| TSG Weekly Market Watch October 31, 2008 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Sunday, 02 November 2008 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending October 31, 2008Topics Discussed This Week: Let the bounce begin Leaders move up New home sales jump as existing home prices slump Bailout bonanza – can we afford the cost?
Performance 2008
Quote of the week "There are only two positions you can have in a market like this – flat and fetal." Dennis Gartman Bounce finally appears… Well it finally happened – the bounce we have been waiting for has come. October will go down as one of the most painful on record and the worst month for the S&P500 since October 1987 even though the index had two of its best days on record. But this bounce is also one for the record books. With a jump of 10.5%, the SPX enjoyed its best week since 1974 according to Bloomberg. Even with this admirable performance, indexes are reeling. As we see from table 2 above, the Dow is down 20%, the Nasdaq nearly 36% and the MSCI Emerging Market ETF (EEM) is off a whopping 83% in 2008. But how long will this bounce last? Technically Speaking Leaders move up After losing nearly 12% last week, Dan’s Sunday pix reversed and headed higher gaining 9%. And after being the worst hit over the last few months, the Emerging Markets ETF was the surprise star performer rising more than 28%. That being said, Zanger recommended that it is best to avoid the market until the wild swings slow down which “could take months.” This week Zanger’s list of market leaders was short, just four stocks that included Apple (AAPL), Google (GOOG), Baidu.com (BIDU) and Potash (POT).  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. Weekly volumes just at or slightly above average this week for the major indexes which given that they all moved up is somewhat bearish. Bounces off market bottoms with high volume are far more bullish. If the rally is to have any staying power we will need to see volume rise substantially in the next few days. After surging to 81.65 on Monday the Market Volatility Index (VIX) settled to end the week at 59.89 versus 79.13 last week. Extreme VIX readings can often presage at least a temporary market bottom especially when it follows high volume capitulation readings we saw two weeks ago and now the rally has begun. After dropping to 356 last week, the 19 commodity NYFE CRB Index ticked up to close at 369.56. Since hitting a high of 611.51 three months ago, the CRB Index is down more than 40% and volatility has continued to climb increasing the chances of a commodity bounce from here. But gold did not share the rally dropping to $719.30/oz from $730.50 last week and $856.60 three weeks ago. A major reason for this weakness is the strength in the U.S. dollar. The U.S. Dollar Index eased this week to close at 86.27 down from 86.37 last week but above 82.55 two weeks ago. Much of this has been due to a rapid repatriation of investment dollars to the U.S. as commodity prices and emerging markets continued their free-fall but we expect this trend to stall if we get continued bounces in emerging markets and a commodity rally. Oil joined the commodity party with a four day rally as crude firmed to $67.48/bbl. up from its 2008 low $64.60 last Friday. But oil is still down more than 50% from its mid-July high. This has been the most volatile year for crude in nearly two decades when it dropped from a high of $40.10 to a low $17.61 between September 1990 and February 1991. The U.S. bank prime rate and the Fed funds target rate dropped 50 basis-points again this week 4.0% and 1.0% respectively but the effective Fed funds rate fell to 2008 low of just 0.24% as the Fed continued to pump cash into the market. Credit markets continued to loosen this week as the 3-month London Interbank Offered Rate (LIBOR) slipped again to 3.02625% from 3.516% last week and 4.41875% two weeks ago. But the Freddie Mac mortgage rates jumped again to 6.46% from 6.04% last week for the 30-year fixed mortgage while the one-year adjustable rate mortgage (ARM) rose to 5.38% from 5.23% 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. About 6 million U.S. mortgages, including the vast majority of subprime home loans as well as 41% of prime ARMs are linked to LIBOR. Earnings worsen again It has been interesting to compare earnings performance of the S&P500 versus the broader market. On November 3, 2008 Bespoke Investment Group posted an article entitled Q3 Earnings Not All That Bad showing that year-over-year earnings for the 500 companies of the S&P500 Index were down 5.6% from Q3-07. But is that an accurate assessment of what is going on in the broader market? In the fourth week of Q3-08 reporting season, with a total of 1837 companies (of the more than 4000 that report earnings on Wall Street) having reported (up from 1056 companies last week), average earnings dropped to -42% (down from -39% last week, -23% two weeks ago and -13% four weeks ago) versus Q3-07. This compares to a year-over-year 36% drop in Q2-08 earnings, a 30% decline for Q1-08, a fall of 57% for Q4-07, a 21% drop for Q3-07 and a 13% jump for Q2-07. Q3-08 also marks the fifth quarter that earnings have deteriorated as the season matured. So far this earnings season, consumer services have seen the greatest declines, with the earnings of 256 companies falling an average 78% from the same quarter last year. Here we compare the difference between tracking S&P500 earnings (lower chart) versus the broader market (upper chart).
Chart A - Year-over-year changes for the broader market.
Chart B - Earnings growth for the S&P500 group of companies. Chart by VectorVest.com As we can see, we knew by the fourth quarter 2007 that earnings were falling for the broader market but we did not get a similar signal from S&P500 earnings until February 22, 2008 when we learned that earnings were falling for that group. We have found that results from a broad range of companies are much more reliable than analysts’ earnings forecasts, S&P500 earnings, earnings surprises and month-to-month changes in seeing the true earnings picture. When earnings are falling for the broad range of companies, it’s a negative indicator of market and economic strength. When they hit a solid bottom and start to rise, it’s very good for both. And that is simply not happening yet. And then there are the broader challenges facing the market (see Bailout Bonanza - Can we afford the cost? )... New homes sales move higher, but prices still falling rapidly On Monday, we learned that September new home sales ticked 2.7% higher following a 12.6% (revised) drop in August. But then came the bad news with the latest Case-Shiller home price index which showed that home prices in the 20-city composite have fallen 16.6% in the last twelve months. We also gained valuable insight into the value of consumer confidence (Conference Board) and consumer sentiment (U.Michigan) in forecasting a slowdown. Both had been showing gains between July and September which would have led followers to believe that things were improving. But then consumer confidence dropped from 61.4 to an all-time low since the indexes inception in 1967 of 38 in October and only served to show that things had gotten considerably worse after the fact. We also learned that GDP dropped 0.3% in Q3-08 down from +2.8% in Q2-08 and GDP is expected to decline further in the quarters ahead. The Chicago Purchasing Managers’ Index (PMI) also took a bigger than expected drop in October to 38.7 from 56.7 in September to the lowest reading since September 2001.
Chart 1 – Here is our heads up display of the new housing market showing housing permits (blue line), starts (green line), new home sales (purple) and the excess of homes being built (red) above demand. A total of 464,000 (annualized) new homes were sold in September, up 2.7% from August and the inventory of unsold homes dropped to 394,000, a 10.4 month supply. The median price of a new home slipped 0.9% to $218,400 from August and prices are down 9% year-over-year according to the data. Chart 2 – The result of the continued building spree by builders is that sales (green) and inventories (red) are merging and once they meet, means that builders will have to effectively stop building homes and concentrate on selling inventories or risk increasing selling times substantially. This does not bode well for home prices (see next chart) or a bottom anytime soon. Even though new home sales represent just 15% of the market, homebuilder stocks provide valuable insight into the health of the existing home market. Chart 3 – Note the huge swings in the median price of a new home and drop in September. More important is the trend since true prices are masked by generous builder incentives to make the sale. Look for further declines as builders discount prices to make sales amid falling demand in a weakening economy.
Chart 4 – Here is a more accurate snapshot of the existing home market (compared to NAR data) showing that prices continue to fall, with August home prices down 16.6% from the year before for the fastest annual rate of decline on record. From their peak in July 2006 home prices have fallen 20.3% in the 20-metropolitan areas tracked by the Case-Shiller home price index. We need to see the lower chart reverse higher and get back to zero before we will see an end to price declines. Six of the 20 metropolitan areas had annual declines in excess of 25%. They were Phoenix (-30.7%), Las Vegas (-30.6%), Miami (-28.1%), San Francisco (-27.3%), Los Angeles (-26.7%) and San Diego (-25.8%). Three cities have lost less than 5% in the last year, Dallas (-2.7%), Charlotte (-2.8%) and Boston (-4.7%).  Chart 5 – It came as no surprise that GDP fell 0.3% in Q3-08 but the one standout in the numbers was the significant 3.1% drop in personal consumption expenditures or consumer spending. It was the biggest PCE drop since February 1991. It should also surprise no one that this number will get worse in the coming quarters. In another report, durable goods rose 0.8% in September after a downward revision to -5.5% (from -4.5%) in August.
Chart 6- The Chicago Purchasing Manager’s index took a big hit in October dropping from 56.7 to 37.8, the lowest reading since 2001. Bailout bonanza – can we afford the cost? A new plan surfaced this week in the form of another $500 billion to help an estimated three million homeowners in danger of defaulting on their mortgage payments. Spearheaded by U.S. Treasury and the Federal Deposit Insurance Corporation, the plan would refinance these loans at more affordable rates. A First American CoreLogic report recently revealed that nearly 20% of mortgage borrowers (on more than 7.5 million properties) owed more on their loans that their homes were worth. Another 2.1 million properties will enter negative equity territory if property prices decline another 5%, according to the report. As of the latest data, 266,000 mortgages are now defaulting every month in the U.S.
Figure 2 – This weekly chart of money supply shows the rapid jump in cash in the system thanks to Fed actions adding another 35% to the monetary base in the last six weeks. It is clear from this chart that the Fed is pulling out all the stops to push inflation into the system and have tossed any inflation concerns out the window in an effort to stop asset prices from dropping. So what does that make the total of bailouts so far this year? By my calculation, if this latest bailout gets passed, and it probably will be by the next president if the current one turns it down, puts the total at $2.7 trillion in the U.S. The bailout bonanza has had a very real impact on money supply in October. According to the latest Federal Reserve figures, the combination of liquidity pumping and the extremely low effective Fed funds rate which dropped to below 0.25% this week has had a very real impact on the monetary base. The source of the nation's money supply, monetary base is controlled to a certain extent by Federal Reserve monetary policy. Defined as the sum of reserve accounts of financial institutions at Federal Reserve Banks, currency in circulation (currency held by the public and in the vaults of depository institutions) jumped 25% in the last six weeks alone as the government kicked printing presses into warp speed in an effort to stop asset bubbles from breaking further. In the last decade, asset prices have been driven by an unparalleled leverage in financial markets that drove prices for everything from merger & acquisitions to priceless art into the stratosphere. Attempting to stop this necessary re-pricing although politically popular is nothing short of financial folly. Even it if works temporarily, what do we get? It will mean a reflation of prices in everything from oil to real estate but that will only prolong the agony. If property prices are not allowed to return to their historic demand norms in relation to rents and personal incomes, sales will be hobbled until incomes can catch up and that will take years. Even if the rate of foreclosures is temporarily stemmed, unrealistically high home prices will mean years of Chinese water-torture declines until one way or the other, the proper balances are restored. Ditto for a host of other asset classes. To sum up, the underlying premise of these bailouts is to stimulate a rapid reversal and return to the days of high prices and bloated valuations. But this will come at a cost – a fiat currency that has no real relationship to true value and rapidly rising inflation. As a best-case scenario, we risk years of anemic economic performance, a rapidly declining dollar combined with stagflation and eventual spike in interest rates as foreigners avoid dollar-denominated assets like the plague in search of those assets that are realistically priced. If it fails, we can expect a continuation of extreme levels of volatility as markets swing between periods of euphoria as new stimulative plans are announced and then depression as prices plummet and the realization hits home that the latest plan has again failed to cure our economic woes. Stories of interest this week… Evil Wall Street Exports Boomed With `Fools' Born to Buy Debt http://www.bloomberg.com/apps/news?pid=20601087&sid=a0jln3.CSS6c&refer=home Case Highlights Real Estate Scam Pandemic http://www.bloomberg.com/apps/news?pid=20601109&sid=aGYlBrRCgtq0&refer=exclusive More U.S. Homeowners Have Mortgage Higher Than House Is Worth http://www.bloomberg.com/apps/news?pid=20601213&sid=aYyk2_TLjGao&refer=home Global stocks bounce, Iceland hikes rates massively Credit `Tsunami' Swamps Trade as Banks Curtail Loans http://www.bloomberg.com/apps/news?pid=20601109&sid=aPA4NMYtDIS4&refer=exclusive `Panic' Strikes East Europe Borrowers as Banks Cut Franc Loans http://www.bloomberg.com/apps/news?pid=20601109&sid=awd1vGnyyBJQ&refer=exclusive Short Sellers Aren't Jackals, Fleckenstein Says http://www.bloomberg.com/apps/news?pid=20601109&sid=a758oOpYTQrE&refer=exclusive Libor Declines on Central Bank Cash Funding, Fed Rate Outlook http://www.bloomberg.com/apps/news?pid=20601110&sid=arfAGj6iNvbo World According to TARP No Laughing Matter for U.S. http://www.bloomberg.com/apps/news?pid=20601170&refer=home&sid=a2VdrjC1TWxE Greenspan Slept as Off-Balance-Sheet Toxic Debt Evaded Scrutiny http://www.bloomberg.com/apps/news?pid=20601109&sid=aYJZOB_gZi0I&refer=home Mizuho $7 Billion Loss Turned on Toxic Aardvark Made in America http://www.bloomberg.com/apps/news?pid=20601109&sid=aPFaqO.S_m.g&refer=exclusive--------------------------------------------------------------------------------------------------------------------- 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 have it sent to them each week). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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