TSG Weekly Market Watch

Week Ending April 13, 2007

TradeSystemGuru.com

• A millennium report card – the real performance of the Dow.
• Oil and a weaker dollar help lift stocks.
• Trade deficit drops for third consecutive time thanks to oil.
• Unchanged core PPI sparks more hopes for rate relief.

Last week we explored the incredible rise and beginning of the fall for home builders and what that may mean for housing and the markets going forward. This week we take a look at the Dow from a number of inflation-adjusted perspectives. How has the index performed in the New Millennium in real terms?

Figure 1 – Chart showing Dow adjusted for inflation using the Fed’s inflation measure that currently shows annual inflation running at around 2.7%.

If you adjust the price of the Dow today using the traditional inflation model, the index is only slightly below where it was in 2000. But does the inflation metric used today and applied by the Fed provide an accurate picture of the real inflation rate?

We have said before that it seriously underestimates the rate at which our purchasing power is being eroded. We saw that clearly in last week’s newsletter that showed that home prices since 2000 have jumped more than 50% above the highest bubble price in history going back 100 years after correcting for inflation.

Before we take a hard look at the Dow, let’s cover a bit of interest rate history. As the stock market began its long decline in 2000, the Fed continued to raise rates until July. Only when the Nasdaq and Dow started to crack did the Fed ease but it then did so at an amazing rate as if trying to catch a runaway bowling ball down a steep hill. Over the next 18 months, the rate plummeted 72%. It continued to drop before hitting a 50-year low of 1% in June 2004 more than a year after the stock market rally had begun. Now hold that thought if you will.


Figure 2 – Chart showing the Fed Funds rate since June 1996. Note the big drop in the rate between late 2000 as the stock market began its big drop and the Fed Fund rate declined from 6.54% in July 2000 to below 2% by December 2001b then down to 1% in late 2003, a 50-year low. Data – St. Louis Fed.

As a U.S. based index, Dow Jones Industrials is denominated in U.S. dollars. But what happens if we measure new millennium performance using some other currencies? In figure 3, we see the Dow measured in euros.  When the US dollar is increasing in strength compared to the euro, the real value of the Dow rises more quickly and the reverse occurs when the dollar is weakening against the euro.

As you see from figure 3, the Dow denominated in euros dropped more than 50% between 2000 and early 2003 compared to an approximate drop of 35% for the Dow in US dollars. But what is striking is the fact that even after the rally began and interest rates started to rise again, the Dow has yet to recover much of the ground lost between 2001 and 2004 and is still down 50% from 2000 while the Dow in USD has risen back above where it was in 2000 in nominal terms.


Figure 3 – Chart showing the Dow Jones Industrial Average in Euros. The DJIA has gained a 47% since its March 2003 low but in Euro terms the index is up just 13.4%.  It is still down 50% from its 2001 high. Chart by Metastock.com

Now let’s look at the Dow denominated in gold. This is accomplished by dividing the Dow by the price of gold in US dollars. As you see from figure 4, the drop from the 1999 peak was more gradual and didn’t really drop strongly until 2002 – 2003. But as the US dollar weakened (as evidenced by rising gold prices) the Dow in gold has continued to fall even though the DJIA is up 47% since March 2003 in dollar terms. In terms of gold, the Dow is down about 20% over the last four years and down 58% from 1999.


Figure 4 – The Dow looks even worse in gold. From its 1999 high when divided by the price of gold the index has dropped 58% putting it back to 1997 levels. Chart by Metastock.com

This means that investors who bought a basket of stocks comprising the 30 stocks in the Dow and changed them as the Dow changed over the last eight years would have a seen the value of that portfolio decline 58% compared to the investor who bought gold. While the Dow in euros is up less than 8% since its 2003, European indexes like the Eurotop and the German DAX (both in euros) have more than doubled thanks in a large part to Euro strength.

I may be missing something as I see it, the easy money policy essentially designed to stimulate a recovery from the last recession has had a veiled but insidious side effect – a rather rapid reduction in dollar purchasing power. And as a great pragmatist once said, there are no free lunches. I say veiled because it has not been discussed by the media, financial or otherwise (or anyone else come to think of it).

However, the inflationary signs are palpable for those even the least bit sensitive to it. What is equally concerning is the fact that even with rates up more than five times what they were at their low, (from 1 to 5.25%), the greenback has continued to weaken and that is unusual. This shows that there are some fundamental problems but that is the subject of a paper requiring greater academic acumen than I possess.

These examples highlight the importance of a having a well-diversified portfolio not limited to the assets of any one country or trading region, even when that country may be near and dear to us and have the best flag in the world. It also shows how the powers that be can surreptitiously stimulate markets and the economy leading into each election. Unfortunately, these efforts usually come by either spending money and ultimately leading to higher declared taxes or reducing the value of the dollar and saddling all of us with a rising hidden tax.

Now let’s check in on what happened in the stock market this week.

Summary

Paraskevidekatriaphobia may be a real mouth-full but it is the word that describes the fear of Friday the 13th. It failed to spook investors and after six weeks of manic market swings the major indexes put in their second consecutive week of positive gains. This week it was continued optimism after the release of British sailors by Iran and an easing in the price of oil that did the trick, especially on the Dow Transports which again led the pack. Stocks were further helped by the fact that Merck raised its profit forecasts but oddly enough they weren’t not hurt by the relatively poor earnings improvements so far compared to last quarter (see Earnings).

Technically Speaking

The classic ‘W’ bottom patterns that we discussed last week continued to provide upward impetus to stocks and not much has changed since last week. The Dow Jones Industrials Average, Transports Average, S&P500, Nasdaq Composite, NYSE Index and Russell 2000 continued to rise above 50-day moving averages.  

Meanwhile, the Philadelphia Housing Index (HGX), remains below its 200-day MA and is doing its best to hold there. And the bear flag chart pattern we identified last week continues to build.
 
Commodities continued to trend higher this week as the NYFE CRB Index closed at 409.66, up marginally 409.64 last week.

Gold also continued to move higher pretty much without a pause since March 14 and it closed at $689.60 up from $679.20 last week.

And after peaking intraday above $68 last week, NYMEX crude oil closed Friday at $63.63.

Meanwhile the rout of the greenback continued as the U.S. Dollar Index closed at 81.93 down from 82.45 last week. Fundamental problems with our currency and growing protectionism being promoted by such unlikely sources as talking financial head Lou Dobbs in a display of patriotic vitriol not seen since the McCarthy era is increasing concerns by more rational minds that this trend will not be short-lived.

A weakening dollar is also helping push indexes like the MSCI Emerging Market Index ETF (EEM) that represents a basket of foreign currencies higher as they appreciate against the dollar. The index closed at 122.97 up from 120.30 last week.

Earnings

Earnings season for Q1-2007 kicked off this week but got off to a slow start. With a little more than 10% of companies having reported (440), Q1 earnings improvements over Q1-2006 came in at a picayune 2% - an inauspicious start to the season. This compares to an overall improvement of 33% in Q4-06 compared toQ4-2005. Since strong earnings have been a strong pillar of this rally, a continuation of this deceleration of earnings could be just what the bears are praying for.

Economic Reports

It was a slow post-Easter week for economic reports. Here’s what the charts had to say.


Chart 1 – Import prices jumped 1.7% hit by a double whammy of increasing oil prices and a falling dollar. However, the combination of a weakening economy accompanied by slowing consumer spending should keep prices falling, that is unless the US dollar keeps submerging and a trade war with China (that will add heavy tariffs to imported goods) becomes reality. In the 12-months ending March, import prices jumped 2.8% and exports are up 5.3% from a year ago, the largest annual increase since September 1995.


Chart 2 – The U.S. international trade gap fell again to $58.44 billion in February. However, by mid-2006 China surpassed the U.S. as the second largest exporter according to the World Trade Organization. So our trade gap is falling but so are our exports relative to China.

Next Week  

A little busier week next week for economic reports. Here are the ones we’ll be watching. We will no longer be following Conference Board consumer confidence since it has been of little help in helping forecast market direction and is at best a coincident indicator.
-    Monday, March retail sales (previous 0.1%) and the National Association of Home Builders housing market index (previous 36).
-    Tuesday, March consumer price index (previous 0.4%) and March housing starts (previous 9.0%).
-    Thursday, April Philadelphia Fed business index (previous 0.2).

Synopsis

Markets were driven higher this week also thanks in part to the investor perception that inflation pressure was weakening as evidenced by an unchanged core producer price index. This spurred that familiar bull’s prayer that the Fed might consider dropping rates but as we see from our introductory article, this hope should be a pipe dream. Yes, the Fed may decide to drop rates under undoubtedly strong political pressure with an approaching election and calls for help for the highly mortgaged who got themselves in a pickle but that would clearly be a bad idea. It would be like escaping from a bully who wanted to punch you in the nose by jumping onto the Titanic as it left Southampton in April 1912.

I must admit until updating my euro and gold denominated charts of the Dow Industrial Average, I had no idea how bad the problem had become of late. Like many, I had been lulled into a false sense of complacency by reports of strong employment, a robust economy and continued rally with stocks and commodities.

Armed with this new information, I intend to diversify my portfolio even further to protect it from the risk of continued dollar weakness. Like most of you reading this, the last thing I need or want is another tax, hidden or otherwise.

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All material presented herein is believed to be reliable but we cannot attest to its accuracy. All material represents the opinions of Matt Blackman. Opinions may change without notice and readers are urged to check with their investment counsellors before making any investment decisions. Matt Blackman may or may not be invested in any investments cited above.