TSG Stock Market Letter

Week Ending September 5, 2008

Topics Discussed This Week:

The 2-ton Wall Street conflict of interest few dare to mention

While leaders drop again

Earnings: It’s official…

Construction spending, manufacturing, services still falling

Job losses and unemployment mount

Home prices – near a bottom or a bear break?

Last Week

Quote of the week

“This [euro slide] is a global recession story. We're seeing a reversal of what's been happening over the past two years. Now the dollar and the yen are benefiting as [carry trade] risk appetite is on the decline.’' Toru Umemoto, chief currency analyst in Barclays Capital, Tokyo.

The 2-ton Wall Street conflict of interest few dare to mention

September lived up to its terrible reputation in the worst week for stocks since May. It was the worst beginning to the month since World War II according to Bloomberg.  But that hasn’t stopped an army of pundits playing their favorite game especially when stocks get clobbered. Bottom picking continues to attract analysts like moths to a flame as they shamelessly, almost desperately talk their books. Attempts to justify their high fees for losing their client’s money shouldn’t fool anyone but it probably does if the popularity of this practice is any indication. And the more depressed stocks get, the more intensely they compete in this game.

As I write this I’m watching Barton Biggs on Bloomberg. “We’re pretty close to a bottom,” he says clearly uncomfortable on camera.  He believes we are in a cyclical bear market but if it turns out to be a secular bear, ventures that “prices could go lower.”

Who is he trying to kid? That’s like the captain struggling to keep his ship afloat after being torpedoed in a storm, telling his crew that if the ship explodes they could be in trouble . 

Maybe Biggs is right about being near a bottom, but what if he's not?

Remember when analyst Dick Bove confidently declared “the financial crisis over” giving us a “once in a generation opportunity to buy” stocks during the week of March 21 (see our March 21-08 newsletter)? Those who took this advice and bought the S&P500 Index have lost 6.6%, which means they now need to earn 10.7% (plus the cost of commissions & fees) just to get their money back. And as the next figure shows, unless you got very lucky, buying ETFs or stocks in the most beaten down sectors at the time was even more costly. But some on Wall Street still can’t seem to break that bottom calling habit. 

Figure A – Here are how the six sectors most beaten up in the six months leading up to March 21, 2008 have performed since March 21. As we see, while the Electronic, Telecomm and Auto & Truck sectors did rally for a short period, they have all resumed their downtrends, as have all the "bargain" sectors. Chart by VectorVest.com

But the motivation for this optimism is as understandable as it is self-serving. According to Bloomberg, Barton Briggs’ Traxis Partners LLC hedge fund has lost 10% so far this year to August 31. Given the brutal September so far, chances are that this loss has since grown. And he’s certainly not alone. Some have fared far worse (see article "Clarium Declines 13% ..."). It is surprising that more investors don’t demand their money back but this is the last thing any money manager wants. Better instead to exude optimism that a bottom is at hand than risk a redemption run.

But few in the media seem willing to discuss the cruel reality that investors are left to face alone and that is the prospect of paying fees for the privilege of having a money manager lose their money.

So what will it take for those in the industry to admit that we might be in a secular bear market?  (Be sure to check out the chart of Global Equity Returns.) Unpleasant as it may be, the probability of this being the case increases with time. And those who are waiting for the Bureau of Labor Statistics and National Bureau of Economic Research to confirm the existence of a recession are way behind the curve.

Whether we are in a recession or not is moot. As the rate of change in jobs figures and the more reliable indicators and the leading stock market sectors and indexes show, we’ve been in a bear market for more than 10 months now. Given that we are, 1) in the final inning of the best period in the election cycle and are facing the two-year post election period when markets have historically performed abysmally, 2) are in the throes of the bloody aftermath of a multitude of asset bubbles bursting around the global, and 3) are facing the very real prospect of having the most left-leaning, anti-corporate president in history empowered by a Democratic Congress and Senate run the country with the commensurate risk of increasing taxes and raising trade barriers at the worst possible time in the economic cycle, the market outlook must be considered challenging at best.

So how accurate have Wall Street analysts' recommendations (upon which many money managers rely for their advice) been so far this year? A report from Bespoke Investments this week discussed stock performance based on analyst ratings from the July 15 low to the August 28^th high. Not surprisingly, the decile of stocks most loved by fundamental analysts gained a paltry 2.59% while the decile most hated (with the lowest ratings) jumped more than ten times as much posting an impressive 29% gain between July 15 and August 28. This compares to a 7.1% gain in the S&P500 over the same period.  

The lessons? First, it is better to use Wall Street analysts’ consensuses as a contrarian indicator, especially when times are tough. Second, unless you are among a fortunate few, it is unrealistic to expect your money manager or financial adviser to tell you when to head for the exits when the time comes – that's a decision that you'll be left to make on your own. 

Technically Speaking

Leaders lead lower

It was another week in negative territory as Zanger’s Sunday shed nearly 10% compared to 2% last week. His week’s list of  17 stocks included Research in Motion (RIMM), Energy Conv (ENER), Apple (AAPL), First Solar (FSLR), Ambac Financial (ABK), MBIA (MBI), Sunpower Energy (SPWR), SunTech Power (STP), Canadian Solar (CSIQ), Potash Corp (POT), Suntech Power (STP), Goodrich Petroleum (GDP), Continental Airlines (CAL), US Airways (LCC), United (UAUA) and Yingli Green (YGE).  That these leaders are heading lower again and that they also led the indexes lower is bearish.

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.

It was a short week, but weekly volumes spiked up as expected for the Dow Industrials, Dow Transports, Nasdaq Composite, Russell 2000 and NYSE Index this week as traders returned to work. Falling volume is considered mildly bullish when price falls but that’s not what happened. Increasing volume with falling price is considered bearish, that is unless you get an extreme capitulation spike that often presages a bottom of sorts and that did not occur. It is also interesting to note that the major indexes are again down 20% or more from their peaks.

As well the Dow Jones Utilities Average looks to have breached its bearish head & shoulders top pattern neckline and that is decidedly bearish although it remains to be seen if this move is confirmed next week (with next week’s price action contained below the neckline). However, considering that market breadth (advancing versus declining issues) is not all that bad and the degree to which stocks have been beaten up, there is the distinct possibility of seeing some sort of bounce in stocks next week.

Figure 2 – Bearish head & shoulders top pattern in the weekly chart of the Dow Jones Utility Average. As we see, the index has fallen more than 18% since it peaked in December. That the neckline breach occurred on relatively low volume this week makes it somewhat suspect. However, this concern aside, the DJU now joins the DJI Average in having confirmed this pattern. Chart by GenesisFT.com  

After spiking to 27.49 nine weeks ago, the Market Volatility Index (VIX) moved up 23.06 from 20.65 last week and 8.81 two weeks ago.  This compares to a VIX north of 31 when the Dow last bottomed during the week of March 14 and shows that fear is subsiding.  The currently level means that investors remain relatively complacent about the state of the market.

After hitting a high of 611.51 seven weeks ago, the 19 commodities that make up the NYFE CRB Index settled some more this week to close at 489.24 from 516.47 last week. Commodity prices have now fallen more than 20% as a group. In an interesting analysis from Bespoke Investments this week, they note that while commodity bear markets are not always associated with bear markets in stocks and recessions, this situation is certainly more common than not.  

After hitting major support around $785 three weeks ago, gold had another challenging week as the yellow metal fell below $799.30/oz down from $831 last week, well below its $860.40 close four weeks ago. Gold exhibits a strong seasonal period from the end of July to the end of September but this strength in quickly running out of time.     

August was the best monthly gain for the U.S. Dollar Index since 1999 and this summer lift continued as the buck closed at 77.88 up from 77.40 last week and 76.65 two weeks ago.  Much of the dollar move has been due to apparent U.S. GDP growth compared to Europe, Canada and much of the OECD. It appears that Forex traders take the GDP growth figures and relatively benign CPI stats at face value. It remains to be seen how long they will continue to pretend not to see through the cheap dress and gaudy lipstick on these pigs.  

Speaking about animals, oil continued to act like a dog and that was a good thing for consumers and most stocks as the price of a barrel of crude fell to $107.10 as it broke key support after closing at  $115.92/bbl last week. Crude oil is now off more than 26% from the weekly high of $145.15 July 11. But it is the twenty-seventh consecutive week that oil has remained above $100. Normally, oil hits a seasonal high in mid-October. Given that oil did experience higher volume than normal and a wide range this week, it could be plumbing for some sort of bottom here.

The U.S. bank prime rate held again this week at 5% and the Fed funds target rate remained at 2%.  The 3-month London Interbank Offered Rate (LIBOR) ticked up again to 2.8144% (from 2.8106% last week and 2.81% two weeks ago).  But Freddie Mac mortgage rates slipped again to 6.35% (from 6.40% last week and 6.47% two weeks ago) for the 30-year fixed mortgage while the one-year adjustable rate mortgage (ARM) fell to 5.15% (from 5.33% 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.

Earnings

Earnings: It’s now official, another bad quarter

A few more stragglers reported this week so as Q2-08 reporting season winds down, a total of 3923 companies (up from 3883 last week) have now reported. Average earnings held steady at -39% (from -37% three weeks ago, -32% four weeks ago and -22% five weeks ago) versus Q2-07.

This compares to an overall 30% drop at the end of Q1-08 earnings season with a grand total of 4214 companies having reporting.  This also marks the third quarter that earnings have shown a consistent trend to drop as more companies have reported.  Looking at past seasons, there was a drop of 57% for final Q4-07 (3900 companies), a 21% drop (4205 companies) for Q3-07 and a 13% jump for Q2-07.  Meanwhile, the Commerce Department also reported a durable goods increase 1.3% in July versus an expected drop of -0.3% due in part, the agency said, to stronger demand for aircraft. But even without this metric, durable goods increased 0.7% again thanks to stronger exports.

Economic Reports

Here are the reports we were watching this week.

Construction spending still falling, manufacturing & service sectors remain weak…

Chart 1 – Not much good news on the construction front in August as construction spending fell another 0.6% versus an upwardly revised -0.4% in July. We also learned that the construction industry shed another 8,000 jobs representing nearly 10% of all jobs losses last month.

Chart 2 – August Institute of Supply Management Indexes were little changed showing manufacturing down slightly to 49.9 from 50 and services up marginally to 50.6 from a revised 49.5 in July. A look at both trends is not encouraging, however.

Jobs losses, unemployment jump

Chart 3 – We learned Friday from the Labor Department that jobs continue to go MIA in increasing numbers. There were a total of 84,000 jobs lost in August but the real story was the revisions in July, doubling the original estimate of jobs lost as the number was revised downward from -51,000 to -100,000. It was the eighth consecutive month of declines. We also learned that August unemployment unexpectedly jumped 6.1% up 40 basis points from July for the highest number of unemployed since September 2003 according to the Wall Street Journal. Remember, its election year and government minions have some very powerful tricks for making the numbers look better than they really are so expect some serious revisions after the election. Service sector jobs fell 27,000, business and professional services lost 53,000 and retail lost 19,900 jobs while surprise, surprise, government jobs rose 17,000.

Next Week 

Here are the reports we’ll be watching next week. The ones emboldened are leading or useful indicators we are tracking, the others have the potential to impact markets short-term. And then there is the fact that most government-back statistics are shameless manipulated… and must be treated like stories about the Tooth Fairy or Santa Claus. When in doubt, use market direction as an indicator. 

- Monday, July Consumer Credit (previous $14.3 billion).

- Tuesday, July Wholesale Trade (previous 1.1%), July Pending Home Sales (previous 5.3%). 

- Thursday, July Trade Balance (previous -$56.77 billion), August Import Prices (previous 1.7%).

- Friday, August Retail Sales (previous -0.1%), ex-autos (previous 0.4%), August Producer Price Index (previous 1.2%), ex-food & energy (previous 0.7%).

Synopsis

Home Prices – Near a Bottom of Just a Bear Break?

If you’ve been listening to the street, you will have no doubt heard more talk of a real estate bottom again. Admittedly, there have been a few encouraging signs emerge in the last month or so. They include an improvement in the rate at which the S&P Case-Shiller 10 and 20-city composite indexes have been dropping and signs from a number of regions that month-over-month changes in selling prices have actually increased.  In some areas hardest hit, buying foreclosures has become the latest fad and sales figures in areas of California, for example, have experienced impressive increases. How long this continues, however, remains to be seen.

But before breaking out the champagne and doing the bottom dance, here are some rather sobering charts (and numbers) to consider.

Figure 3 – Quarterly chart showing changes in the price-to-rent ratio over the last two decades. The bubble beginning in 2002 and ending in 2005 is clearly visible on the right-hand side. It also shows that we have a long way to go to get back to the historic norm in mean (average) prices to average incomes over different periods. Chart – Northern Trust

As we see from Figure 1, although the price-to-rent ratio has fallen dramatically since peaking in 2005, the correction still has a way to go to return to any of the historic norms. To return to the average (mean) prices, either home prices would have to fall roughly 12% nationwide or rents would have to increase roughly 15%. This is possible, but given the history of bubble aftermaths and the fact that our economy is deteriorating and already in recession (unofficially), prices have a greater probability of falling well below trend before finally leveling off.

Next, we see a chart of the ratio of the value of the family home as a percentage of household income.

Figure 4 – Value of the family home as a percentage of median income showing that the correction still has a long way to go. Chart – Northern Trust

This chart bodes even more ominously for a bottom or recovery in home prices anytime soon. Historically, home prices have increased roughly in line with real income growth that is until 2001. Fueled by historically low interest rates and a flow of capital out of stocks and into housing, prices were propelled far above the level incomes could support. According to this chart, home prices must fall another 27% to get back to the normal ratio of average incomes to the mean price of the family home from 1968 through 2007.

Figure 5 shows another view of this relationship – median home prices to median household income for the US and a number of major cities.  As we see, US home prices still have to drop another 20% or more to return to the historic ratio of home prices/income of 3.5. For places like Los Angeles (10 x income), Miami (7.25 x income) and even Chicago (5 x income), prices still have a long way to fall to return to the historic norm.

Figure 6 – Relationship between median home prices and median household income for the US (blue dashed line) and a number of major US cities. Data – RealtyTrac

No one, not even eternal property bull and head cheerleader for the National Association of Realtors, Lawrence Yun will dispute the fact that stubbornly high unsold housing inventories remain a serious challenge. As of the latest figures (July), inventories continue to grow and are above 11 month supplies for both existing and new homes. Increasing foreclosures are a major source of the problem. Where foreclosures go, the housing market is sure to follow, at least for the foreseeable future.

As we see from Figure 4, there are no signs of foreclosures slowing. Just the opposite is true as this chart clearly demonstrates. Even if foreclosures level of at their Q2-08 rate, it means another nearly 3 million foreclosed homes will be added to unsold inventories by Q2-09. 

We got more bad news on the foreclosure front Friday when we learned that Q2 foreclosures accelerated at the fastest pace in nearly 30 years according to the Mortgage Bankers Association. New foreclosures increased 1.2%, rising above 1% for the first time in the survey’s 29-year history according to Bloomberg News. As well, the total inventory of homes in foreclosure reached 2.75% almost tripling since 2005. On top of it all, the share of loans with payments overdue rose to 6.41% (seasonally adjusted) of all mortgages, an all-time high and rise from 6.35% in Q1-08.

Figure 7 – Increases in homes foreclosed between Q1-05 and Q2-08. Chart – ForeclosurePulse.com

Optimism can be a good thing. But can also be a very costly emotion to traders and investors, especially when it’s misplaced. And judging by this data, it is certainly too soon to break out the housing bottom party shoes and start buying again just yet. 

Global Equity Returns – Chart

http://seekingalpha.com/article/94182-global-equity-market-returns

U.S. Stocks at 25.8 Times Profit Means Rally May End (before Thursday’s melt)

http://www.bloomberg.com/apps/news?pid=20601213&sid=aBgaQ4tuM8Xo&refer=hom

Morgan Stanley's Roach Says Slump Has Only Just Begun

http://www.bloomberg.com/apps/news?pid=20601110&sid=avEus.1FMkt4

Biggs Says U.S. Stocks `Close to Bottom,' Fund Down 10%

http://www.bloomberg.com/apps/news?pid=20601087&sid=ahGpkom8SbJk&refer=home

Clarium Declines 13% in August, Biggest Monthly Loss

http://www.bloomberg.com/apps/news?pid=20601087&sid=a2wpemWLGRtQ&refer=home

U.S. Mortgage Foreclosures, Delinquencies Reach Highs

http://www.bloomberg.com/apps/news?pid=20601087&sid=aHlLc59LsJDs&refer=home

U.S. Faces Stagnant Growth for Foreseeable Future, Fosler Says

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNL5N4J3u4aU

Euro Slides to 11-Month Low Versus Dollar on Recession Risks

http://www.bloomberg.com/apps/news?pid=20601087&sid=aHTN6MQee3K4&refer=home

UBS, Credit Suisse Face Leverage Cap, Regulator Says

http://www.bloomberg.com/apps/news?pid=20601087&sid=aQV7ZhykX9eg&refer=home

OPINION

Here Are Five Things Democrats Won't Tell You: Caroline Baum

http://www.bloomberg.com/apps/news?pid=20601039&sid=azFMl109VO8I&refer=home

Here Are Five Things Republicans Won't Tell You: Caroline Baum

http://www.bloomberg.com/apps/news?pid=20601110&sid=a33YVKQ7OoaU

(You decide which one you think is best…)

VIDEOS

Gabelli Says Concern About 2009 Earnings `Well Founded'

http://www.bloomberg.com/avp/avp.asxx?clip=mms://media2.bloomberg.com/cache/vjFimwClUHp4.asf&vCat=&RND=373663082

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