If the US is really Japan, as many folks think, the S&P 500 could soar another 40% by December 2010 before it completely collapses, say Merrill Lynch Asia strategists Sadiq Currimbhoy, Arik Reiss, and Jacky Tang.
The comparison requires some torturing of the numbers, but once that torturing is complete, the similarity between the markets is startling.
The bottom line here is that the strategists have identified a pattern that supports the idea of major additional gains in the US stock market even without a strong economic recovery. This is important. We have yet to see a bullish market forecast supported by anything other than hope, arrogance, or a prediction of a v-shaped recovery (which seems unlikely).
The fact that the market does not need a v-shaped recovery to go from here to the moon is important. In our opinion, it makes it far more likely that the rally can continue through next year.
Some investors like to compare the US to Japan. From a market perspective, plotting the Nikkei and the S&P500 shows no similarity. However, a peculiar variation shows an uncanny relationship.
Chart 1 shows the Nikkei in US$ (so Japanese equities to US$-based investors) compared
to the S&P500*US$ index (or the S&P to investors outside the US). The S&P500 in DXY has been rebased to the same peak as in Japan, except 117 months later. If this pattern repeats, there is potential for 40% upside over the next 12 months…
Assuming a relationship similar to what Japan went through, the S&P500 in DXY terms would rise another 40% pretty much from now until early December 2010. Importantly, this is in DXY terms, so if the US$ were to rally 20% and the S&P500 17% (as it’s multiplied), that would do it. If the
market only rallies to the lower trend line in the… chart, then the total upside would be 33%, split between the US$ and the equity market.
And here’s the chart. The S&P is the blue line, the Nikkei the black line:
The Merrill strategists are at a loss to explain this relationship. They wisely note, however, that the consensus is usually wrong and that it is always smart to consider the alternatives. And this is certainly one of them.
We do not know precisely why this relationship has worked. Could this be what a market submerging under debt might look like to a foreign investor? And why does the trading pattern look the way it does? And, that even in economies overcoming credit booms, rallies can be powerful and last much longer than you think.
We look at three scenarios that could drive a “melt-up” in US equities, including the possibility that the US$ rallies with US equities should investors decide that US assets are attractively valued. Within Asia, the scenarios suggest that laggard markets would benefit most.
The strategists went further, constructing an index (average) of all markets that have crashed more than 45% since 1975 (including the US Great Crash). They averaged the recoveries from these crashes into the chart below. They found that strong “relief rallies” are common (“The world’s not going to end!”). If this pattern holds for the US. the market rally has another 40% to go.
One issue in this cycle is the sheer size of the equity market correction. We looked at all the markets since 1970 that had serious crashes, ie, more than 45% in the previous 12 months in US$ terms (or 50% in local currency terms). We then added the US in 1930, and built an equally-weighted index of these. This is shown in the chart [below], with 25th and 75th percentile bands.
We then compared it to markets currently where there has been a similar deterioration. The bulk of the indices used are emerging market ones, though we added the BKX in this cycle. The current index looks like it’s following a similar pattern, and set to peak in about 12 months, some 40% higher than current level.
The chart suggests that after the initial crash, there is a relief rally that the world is not going to end. Two additional points:
1. Only one market was able to return to new highs quickly after such a large correction – the Hang Seng Index in 1998-99 managed it in 16 months. No other market managed that, even after three years.
2. This reminds us of the Asian financial crisis. The initial recovery is better than expected, but its sustainability is worse than expected. Crises, it seems, display this pattern.
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