TSG Stock Market Letter

Week Ending February 8, 2008

Topics Discussed This Week: 

• Global Market Disconnect or a Decoupling Myth?
• January Barometer Reading
• Crashonomics 101
• Bear grows fangs
  
• Leaders rollover
• Earnings still a concern
• Service industry on the skids?
• More bad housing news
• Stock outlook more questionable
• Take on the latest homebuilder rally
  

Global Market Disconnect Discussed

Over the last six months as evidence mounted that the U.S. economy was slowing, market pundits have promoted the theory that American weakness would have limited impact on emerging and industrialized markets and economies. They argued that since the size of the U.S. economy relative to global output had declined, it was likely that a slowdown here would not have the same negative affect that it has in the past – in other words global economic (and market) performance had effectively decoupled from that of the U.S. 

Table 1 – Here is a list of how U.S. indexes performed from their 2007 highs to January 2008 lows. Only Dow Industrials, S&P500 and NYSE Index avoided the 20% drop that typically defines a bear market.

With that idea in mind, we set out to determine what impact the last U.S. recession had on global markets and compare it to this time around.  First, here is a summary of what happened in U.S. markets from the 2000 high to October 2002 low. Over that period, the S&P500 dropped 50.5%, the Value Line Index dropped 57.2% while the Nasdaq dropped more than 80% and the Dow Industrial Average fell 38.7% over the same period.

How did this compare with some of the major global markets? As we see from Table 2, only one index missed a major drop and that was the Russian Moscow Times but that was only because it went through its gut-wrenching drops in 1998 during the Ruble Crisis and was in recovery mode by the time the recession hit our shores.

The important takeaway is that even though all countries did not officially enter recession in 2001-02 (Canada’s GDP dropped to +0.7%), every international stock market (including Canada’s Toronto TSX Index) experienced serious bear markets with Australia performing best and the German DAX getting hit hardest. On average, these markets dropped 55%!

It is interesting to note that the TSX drop (50.2%) was almost identical to that of the S&P500 (50.5%).  In other words, global markets including Canada’s were highly coupled to U.S. economic performance. The big question remains, is it different this time as many analysts would have us believe?

Decoupling Myth Debunked

Now let’s take a look at the right-hand side of Table 2 showing the performance of the same international indexes from their most recent highs in 2007 to recent lows. January was one tough month no matter which way you slice it. Before bouncing, the Dow Jones Industrial Average, S&P500, Nasdaq and Russell 2000 Indexes had dropped an average 18.7% by the third week of the month. Although stocks experienced miraculous recoveries by the end of January, with the exception of the Dow Transports, all indexes were still underwater. 

But as we see from Table 2, with the sole exception of the Chinese Shanghai Composite Index that dropped 10%, every other global market suffered a greater decline than the S&P500 with the Japanese Nikkei 225 and Hong Kong Hang Seng tying for poorest performers with drops of more than 31% from their 2007 highs. It is interesting to note that the powerhouse Chinese and Indian indexes peaked in October 2007 and January 2008 respectively after coming off bearish parabolic blow-off tops. This means that they have the potential to fall far further than their emerging and industrialized market counterparts.  

Table 2 – Table showing how the major international indexes performed during the bear market of 2000-02 and from their most recent peaks in 2007-08 to the January lows.

As a group, not only did global markets NOT miss the most recent U.S. downdraft, they were more seriously impacted.

But markets around the world have recovered since mid January. Did global markets experience better performance than their U.S. counterparts as a decoupling might imply?

As we can see from Table 4, the worst performer was the Chinese Shanghai Composite which shed 17% followed by the Russian Moscow Times (-16%), Singapore Hang Seng (-16%) and German DAX (-15%). Those performing best were the Dow Transports (the only major index to post a monthly gain), Dow Industrials, Toronto TSX and S&P500.

So whether we look at peak to trough losses or January performance, global markets underperformed their U.S. counterparts. So much for the decoupling myth!

January Barometer – Market outlook

According to Bloomberg, as of Tuesday’s close this is the worst start to a year for the S&P500 ever, including during the Great Depression. The index was down more than 14.5% for a drop in value of more than $2.1 trillion.

As Januarys go, this one will go down as among the worst Januarys for the S&P500 since World War II with the index dropping 6.1%. Only five Januarys were worse and they were 1939, 1960, 1970, 1978 and 1990. In only one case – 1978 – did the S&P manage a positive gain for the year (+6.5%) and interestingly enough it was in the middle of the 1968 to 1982 bear market showing the power that bear market rallies can exhibit (Table 3).  So what does this mean for 2008?

Table 3 – Year-end S&P500 performance following the worst performing Januarys since World War II.

Without a doubt, the best early year warning indicator is the January Barometer. First devised by Yale Hirsch in 1972, it says that as January goes for the S&P500, so goes the rest of the year. According to The Stock Trader’s Almanac 2008, the indicator has only registered five major errors (most of which occurred in times of war) since 1950 for an accuracy of 91.2%. It is worth noting that losses in January proceeded down years in ten of the last 14 years election years (71.4% accuracy) since 1950.

Given the strong historic link between U.S. markets and global markets, this is bad news for stocks around the world in 2008.  For those of you who have followed our technical and economic indicators over the last few months, this conclusion comes as no surprise. For our new subscribers, it is further confirmation of the bear market and coming recession. It will hopefully serve as a wake-up call for those sanguine about their portfolios in non-U.S. markets. Even if these economies are lucky enough to avoid recession, there is a low probability that they will be as fortunate from a market perspective if history is any guide.

Table 4 – January performance for the global and U.S. indexes. 

'Crashomics' 101

So far, the credit problems that have led to the drops in stocks have been limited to residential mortgages and credit. This week luxury homebuilder Toll Brothers declared that the company expects to announce its seventh consecutive quarterly loss. But there is growing evidence that it is spreading. This week we also learned that the Institute for Supply Management non-manufacturing (service) index for January suffered its biggest drop on record to 41.9 from 54.4 in December. It was the worst reading since October 2001 in the wake of 9/11. 

Throwing more water on the decoupling myth, this week it was learned that economic indicators for the 30 developed countries in the Organization for Economic Cooperation and Development (OECD) are declining even more rapidly than those in the U.S.  (This is bad news for hopes that a cheap dollar would boost to U.S. exports and drive the economic recovery at home.) 

David Tice, manager of the Prudent Bear Fund, told Bloomberg this week that Wall Street finance and the securitization markets have broken down. Recent efforts by the Fed mark the first post-crash reflation attempt. So far at least it has failed to work. In other words, even though the Fed has aggressively cut rates, they have not been able to reignite credit markets. Hedge funds continue to line up to sell high yield credit instruments and banks continue to tighten lending standards. This had led to something Tice calls “credit revulsion.”

Although problems have focused on the residential mortgage meltdown, post-bubble contagion is quickly spreading to other areas including leverage-lending merger & acquisitions which has all but disappeared and credit cards that are experiencing rapidly rising defaults.  As of January 23^rd, investors demanded a premium of 748 basis-points to own high-yield, high-risk bonds, more than triple the record just seven months earlier and the highest in four years according to Merrill Lynch. 

There is a growing risk that this situation will continue to spread to a myriad of other asset classes. Commercial real estate markets are already getting hit.  A record 80% of banks have already tightened lending standards on commercial real estate loans. It is the most severe commercial real estate tightening since the Fed began monitoring the metric in 1990.  Examples of this have shown up as reduced maximum loan size and maturity and loan-to-value ratios. Not surprisingly, demand for business as well as residential loans has weakened as banks have increased the cost of funds even though the London Inter Bank Offered Rates (LIBOR) which have been historically used to price about 90% of mortgages have been dropping. This is putting a serious crimp in business capital spending and investment as the cost and lists of conditions for commercial property and business loans rise. The Fed can lower rates till the cows come home but until banks are sure that risks of default are falling, credit standards will remain tight. Given the size of the credit bubble and the speed at which it is breaking, we don’t expect that to happen anytime soon.

We also learned Wednesday that the four major indicators (industrial production, real personal income less transfer payments, real manufacturing and trade sales and finally, employment) used by the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee (BCDC), have now turned south. It is the BCDC’s job is to tell us when a recession has begun but it usually waits anywhere from six to 18 months after a recession has started to make it official. The last time the BCDC announced that expansion had peaked was on November 26, 2001 even though personal income was still rising. Only later revisions revealed the peak. But like the kid who announced that the cow has escaped the barn, by then it was too late to do much about it. 

As we have said before, by the time corporate and market fundamentals begin to show signs of trouble, the lion’s share of the damage has been done. This was made painfully clear in the case of the new home market (see http://tinyurl.com/2nbd6j ). Homebuilder’s stocks peaked in August 2005 and broke major support a year later but the fundamentals only began to seriously fall in October 2006.  By the time the fundamentals revealed a problem, the homebuilders had dropped by more than half! 

As we see from Figure 1, the major market sectors (with the exception of homebuilders) peaked in October 2007. Since their peaks, Auto & Truck, Financial, Retail and Bank stocks have dropped approximately 28%, 20%, 20% and 14% respectively. All remain in strong downtrends as the trendline below clearly shows. 

How long it takes the NBER to officially declare a recession is moot. The bear market is now more than three months old and other than the intermittent bear market rally like we saw in late January, we see no credible indication that this bear will end anytime soon. On that note, brutal bear markets are occasionally punctuated by explosive rallies that can humble even the most experienced short sellers so caution is paramount.

But unless you are a short-term trader who is an expert in both longs and shorts, cash isn’t a bad place to be.

Figure 1 – Daily chart comparing performances over the last six months between various major sectors in the U.S to February 5, 2008. Since the first week in August 2007, Auto & Truck manufacturers have dropped most (-19%) while Banks were the least hard hit (-11%). All except Builders put in highs in early October. Over the six-month period, the S&P500 has fallen 9%. As we see from the dashed purple trendline, all have resumed their downtrends after their most recent peaks February 1.

Stocks this week...bear grows fangs

With a drop of 4.4%, it was the worst weekly performance for the Dow Industrials in nearly four years as a barrage of bad news rattled investors. The biggest hit came with unexpected news that the Institute of Supply Management (ISM) service index suffered its biggest drop since October 2001. Falling retail numbers and more bad real estate news didn’t help. Financials, which had been among the best market performers over the last two weeks, suffered some of the greatest losses this week and earnings continued to disappoint.  But there are some technical indications that a bounce is very possible from here.    

Technically Speaking

Leaders head higher

After two weeks of gains, Dan Zanger’s Sunday portfolio took a hit along with the rest of the market dropping more than 5% on the week.

His 9 picks this week included Apple (AAPL), Mastercard (MA), Intuitive Surgical (ISRG), Hess Corp (HES), Research in Motion (RIMM), and Bear Stearns (BSC), Flir Systems (FLIR), Ryland Group (RYL) and Centex (CTX).  

Figure 2 – Weekly performance of Zanger’s market leaders compared to the S&P500 (SPX), the Dow Jones Industrial Average (DJX), Dow Transports (DTX) and Nasdaq Composite (IXIC). Data courtesy of The Zanger Report, performance chart courtesy of VectorVest.com. 

Major indexes struggled but the Dow Transports Average continues to perform the best among the major indexes. On the weekly charts, the Dow Industrials failed to break resistance of the 12,785 level discussed last week and in the process put in a bearish engulfing bear chart pattern.  A similar pattern appeared on the weekly S&P500 chart after hitting resistance just below 1400 but what makes this pattern more bearish is that it was also a tweezer top pattern except that it did not come at the top of a rally. On the positive side indexes remain above their January lows, which if they can hold as support, will provide a solid base from which stocks could rally on positive news.  This possibility is further supported by the fact that volume was much lower this week than in the past capitulation low that occurred in the third week of January. But we do not expect anything more than a bear market rally especially considering that the Dow and S&P are putting in bear flag patterns that have ominous implications when it breaks, especially if the January lows are broken. This pattern can last anywhere from a few days to more than three weeks or so.

Volatility jumped again this week as the Market Volatility Index (VIX) rose to 28.01 from 24.02 as stocks fell but it is still lower than two weeks ago when it rose above 30. 

It was another strong week for the 17 commodities that make up the NYFE CRB Index, which soared to close at 518.47 gaining more than eight points Friday up from 502.26 last week. It pushed the index further above its upper 2-standard deviation trend channel, a level it has remained above for eight consecutive weeks. 

After dropping the first two days of the week, gold rose to close at $922, up from $913.10 last week with resistance at its recent high just above $930. 

But the dollar had a better week as the U.S. Dollar Index closed at 76.82 up from 75.57 last week and 76.11 two weeks ago.

The NYMEX crude oil (continuous) contract moved higher as well closing at $91.77/bbl up from $88.96/bbl last week and $90.71/bbl two weeks ago.

This week, the U.S. prime bank rate held steady at 6.00% as did the Fed funds rate at 3.0%. The 3-month London Interbank Offered Rate (LIBOR) fell in sympathy to 3.088% from 3.095% last week and 3.3% two weeks ago. Meanwhile, Freddie Mac mortgage rates held steady at 5.67% from 5.68% last week and 5.48% two weeks ago for the 30-year fixed mortgage while the rate held at 5.03% from 5.05% last week for the one-year adjustable rate (ARM).    

Earnings

Earnings remain weak

Q4-07 reporting season ended its fifth week and with a total of 1968 companies having reported (up from 1453 companies last week) average earnings were down 37% (from -45% last week) from the same quarter the year before. Not surprisingly, consumer goods were the hardest hit sector with financials next.  This compares to a drop of 21% (4205 companies) at the end of Q3-07 reporting season and a 13% jump in Q2-07. 

Economic Reports

Here are the reports we were following this week. 

ISM non-manufacturing takes a dive

Chart 1 – While the market hardly showed it Monday, the 2.3% jump in factory orders was good news for manufacturers but few were prepared for the number we got in the service sector January ISM Tuesday with a reading of just 41.9. It was more than a dozen points below December’s revised 54.4 reading and the lowest reading since – yes you guessed it – the last recession in October 2001. How bad was it? The Dow dropped more than 370 points on the news as losses accelerated throughout the day. The January number was also well below the economic contraction threshold of 50. 

More bad housing news

Chart 3 – Despite rising credit defaults, we learned Thursday that consumers continued to borrow with consumer credit expanding $4.5 billion in December. But it was well off the November number of $15.5 billion and the linear regression average (magenta trendline) near $10 billion. But as we see from the trendline, there is little indication of a contraction yet. However, this was offset Thursday by news of weak January retail sales growth of 0.3% versus the consensus forecast of 1%. According to Thomson Financial, half of retailers in their survey turned in disappointing results. Kohl’s turned in the worst January results with a drop in same store sales of 8.3% while Costco was tops with a gain of 7%.  

One big concern now is that the next credit-related shoe to drop is credit card defaults.  According to the latest data, Americans had a total of $944 billion in revolving credit card debt up 2.7% (annualized) in December. But this increase was well below both the November (+13.7%) and October (+11.1%) growth rates that together with falling retail sales is  further evidence of declining consumer demand. In December, an average 7.6% of credit-card debt was either in default or was more than 60-days delinquent, up from 6.4% the year before according to RiskMetrics. In the past downturns, credit cards have been used for discretionary purposes but today they are increasingly used for necessities like groceries and gas. A January survey by Discover Financial Services revealed that 49% of consumers plan to reduce discretionary spending amid rising credit card interest rates and drops in credit limits by lenders in the wake of the subprime fiasco as well as a weakening economy.  The problem is that with home prices falling, mortgage equity withdrawals are no longer possible for many as a way of financing consumer spending and evidence indicates that credit cards with much higher interest rates are taking up the slack.  This squeeze will accelerate as home prices fall.   

Next Week 

Here are the reports we’ll be watching.

·        Wednesday, January retail & food sales (previous -0.4%) and retail & food ex-autos (previous -0.4%).

·        Thursday, December trade balance (previous -$63.1 billion).

·        Friday, January import prices (previous - unchanged) and December Treasury International Capital Flows (previous $149.9 billion).

Synopsis

Stock outlook questionable

Given that we remain above the January lows, Transports have been moving higher and volumes have been low, the probability for a rally of some sort from here must be considered better than 50-50 short-term.  But that will depend on the news and economic reports this week. More poor news could easily cause a breach of these lows and manifest a bearish outcome. Whatever the short-term outcome, we are in a bear market and while rallies can be explosive, ultimately indexes head lower pulling the majority of stocks with them.  

Home Builder Update

Homebuilders are again rallying. But is this rally any different than the one that occurred from July 2006 through April 2007?  As see from the next chart, the last rally took place while the fundamentals continued to deteriorate. Since price is the leading indicator, it takes off first but as we saw last time, if the fundamentals do not begin recovering to support the rally, it will be short-lasted.  

Figure 3 - Weeky chart of Builders index of 26 home builders together with the fundamentals of the group. The earliest metric to take off is earnings growth (GRT). As of the latest data, earnings growth for the group dropped to -4%. Growth to PE has also continued to decline to -0.25. Taken together, it does not bode well for the long-term strength of this latest rally.

Stories of interest this week…

David Tice Sees Dramatically Lower Stocks in Five Years (Video)
http://tinyurl.com/38bzv4

Dire data signal U.S. economy stagnating
http://tinyurl.com/22czfq

U.S. Recession Indicators Are All Pointing South
http://tinyurl.com/2d2kv7

Bear Stearns Makes $1 Billion Bet on Subprime Market Decline
http://tinyurl.com/2yojdg

Summary of Fed and ECB Statements plus Economic Overview (Video)
http://tinyurl.com/39afqc

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