JSE likely to outperform US stockmarket for fourth year in a row


Friday, February 23, 2018

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This year I am late with my normal forecast of the stock market and economy. Instead, I thought it wise to take time to ponder the global situation, which reminds me of February 2007.

In January of that year I had been arguing with my father, Roy Collister, over the timing of the next recession and the next US stock market crash. We both agreed that the then US credit bubble would come to a very bad end, and our disagreement was simply over timing.

I had stated that there was currently still “plenty of liquidity”. He responded dryly, “In my experience, there is always plenty of liquidity until there isn't.”

A few short weeks later in February, when Digicel raised a then unheard of US US$1.8 billion on essentially the credit risk of Jamaica and Haiti, in one person's words at the time “feeding the ducks while they were quacking“ (ducks meant investors), I decided that it was indeed time to agree with my father.

I wrote in an article a few days after the bond issue (followed up by a series of warning articles over the next year and a half) that Digicel was “ringing the bell” on the end of the global expansion, meaning that they had signalled closing time at the “liquidity” bar.

The purpose of this analogy is to state that in my view the recent correction should not be regarded simply as another opportunity to buy the dip, but the beginning of a major regime change, with the US Federal Reserve finally taking away the punch bowl by hiking interest rates.

The problem is that instead of taking it away before the party got started, we have already once again had a huge credit party, so in the words of investment guru Warren Buffet, we are now about to find out who has been “swimming naked”.

The blow up of the “volatility” funds are likely the canary in the coal mine, and we will know shortly whether other signs of “vanishing” liquidity confirm the current “storm” warning.

The US market had a huge rally for most of January (and in the months before it) based on the prospect of sharply increased earnings from the recent US corporate tax cut, while volatility based quant strategies created a feedback loop that themselves reduced stock market volatility, and thereby raised stock prices.

The long period of easy money has created multiple areas of speculative excess -- Bitcoin and its relatives, “possible” Davinci paintings selling for US$500 million, Canadian marijuana stocks, and short volatility index trading strategies (akin to picking up pennies in front of a steam roller).

The key issue is not these signs of excess, which in themselves have limited macroeconomic impact, or such other evidence as US retail investors finally getting excited enough to enter the market just in time to get their “heads” handed to them, but the enormous bond bubble that quantitative easing has left behind, with no obvious “exit strategy”, itself a much longer conversation.

This period of “irrational” exuberance over the last few months ended with the recent US stock market correction, roughly 10 per cent at the peak, although it has since rallied back somewhat.

It is now clear, however, that stock market volatility, which has been suppressed by Central Bank easy money for nearly a decade, has returned with a vengeance.

More importantly, the US is about to run trillion-dollar budget deficits (representing five per cent of its GDP and over) as far as the eye can see. Despite that excess, US growth is unlikely to budge much above its existing two per cent range this year, with worse news thereafter.

In contrast, Jamaica's liquidity situation is still improving, on the back of the continued balancing of the central government budget, and relatively small current account deficits more than covered by foreign direct investment.

On Tuesday, our central bank just cut our main policy interest rate again (the interest rate paid by the Bank of Jamaica on overnight deposits) from three per cent to 2.75 per cent.

Unlike in 1993, and 2004, when the main indexes and stocks rose to average price earnings multiples of roughly 20 or higher, there does not yet seem to be signs of speculative excess in our local market, with most of our large blue chips still trading in the range 10 to 14 times historic earnings.

In any case, both the previous short-lived bull markets were ended not so much by high valuations but by sharply rising macroeconomic and debt distress.

Our local institutional investors still remain underweight equities, with the strong likelihood that the FSC will double the individual investment concentration limit from five per cent to 10 per cent in the second half of this year — removing the cap on our institutions' ability to acquire the few available blue chip shares.

In short, both our relative valuations (Jamaican blue-chip stock valuations are at roughly half US levels), positive liquidity direction and technicals all suggest that this will be the fourth year in a row where Jamaican stocks will outperform US stocks.

Interestingly, the situation in the first few weeks up to January 26th, when Jamaican stocks were down somewhat, and US stocks were up sharply, has now completely reversed, with US stocks down, and Jamaican stocks back in the black for the year so far.

Expect this to continue this year, barring external shocks such as natural disasters, with a reasonable prospect that Jamaica will finally record economic growth of two per cent or above this calendar year, and perhaps the fiscal year thereafter.

Based on this outlook, Jamaican stocks should rise broadly in line with profits (say by 15 to 20 per cent over the year), compared with a likely very volatile US market (say, in the negative 5 per cent to positive 10 per cent range). More anon.

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