Is the US about to sneeze?

At a glance

A newsletter suggests that US markets currently are ripe for a huge correction – This is a result of the Fed’s Quantitative Easing programs that have pumped huge amounts of liquidity in the system – We look at historical relationship between market levels in the US with India and 3 other countries – Long-term (17 year) view suggests strong correlation between emerging markets but not as much with US and UK – However data from since the 2008 credit crisis paints a different picture – Three possible views and corresponding actions exist

“Oh…you know…everything is screwed up here. Airline tickets are very cheap. It’s cheaper for me to fly to Moscow to buy a toilet seat than it is to buy the seat in Minsk. Besides, there aren’t any toilet seats in Minsk.” – a young woman in Russia, sometime in the late 80’s or early 90’s

This quote was in a daily newsletter I subscribe to called ‘The Daily Reckoning’ by a company called Agora Inc., distributed in India by Equity Master. As US markets have made new highs, the tone of this newsletter has been decidedly pessimistic to the point of predicting a meltdown, as bad if not worse than in 2008. Their reference to the Soviet Union was to highlight the fallacy of central economic planning and it’s contribution to the crash of the USSR. It goes on to say that QE, QEII, ZIRP and other assorted mechanisms adopted by the US Fed are leading the US down a similar path.

Their premise is simple. According to them, the Fed has distorted markets by flooding the system with “cheap money”. This cheap money sloshes around the system and in the absence of real economic growth, finds its way into asset prices, inflating them to form bubbles, bound to burst sooner or later. And apparently, a bubble has been forming in the US markets over the last few years.

I took a quick look and sure enough, US markets have been on a tear since the 2008 crisis. Although not to say it proves causation.

US Interest Rates (1997 – 2014)

Dow Jones Index (1997 – 2014)

Given the consistent warning bells rung by these guys, and the old adage “When the US sneezes, the world catches a cold”, I wondered if there are any clues from history on what market movements  in the US mean for others, especially India.

Note that this was a largely back of the envelope effort given limitations in my knowledge of macroeconomics. For an example of what a comprehensive study looks like, head over to this paper by Mark Crosby and Philip Bodman examining the linkage between the economies of the US and Australia.

Long term view

I compared the US with UK, India, China and Brazil. On a normalized basis, Brazil has done the best over the last 17 years with India close behind. US, UK and China have had similar patterns but not as good as the other two.

Correlation Matrix (1997 – 2014)

As messy or pseudo-scientific the above chart looks, it’s simply a measure of the extent to which two markets move together, namely, the correlation.

How to read this chart:

• Each plot is a graph of one market versus another over 17 years
• The name of the index mentioned in any row tells you the x-axis and the intersecting column is the y-axis
• Starting from the top, the 1st row shows Sensex correlations with other markets. Therefore 0.2772 is the correlation of the Sensex with the S&P100 (US)
• The more scattered the chart, the less in sync, the two markets have moved. The more tightly bunched into a slim oval the points are, the more two markets have moved in lock-step

What the long-term patterns say:

1. Brazil shows least correlations with US and UK, at 0.1 and 0.25 respectively
2. Of the emerging markets, China has historically moved the “most” in lock-step with the US and UK markets
3. Over 17 years, Sensex shows highest correlation with Bovespa (Brazil) and Hangseng (China). At 0.948, the relationship between India and Brazil has been the strongest followed by India with China
4. Downside correlations did not yield a significantly different relationship between the indices (this was meant to be the “Aha” that wasn’t. I was hoping to say that they rise independently but fall together. That’s not the case – A downside of resisting the temptation to fit data to convenient inferences)

So, given the US and Indian markets don’t move together, it should mean we have little to worry about from the predicted correction in the US markets, right? Not quite.

Since the Lehman crisis

Shortening our time horizon to just after the Lehman crisis shows a different picture. Sensex and the S&P100 are now the best performing markets since 2009 and Brazil is the worst-performing by a distance. China and the FTSE are in the middle of the pack.

Correlation Matrix (2009 – 2014)

The correlations now look very different. Note 5 years and 6 months of data is still sizable.

What stands out:

1. The Bovespa’s relationship with almost all other markets becomes substantially weaker, just 0.02 with FTSE, 0.17 with S&P100. The previously strong relationship with India is now down drastically from 0.95 to just 0.28. The deteriorating macros in Brazil with high inflation could be the reason
2. Except for a slight decline in correlation between India and China (0.91 to 0.83), all other relationships have gotten significantly stronger. S&P100 with Sensex (0.82), with FTSE (0.91), with HangSeng (0.60)

So markets seem to have become much more integrated in their movements over the past 5 years, since the time Fed started quantitative easing and pumping billions of dollars of liquidity into the monetary system.

Going back to the dire predictions from the folks at Agora for the US markets, we can consider three scenarios:

The Pessimist:

View: The US market will correct significantly and do what it always does; suck liquidity out of the system as all money goes back into “safe” US treasuries. Risk appetites dip and markets all over, including India, fall off a cliff, followed by prolonged pain as investors shun equities like the plague.

Action: Sell everything, buy Fixed Deposits and hunker down in bomb shelters

The Optimist:

View: The US markets continue their merry ride for a while before flattening out. In the meantime, interest rates in India start lowering on the back of improving fundamentals thus driving funds into the stock markets, both from international and domestic investors. All stocks are “re-rated” (the equivalent of what Neo experienced as he came alive after being killed in the 1st Matrix movie), and soar to new heights

Action: Shovel everything you have into the markets today! Borrow as much as your property, gold etc will allow you to and buy some more

Calm Investor:

View: Not sure what the US markets will do, but they look a bit frothy. Not sure what the Indian markets will do, they too have gone up quite a bit on expectations. So results in the form of rising earnings need to start showing to sustain these levels. Therefore some correction is likely.

Action: Don’t sell unless there’s some garbage you’d like to offload. Continue monthly buys of currently un-sexy stocks. Maybe even consider funds investing in China, Europe other under-performing markets. Stay invested, and just stay…