Markets Climb a Wall of Worry

As we approach the end of 2016, it’s worthwhile to remind ourselves how the year opened.

Remember the turmoil? As soon as markets opened for the year, Wall Street tumbled. Mainly on concerns over weakness in China.

The Dow Jones Industrial Average dropped 6.2% in the first five trading days. It was the worst opening five days in the index’s history.

Billionaire George Soros came out warning events were looking a lot like 2008.

It seemed markets around the world were standing on the edge of a precipice.

Then the Royal Bank of Scotland (RBS) joined the chorus on 8 January, warning investors to ‘brace for a cataclysmic year’ and advising clients to ‘sell everything’.

The RBS said that markets were giving out the same stress alerts as before the Lehman crisis and that the opening of 2016 looked ‘very much like 2008’.

We can now look back in hindsight and say the RBS call predicting a market collapse was a bad one.

The major indices like the Dow Jones Industrial Average, the S&P 500, the NASDAQ and the FTSE have all finished the year strongly, and are trading at or around all-time highs.

The forecast collapse never happened; markets climbed the wall of worry. That’s what markets do.

Two things come to mind when looking back at those events in January. The first one is this. The same bank that was completely blindsided by the events leading up to 2008, could see with crystal clarity, the ‘cataclysmic’ year ahead in 2016.

The only reason the RBS is still with us today is because of a UK government bailout, which ended up costing British taxpayers £45.5 billion.

Markets don’t collapse while everyone is sitting on the sidelines waiting for them to. Markets can only collapse when everyone is all in, fully invested, and convinced there are only blue skies ahead.

The RBS is a classic example of this.

In the autumn of 2007 there was nothing but blue skies ahead for the Royal Bank of Scotland. It announced an operating profit of £10.3 billion, the biggest ever for a Scottish company, and the equivalent of earning £1 million per hour.

Just 18 months on, the very same bank set another record, by posting a loss of £28 billion, the biggest in British corporate history.

This is how markets collapse, when everyone is fully invested and few if any see it coming.

In June 2006, the American banking arm of the RBS built a new facility in Stamford, Connecticut. Housing the banks RBS Greenwich Capital office, it contained what is reputed to be the largest trading floor in the world. At the time, those in charge were earning up to $25 million a year in cash bonuses.

Traders were under instructions to buy assets. Bonuses were paid based on the interest earned on those assets. This encouraged traders to take on riskier prospects, for the bonuses. It was against this background that traders started buying into the American sub-prime mortgage market.

By 2007 the RBS had amassed billions of pounds in sub-prime exposure. And the rest, as they say, is history.

The second point one can make about those events in January is about the comments from George Soros and the RBS that the start of 2016 was very similar to 2008.

In fact, is it was nothing like it.

It’s not the equities market which drives the economy, but the real estate cycle. And it’s in this important difference that 2016 was completely different to 2008.

2008 marked the extreme peak of a real estate cycle, when land price was bid up so high, that the productive economy simply could no longer afford it. While property kept rising things were OK, but when real estate started to fall below the level of loans outstanding it put the banks under extreme pressure.

By contrast, the start of 2016 was nothing like this. Real estate was continuing to move off the lows it made in 2011–12. The reforms and constraints placed on the banks after the last crisis meant none of the banks are lending loosely or overextended.

In its results presentation in August the Commonwealth Bank reported that 77% of its customers in its Australian home loan portfolio are two and a half years ahead on their mortgages.

Real estate is not stretched, nor are the banks in trouble. The landscape is very different to 2008. This cycle is still in its early stages, and still has a long way to go yet.

Understanding this, knowing where you are in the cycle and what causes it to repeat, will make you a better investor.

Now looking forward to next year, 2017 promises a phase of expansion associated with easier credit.

When looking at the real estate cycle, the US is always the country to watch. It’s the world’s largest economy, and leads the world in and out of the boom-bust cycle.

A phase of loosening in credit seems to fit in nicely with recent events in the US.

The president elect Donald Trump has made no secret of his intention to totally do away with the rules and regulations placed on the banks after the global financial crisis.

In May this year Trump told Reuters in an interview that the reforms put in place made it impossible for bankers to function. ‘It makes it very hard for bankers to loan money for people to create jobs, for people with businesses to create jobs. And that has to stop.’

You can see where all this is leading. Easier credit conditions and more lending should lead to increased profitability for US banks.

The market is factoring that in very quickly, with US bank stocks moving up strongly on the Trump win.

Add the promised tax cuts and infrastructure spending, it’s pointing to a bullish year ahead for US markets.

According to Bank of America’s David Woo, ‘Trump and Republicans in Congress are poised to unleash the mother of all fiscal stimuluses in the next two years.’ He believes the market has yet to fully price in this new environment.

As for US real estate, massive tax cuts, infrastructure spending, job growth and easier credit standards should continue to push US real estate higher.

Whilst 2017 may deliver further market panics, don’t expect markets to completely collapse while the world’s largest economy goes through this phase of tax cuts and infrastructure spending.

This current real estate cycle continues to move as expected. To learn how to profit from it and time it all to your advantage, go here.


Terence Duffy,
Lead Researcher, Cycles, Trends & Forecasts


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Terence Duffy is an analyst and chartist, specialising in researching economic trends and cycles.  His primary focus is housing and land affordability. But you can also depend on him to offer his unique analysis of stock market charts. As Terence will show you, the charts often forecast, well in advance, the good or bad news to come.

Money Morning Australia