TSG Stock Market Letter

Week Ending May 1, 2009

Topics Discussed This Week:

Rally re-ignites?

Leaders fall behind…

Earnings forecasts still looking bullish but…

Case-Shiller shows prices still declining but at slower rate

Comparing rallies

Elliott Wave SPX Perspective

Last Week

Quote of the week

“If [the 1918 Spanish Flu Pandemic that killed more than 20 million] that affected half the world’s population only caused a correction in the market,  a  flu  outbreak  that  has  only  affected  hundreds  of  people  barely  deserves  the  ink  for  a headline.” – Bespoke Investment Group  

Rally re-ignites?

This marked the eighth week that stocks have rallied with the S&P500 up nearly 30% from its lows in the first week of March. Last week we mentioned that the S&P500 index was 9.5% above its 50-day moving average. This week it moved up to 10% above the 50 DMA and so remains quite overbought. That being said, the correction we have said was coming has yet to arrive – an indication of just how strong this rally has been.

However, there is one key ingredient missing in this rally that should concern all those who are long or considering doing so and that is the way stocks have moved up.

Technically Speaking

Leaders bounce back…

This week Dan’s Sunday April 26 watchlist included 12 stocks of which 6 were breaking out or poised to do so. They were Intuitive Surgical (ISRG), Jones Lang (JLL), SL Green Realty (SLG), Sohu.com (SOHU), sTracks Gold (GLD) and Whirlpool (WHR). Last week Dan’s leaders dropped and then took off to end the week higher. This week, they trailed the pack and that is bearish for next week.

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.

After steadily dropping from March 20 to April 10 and temporarily spiking last week, weekly volumes were again below average for the Dow Jones Industrials and S&P500 Indexes. This is bearish since declining volume in a rally shows buyers dropping out. As we have said before, a rally needs a steady supply of new bulls buying stocks to give it strength and that is not happening. 

And although the Market Volatility Index (VIX) dropped this week, it is higher than it was two weeks ago and that is also bearish. The VIX closed the week at 35.30, down from 36.82 but up from 33.94 last week. 

Since rebounding off its December 5 bottom, the 19 commodity NYFE CRB Index gained ground again this week to close at 381.27, up from 372.50 last week and 376.25 two weeks ago. Since hitting a high of 611.51 in July the index is still down 38% from its peak.  

After the surge in gold to $1001.10/oz February 20, the precious metal fell this week to $886.50/oz versus $913.80 last week but still up from $869.50 two weeks ago.  But volume and open interest remain low which is bearish following the second of two tops February 20. It is important to point out that gold has a seasonal low in July and then rallies into year-end. 

Meanwhile, after putting in another bottom seven weeks ago then rallying, the US Dollar Index slipped again to 84.54 down from 84.72 last week and  85.98 two weeks ago. Since bottoming in July, the U.S. Dollar Index is up nearly 20%. 

Crude oil futures firmed this week as a barrel of crude closed at $54.06 up from $51.49 last week and $52.31 two weeks ago. Oil is still down more than 62% from its mid-summer high of $147.20.  

The Baltic Dry Index, an indicator that tracks the cost of shipping dry goods by sea, slipped this week to 1806 or about where it was six weeks ago showing that shipping demand has leveled off. This is neutral for both the economy and the price of oil but clearly shows the global economy is not growing as quickly as some pundits would have us believe. 

The U.S. bank prime rate and the Fed funds target rate held steady at 3.25% and 0.00% - 0.25% respectively while the effective Fed funds rate firmed again to 0.23% (up from 0.18% last week). Meanwhile, the 3-month London Interbank Offered Rate (LIBOR*) slipped again to 1.00688% (down from 1.0725% last week and 1.10188% two weeks ago). This compares to LIBOR 52-week high of 4.81875% last October. 

On the mortgage front, Freddie Mac mortgage rates slipped this week to 4.78% (4.8% last week) for the 30-year fixed mortgage while the one-year adjustable rate mortgage (ARM) slipped to 4.77% (4.82% 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

As we see from the next chart, earnings forecasts continue to improve. This week, the earnings forecast ratio of companies with downside revisions versus upside revisions improved to -21.2% (versus -28.4% last week) as analysts raised estimates for 442 companies (340 last week) while cutting them for 760 companies (766 last week) for a net negative of 318 companies (426 last week) in the S&P1500. Two weeks ago the ratio was -32.1% according to Bespoke. 

But Bespoke put true earnings performance in perspective this week.

“Make no mistake however, just because companies have been beating forecasts doesn’t mean that earnings are good. In terms of actual earnings, the S&P500 is on pace to show a 32.5% year-over-year decline in earnings.” As we saw for the broader market until discontinued by the Wall Street Journal, earnings for the roughly 4000 companies dropped a lot more than that.

Unfortunately, Bespoke only presented data going back 18 months so no significant conclusions can be drawn but improving earnings forecasts are positive, that is as long as they continue.

Economic Reports

It was a slightly busier week for economic reports that included more useable data. On Tuesday we learned that as of February, home prices were still falling but also got some potentially good news – price declines showed the first real sign of slowing according to the latest Case-Shiller home price index. On a year-over-year basis as of January, home prices for the 20-city composite index dropped 19.01% from January 2008. That rate dropped to 18.64% in February marking the first time since prices began to drop in January 2007 that prices were dropping more slowly than the month before.

The bad news is that home prices are still falling rapidly with the average paired home sale price down 30.7% since prices peaked in July 2006! Even if the rate at which prices are dropping continues to lessen, it will still take a year or more for prices to stop declining altogether.

As well, the latest report from Realtytrac showed that foreclosures continued to climb and were up 24% in Q1-09 versus Q1-08. The group reported a total of 803,489 default notices, auction sale notices and bank repossessions in the quarter which was a 9% increase from the previous quarter. The data also showed that foreclosure activity was increasing – there were 341,180 foreclosures in March 2009, a 17% increase from February and a 46% increase from March 2008. 

Barely visible is the tip in January 2009 and slight decline in February as home prices registered the first decline in the rate at which they were dropping. Data by S&P Case-Shiller.

Then on Wednesday we learned that Q1-09 GDP was worse than expected at -6.1% but slightly better than Q4-08 (-6.3%). Areas of the economy hardest hit last quarter were government purchases, housing and fixed business investment. Meanwhile, consumer spending gained 2.2% following a 4.3% drop in Q4-08. On a year-over-year basis, GDP contracted 2.6% from Q1-08.

Finally, the Institute of Supply Management manufacturing index moved up to 40.1 in April versus 36.3 in March as the manufacturing sector has shown slow but steady increases over the last four months. We’ll find out Tuesday if the service sector has enjoyed a similar lift.

Synopsis

A 20-month rally history…

It is interesting to compare the current March 6 rally to the previous seven rallies since the market peaked in October 2007.  

There are a number of similarities between the latest one and the rally that began almost exactly a year before on March 10, 2008. Prices moved higher for 49 days before rolling over and the rally experienced a period of 8 trading days without putting in a new high. This compares to 7 trading days in the current rally. But there are differences as well, perhaps the biggest being difference between the current rally and the prior seven is the percent change – this rally has moved the S&P500 up 29.7% so far versus the next best performance of 24.2% for the November 20, 2008 to January 6, 2009 rally.

Only time will tell if this latest rally turns out to be just another bear market rally or the beginning of a new sustainable bull. But as we have said before, the current rally has not been accompanied by expanding volume and that should also concern the bulls. Be sure to read William Hester's Trading Volume Separates Bull Markets from Bear Rallies in Suggested Reading below. 

Elliott Wave S&P500 Perspective

As we said last week, a rally above 880 would point to several extensions to the upside and may indeed mean a strong bull has taken over. In the meantime however, we are still due for a correction given the current corrective patterns we see in the S&P500. The key ingredient missing in this rally is the lack of a primary Impulse pattern – instead the upmoves have been achieved through a series of corrective moves which indicate that this rally has, so far at least, been moving counter to the primary trend. Perhaps just as important is volume. As RN Elliott discussed in his first book, The Wave Principle (1938) a good way of differentiating Impulse from Corrective waves are the differences in volume. Impulse waves in both bull and bear markets are accompanied by strong and expanding volume while Corrective waves show declining volume which as been clearly evident in this rally. 

As the next chart shows, another Ending Diagonal (ED) began March 30 which has at least short-term bearish implications (see magenta rectangle). And the severity of the correction will tell much about the underlying strength of this rally – a shallow correction will be bullish while a deeper one could signal that this rally is running out of steam.

But no matter which way you slice it, the move since March 6 can’t be an Impulsive move because Wave 2 was a triangle and Impulses do not have triangles in their second waves – Zigzags are they only five-wave patterns in which this can occur.  To complete the current Ending Diagonal, Wave 4 (down) will have to finish at or near the upward sloping lower trendline and be followed by Wave 5 up. After that, prices should drop into the rectangle (range of 830-870) unless this count evolves into something else. 

Three-minute chart of the SPX showing the complex corrective wave pattern that has evolved following the completion of the initial Impulse wave from March 6. Chart provided courtesy of Refined Elliott Trader (RET) software produced by Elliottician.com Data by eSignal.com 

On the lighter side…

Here is our third installment of actual answers from a Grade 6 history test.

10. It was an age of great inventions and discoveries. Gutenberg invented removable type and the Bible. Another important invention was the circulation of blood. Sir Walter Raleigh is a historical figure because he invented cigarettes and started smoking.

11. Sir Francis Drake circumsized the world with a 100-foot clipper.

12. The greatest writer of the Renaissance was William Shakespeare. He was born in the year 1564, supposedly on his birthday. He never made much money and is famous only because of his plays. He wrote tragedies, comedies, and hysterectomies, all in Islamic pentameter. Romeo and Juliet are an example of a heroic couple. Romeo's last wish was to be laid by Juliet.

13. Writing at the same time as Shakespeare was Miguel Cervantes. He wrote Donkey Hote. The next great author was John Milton. Milton wrote Paradise Lost. Then his wife died and he wrote Paradise Regained.

14. Delegates from the original 13 states formed the Contented Congress. Thomas Jefferson, a Virgin, and Benjamin Franklin were two singers of the Declaration of Independence. Franklin covered electricity by rubbing two cats backward and declared, "A horse divided against itself cannot stand." Franklin died in 1790 and is still dead.

Stay tuned for the final hilarious installment!

Stories of interest this week…

Trading Volume Separates Bull Markets from Bear Rallies

http://www.hussman.net/rsi/rallyvolume.htm  

World Bank Bonds Show What Happens in State Rescues

http://www.bloomberg.com/apps/news?pid=20601110&sid=au0tygvChAcM

Mortgage-Bond ‘Torture’ Carries Risk

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

London’s ‘Twin Pillars of Doom’ May Spark Hedge Fund Exodus

http://www.bloomberg.com/apps/news?pid=20601109&sid=aIjy4wLC4eJA&refer=exclusive

Fed Authorizes Five-Year TALF Loans for Commercial Real Estate

http://www.bloomberg.com/apps/news?pid=20601110&sid=a35lE8fRFhF4

Treasury Yields Reach Five-Month High as Fed Stands Pat

http://www.bloomberg.com/apps/news?pid=20601087&sid=aEqjv7jiauoc&refer=home

Home Prices in Major U.S. Cities Probably Fell at Slower Pace

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=af5zW9kN.2zo

Foreclosure Activity Increases 9 Percent in First Quarter

http://www.realtytrac.com//ContentManagement/PressRelease.aspx?channelid=9&ItemID=6180

Tax Evasion in Panama Becomes Roadblock to Trade Pact With U.S.

http://www.bloomberg.com/apps/news?pid=20601110&sid=aOjRYA47d8ms

Wine Adds Five Years to Life, More Than Beer, Dutch Study Finds

http://www.bloomberg.com/apps/news?pid=20601124&sid=alUESRae.1tc&refer=home

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