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Dividend Alerts, October 2010 Issue
October 12, 2010

12 October 2010

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  • Market crash alert!

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Dear Subscriber

Rather than letting you know that we have released a new write up on some high-yield defensive stock, I have decided to concentrate this issue of Dividend Alerts on the impending market crash which in my view is on its way.

Don’t get caught out this time! The risks for the UK stock market are rising the higher it goes. It's time to be very wary.

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Market Crash on its way!

Despite my longer term prediction of a substantial sell-off, several weeks ago, the FTSE 100 share index is closing in on its highest level since May 2008 (6,376). In fact, the FTSE 100 index is now only a few per cent away from its April 15th 2010 closing high of 5,825.

So what's going on? It's all good news isn't it?

Let’s start with housing . . .

The latest announcement from the Halifax housing market index was an eye opener. House prices fell by 3.6% in September from August - the worst monthly reading on record. That took the year-on-year rate of house price inflation to -0.7%. It's the first time this has been negative since October 2009. Also, the IMF warned that UK house prices could "correct" further.

And if property values tumble again - well, we learnt from last time what can happen next. Many loans made by the banks could go sour. In turn, that could mean more write-offs and less lending. In short, another vicious circle could start - which would hurt bank shares and house builders just for starters.

It wouldn't be great for consumption either. Falling house prices make consumers feel poorer and more cautious about splashing out. So the recent warnings from some of the supermarkets such as Marks & Spencer that trading conditions are likely to get tougher should come as no big surprise.

Consumers are right to be cautious - everyone ‘knows’ that huge government cutbacks are on their way, with the Government already having announced several state benefits and tax credit cuts for millions of people. Lower state spending - and the inevitable job losses - are hardly ideal for rising UK share prices.

So the outlook is generally poor for banking and retail - but what about manufacturing? Currently, this is UK's Star sector. Who had ever thought that? At least in comparison to most other sectors, British industry has held up quite well recently. A 0.3% rise in manufacturing output lifted its annual growth rate to 6%. The problem is that this is unlikely to be repeated going forward.

Demand in key export markets like the Eurozone remains weak and exporters' order books are deteriorating. The coming UK fiscal squeeze is likely to hit domestic demand for manufacturers' products even further. Forward looking industrial indicators have already weakened over the last few months, pointing to a fairly sharp production growth slowdown ahead.

In other words, we can't expect much more growth from many of our manufacturers - or indeed their share prices - in the near future.

However, fears over European sovereign debt contagion, the possibility of a double-dip recession in the United States and the UK, the prospect of further tax increases and increasing unemployment, the prospect of ‘Weimar’ type inflation deflation and/or stagflation (what do I know?), and a cooling of growth in China seem to have ebbed away, for now.

And that’s not all. Gold hit another record high earlier last week, backed by a weaker dollar and demand from investors attracted by the metal's role as a possible hedge against both deflation, inflation and the world as we know it.

So, what's holding the market up then? It's QE2

For some reason, investors certainly don't seem to be fazed by all this pain in the 'real' economy. Apart from the occasional dip, the FTSE 100 index has steadily marched upwards since early July. It's now even within reach of its recent April peak (5,825), which was the highest point since May 2008.

In a nutshell, with the UK's economic outlook heading for the doldrums, it looks like to me that some investors' hopes are firmly resting on the Bank of England and how much new money it will print via quantitative easing (QE version 2).

Their views are sort of as follows: if the Bank creates enough cash, eventually this must force up prices somewhere. Much of the first batch of QE cash ended up in the financial markets - pushing up share and bond prices - so they expect history to repeat itself: if the economy weakens, we get QE2, which drives up stocks and shares. If instead the economy strengthens, corporate profits will improve, which drives up shares.

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But here's the rub: this might not do the trick this time round.

Yes, with QE2 bond prices would probably get pushed even further up, driving down yields. But equities could be an altogether different matter.

QE1 has so far failed to make much of an impact on real business activity as bankers have run scared from lending. And if property prices, both residential as well as commercial, keep on plunging further, giving lending departments even more the jitters, that could seriously hurt our economy, regardless of QE2 or even version three for that matter.

So, here is my thesis: there's likely to be a point at which investors' faith start to waver if and when QE2 appears to fail to make any difference to the economy. When that point is reached, domestic equity prices would be vulnerable to a significant pullback.

In the current situation, I am afraid, I also don’t buy the argument that because gilt yields are now ‘sooo’ low (ten-year gilts currently yield less than 3 per cent), investors “must” therefore switch to shares in order to get better returns.

Clearly another bubble in the make with people converting their Cash ISA's en masse into stock and shares ISAs!

Historical precendent?

Just remember what happened last time round when ten-year gilts yielded about 3% - around end-2008. The FTSE 100 tanked - because investors panicked that company profits were about to be crushed by the recession.

Also remember a revisit of the highs was exactly what happened in 2000 and 20007. The market sold off by double-digit percentages, and, subsequently rallied back up again, even beyond their highs. And then, the bear market really got going.

Don’t get caught out this time! The risks for the UK stock market are rising rapidly the higher it goes. It's time to be very wary.

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Until next time.

Kind regards

Steven Dotsch Editor Early Retirement

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