| TSG Weekly Market Watch November 9, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Sunday, 11 November 2007 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending November 9, 2007Topics Discussed This Week:
The dragon has landedOver the last two weeks there has been yet another credit crunch impact stocks. It began with a rosy forecast from Countrywide Financial downplaying their Q3 loss and telling those silly enough to listen that the worst of the real estate market and mortgage losses were behind us. The stock rallied 33% on the announcement thanks no doubt to those who bought the October 26 propaganda. See http://tradesystemguru.com/content/view/100/58/#Countrywide Since then however, the stock has dropped 20%. Then last week, we got news that Citigroup’s losses were far worse than had been projected just three weeks before, prompting investors to dump the stock en mass. See http://tradesystemguru.com/content/view/105/58/#Citi Then came a series of earnings revelations, the likes of which should have been enough to shake up even the most steadfast bulls. Trying to draw a bead on a level 3 ghostSo far we have had losses as a result of sub-prime writedowns from Merrill Lynch ($8 billion), Citigroup ($14 billion), JP Morgan ($4 billion) and Bank of America ($ 5 billion). More troubling are the ratios of level 3 liabilities to total assets held by various firms on Wall Street. According to Bloomberg, they are as follows. Merrill Lynch – 38%, Citigroup – 105%, Bear Stearns – 154%, Lehman – 159%, Goldman Sachs – 185% and Morgan Stanley – 251%. And this is only the major institutions that we know of so far and does not include similar type debt on the balance sheets of hedge funds and other institutions. What does this mean? Level 3 assets are those that according to John Mauldin are based on unobservable inputs reflecting the company's own assumptions about the way they would be priced. In other words, these estimates are totally subjective and it is anyone’s guess how those holding this toxic debt are pricing it. As Macbeth once said in Shakespeare’s most famous soliloquy, therein lies the rub. In a Bloomberg interview this week, James Grant editor of Grant’s Interest Rate Review explained the importance of the recent drops in the market and what they may mean for the future. “We have a very interesting intersection of crises – 1) a crisis of credit which is the promise to pay money and 2) a dollar or money crisis [the value of the dollar is down more than 50% against a number of other currencies since 2001]. It’s rare that we have had those two occur together and I can’t say as it’s a very good sign.” “Our credit system is one of promises based on faith and confidence. So is our monetary system – our dollar has been uncollateralized since 1971 [when the U.S. discarded the gold standard]. Our dollar is now supported by the opinion of the United States. Both the dollar and credit system are faith-based and when stocks are down 5, 10 or 15% in a given day, it is a worrying sign,” he opined. Grant says that the subjectivity [lack of transparency] in pricing level 3 liabilities presented no problem during the age of faith until about three months ago. But all that ended in August and we have now entered a period of doubt and suspicion. The dominant market fear now is a result of a mistrust of companies holding this level 3 debt to honestly tell us its true value, creating what Grant labelled a “poisonous atmosphere.” Sub-prime loans are a great example. According to the ABX Indexes monitored by Markit.com, triple B minus loans have dropped to about 20 cents on the dollar compared to their value in January. If this level 3 debt were to be marked to zero, many of the financial institutions would be broke Grant says. This is one reason why he considers the current crisis one of “old testament” proportion. Investment bank breakdown
Figure 1 – Industry chart of Banks (Investment) of which Citigroup is the largest company showing a strong uptrend that was broken this week (red arrow). This is a technical sell signal. Also note that the fundamentals including earnings growth (GRT), earnings per share (EPS) and the dividend (DIV) have remained strong. As we have said in the past, the fundamentals lag stock price by anywhere from three to six months and do not provide advance warning of a breakdown or bear market. Charting our trajectorySince few have any ideas what the stocks of companies holding level 3 debt are really worth, what are the charts telling us? Since stock price is supposed to contain the sum total of what market participants know at any given time, it is considered the best advance market indicator. The VectorVest Bank (Investment) industry group just broke long-term trendline support so what about the major institutions holding level 3 debt (that we know about to date)?
Figure 2 – Here are the six-month relative performances of the companies with the highest disclosed ratios of level 3 debt to total assets – Merrill Lynch (MER) with 38%, Citigroup (C) with 105%, Bear Stearns (BSC) with 154%, Lehman (LEH) with 159%, Goldman Sachs (GS) with 185% and Morgan Stanley (MS) with 251%. Note that even though Goldman Sachs has the second highest level 3 liability, its stock is the best performing of the group. The worst hit stocks so far have been Citigroup and Merrill Lynch. Now let’s compare the Bank (Investment) industry with Financial (Brokers) and Financial (Mortgage) industries (Figure 3). As the housing and mortgage situation continues to deteriorate, it will most strongly impact that banks and financial institutions holding the greatest debt. As we see from figure 3, the Financial (Mortgage) group broke down in early 2005 (around the same time residential home builders began to break down). However, Brokers and Banks remained strong, that is until recently. Now Brokers look to be in the process of completing a very bearish indicator of a market top called a head & shoulders top (or inverted) pattern that looks close to breaking the neckline (orange arrow 4). Banks (Investment) also broke mid-term uptrend support in July (red arrow 2). In other words, each group has broken significant support levels and Brokers look close to confirming a market reversal. Industries play follow the leader… Figure 3 – Chart comparing industry performance showing the breakdown last year in the Mortgage services industry and bearish signs for Investment Banks and Brokers.
Figure 4 – Another chart showing Investment Banks compared to Equity and Mortgage REITs. As one goes, the other two could well follow especially as the housing and mortgage markets deteriorate further. Bank, REIT, building and financial sectors rolling over
Figure 5 – Here we see a sector comparison chart over the last five years showing Bank, REIT, Financial and Building sectors rallying until about mid-2005 but then one-by-one, they began to weaken. Residential housing was first and now as the commercial building sector weakens the overall sector is beginning to break down (brown). REITs (Mortgage and Equity) are in the same situation. As we saw above, Mortgage REITs began to break down in early 2005 but Equity REITs remained strong until July 2007. Now all four sectors are withering on the vine with Building, then REITs with the farthest to fall. So what does it all mean? In his book, Technical Analysis Explained, Martin Pring described something he called the four-month rule that used the price of GM stock as a proxy for market strength. “If in a bull market, GM fails to make a new high within 4 calendar months of its previous peak (although some analysts prefer a 19- to 21-week rule), the bullish trend of the market has reversed or is just about to do so,” he wrote. “Similarly, during a market decline, if GM fails to make a new low within 4 months of its previous trough, a reversal in the downtrend of the market has already taken place or is just about to occur.” As the world’s largest automobile company, the idea was that like the effect of the moon on the tides, the direction of General Motors stock impacted the broader market. When the bull market came to an end in 2000, GM dropped while the Dow and S&P500 remained strong. Traders and money managers alike used GM as a proxy for the Dow and it worked especially well as a warning of a market top. Although GM’s star has fallen as a market indicator as it has lost significant market share, the principle remains sound. There are stock sectors that lead the general market in a reversal and when these events occur, we need to pay attention. One such market proxy has been the financial sector. Financials flash the sign of the bearAs we see in Figure 6, financials broke down in April 2000, more than six months before the S&P500 began to seriously drop. Financials also began levelling off before the SPX in 2002 and rallied more quickly in 2003. More recently financials peaked in early February 2007 while the S&P500 continued surging higher and as we can see now, the financials have broken down hard again (negative divergence – see right red and orange-dashed arrows). Since financials have a habit of leading the broader market, unless it is different this time we must take this as another bear market – recession warning. More bearish, the financials confirmed a bear head & shoulders top pattern by breaking the neckline last week (not shown on chart).
Figure 6 – Comparison between the financial sector and the S&P500 over the last seven years. Note that Financials broke down hard in April 2000 (first red arrow) but the S&P500 didn’t do so until November (first orange-dashed arrow). (It is interesting to note that GM broke down in June 2000). Financials then started leveling off at the tail end of the 2001-2002 recession before the S&P500 and put in a low about the same time (October 2002) as the S&P500. But when the rally began, Financials recovered faster (see green arrows) in something technicians call positive divergence.
Last month we summarized the charts flashing a recession warning (see http://tradesystemguru.com/content/view/97/58/#Recession ) Now there is growing crisis of faith in both corporate reporting and the U.S. dollar. Finally, we have a major market sector that is showing strong signs of a reversal.
The reason that recessions are so devastating is that few see them coming. We are still in a pre-election year which has historically been the best time to be in the market and for this reason, many have remained steadfastly bullish. But this factor would be more than offset by the bursting of a number of bubbles that exist today that when it comes, will cause assets to get rapidly re-priced. Based on the data we are now seeing, if this time has not yet come, it looks to be just around the corner. It is also important to remember that by the time a recession has been confirmed, the bear market that precedes it has already seriously mauled your portfolio. With the speed at which a growing number of indicators and pivotal sectors are flashing red, it would be foolhardy not to sit up, pay attention and take appropriate defensive action.
Market atmosphere turns poisonousIt was another week of suffering, especially for those who bought into the line of bull last week and the week before (and the months before that) that the sub-prime fallout has now been contained. As James Grant, editor of Grant’s Interest Rate Observer commented this week, "sure, the sub-prime fallout is contained. It’s contained on planet earth." Technically SpeakingMarket leaders turn downIt was a tough week and even though Zanger’s market leaders were able to post gains last week against an ebbing market tide, they were unable do so again this week. The last time these leaders registered a loss was August 17 as the world struggled with the first credit crunch. Perhaps more bearish were Dan's introductory comments in his November 7 newsletter.
“This market now looks ready to move much lower as a result of today's actions. This means cash is king again unless you're in some of the very strong solar stocks.” As well this week, Dan pointed out a number of previous rockets that have recently broken trendline support. Hits picks this week included past favorites, Research in Motion (RIMM) , Apple (AAPL), Bidu.com (BIDU), Mastercard (MA) and Transocean (RIG) but included concern for the likes of iShares MS Emerging Market ETF (EEM), National Oilwell (NOV), the Holders Trust Oil-Service (OIH). One of the few market positives last week, this week's composite drop is very bearish.
This week, weekly trading volumes surged for the S&P500, Dow Industrial Average and Nasdaq Composite as markets fell in unison with the Nasdaq taking the biggest hit. But the recent divergence between the Dow Industrials and Dow Transports ended – now both are trending down (see Figure 9 below). This confirms the trend according to Dow Theory. This downtrend should not be a surprise considering that the last time when the Transports began to fall while the Industrials rallied was in the summer of 1999 eight months before the market began to fall apart. Volatility jumped this week as the Market Volatility Index (VIX) surged to 28.50 from 23.01 last week indicating that fear has continued to surge into markets. Commodities represented by the NYFE CRB Index surged again to close at 456.36 from 455.10 last week and 450.34 two weeks ago. The index remained in nose-bleed territory above its upper 2-standard deviation (2 sigma) trend channel for the second week. Gold also continued higher as the yellow metal closed at $834.60/oz level up from $809.30 last week and $768.6 three weeks ago. And it was yet another week of new all-time lows as the U.S. Dollar Index dropped to close at 75.39 down from 76.30 last week and 78.16 four weeks ago. Oil surged to another new all-time high before backing off slightly as the NYMEX crude oil (continuous) contract closed at $95.30/bbl from $95.93 last week and $86.95 three weeks ago. Fed keeps on pumping
Figure 8 – Bernanke may have talked tough on inflation and holding the course on rates this week but his actions were anything but. As we see from the right-hand side of the chart to November 7, he dropped the effective rate as low as 4.22% in an attempt to stem the ebbing market tide (lime green arrow) but with little desired effect. But it did have an impact on the dollar, helping to pull it down to yet another all-time low. Still shaken by plummeting U.S. markets, the MSCI Emerging Market Index ETF (EEM) gave up more ground to close at 153.60 down from 161.70 last week. Like the CRB Index, the EEM remains well above its upper 2-standard deviation trend channel. On rates, the U.S. prime bank rate held steady at 7.5% while the 3-month London Interbank Offered Rate moved up this week to 4.879% from 4.865% last week which put it back above where it was a year ago. LIBOR is important in computing mortgage rates. Fannie Mae 30-year mortgage (30 day) yields moved up to 6.168% from 6.1% last week (versus 5.913% a year ago). EarningsWith 2991 companies having reported Q3-07 earnings so far this season, earnings have now fallen an average 20% versus the same quarter last year! This is a big drop from -4% after 2205 companies had reported last week and an even bigger decline from an average in earnings improvements last quarter of +13%. Earnings deterioration is yet another troubling macro market indication. Economic ReportsAt least there were no troubling economic reports to add…
Chart 1 – On Monday, the October ISM service index was released with a reading of 55.8 up from 54.8 in September. As we you can see, while the service sector has been consistently stronger than the manufacturing ISM, it is also in a strong downtrend. Consumer credit continues to grow
Chart 2 – On Wednesday, September consumer credit came in at $3.7 billion but the big news was the sharp revision upward in August to $15.4 billion from $9.5 billion originally reported. Consumers may not be pulling much money out of their homes but they appear to be finding it somewhere even as the buying power of the dollar has dropped.
Chart 3 – Import prices have also been slowly but surely declining which is a bit of a puzzle given the declining greenback. It is likely a combination of two factors 1) declining demand that makes it difficult for importers to pass higher prices on to customers and 2) the tendency of China, one of the largest importers into the U.S., to keep its currency weak so as not to lose market share. For example, vehicles manufactured in Canada can be up to $20,000 more expensive to Canadians than Americans even though the Canadian dollar is now worth more than the greenback.
Chart 4 – One benefit of a rapidly falling dollar is that the trade gap gets taken care of as the September deficit fell to -$56.45 from -$57.8 (revised) in August. Next WeekHere are the reports we’ll be watching.
SynopsisBear market and recession risks compoundingIndications of a potential bear market and recession are getting louder. While having a bear market begin now would defy a number of historic trends including the powerful pre-election lift, it would surprise most including those hoping that any market meltdown is still some way off. But markets have a habit of doing what is least expected.
Figure 9 – Weekly chart of the Dow Jones Industrial Average and Dow Jones Transport Average (purple) showing the reversal of trend. As mentioned above, the last time there was a serious negative divergence between the Dow Transports and Industrials was in late 1999. We also got a couple more recession warning indicators from Hugh Moore of Guerite Advisors this week.
Figure 10 – Chart showing peaks and the percentage declines going back to 1959 showing that each time housing starts have declined significantly, a recession has followed with one exception and that was in 1967.
Figure 11 – Another chart that compared total construction with residential construction showing that with one exception (1966) recessions have been preceded by significant declines in residential and total construction. We are again in negative construction territory. As we see from the chart, construction never went negative in 2001 thanks to the cheap money policies of Allan Greenspan and the Fed. Our cautionsly bullish outlook from last week has changed for a number of reasons. First Dan Zanger’s market leaders have rolled over and this is never a good sign. Secondly, the Nasdaq which has been leading the market also rolled over hard this week. Finally, the financial sector, as tracked by the VectorVest Financial Sector Index, as well as a number of banking and financial industry indexes have been heading lower. Given that financials have a habit of leading the broader market, this has further bearish implications. Reiterating what we said last week, unless you are a short-term trader with very fast reflexes and money to burn, cash is a good option. Best if you also hold some gold or foreign currencies though while the U.S. dollar continues to drop. Useful Links James Grant – Bloomberg sub-prime interview with Pimm Fox – November 7 http://tinyurl.com/26v765 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 added). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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