Are we in a primary bear market? Between Monday 11^th April and Monday 8^th August the All Ords index fell by 19.9%, just 0.1% shy of technically making a crash. Since then its recovered ground, but is still more than 18% below its last peak.

The occasion of a death cross (when the market’s 50 day moving average falls below its 200 day moving average) is a bad portend for the market since its occurred only three times in eight years. But half of death crosses prove false alarms as we saw in mid 2010.

Analysts are debating whether conditions now are better or worse than they were on the 1^st November 2007 after which the All Ords descended by 55% until the 6^th March 2009.

The case for Better is:

• The last share market peak in April 2011 was still 26% below its previous peak in Nov 2007 so the market has less to fall.
• The forward price/earnings (PE) ratio for the Australian share market is around 10 which is 30% below its 10-year average suggesting shares are already cheap.
• Investors are less leveraged in shares and theUShousing crisis has stabilised though not improved.
• Companies and banks both here and abroad have recapitalised and deleveraged so their balance sheets are much stronger than in 2007.
• Most banks now know their counterparty risk so are lending to each other which they weren’t in 2008.
• The world economy is still growing albeit it slowly. Many companies are enjoying record earnings thanks to cost cutting and productivity improvements.
• The world’s leading central banks by offering 3 month US dollar loans to European banks have demonstrated a resolve to avoid a Lehman Bros like collapse.
• World leaders are much better briefed and prepared for an economic crisis than they were four years ago.
• Germanyhas no choice but to rescue the Euro if it wants to avoid a financial contagion that could plunge it and its neighbours into depression.
• The Chinese craving for Australian resources is set to remain strong helping to prop up our economy even if domestic demand for goods and services is weak.
• America’s Federal Reserve Bank has promised to keep interest rates low for another 2 years and is likely to come to the rescue with more money printing (QE3).
• Australia’s government debt and deficit relative to the country’s GDP is much lower than that of almost every other developed country making us a safe haven. See chart below.

The case for Worse is:

• The global financial crisis (GFC) never went away – the excessive and toxic debt of banks was merely shifted to governments and central banks.
• Large economies likeItalyandSpainrisk a debt trap likeGreece,IrelandandPortugal, yet are too big to be rescued by the European Central Bank.
• Many European banks are heavily exposed to the debt of Mediterranean countries which if they default will leave the banks insolvent.
• Americahas lost its triple-A credit status and could be downgraded further proving it’s no longer too big to fail especially if the US dollar lost its reserve currency status.
• Governments now have too much debt and too large deficits to afford another round of stimulus and rescue packages.
• Central banks have cut their interest rates to almost zero so can’t cut them further to avoid a double dip recession.
• Central banks risk more asset bubbles like those of commodities, precious metals and shares if they turn to the printing presses once more.
• Three in four German voters oppose their government rescuingGreeceor any other country so their Parliament may not approve further action.
• Political leaders around the world no longer have the political authority or fiscal ammunition to act decisively should there be another meltdown.
• Chinais already battling high price inflation (6.4% per annum) so won’t resort to a massive fiscal and monetary boost as it did in 2008.
• P/E ratios only look low because earnings have been boosted by government stimulus which now is going into reverse inAmericaand elsewhere (see next chart).

How the ongoing GFC drama pans out from here on no one knows. But what we can say is that being out of the market at present is being out of harm’s way. Should it crash further a trend-timers like myself shall continue to stand back and watch it fall until the trend reverses. Should it bounce back we will catch the uptrend for as long as its lasts. Bear markets are manna for market timers because they eventually allow us to buy back shares (i.e. exchange traded funds) at fire sale prices.

Investors without an objective and disciplined market timing system intently watch the news and worry whether to exit the market or hang on. And if they have already left the market they are not sure when to return.

It’s interesting to observe the contradictory opinions of so called market experts since it corrected. Most fall into the category of “we have been telling you the market is sick for a long time” or “everything will be OK as long as you hang on for the long term”.

The first group never alerted their readers when to actually get out of the market. The second group refuse to acknowledge we have been in a secular bear market since late 2007 (Americasince 2000) which based on precedents (1929-42 and 1966-82) could last for a long time.

During such periods ordinary share investors experience a rollercoaster ride only to accrue dividends assuming the companies they have invested in survive. In real terms (after inflation) they lose capital. By contrast a trend follower uses exchange traded funds (that diversify company risk) catch the market’s upswings and avoid its downswings having a smoother ride and making good money.

Note in the next chart how even an ultra-conservative trend-timing strategy (which issues the very few buy and sell signals) avoided the worst of the 2008 crash yet got back into the market in s time to enjoy the strong rally of 2009.

Trend traders that adhere to a proven strategy can relax knowing they are on the right side of the market whether it’s soaring or correcting. Yes, there are occasional whipsaws, but these are small insurance premiums for staying out of every crash and catching every rebound.

Percy Allan is Chairman of Market Timing Pty Ltd. For more information about trend-trading visit www.markettiming.com.au

Debt / GDP, Unemployment Rates, S&P Credit Ratings

To help put things in perspective we have complied the following table which compares three important and highly topical economic statistics as at Oct 2011.

The 21st century will be the century of old age, where declining birth rates meet longer life expectancies. This ageing of the population will affect many areas of the international economy, from consumption and growth to asset valuations.

The impacts from ageing will likely be most acute in Western Nations, although some developing countries, most notably China, will also be negatively affected.

Australia is not immune from these demographic headwinds. As shown by the below chart, for the past 25 years, Australia’s total dependency ratio – the ratio of the non-working population, both children and the elderly, to the working age population – has been in a demographic ‘sweet spot’. That is, there has been a high proportion of working age people supporting only a small pool of dependents. This ‘sweet spot’ has come about from two main factors:

The Baby Boomer generation – defined by the Australian Bureau of Statistics (ABS) as those born between 1946 and 1965 and comprising around 25% of Australia’s population – has been at working age; and
Declining birth rates from the mid-1970s.

However, 2011 marks the year when the oldest members of the Baby Boomer generation – those born in 1946 – turns 65 and reaches official retirement age. Accordingly, Australia’s dependency ratio is projected to worsen progressively each year from now on as the Baby Boomers gradually enter retirement.

Australia’s demographics are similar to those of other Western nations, which have also experienced similar demographic ‘sweet spots’ as well as rising dependency ratios going forward (see below chart).

To put the number of retirees in Australia into perspective, consider the number of Australians turning 65 each week between 2000 and 2030:

As you can see, the number of retirees has been on the rise since 2000. And this trend is expected to continue for another 15 years or so.

Accordingly, the proportion of Australia’s population aged 65 or above is projected to rise from around 14% currently to 24% in 2050. Similarly, Australia’s median age is expected to increase from around 38 years of age currently to 43 years in 2050 (see below chart).

An increase in the dependency ratio will, other things equal, lower Australia’s growth potential via reduced expenditure, lower asset valuations, and higher rates of taxation. These impacts are summarised below.

Consumption expenditure:

First, consider the below chart showing how much household income falls once retirement is reached.

As you can see, household income peaks between the ages of 45 and 54, before dropping sharply. A household in retirement earns just over a third of what a 45 to 54 year old household earns.

A similar situation applies with respect to expenditure. Household spending peaks between the ages of 45 and 54, before falling sharply. A household in retirement spends less than half of what a 45 to 54 year-old household does (see below chart).

Asset values:

An earlier article, Baby Boomers, Retirement and Asset Prices, provides a comprehensive examination of the negative effects that ageing will likely have on Australian asset prices (particularly housing). Here are the key takeaways from that article:

Despite representing only 25% of Australia’s population, the Baby Boomers collectively hold 45% of owner-occupied dwellings and 51% of other dwellings (i.e. investment properties and holiday homes). However, since the older Boomer cohort (55-64 year-olds) are relatively small (accounting for 11% of the population), they hold a smaller (20%) share of Australia’s housing assets. By contrast, the younger Boomers (45-54 year-olds) hold 26% of the housing assets, reflecting their larger (14%) share of the population (see below chart).

Around 30% of Baby Boomers hold second homes and around 13% have loans over these properties

When it comes to financial assets, the Baby Boomers hold 54% of the total (see below chart).

Most Baby Boomers are heavily exposed to property and hold relatively little in the way of financial assets – certainly not enough to fund a comfortable retirement. It is, therefore, highly likely that many will look to sell their investment properties/holiday homes and/or downsize in order to free-up the equity in their housing assets to finance retirement. The incentive to sell-out of their properties will likely intensify once the Boomers realise that there is little prospect of continued high capital appreciation.
A recent Bank for International Settlements (BIS) Working Paper found that the ageing of the Baby Boomers is projected to reduce Australia’s real house price growth by around 30% in real terms over the next 40 years compared to neutral demographics (see below chart). The BIS also expects ageing to have a similar impact on the value of financial assets.

Again, readers seeking to gain a better understanding of the Baby Boomer retirement’s impact on asset prices are encouraged to read my earlier detailed examination.

Government revenue and taxation:

The 2010 Intergenerational Report (IGR) had the following to say about the impact of ageing on Government finances:

Population ageing will create pressure for increased spending, particularly in the demographically sensitive areas of age related programs and health. Health costs will also escalate as a result of technological enhancements and rising demand for better quality health services. Population ageing, by reducing the proportion of working age people in the population and hence potential economic growth rates, will also reduce Australia’s capacity to fund these spending pressures.

Unless action is taken to increase the growth potential of the economy and ensure spending is sustainable, spending will exceed revenue and result in a fiscal gap of 2¾ per cent of GDP by 2049–50.

However, the IGR possibly underestimated the fiscal impact of ageing, since it ignored the impact of declining property valuations on state government budgets. As shown by the below HIA chart, Australia’s state governments have become increasingly reliant on property taxes. And any decline in valuations brought about from the retirement of the Baby Boomers would clearly have a detrimental impact on state finances.

Clearly, any loss of revenue arising from the ageing of the population will need to be met with 1) reduced government outlays; 2) an increased tax burden on younger generations; or 3) a combination of both.
Demographic headwinds are the new normal:

For the past 30 years, the Australian economy has been powered by the Baby Boomers, whose entry into the workforce en masse in the 1980s saw Australia’s dependency ratio fall to all time lows. This demographic ‘sweet spot’, whereby Australia’s dependency ratio was at its lowest ever level, lasted for 25 years from 1985 to 2010. During this period, Australia’s economy benefited enormously from the Boomer’s productive capacity, consumption spending, and taxation receipts, which peaked after the 1990s as they reached peak earning/spending age (45 to 55 years of age).

Asset values, too, were pushed-up by the Baby Boomers as they accumulated vast amounts of housing and financial assets with the aim of funding their retirements.

From 2011 onwards, however, Australia’s economy will face significant demographic headwinds as the Baby Boomers gradually: enter retirement; cut back on spending; draw-down on assets; cease paying tax; and receive increasing levels of health care and social security, funded by increasing taxes on the younger generations.

These factors will likely significantly lower Australia’s growth potential and asset valuations going forward.

The Unconventional Economist

www.unconventionaleconomist.com