| TSG Weekly Market Watch October 17, 2008 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Saturday, 18 October 2008 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending October 17, 2008Topics Discussed This Week:So, are we finally at a bottom? Leaders back out in front Earnings still falling in Q3 Retail sales, permits, starts and homebuilders indexes still falling Treasury income flows continue to deteriorate! So are we finally at a bottom? Looking ahead to next week… Long-term PEs reveal challenges ahead
Last week
This week's quote “If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wilder and wilder. That might not matter were the consequences limited to the partygoers. But they are not.” Mervyn King, Governor of the Bank of England, June 2008 So is this finally the bottom? Since this bear market began a year ago, talking heads have been calling a bottom every time we had a any sort of rally. After more than a half-dozen wrong calls, could they be right this time? Stay tuned for our take in this week's Synopsis. Technically Speaking Leaders back out in front After shedding 12% last week, Dan’s Sunday pix led the major indexes with a gain of more than 7% this week. We said last week that the fact that Zanger’s market leader performed best was good news for overall markets and the fact that they are leading the market again with strong gains is downright bullish. This week’s list was down to 8 stocks including Apple (AAPL), Potash Corp (POT), Amgen (AMGN), Goldman Sachs (GS), Google (GOOG), Baidu.com (BIDU), sTracks Gold (GLD) and Agrium (AGU).
Figure 1 – Five-day performance of Zanger’s last Sunday pix (green) compared to the S&P500 (SPX), the Dow Jones Industrial Average (DJX), Dow Transports (DTX), Nasdaq Composite (IXIC), Russell 2000 (RUT) and MSCI Emerging Market ETF (EEM). Data courtesy of The Zanger Report, performance chart courtesy of VectorVest.com. Although not as high as last week, weekly volumes were back near their highs again for the major indexes. High volume is considered bullish when prices rise which happened this week, while increasing volume on falling prices is usually considered bearish. This is looking more like a slow-moving capitulation bottom further evidenced by the presence of a high volume test indicating the possible early stages of accumulation. A day with wide intraday price swings on extreme volume near a major low with a strong close, like we saw in the Dow on October 10, followed by a few days of higher closes on lower volume is a great example of this (see Figure 3 in the Synopsis). It shows that professional money is trying to shake out weak hands in preparation for running the market higher. Indexes and stocks can remain extremely oversold for an extended period but when they finally bounce, often do so with a vengeance. We discuss this in further detail in the Synopsis. After peaking at 69.95 a week ago to the highest daily reading since 1982, the Market Volatility Index (VIX) took off again to close at a new high of 70.33 this week. As we mentioned last week, extreme VIX readings can often presage at least a temporary market bottom especially when it follows a high volume capitulation reading like we saw last week and last Friday's bottom has all the makings of a test of a major low. After staging a brief comeback three weeks ago, the 19 commodity NYFE CRB Index dropped again to 384.57 from 392.80 last week. Since hitting a high of 611.51 fifteen weeks ago, the CRB Index has now fallen more than 37%. The VIX reading for this index is now at extremes not seen since at least 1985. We expect that commodity prices may also be getting ready to put in a low and will be looking for further signs of a potential rally. It was another volatile week for gold as it dropped back to close at $788.00/oz from $856.60 last week. With the financial turmoil, gold could head in two directions but given the extreme drop experienced by commodities, we could see gold move higher in sympathy when commodities bounce. Panicked investors run to gold in times of trouble and if central banks and governments get more focused on inflating their way out of this mess, gold will definitely benefit. The dollar continued to rise this week as the U.S. Dollar Index climbed to 82.55 from 82.41 last week while other currencies, especially those commodity-based in Australia, New Zealand and Canada, have been hammered. Worst hit is the Icelandic krona that has lost more than 60% of its value since August amid a collapse in the country’s banking system. Forex investors believe the greenback is the safest place to be given the dauntless efforts of the federal government to try to fix the financial mess. Unfortunately, foreign investors don’t hold the same view of U.S. Treasuries which if this trend persists, will mean significantly higher interest rates ahead no matter what the economy is doing. After falling to a low of $68.92/bbl Thursday, crude oil recovered to end the week at $71.91/bbl. Normally oil hits a seasonal high in mid-October but this trend failed to materialize this year. Oil is now down more than 50% from its mid-July high. This has been the most volatile year for crude in nearly two decades when it dropped from $40.10 to $17.61 between September 1990 and February 1991. After falling 50 basis-points last week, the U.S. bank prime rate and the Fed funds target rate held at 4.5% and 1.5% respectively. We finally got evidence this week of a loosening up in credit as the 3-month London Interbank Offered Rate (LIBOR) slipped to 4.41875% from 4.819% last week and 4.33% two weeks ago but it is still well above the 3.76% rate three weeks ago. But Freddie Mac mortgage rates rose again to 6.46% for the 30-year fixed mortgage versus 5.94% last week while the one-year adjustable rate mortgage (ARM) firmed to 5.16% from 5.15% last week. LIBOR is the benchmark for $900 billion in subprime mortgage loans which typically adjust to it every six months. Corporations around the world have the interest rates on roughly $9 trillion in debt pegged to LIBOR and rates on more than $380 trillion in derivative interest rate swaps also are based on LIBOR. About 6 million U.S. mortgages, including the vast majority of subprime home loans as well as 41% of prime ARMs are linked to LIBOR. Earnings Earnings still falling in Q3… In the second week of Q3-08 reporting season, with a total of 569 companies having reported (390 last week) average earnings fell to -23% (down from -13% last week) versus Q3-07 for which earnings had fallen 21% from Q3-06. This compares to a year-over-year 36% drop in Q2-08 earnings, a 30% decline for Q1-08, a fall of 57% for Q4-07, a 21% drop for Q3-07 and a 13% jump for Q2-07. Q2-08 also marked the fourth quarter than earnings showed a trend to deteriorate as the season matured and this quarter looks to be continuing this trend. We have found that results from a broad range of companies are much more reliable than analysts’ earnings forecasts, S&P500 earnings, earnings surprises and month-to-month changes in seeing the true earnings picture. When earnings are falling for the broad range of companies, it’s a negative indicator of market and economic strength. When they hit a solid bottom and start to rise, it’s very good for both. Economic Reports We can usually ignore the consumer price index and simply take a glance at the producer price index (PPI) which fell 0.4% in September but retail sales are worth a serious look. In September retail sales came in at -1.2% and -0.6% ex-autos (see Chart 1) indicating continued weak spending. We also learned this week that the National Association of Home Builder (NAHB) housing market index (Chart 3) dropped again to another new low of 14 which when lumped together with drops in both housing permits and starts to 17-year lows (Chart 4), is extremely bearish for the industry. Finally, and what should be of greatest concern to us all is that U.S. Treasury international flows continued to remain weak in August which has very negative implications for real interest rates in the months ahead given the exploding need for large amounts of capital by the government as a results of the raft of bailouts combined with a weakening economy (see Chart 5). Retail sales fall again…
Chart 1 – We learned this week that September retail sales again fell further than expected. Overall sales fell 1.2% and retail sales ex-autos dropped 0.6% versus the expected -0.7% and -0.3% respectively. What is surprising given the overall macro economic picture is that retail sales have not fallen further! This may be due to the all the pumping the Fed and government have been doing leading up to this election which we expect to drop off after November 4.
Chart 2 – The Baltic Dry Index, an indicator of the cost for shipping dry bulk goods like iron ore, coal, grain etc (not tanker or containers) continued to plummet this week to 1438 on Friday. This is down from a reading of 3002 October 3 when we last checked and well off the all-time high of 11,793 in May. While this is very bearish, this index has proven to be a dependable leading economic indicator in market recoveries and we will be tracking it closely in the coming months for any signs of increasing demand. Builders grow more pessimistic as housing permits and starts plummet
Chart 3 – We got further evidence that conditions in new home markets continue to deteriorate with the October National Association of Home Builders housing market index fell to 14, another new all-time low. The three-part monthly survey of builders came in as follows, current sales condition dropped 3 points to 14, expectations for the next six months fell 9 points to 19, and most ominous, the traffic of prospective buyers fell 2 points to a new record low of 12.
Chart 4 – September was also another brutal month for housing permits and starts with permits dropping 8.3% from August to 786,000, while starts fell 6.3% from August to 817,000, both at 17-year lows. More importantly, year-over-year changes are -31.3% from permits and -31% for starts. From their peak these two metrics have fallen 64.7% and 64.4% respectively. This is bad news for both the housing market and the overall economy as permits, then starts lead homebuilding demand. Next Friday (October 24) we get existing home sales, on October 27 new home sales and on October 28, the Case-Shiller home price index. Treasury income flows still deteriorating
Chart 5 – Undoubtedly the most important chart in our indicator library currently as governments, especially here in the U.S., spends like there is no tomorrow. And judging by the lack of interest over the last six months in U.S. Treasuries from abroad, there may not be. I find it interesting that the financial media has not picked up on this. Treasury income flows were minus $400 million in August (more Treasuries were sold than purchased) down from the net redemption of $33.6 billion (revised) in July. But as we see from the orange trendline, this trend has been falling over the last three years. The important takeaway is that Treasury must sell an average of a minimum of $33 billion (yellow dashed horizontal line) every month just to pay the bills – assuming the final 2008 budget deficit is $400 billion. In all likelihood it will be substantially higher especially given the more than $2.2 trillion in bailouts this year so far. Now imagine what would happen if the budget deficit soars above $1 trillion in 2009 (a very conservative estimate) which would push the federal government’s monthly requirement for cash up to more than $80 billion! Now imagine what this would do to real interest rates as Treasury was forced to increase the return in pays to attract enough foreign investors in a deteriorating economy! So are we finally at a bottom? Volatility for the major indexes hit highs not seen since 1987 in another week of price extremes. We then had to go all the way back to 1938 to find another period of such extreme volatility again. After surging to its biggest one-day gain since 1933 with a rise of 11%, the Dow spent the rest of the week swinging wildly between intraday extremes and had given back most of the gains by Wednesday’s close. Thursday’s 401 point Dow rise revitalized the index and even after another 127 point loss Friday, it managed to finish the week with a respectable gain with the other indexes trailing behind. But the action again raised calls from talking heads calling this a bottom for the umpteenth time since this bear market began a year ago. However, they may have a point this time. We are at an inflection point on the S&P500. The index fell to a multi-year low last week and this week tested the bottom. There is major support around 900 on the index and based on action this week, we may see a re-test of that support in the next two weeks. If it holds, we expect to see at least a short-term bottom and some sort of rally. If it breaks down on increasing volume on the down moves, look out below. For the Dow Jones Industrial Average and Nasdaq Composite Index, the critical support levels are 8450 and 1585 respectively.
Figure 2 – Daily chart showing the action this week on the Dow. Note the horizontal green bar that indicates a down day (October 10) on high volume showing professional intervention that has the effect of stopping downward price movement. As the window on the chart says, if the high volume had been selling volume, the next bar would not be up. This shows a shake-out of the market in an attempt to see how much selling it generates. Also notice that volume was substantially lower in the next four days and indicates that investors are neither buying or selling with any commitment. We expect to see another test next week and if Dow support holds around 8,500 and if successful, an attempt to run prices higher. Chart by TradeGuider.com Data by RealTimeData.com However, we are at multi-decade high levels of volatility and it is important to point out that at such times in the past, prices have had a tendency to rebound sharply. The Dow Industrial Average is now off 40% from its October 2007 high and the last time we had such high volatility was in October 1987 when the Dow lost 35% in three months. Before that, the only periods to experience such high levels of volatility were 1937 when the Dow lost 45%, 1932 when the Dow hits its Great Depression low after losing more than 90% from its peak and in 1929 when the Dow suffered the first leg down of the Great Depression bear market dropping 40%. In each case in the months following these brutal drops, the Dow jumped significantly, gaining an average 57.5% over the next six months. Yes, this time might be different but in every major drop accompanied with extreme levels of volatility to happen last century and this, there was a significant reactive rally with the smallest being 25.6% (1966-67) and the largest being 83.4% in the two months immediately following the 1932 Dow bottom. The powerful 30% rally from October 1929 through April 1930 was followed by a further gut-wrenching drop of more than 80% over the next two years as the bear market resumed with a vengeance. And the 50% rally in 1938 and 26% rally in 1966-67, saw the Dow give it all back and more by 1942 and 1970 respectively. In other words only the 1932 and 1987 rallies saw gains that withstood the test of time. Long-term price/earnings ratio reveals challenges ahead And now for our macro market outlook. Last week we discussed Robert Shiller’s S&P500 trailing 10-year price earnings ratio that has averaged 16.3 since 1881 and the fact that it had dropped to 15 as of the October 10th. While we saw prices increase this week and a rise in PEs, what does the longer-term future hold? In our next chart, we show annual trailing 10-year PEs from 1920 to August 2008 using Dr. Shiller’s data. As we see from this chart, every major recession has resulted in PEs falling below 10 for an extended period of time, lasting decades not years, typical of secular bear markets.
But at 15 last week, the PE was back to just below the long-term average but this was a daily drop, not an annual PE. It will take many more months (possibly a year or more) to get back below 15 on an annual basis meaning we probably won’t see this occurring till 2009 or even 2010. After that, it could take a few more years to get back to single digits like we had during the last major recession in 1981-1982. In other words, markets and economies needed a long rest with PEs below 10 before they will be able to mount the next sustainable bull market. A similar situation occurred during the Great Depression into the early 1950s as we see from the chart above. Could we get another cyclical bull market rally lasting a few weeks, months or even years as we saw between 2003 and 2007? Very possibly but as we learned, more often such rallies are short-term and often end abruptly and rather unexpectedly. There are also the raft of fundamental financial challenges facing a sustained U.S. economic recovery like the crushing levels of debt, rapidly deflating derivatives and housing bubbles, falling Treasury sales and mounting government deficit as a result of more than $2 trillion in bailouts so far. But that doesn’t mean you can’t make money trading the powerful reactive rallies embedded in every secular bear market. This is a trader’s market where it’s important to set tight stops and take profits off the table regularly, not a time to buy and hold for the long-term, as the so-called pundits would have us believe, if we are in a true secular bear market. Stories of interest this week… CDOs Imperiled by Collapse of Iceland Banks, S&P Says http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a12vpvlgmiOc Lahde Quits Hedge Funds, Thanks `Idiots' for Success http://www.bloomberg.com/apps/news?pid=20601110&sid=aLmRPHKZLYmY Recession may be deepest since 1970s http://www.reuters.com/article/GCA-Economy/idUSTRE49F8NX20081016?sp=true California Saved by Mom, Pop as Rates `Choke' Issuers http://www.bloomberg.com/apps/news?pid=20601109&sid=aYgvqAjTESfo&refer=exclusive `Armageddon' Prices Fail to Lure Buyers Amid Selling http://www.bloomberg.com/apps/news?pid=20601109&sid=a2bXQaolDINs&refer=exclusive Short-Term Commercial Paper Rates Fall to Lowest in Three Weeks http://www.bloomberg.com/apps/news?pid=20601110&sid=avIQ22bVnbjU Stock Gyrations Roil Trading as U.S. Options Expire http://www.bloomberg.com/apps/news?pid=20601110&sid=aOzfGEr8.G3Y Goldman Lowers Forecast for Emerging-Market Economies http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aCj46gmqHM88 Harley's $35,000 Cruisers Caught in Credit Crunch http://www.bloomberg.com/apps/news?pid=20601109&sid=aULFXBEO3RWU&refer=exclusive Iceland Crisis Brings `Justice' to U.K. Port for 1970s Cod War http://www.bloomberg.com/apps/news?pid=20601109&sid=aFOVig6chJls&refer=exclusive ---------------------------------------------------------------------------------------------------------------------- If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be have it sent to them each week). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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