A Look at the Big Picture for 2008 

What a way to start a year!

The first week in January was a rough one no matter which way you slice it. Here are a few factoids gleaned from Bloomberg to drive the point home…

• “Dow loses most on first trading day of the year since 1983.”

• “Dow puts in worst start to the year since 1904.” In just three trading days, the Dow Industrials Average lost more than half of its gains for 2007.

• “The economy is in recession.” Bill Gross Pimco

• “Nasdaq down 5% in first 3 days of year - worst start ever.”

So what does it all mean?

In our December 7 newsletter we mentioned that over the last 110 years, the 17-day stretch from December 21 through January 7 has been responsible for more than 40% of annual Dow gains.  With only one day left, the Dow has lost 3.4% since the December 20 close which is not a good sign. Not only was the Santa rally a no-show this year, with only two days left in the First Five Days (FFD) of the year otherwise known as the January Early Warning System, prospects for a positive 2008 are looking increasingly uncertain.  

According to Yale Hirsch, founder of the Stock Trader’s Almanac, “the last 36 up Five Days in January were followed by full-year gains 31 times for an 86.1% accuracy ratio and a 13.7% [S&P500] gain in all 36 years.” However, a negative First Five Days in January is less than 50% accurate. “The 21 down First Five Days were followed by 11 up years and 10 down years.” So the fact that we got off to a rough start is not necessarily bad news for the rest of the year.

Charts worth a thousand words

Now let’s compare weekly charts of the Dow Jones Industrial Average and the Dow Jones Transports Average in 1999 – 2000 compared to now.  Both indexes are in downtrends and the Industrial Average is sitting at 12,800. According to Dow Theory the downtrend was confirmed when the Industrials Average breached 12,845.78. This week marked the second time this level was broken. One positive is that volume was muted indicating that most investors have yet to head for the exits en mass.

Figure 1 – Weekly chart of the Dow Industrials and Dow Transports 1999 to 2000 showing how the Transports Average led the Industrials into the bear market and then recession in 2001-2. Note how volume was well above average in beginning in January 2000 when the Industrial Average broke down in earnest. Chart by GenesisFT.com

Figure 2 – Weekly chart of the Dow Jones Industrial Average versus the Dow Transports showing both now in downtrends that started July 20, 2007. The next area of support for the Dow Industrials Average is 12,780 that if broken would confirm a very bearish head & shoulders top pattern. However, the Transports Average has clearly broken major support from mid 2006. Red arrow showing volume was well below average this week. Chart by GenesisFT.com 

Figure 3 – Weekly chart of the Dow Transports showing the decisive breach in the up trend support line that started in 2003. This is not a good omen. Chart by GenesisFT.com 

The last time the Dow Transports Average headed down ahead of the Industrials presaged the bear market of 2000-02. It is still early and volumes have so far remained light, but the fact that both are in downtrends again is a concern, especially when taken together with the following charts.

A look at the market from 30,000 feet now and then

Next we look at how some major sectors have performed over the last nine months. Hardest hit have been Retail, Financial, Banks and Building. We will examine Auto & Truck sales in more detail below. In the last bear market, Financials led the downturn in the broader market by as much as nine months so the fact that they are breaking down hard is a concern. 

Figure 4 – Daily chart comparing the performances of mainstay sectors in the U.S. stock market. Since April 1, 2007 while the S&P500 remained flat, the Bank, Financial, Retail and Auto & Truck sectors have all lost significant ground with Retail registering the largest loss at -25% followed closely by Financial (-19.2%) then Banks (-18.6%). 

Here is a chart of two sectors that have led downturns in the market – Auto & Truck and RV sales. In 2000 they broke down well ahead of the S&P500.

Figure 5 – Daily chart showing auto & truck manufacturers and RV manufacturers in early 2000 through the end of the year showing both industries leading the S&P500 down in the bear market that preceded the 2001-02 recession. 

Here is what both sectors look like now. After an initial breakdown in August they recovered through October but as you can see both have broken down hard again with Auto & Truck stocks dropping more than 20% since late September 2007 and RV stocks dropping about the same.

Figure 6 – Nine month daily chart from April 2007 showing how fast auto/truck and RV manufacturers have plummeted since August while the S&P remained flat. Note that both fell further and faster than they did in 2000 (Figure 2).

This time IS different, sort of…

We have so far seen similarities between 2000 and now. However, there are a number of differences. As we see from the next chart, software and computers were among the hardest hit sectors in the wake of the late nineties tech bubble. Banks continued to perform well while the Retail sector was modestly hurt dropping 5% in 2000.

Figure 7 – Daily chart of five sectors in 2000 showing how each performed leading up to the last recession. Note that in the wake of the tech bubble breaking in March 2000, software and computer stocks took a huge hit while retail and banks held up reasonably well. 

This time around, Software and Computers have done relatively well while Retail is down 25% and Investment Banks are down nearly 10% since April 2007.

Figure 8 – However, this time around the chart is close to a mirror image with retail suffering the largest losses followed by banks while computer and software stocks have held up reasonably well in the last nine months.

This week, non-farm payrolls came in much weaker than expected with just 18,000 new jobs being created for the worst performance in four years and the unemployment rate jumped from 4.7% to 5% which is the highest number in more than two years. However, both indicators are lagging. Now that they are firing warnings means that the slowdown is well upon us and chances for recession have risen sharply. 

However, we have had continual warnings that the economy was weakened in corporate earnings of more than 4000 companies since October which as well see from the next chart really fell out of bed in Q3-07 dropping more than 20% from the same quarter the year before. An expectation for increasing earnings drives stock prices and when they fall, so do stocks. What is surprising is how muted this impact has been so far.

Figure 9 – Chart showing earnings performance by more than 4000 companies tracked by the Wall Street Journal. This indicator shows that corporate earnings for Q3-07 dropped 21% versus Q3-06. In the early stages of Q4-07 reporting season, average earnings dropped 26%. This compares with a 13% gain the quarter before. Financials as a group were the biggest losers posting a 28% drop in earnings versus the year before followed by consumer services with a drop of 13%.   

Figure 10 – Unemployment rate of change chart with December data showing a 60 basis-point jump. According to Merrill's chief economist, David Rosenberg, anytime the unemployment rate has jumped more than 0.5% or 50 basis-points, a recession has occurred 100% of the time causing Rosenberg to declare a U.S. recession a "foregone conclusion."

Looking ahead

Hirsch’s January Barometer that uses S&P500 January performance as a proxy for the rest of the year is a better prognosticator of both good and bad years than his First Five Days. Since 1950 the January Barometer has registered only five major errors for an accuracy rate of better than 90%. (Major errors occurred when the country was at war in years 1966, 1968 and 2003. The other two were 1982 at the start of the bull market and 2001 following 9/11.)  It is interesting to note that between 1935 and 2001, the January Barometer had a perfect record in odd years – up Januarys were followed by positive S&P500 annual returns and down Januarys accurately warned of negative years. 

Looking at the coming year, in nine election years since 1970, the January Barometer was right seven times (negative S&P returns in January 1992 and 2000 preceded positive annual gains). Looking at it from a trader’s probabilistic point of view, if the S&P loses ground this January, there is a 71.4% chance that it will lose in 2008 – something that pro traders would consider very tradable odds. 

So while we have another three weeks to wait for the January Barometer signal, the overall picture is deteriorating.  In some ways, the bear market and recession will be different this time – stalwart sectors that held up reasonably well last time are now among the weakest – namely Financials, Banks and Retail. In my books this increases the probability that the next recession will be worse than the last since Retail provides an insight into the consumer which is responsible for 70% of our economy. Last time around, the housing and real estate markets helped offset the severity stock market melt and recession. It is clear that that scenario looks increasingly unlikely now. 

In other words, unless we have some sort of biblical epochal miracle it’s time to batten down the hatches. There is a storm coming. We have increased our probability for recession to 85% in the coming year despite all the economic stimulus packages and government fiscal pumping that presages elections. 

Two more points worth repeating here. First, it’s the bear market not the recession that should concern us because it is the bear market that hurts your portfolio the most. If our forecast is correct we are now in stage one of a bear market. Second, don’t rely on economists to tell you a recession is coming. They have a 95% error average when in comes to forecasting such economic events. But most importantly by the time they admit we are in recession, like closing the barn door after the horse has escaped, it is far too late to do anything about it. 

Making money in this type of environment gets tougher and trades, especially those to the long side, are quick and dirty. It is certainly not a market that favors the buy & hold investor! 

Articles of interest

A subprime view from across the pond – FT
http://www.ft.com/indepth/subprime 

Global property sector feels heat – FT
http://tinyurl.com/29uvmv

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