is described as inverted or inverse. An inverse yield curve often leads to an economic downturn and/or falls in stock markets.

See the animated yield curve at Stockcharts and watch how it is inverse in 2001 as the market peaks and then starts to fall significantly, gets normal in mid 2001 after the market has fallen significantly and the Fed eases, steeply normal in late 2002 early 2003 as recession bites. The market starts to rise and the yield curve moves up and gets less steep as the Fed tightens slightly, but goes inverse in mid to late 2006. The crash followed within about 15 months of the curve turning consistently inverse.

The New York Fed has a publication called "Probability of U.S. Recession Predicted by Treasury Spread". The NY Fed's model uses the difference between 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead. The NY Fed's model has accurately predicted the last 7 recessions, back to 1960.

Interest rates
Bloomberg's rates page lets you view current rates and current yield curves for many countries. As at April 2009 medium to long term interest rates even for government risk have begun to increase as the likely future demand for funds by government through bond issuance sinks in to market commentators and investors. The rising term interest rates are not controllable by central banks in any meaningful sense at the proposed volumes. The rising rates reflect fear of inflation (unlikely risk in the 2 to 5 year time horizon due to existing substantial surplus capacity and a pool of un/underemployed) and the volume of demand around the globe as governments seek to finance stimulus packages. The rises in rates will have an impact on home loan rates, and fixed rate commercial and residential mortgage rates and on term commercial loans. 10 to 30 year bond holders in the US have suffered substantial per centage losses since mid April. Increases in long term rates for government loans will also put pressure on the stock market because of the bigger difference between stock yields and "risk free" return rate of 10 to 30 year bonds. In Australia, variable home loan rates have already started to rise as they are funded through a cocktail of funds of differing types and maturities. This may also begin to constrict supply and demand for home loans as affordability decreases.

Market cycle
Are you proposing to invest after 10 consecutive years of growth or has there recently been a 50% fall in markets. Which is the riskier time to invest?

Has the great balance of economic news been very good for a long time?

Is there lots of "It's different this time because...." opinion?

Inventory cycle
When sales slow at unexpected times of the year inventories build as forward orders have been based on a higher level of sales. When stock inventories begin to grow as a percentage of estimated short term future sales, not only are orders reduced, but carrying levels are reduced in absolute terms to meet the new lower level of sales. This de-stocking causes a slump in manufacturing, often requiring manufacturers to enforce production holidays or to close less economic plants and lay off workers. Economic activity cannot pick up until de-stocking is complete.

Vacancy rates
If vacancy rates are rising then stocks are likely to be too high to allow recent rates of construction activity to continue. There are different types of buildings / vacancy rates and not all rise at the same time. Hotels, residential apartments, freestanding homes, commercial office buildings (often multiple grades with different vacancy rates - eventually vacancies tend to move to lower grade buildings), factories, warehouses are examples. There can also be significant regional variances.

Housing stocks
Housing stocks are similar to other stocks. If sales slow, often because interest rates go up and the yield curve inverts to fight inflation, stocks grow and production falls. If there are less new houses being sold there are also likely to be less sales of furniture, appliances, furnishings and less need for transport. If housing and commercial office space stocks are grossly excessive at the same time the danger of recession is dramatically higher.

Commercial office space stocks
If commercial office space stocks are excessive the same thing happens as for housing stocks. If housing and commercial office space stocks are grossly excessive at the same time the danger of recession is dramatically higher.

Construction loan approvals
When loan approvals start to increase from a low base it is an indicator that there is likely to be an increase in economic activity in 3 months time. Loan approvals generally only start to fall once excessive stocks have become obvious or the economy has already started to slow (often because of an inverse yield curve) or loan default rates have started to increase on loans written in the last few years because credit standards had been allowed to slip too far (there was an increase in the proportion of sub-prime loans).

Building starts
Building starts are highly unlikely to increase unless construction loan approvals have already started to increase.

Production
As at March 2009 according to the article A Tale of Two Depressions by Barry Eichengreen and Kevin H. O’Rourke © voxEU.org world production is in a continuing decline as bad if not worse than the during the Great Depression of the 1930's when looked at on an index basis with the peak of production in 2008 being 100.


 * 1) World industrial production continues to track closely the 1930s fall, with no clear signs of ‘green shoots’.
 * 2) There are new charts for individual nations’ industrial output. The big-4 EU nations divide north-south; today’s German and British industrial output are closely tracking their rate of fall in the 1930s, while Italy and France are doing much worse.
 * 3) The North Americans (US & Canada) continue to see their industrial output fall approximately in line with what happened in the 1929 crisis, with no clear signs of a turn around.
 * 4) Japan’s industrial output in February was 25 percentage points lower than at the equivalent stage in the Great Depression. There was however a sharp rebound in March.

Transport activity and rates
As economic activity declines transport tonnages and rates decline. When de-stocking is complete, then transport tonnages begin to recover as a flow of goods resumes albeit at lower levels than at the peak. The [Baltic Dry Index] measures the demand for shipping capacity versus the supply of dry bulk carriers. The demand for shipping varies with the amount of cargo that is being moved. The Baltic Dry Index seems to be a slightly leading indicator of the stock market a significant amount of the time. It seems to have made a bottom in about December 2008/January 2009 at around 1050. The Shanghai Composite seems to have established a bottom about the same time, but not other stock markets. Whether these indicate a change in long term trend remains to be seen.

Inflation
Are there legislated inflation targets or ranges?

Is the central bank independent of government?

Is inflation under control and stable within any legislated targets? Australia has a relatively independent central bank with clearly identified inflation targets but the Reserve Bank didn't act strongly enough to keep inflation within the target range, but reacted strongly once it broke above the range, causing a dramatic increase in interest rates which hurt most home owners with mortgages.

Do inflation definitions include measures of asset price inflation? Has inflation been very high (&gt;10%) for an extended period of time (&gt;3 years) and prompted high interest rates which have caused a severe recession? If so as interest rates fall then capitalisation multiples will increase leading to potentially large increases in asset prices based on the transition to higher capitalisation multiples. At 10% the capitalisation multiple is 10, at 5% the capitalisation multiple is 20. If the multiple moves from 10 to 20 asset prices with a long income stream double. The same happens if the long term bond rate falls from 4% (x 25) to 2 (x 50).

Asset price inflation
Most countries eliminate asset price inflation from their measures of inflation. They do this by substituting other measures for house prices. If rents are only rising slowly then reported inflation is low, even if house prices have doubled as a result of credit creation.

When looking at the return of various investments you can look at them on a "real" (adjusted for inflation) or nominal basis. The price of homes and the Dow in the US can be seen on a real basis from 1920 to June 2007 at iTulip Dow and Home Prices adjusted for inflation: 1924 - 2006. As at 1 March 2009 it would appear from the percentage fall in the Dow since 9 October 2007 that the Dow is about back to the long term 1.64% real return calculated by iTulip. Based on recent Case-Shiller data, home prices in the US may have further to fall. Both home prices but more likely the Dow can overshoot on the downside.

A March 2008 comparison of CPI deflated US and Australian house and stock market prices shows that Australian stock prices have not been as dramatically inflated as the US, but house prices have. Us house prices had clearly started to fall by March 2008, but Australian house prices had, after a pause in 2004 and 05, resumed rising through 2007 and 2008. This may imply that in spite of first home buyers grants and falling interest rates, Australian house prices still have some way to fall. .

The big difference between Australia and the US was a huge excess of new housing stock in the US which is now rapidly diminishing with the fall in construction, but foreclosure sales are keeping downward pressure on US house prices.

Graphs show clearly the extent of the bubble in US stock and house prices and the Australian and US private debt which funded the asset price boom.

Credit creation
What is the rate of credit creation? How does it compare to the rate of population growth and the rate of inflation? Is it fuelling a boom in asset prices? Rapid credit creation might be sensible in a period of recession, but should reduce steadily once growth is restored, otherwise future stability is undermined and the seeds of the next boom (and bust) are sown.

Debt growth funding demand
If debt is growing rapidly then it will be funding a larger portion of demand. Once debt has to stop growing, demand must also reduce.

Steven Keen (Debtwatch) says:

If we go back to 1994, when the current boom began, the increase in private debt over the year was about $32 billion, compared to (nominal) GDP in at the beginning of 1995 of $507 billion: even then, the increase in debt accounted for about 6.5% of total spending.

Thirteen years later(ed: 2008), the increase in debt over the year was $196 billion, compared to annual GDP of roughly $1,000 billion at the beginning of 2007. The increase in debt last year thus accounted for almost 16.5% of total spending.

How beautiful do you think the unemployment numbers would look if we reduced aggregate demand by 16%?

But that is only no growth in debt. What happens if people and businesses seek to repay debt? What if debt reduces at 4% - Does this now mean that the fall in spending will be 20%? As Steve Keen of Debtwatch says in a recent satirical article about comparing Debt and GDP "rather than spending being augmented by additional borrowing, spending is now less than income as individuals (both firms and households) struggle to repay debts."

Keen says: "Rudd’s stimulus package will inject $42 billion into the economy, but a 5% reduction in debt by the private sector will remove $100 billion from it. Even the slowdown in debt accumulation will swamp the government’s stimulus. In 2007-08, the last year of our debt bubble, private debt rose by $259 billion–adding 20% to aggregate demand. The fall of this to zero–a simple stabilisation of private debt–will remove 20% of demand from the economy. This is what is causing unemployment to explode now."



House price affordability
Are median house prices an unusually high multiple of median earnings?

The long term multiple of median household income for house prices is 2.7. In 1998 it was only 2.4 times. In 2006 it was over 5 times.

See Case-Shiller Index

"As of December 2008, 18 of the 20 metro areas are in double digit declines from their peaks, with half posting declines of greater than 20% and four of those (Las Vegas, Miami, Phoenix and San Francisco) in excess of 40%."

Real estate prices do fall!!

Credit quality
Are companies and people able to borrow more funds easily against recent large increases in real estate values where there has been no rezoning or refurbishment?

Are the requirements for saved deposits, documented sources of taxable income, proportions of income which can be borrowed, proof of earnings being relaxed by banks?

Asset complexity
Are greater proportions of financial assets being packaged in more complex, less transparent ways?

Commodity prices
Are prices for commodities used in the manufacture of a large proportion of manufactures at record highs?

Has the oil price moved to record highs? Oil shocks were relevant in 1974 and 2007. Oil prices wnet up by about 130% from Jan 2006 to June 2008

Are commodity stocks high or low? and are they continuing to reduce or are they now increasing as new mines and wells come on stream or usage declines?

The trend is your friend
Only invest when there is a consistent uptrend established and bail out if there are xx days/weeks/months of the market closing below your entry price. Alternatively, invest or disinvest based on signal for changes in trend. Mebane T Faber suggests using a 10 month (200 day (20 trading days a month)) moving average compared to the end of month closing price.

Faber mentions that in his book, Stocks for the Long Run, Jeremy Siegel (2008) investigates the use of the 200-day SMA in timing the Dow Jones Industrial Average (DJIA) from 1886 to 2006. His test bought the DJIA when it closed at least 1 percent above the 200-day moving average, and sold the DJIA and invested in Treasury bills when it closed at least 1 percent below the 200-day moving average. Faber says "He concludes that market timing improves the absolute and risk-adjusted returns over buying and holding the DJIA. Likewise, when all transaction costs are included (taxes, bid-ask spreads, commissions), the risk-adjusted returns are still higher when employing market timing, though timing falls short on an absolute return measure. Had the results included 2008 they would favor timing even more." Shorter length moving averages are whipsawn more, longer ones miss more of the rise and avoid less of the fall. See Faber's article Where the black swans lie for tables of returns for timing vs buy and hold including for some different asset classes.

Faber says: "..on average, the timing model increased returns by approximately 20%, decreased volatility by 20%, improved the Sharpe Ratio by 0.20, and reduced the maximum drawdown by nearly 50%. Put differently, in the five asset classes tested, the timing approach improves the results over buy-and-hold in each of the four metrics (return, volatility, Sharpe and drawdown) for each of the five asset classes. The timing model keeps the investor invested roughly 70% of the time. Approximately half of the trades are winners, and winning trades are nine times bigger than losing trades. Time spent in winning trades is roughly 20 months, compared to only three months for losing trades."

Portfolio rebalancing
Set an asset allocation between asset classes. EG 20% domestic shares, 20% global shares unhedged, 20% emerging markets unhedged, 20% long term bonds, 20% cash. As some investments increase or decrease in value the actual balances will change, changing your asset allocation. Assets which increased in price will go over their set allocation, assets which underperformed will go under their set allocation. Each say 3 months, rebalance the portfolio back to your set asset allocation percentages.

Dollar cost averaging
Buy 100 dollars every month whether the market is up or down and irrespective of what you think will happen to the market next month or year

Buy and hold
Buy quality stocks and never sell them. The share price history of General Motors shows the risk in this approach. The rolling 20 year returns from the US share market range from an annualised 1% pa for the 20 years ended 1949 to over 14% pa for the 20 years ended 1999. There are dramatic differences based on the height of the market at the time of investment. Very high PE ratio at the time of the investment is an indicator of returns over even 20 years being at the low end of the range.

Bottom picking
Hold out of the market unless you are confident you are around the bottom of a bear market. If you are confident that it is the bottom, buy in big or use dollar cost averaging to reduce risk from further falls. Two adages against this approach are:
 * 1) it's time in the market, not market timing (but in Feb 09 the market is back almost to 1998 levels)
 * 2) no one rings a bell at the bottom - there are some times when the market has continued lower even after large falls. Look at a chart of the 1929 to 1932 crash and the bear market that ended in 1942. There are times it has rebounded very rapidly. Look a t a chart of the recovery after the September 1974 crash.

Stock picking
Pick the best stocks and invest in them. Generally this is in the stock market of your own country. This can be done on a "buy and hold" basis or it can be more actively managed.

Bottom up approach
Find the best stocks and invest in them. It is too hard to understand what will happen in the economy as a whole.

Top down approach
Find a good economy and invest in it. Most stocks and indices in that economy will do well - but it is a global economy and consider the currency risk. Once you have found a good economy, see if you can select the sectors which are most likely to do well. Within those sectors, which stocks will do best?

Fundamental analysis
Fundamental analysis is doing detailed analysis of a large number of companies to identify which are likely to be the best investment

Technical analysis
See charting

Charting
Technical analysis is looking at charts for patterns which indicate the likely direction of markets or stocks in the future. See one person's [top 10 technical indicators]

Moving averages
Look for crosses of moving averages. If the 10 day moving average has been below the 100 day moving average and crosses to be above it then it indicates a reliable uptrend has been established. The higher the number of days in the higher moving average the more of the upturn you are likely to miss. The shorter the moving averages you use the more likely you are to be whipsawn.

Currency risk
If it is not your home country are you prepared to accept that your return in your home currency will be affected by currency fluctuations. Is your prima facie currency risk hedged?

Portfolio effect
If you are invested 100% in the shares of 1 company and it goes bad you lose everything. Your risk is relatively high. If you are invested evenly in 10 companies in 10 different sectors of the economy across 10 different countries/currencies your risk (and expected returns over the long term) is low.

Asset allocation
What proportion of your total assets are in each of cash, stocks, bonds, direct property, collectables, commodities and in what currencies? Should you be diversified across multiple currencies as well as multiple asset classes?

Leverage
Leverage magnifies the losses and gains. If you borrow 50% to buy an asset worth 100 and it falls 50% you lose 100% of your investment. If it gains 10% and your interest cost is 5% you make 5 on 50 which is 10%, same as if you had no leverage. If it gains 20% and your interest cost is 5% you make 15 on 50 which is 30%. Borrowing against shares is doubly risky as the company in which you are purchasing equity already has borrowings or leveraging.

Comparative rates of return with bonds
The yield on short term government bonds of a low risk country are normally thought of as the risk free rate of return. If you invest in anything else your risk is increasing so you would expect to get a commensurately higher return over the long term. Shares have more risk so you would expect that capital growth plus yield on shares should exceed the yield on bonds in the long term. The more risk you are taking with any investment, the higher the rate of return you are looking to achieve. If dividend yields on shares are very low compared to bonds then there must be a big expectation of capital growth - this does not always happen eg look at comparative yields of bonds and shares at September 2007 and then look at what happened to capital growth - massive losses.

Dividend yields
The after tax yield can be compared to the risk free rate of return - short term government paper or for consumers deposit rates in AAA rated banks.

The current (13 April 2009) DJIA Dividend Payout is $307.88. That yield's 3.84% on last Friday's closing price of 8017.59. If the 2007/09 Bear follows the historical pattern, and yields 6% on the DJIA, the current payout of $307.88 fixes the DJIA at 5131.26. That is a BEV valuation of -63.77%. The low to date on 6 March 2009 was a loss of 52.3%. The loss at 13 April is back to -42.6%.

When the Dow Jones dividend yield is less than 3% consider selling, when the Dow Jones dividend yield is greater than 6% consider buying. This is based on Mark Lundeen's Dow Jones Dividend yield analysis chart in his article Stock Market Earnings & Dividends - Wealth is Fragile in 2009, it's a "Policy Thing".

Price earnings ratios
You can't look at PE's in isolation. In isolation they are a virtually meaningless number. The PE ratios ignore the other competing opportunities for funds such as bonds, real estate etc. They ought not be looked at in isolation.

The PE is the result of dividing the price by the earnings. Because this is a backward looking measure it does not take into account a dramatic deterioration in earnings that has occurred after balance date. It also does not take into account cash flow, quality of earnings, riskiness of the business or balance sheet structure. The Price to Forward Earnings is a better indicator of the PE at which stocks are actually being bought. Different sectors often have quite different PE's. Mining exploration companies may have huge PE's as they have no significant earnings but may have issued very favourable exploration reports. Loss making companies don't have a meaningful PE as they don't have earnings.

In 1974 the price of the market was 7.3 times earnings. In the early 1990s recession for example, earnings fell 25% between 1989 and 1992, but the S&P 500 index rose 23% over the same period. Recent PE's from S&P are 30 September 07 - 19.42, 31 December 07 - 22.19, 31 March 08 - 21.90, 30 June 08 - 24.92, but these are historical backward looking PE's. Check what happened to 3 year interest rates and share prices since then.

Forward looking PE's of around 10 have generally been near a bottom.

PE's have only been above 20 for about 9 of the 60 years between 1930 and 1990. However PE's have been above 20 for the whole period 1991 to 2007, 16 years.

From 93 to 99 was a huge bull market and watching 30/100 moving averages would have kept you in the market most of the time during that bull run. The period from 1999 to 2001 would have been whipsawn many times, May 02 to May 03 would have kept you out of the market almost completely, May 04 to Oct 05 would be whipsawn, Nov 05 to Nov 07 would have been consistently in the market for a major bull run, and Nov 07 to the present you would have been almost entirely out of the market, being spared a near 50% loss of value. The November 08 30/100 cross would also have been confirmed by the inverse yield curve of about that time.

Net tangible asset backing
A dangerous measure when asset values are falling and book values have not been adjusted. Valuations supporting recently adjusted book values may be 6 months old by the time audited accounts are released.

Net operating cash flow
You can only pay debts with cash. Cash can only be earnt, borrowed or raised by selling assets. A company can sell more shares. During a credit squeeze you can't borrow more and are likely to be asked to repay part of outstanding indebtedness. During a stock market crash it becomes difficult to issue new shares except at a significant discount to market. If operations don't produce positive net cash flow and new funds are not available, liquidity crises require assets sales at the worst time in the cycle.

Stage of development
Does the country have well developed and stable institutions?

Is it a Developed Market or an Emerging Market economy? Morgan Stanley has indices for Emerging Markets as well as for Developed Markets. Some funds specialise in emerging markets. Brazil, Russia, India and China are emerging markets. The US, UK, Germany, Australia are Developed Markets.

Market or planned economy? US is a free market economy with relatively small government interference compared to North Korea which is a planned economy.

Sovereign debt rating
Is sovereign debt finely priced compared to eg the US and Germany?

What is the price of a credit default swap for sovereign with 5 and 10 years to maturity?

Is previously issued debt stock trading at a big discount to par value reflecting a real risk of default?

Has the country ever defaulted eg Russia and Argentina.

Given the reputed lack of reliability of ratings agencies in assessing the likelihood of loss on financial products over the last one should consider the cost of Credit Default Swaps ("CDS") on sovereign debt as at least a partial indicator of sovereign debt default risk. See US CDS above 100bps: it’s a MAD MAD MAD MAD World! for some analysis of CDS and their pricing.

Political risk
Is the country likely to remain politically stable for your investment horizon?

Population growth
A stable population generally means lower growth rates. Europe and Japan

Demographics
An aging population generally means lower growth rates. Europe and Japan.

Household indebtedness
Highly indebted households have limited capacity to borrow and spend more and are highly subject to movements in interest rates - monetary policy. US and UK

In Australia, the household debt binge, which began in 1991 in the depths of Keating’ recession, took the household debt to GDP ratio from 30% to a peak of 99%, from which it is now falling.

Government indebtedness
What proportion of GDP is government indebtedness?

Debt to GDP ratio
The debt to GDP ratio: What proportion of GDP is total indebtedness?

During the period 1985 to 2008 total total credit-market debt(or “credit”) in the U.S. to GDP (or Gross Domestic Product) on a percentage basis rose from 160% to 340 \% of total GDP

Financial system
Are the banks tightly regulated with clear capital adequacy requirements? Are banks required to be widely held? Are banks too big to be bailed out eg Iceland's major bank had grown internationaly and was so big the Iceland government couldn't save it without bankrupting the country? Are there state owned banks that are politically influenced?

Investment regulation
Is mark to market required for financial assets? Is there an independent securities regulator? Does the regulator have a record of successful enforcement? Are penalties for insider trading significant?

Corruption
What rating does the country have on the corruption index?

Freedom of the press
Is there a free press? Is there freedom of information?

Budget outcome
Does the government sector run an overall surplus or deficit?

Wealth distribution
Is wealth distribution broader or narrower than the Pareto principle?

Current account
Does the country have a current account deficit or surplus?

Balance of trade
Does the country export more than it imports. China does and has a surplus. The US doesn't and has a deficit.

Debtor or creditor nation
US is a major debtor. China is a major creditor, it holds lots of US bonds.

Boom bust cycle
Is there a repeated pattern of booms and busts?

Debt productivity
In late 2008 the US debt was 4 times GDP. From 1952 to 1972 debt was less than 1.5 times GDP.