The Contagion That Comes With a Dow Drop

If Wall Street tumbles, look for a correction worldwide.
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Greed & Fear may have gone bonkers. But it is hard to focus on anything in world financial markets today other than the extraordinary technical deterioration in the U.S. stock market. For if Wall Street stumbles badly, virtually all stock markets in the world will correct sharply.

Why the obsession with technicals in the U.S.? Because in a bull market as mature as America's, internal market action probably provides the best clue as to when the option remuneration-driven mania will end.

The

Dow's

flirtation with and, for now, failure to conquer the 10,000 level prompts a new look at this picture. It reveals a further deterioration in the breadth of the market. The advance/decline ratio is now back at levels seen in May 1997 when the Dow was still trading below 7000.

The compression of the bull market into a smaller and smaller number of fashionable blue-chip stocks is partly explained by the dominance of technology as a theme and partly by the liquidity premium.

Closet Indexing

Still, there is another point. The narrowness of the market means that more and more active money managers are failing to keep up with the indices.

About 90% of mutual funds have been underperforming the Dow and

S&P 500

in recent months. As a consequence, fund managers are closet indexing and mutual fund buyers are opting for index equity funds.

There is now $220 billion in such U.S. index funds, according to

AMG Data Services

. This compares with the $354 billion in overseas equity funds, according to the same data provider.

The logic of this trend is that the index has become the market. This is investor socialism gone mad and, obviously, contains the seeds of its own destruction. But do not expect the nauseous talking heads on

CNBC

and other noise distributors to understand that.

Cause for Concern

The narrowness of the bull market, combined with the continuing failure of the

Dow Jones Transport Index

and other major indices such as the

Russell 2000

(a measure of 2,000 small-cap stocks) to confirm the Dow's recent run of new highs, is sufficient cause for concern.

But Greed & Fear is also influenced by the uncompromising sell signal now being flashed by the key proprietary indicator published in the splendid

Dow Theory Letter

by Richard Russell (no relation to the index). Greed & Fear has followed this indicator throughout the 1990s, and for nearly the whole time, save for short periods such as before last summer's selloff, it has been above its moving average. That is no longer the case. Indeed, it has been below it since late February.

These technicals are all the more worrisome because the Dow has parted company with corporate earnings in 1998 and appears to be trying to do so again this year. From a macroeconomic level, corporate profits also look like they have peaked as a share of national income. Meanwhile, it is worth noting that although equity mutual fund inflows remain extremely large, they have decelerated from the peak levels seen in 1996 and 1997.

A point to note here is that any sustained correction in the Dow is likely to lead to a flood of cash into government bonds in a so-called flight to quality. Greed & Fear therefore remains a buyer of the Treasury bond even though the consensus community of macroeconomists has again become bullish on oil prices after the event (i.e. after the rally).

Mixed Message for Asia

For Asia, the looming end of Wall Street's extraordinary period of stellar performance has a mixed message. The short-term impact will be negative for obvious reasons, both from a stock-market point of view and from a macroeconomic aspect, given the well-known importance of the U.S. consumer. China's exports to the U.S. are still growing by an annualized 6.2% in the first two months of 1999. Still, there will be opportunities if Wall Street goes off the boil, since it will force mobile capital to look elsewhere for returns.

Here Japan has to be the best long-term opportunity. Japan is the major world stock market least correlated to Wall Street. If the Japanese corporate sector really embraces restructuring to the extent anticipated by current market hype -- and the jury is still out on this -- then the Tokyo stock market has the opportunity to be the best performer for the next 10 years given the huge Korean-like scope to improve profitability.

Sensing this, global fund mangers who have been parked overweight in Europe in recent years, playing convergence and restructuring, have been moving into Japan during the first quarter. The buying is understandable and even with merit from a longer-term perspective, though in the short term it has clearly gotten well ahead of itself.

More Corporate Selling to Come

A glance at the numbers shows that foreigners have been the only net buyers of Japanese stocks in the first quarter, save for proprietary trading desks. Foreigners bought a net 1.5 trillion yen of Japanese equities in the year to March 12. Half of that buying, or 777 billion yen, occurred in the second week of March as hedge funds doubtlessly jumped on the bandwagon.

Japanese companies and individuals have remained net sellers. Japanese financial institutions have sold a net 676 billion yen so far this year, and Japanese corporates have sold 549 billion yen worth. There may be a lot more corporate selling to come. If Japan is really to change its system of corporate governance and pursue value for shareholders, which is what is meant by restructuring, then the entire cross-shareholding system has to be unwound.

The recovery of Japan is also clearly key for the Asia ex-Japan region. There is a reasonable argument that Japan needs Asia more than Asia needs Japan, given that 10.8% of Asia's exports went to Japan in 1998 whereas 34.3% of Japan's exports went to Asia.

Still, it is a reality of market sentiment that if Japan is seen finally to be recovering, the investment world will become that much more positive on the rest of the region, for Asia ex-Japan will be seen as a leveraged play on the Japanese recovery.

This is clear from market action in recent weeks, most particularly the degree to which the

Hang Seng

has been following the

Nikkei's

fluctuations. The correlation between the two indices is 0.85 in the month to date.

Greed & Fear believes Japan is out of denial, as discussed in a previous

column. But there are reasons not to adopt a wholesale bullish stance toward the market at this juncture.

First, the coming fiscal year will again be one of contracting

GDP

in Japan.

Second, corporate restructuring is not proven yet, especially since not every Japanese corporate is a

Sony

(SNE) - Get Report

.

Third, bond yields are going higher as government finances deteriorate.

Fourth, the yen is too strong now to be bullish for Japanese equities. That strength is in part based on foreign buying of equities, but also because Japanese monetary policy remains not as easy as might be expected.

Hong Kong a Beneficiary of Liquidity

The same caution applies to Hong Kong. This market has been primarily a beneficiary of its liquidity premiums as it is seen, correctly, as the liquidity proxy for Asia ex-Japan. It has moved up in a classic short squeeze to test the 11,000 level despite continuing horrible macroeconomic news.

There is clearly a Wall Street effect also at work given the huge impact on the index of the moves in

HSBC

and

Hongkong Telecom

.

Greed & Fear is concerned about the moderately underweight stance in Hong Kong relative to the

MSCI

Asia ex-Japan, but this concern is mitigated by the fact that HSBC is not a constituent of the MSCI benchmark in Hong Kong. The bottom-up decision to own or not to own HSBC has been the clear driver of performance for fund managers this year in the Asia-ex Japan region, given the stock's extraordinary outperformance: HSBC's share price has risen 20.7% in the year to date, outperforming the MSCI Hong Kong index by 16.5%. That has been driven in part by talk of a

New York Stock Exchange

listing, in part by a more investor-friendly top management and in part because of HSBC's liquidity premium.

Still, enough is enough. Momentum can clearly drive liquid index plays to absurd levels. But it is time to call a halt to the trend since valuations have been stretched to traditional extremes, especially as the

Hong Kong Monetary Authority

has appointed the investment bank advisers to the stock-market support fund.

Full details on the case against HSBC can be found in the sell recommendation issued by

ABN Amro Asia

titled

HSBC Holdings -- On the Edge

. There are three key points to note.

First, HSBC is now trading near the 1997 peak in terms of the premium valuation to the sum of its parts. At a share price of HK$244, we are only 4% away from the 35% peak premium reached in the summer of 1997 during a roaring bull market.

Second, at a price-to-book ratio of 3.1 times, HSBC is now fully valued against its global peers.

Third, with

Hibor

only 37.5 basis points above

Libor

, Hong Kong has seen the bulk of interest-rate declines, at least until the world starts worrying about global deflation again and

Federal Reserve

Chairman

Alan Greenspan

starts cutting interest rates again to bail out Wall Street. The one area left in HSBC's interest-rate universe where there remains scope for significant interest-rate declines is probably the U.K., based on the euro convergence trade.

The Currency Board Problem

The rush into HSBC also reflects a Wall Street effect in the sense that the big stocks have been doing all the moving in Hong Kong. The Hang Seng has diverged sharply from the

Hong Kong Stock Exchange's

cumulative advance/decline ratio since August 1998 and the onset of the Hong Kong government's extraordinary decision to buy its own stock market.

This raises the other fundamental problem with Hong Kong, namely high real interest rates and the lack of an exchange-rate adjustment. Currency boards are great systems in terms of their intellectual integrity, but they are very deflationary mechanisms on the downside. Hong Kong consumer prices declined by 1.8% year on year in February.

This is one reason why Hong Kong's economic recovery may take longer than the bulls suppose.

It is true, however, that the latest figures out of China offer some sign of encouragement in terms of a sharp pickup in money supply growth and electricity consumption. This explains the renewed run in China-related shares.

Longer term, there are also some encouraging signs that government policy in Hong Kong is finally becoming more imaginative. The recent budget contained interesting privatization initiatives, not least the downsizing of government. There have also been interesting, though little discussed, developments in land policy, which should make the property market more responsive to market pressures.

Ultimately the investment case for Hong Kong and China represents a tug of war between fundamental deflationary pressures, which are in part the consequence of the lack of an exchange-rate adjustment and both governments' fiscally expansionist efforts. At a time when investors chose to believe the global reflation story, like now, this is a positive. When sentiment changes, Hong Kong and China will be sold down again.

Greed & Fear will retain the underweight position for now. If Hong Kong spikes up toward the 12,000 level, which is quite possible if we break decisively through 11,000, the modest underweight position will be increased.

It is interesting to note that the 1998 selloff took the Hang Seng down to its 120-month moving average, whereas the 1994 correction only took us down to the three-year moving average. Does an eight-year head-and-shoulders pattern beckon? If so, Greed & Fear's longstanding prediction of an 80% decline in property prices will be vindicated.

But for now the Hong Kong market's short-term direction will be dictated by moves in New York and Tokyo. Hence that obsession with Wall Street.

Christopher Wood is the global emerging market strategist for ABN Amro and the author of The End of Japan Inc. (Simon & Schuster, 1994). Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy. While Wood cannot provide investment advice or recommendations, he welcomes your feedback at

commentarymail@thestreet.com.