- New Science in old markets -

Last week’s US equity turn and German long-term update

The cluster of US stock market turns that was due last week on the 8th of the month appears to have marked a low point, not the high that we had expected. There has been quite directionless trading before and after the turn but the immediate prior trend was downward, so this was probably a ‘swerve’ as defined in our user guide. These usually happen in quite strong trends when the market is rising toward an expected high point at a nearby turn date, only to dip briefly into a low point instead. The uptrend can then resume, as this one probably now will do. This happens in about one in ten turns, although we warn about them more often.

The next turn is another ‘US only’ turn due on Wednesday the 23rd January or perhaps one day earlier. This is single turn signal that comes from the Dow long-term series that we analyse using slightly different methods from usual. These turns tend to pick out the longer-term peaks and troughs but the basis is the same - whatever trend the price is following at the trend date will reverse.

In Germany, the stock market has been swinging in a sideways range for a few weeks and other European markets have gained some ground against it. Germany has generally been stronger than the rest for the whole of the 5 years of the financial crisis, prior to which it was a slight underperformer against the debt-fuelled and racier competition from Italy, Spain and others. Now that some commentators are starting to claim that the Southern countries may surge ahead again, it is worth examining why things have turned out the way they have. It is all to do with the Euro.

Germany and its immediate satellites comprise about 40% of the Eurozone economic output. These countries have all done well from the Euro and they are locked into a common currency with Spain, Italy, Portugal, France and so on – the underperformers. The reasons for the disparity have little to do with the higher indebtedness of some countries or the imposition of austerity on the poor Mediterraneans by stern outsiders. These are just symptoms. The underlying problem is that Germany is competitive in the world and its labour force and other aspects of the economy can adapt to changing circumstances whereas the underperformers cannot (yet).

Formerly, national economic success resulted in an appreciating currency and interest rates that were raised by the local central bank to ward off inflation. Economic weakness resulted in the opposite – a weaker currency and low interest rates. This was common to most countries and the effects were to keep all the European economies within sight of each other. The German currency was generally strong, the Italian and Spanish tended to be weak but these ‘automatic stabilisers’ – what we at HED call ‘negative feedback’ kept everyone roughly competitive. With the arrival of the Euro in 1999 that all changed. In 2003 Germany enacted sweeping reforms to a rigid labour system that made it much more competitive compared to the other Eurozone members. The difference started to show in 2007 and then really became important once the banking crisis began in 2008-as this example of Spain vs. Germany shows.

The main contra-trend movement in this 5-year uptrend was in the 'false dawn' of 2009. Then it was assumed that the normal situation of brisk growth in the Southern countries would resume as ‘economic convergence’ continued. Remember that?

Now some say that Spain, Italy and the rest are cheap so should represent the best ‘value’ for investors. The trouble is that this view is based on the old kind of analysis that prevailed before the advent of the Euro. It assumes that all these economies are loosely tied together by the benign old stabilisers that existed before they were lashed firmly together with no room to move. The negative feedback that kept everyone within sight of each other has been replaced by positive feedback that reinforces success and punishes failure. The ideal of convergence is replaced by the fact of divergence. Germany is unrestrained by a rising currency or rising interest rates and so is now booming. There is low unemployment, wage inflation and the first proper bull market in real estate in living memory. In rigid Spain by contrast, youth is un-unionised and so the under-25 unemployment rate is over 50%. Property prices are dropping hard and there are plans to return built land to arable use – a remarkable step in the 21st Century when rural flight to the cities is the norm everywhere else.

There is no help in sight – any business is more competitive in Germany than in the Mediterranean countries and this will remain the case now the feedback has turned positive. The only adjustment possible will be if German pay and real-estate prices reach such high levels that the cost of doing business there levels out with the cheaper South. In the meantime, a plentiful supply of Southerners is heading to Germany to work, as evidenced by the growth of German language classes in Athens and elsewhere. That will keep wages down and so this will be a very long process. Buy Germany and keep buying it on any dip.

RE