TSG Stock Market Letter

Week Ending July 31, 2009

Topics Discussed This Week:

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Best month for Dow since 2002 & look at the big picture

Earnings still stuck as PEs rise

More good housing news…

Faltering Treasury demand – should we be concerned?

Positive economic signs but GDP gives mixed signal…

Bullish S&P500 pattern….

This week

2009

Last 12-months

Since October 2007 peak

Quote of the week

“It is amazing that anyone would go long an equity market with a reported P/E multiple of 700x but that is indeed what we have on our hands. The end of the recession and the onset of a sustainable recovery, as we saw in 2002, are not the same thing. So this could still end badly but we will await confirmation signs that this is more than a very flashy bear market rally before shifting gears.”    ― David Rosenberg, Chief Economist Gluskin, Sheff in a note to clients July 31                                              

Best month for Dow since 2002

This week we took a step back to see where we have come in 2009 and in the last twelve months for the six major indexes we track. It has been a good week and month for the indexes and the best month for the Dow since 2002 according to Bloomberg. As the above tables show, 2009 has been kinder to some indexes than others.

What jumps out is the much stronger performances since the beginning of 2009 for the Nasdaq Composite (+25.46%) and the Emerging Market exchange traded fund (EEM) (+43.29%) compared to +4.5% for the Dow Industrials.

Market at a Glance

Instead of describing what happened in various markets each week, we have put them in a table. In the last column, the trend is marked in green if positive for the market, red if negative and black if neutral.

* 52-Week High / Low

†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.

Here is a continuation of David Rosenberg’s quote from his July 31 note to clients.

“The bullish news is how three-quarters of S&P 500 companies are beating their earnings estimates and doing so by an average of 9%.  Of course, these estimates were low-balled to begin with and the fact of the matter is that profits are down 31% from their already recession-depressed levels of a year ago. Cost-cutting remains intense as non-financial revenues have declined 15% on a YoY basis.”

This week, earnings for the 8,013 US stocks of the VectorVest Composite Index (VVC) held steady again at an average $0.16/share from $0.13/share four weeks ago.  Rising stock prices again lifted the VVC average PE again to 132.32 from 130.97 last week, 125.4 two weeks ago and 118.42 three weeks ago. Earnings growth, which tells us how fast earnings are appreciating, remained stuck on the floor again at 1% this week, the lowest growth rate in at least 15 years. On the positive side, the VVC remained well above the 50-week moving average (purple line in next chart).

June 5, 2009 proved the all-time high water market for average PEs at 155.58 for the VVC Index with average earnings of $0.13/share.  

These recent all-time highs compare to the previous peak PE of 60.51 in mid-May 2003 during the last recovery. But the difference is that during that period, earnings growth remained much healthier at 8% and earnings had begun improving nearly a year prior after hitting a low of 3%. Looking back to the price peaks in March 2000, average PEs were 32 and earnings growth was 11%. 

Figure 1 – Chart showing weekly prices, average Price/Earnings ratios (blue), earnings per share (black) and earnings growth (GRT in red) for 8,013 US stocks tracked by VectorVest showing the average PE for the broad range of publicly trading companies. The purple line is the 50-week moving average (MA). Chart courtesy of VectorVest.com

Meanwhile average earnings for the 2,978 stocks in the Canadian Toronto Stock Exchange (TSX) tracked by VectorVest Canadian Index (VVC/CA) remained stubbornly negative again at -$0.01 up from -$0.03/share four weeks ago and earnings growth was steady at 3% down from 4% during the week of July 10.  

Earnings for the VVC/CA peaked at an average $0.73 per share in September 2005 after which they steadily declined. By the week of March 6, 2009 they had fallen to $0.16/share and on June 12 to -$0.02/share during a period in which the TSX exchange index rose more than 40%. Although prices continue to rally, earnings have yet to respond.  

Economic Reports

More positive housing news…

Last week, we learned that June existing home sales improved 3.6% to an annual sales rate of 4.89 million, which is very near the sales rate a year ago. This week, two housing reports confirmed that sales are in fact improving, although prices have not.

First thing Monday, we learned that June new home sales jumped an impressive 11% to 563,000 from May which was a double-whammy – it helped drop the time to sell home to an average of 8.8 months from 10.2 months in May. However, home prices continue to show weakness with the average new home selling for $206,200 in June down 6% from May and 12% from June 2008.  

On Tuesday we learned that the Case-Shiller home price index which tracked paired home sales in 20 major cities in the US, reported that on average home prices rose month-to-month in May for the first such increase since July 2006. Home prices are still falling year-over-year at nearly 17% but the annual rate is down from its peak of 19.45% in January. Since January, the rate at which home prices are falling year-over-year, has steadily declined (green arrow). From their peak, home prices are still down 32.3% but it appears that the worst declines may be over, at least for the next while. Fifteen of the 20 metropolitan areas tracked reported month-over-month price increases with the largest occurring in Cleveland with a 4.1% jump. Prices fell fastest in Las Vegas with a monthly decline in May of 2.6%. Phoenix reported the largest yearly decline with prices off 34.2% with Las Vegas second with a decline of 32% from May 2008.

Treasury demand falters, should we be worried?

We have an update to US Treasury International Capital Flows which we discussed 2 weeks ago. Auctions for both the 2 and 5-year Treasuries this week were described as “very weak” by Bloomberg. The cover ratio for the 5 –year were just 1.92 and the 2.689% yield was 5.5 basis points above expectations but perhaps more concerning is the fact that indirect buyers which include foreign central banks dropped to 37% versus 63% in June.

But then on Thursday, there was “surprisingly strong” demand for 7-year Treasuries despite another record auction size of $28 billion. The cover ratio was a respectable 2.63 driving yields lower with indirect bidders taking 63% of the notes. What this shows is that Treasury demand appears to be somewhat fickle and investors, especially the all-important indirect group can turn their backs on auctions at a moment’s notice. Weakness at a time when Treasury needs to sell significantly more bonds than ever before has bullish implications for interest rates, something that the economy can least afford in a fragile recovery.   We will continue to track Treasury auctions for more signs of falling interest from indirect buyers.

Positive economic signs but GDP gives mixed signal…

On Friday we got two pieces of economic news, both positive at first blush. First, US GDP showed a narrower than expected loss in the preliminary estimate of Q2-09 economic growth number at -1.0%, much improved from the downwardly revised final of -6.4% for Q1-09. However, the strength occurred in a narrowing of the trade gap (due to weaker consumer spending) and a 5.6% jump in government spending (due to continued stimulus programs), both of which have negative implications for a sustained economic recovery if they continue. 

What was not widely discussed in the media is that downward revisions show the recession has so far been deeper and more protracted that previously indicated. The previous estimate for Q1-09 was -5.5% which was downgraded nearly 100 basis-points to the most recent estimate of -6.4% in a trend of downward revisions that has occurred sinceQ2-07. As David Rosenberg pointed out, this is the first time we have had a full-year of economic contraction (and an annual GDP drop of 3.9%) since the Great Depression – a reality made all the more stark by the fact that government GDP statistics have been heavily modified over the last three decades to make them look better than they really are. This is also the most serious period of consumer retrenchment since 1980 as consumer spending fell 1.2% versus a drop of 0.6% in Q1.

Here is a comparison between the annual original GDP growth as it was calculated pre-1982 (in red) and the current official GDP with the changes post 1982 by the Reagan and subsequent administrations to make it look more “attractive” (in yellow). As we see from the chart, the current recession actually began in Q4-2004 after only three quarters of real positive growth. Q2-09 official GDP registered an annual decline of 3.9%. It is important to point out that it is not credible to compare economic performance in the 1980s and today using official GDP because it is not the same calculation. As we see above, the original GDP shows the economy is now suffering a more serious annual drop of 5.93% (a 50% greater decline than the official GDP) which is significantly worse than any contraction since WW II.     

                                    Link – ShadowStats.com

 The Chicago Purchasing Managers Index registered a 3.5 point rise in July to 43.4, the highest reading since last September as confidence continued to grow in the mid-west business sector. This indicator provides an advanced insight into the national Institute of Supply management reports (manufacturing and service) due out a week later.

 SYNOPSIS

Bullish S&P500 pattern….

                                           ―Weekly chart of the S&P500 courtesy of www.genesisFT.com

A month ago, we pointed out a bearish head & shoulders chart pattern on the S&P500 and some of the other indexes. As we learned a week later, these patterns were invalidated when the market took off to the upside. Now, we are seeing an inverse bullish head & shoulders chart pattern that although rough, fits the classical definition of the pattern with one caveat.

In a bullish reversal, the volume should be well above average when the pattern breaks through the neckline and heads higher but that is clearly not happening as the chart below shows. As we see from the green arrows in the next chart, volume was strong when the index first hit the neckline and subsequent albeit brief rally, then again off the March 6 bottom but this week’s move through the blue neckline was anything but convincing from both a volume and price action standpoint.

We have discussed in the past that to have any chance of lasting, a rally must be accompanied by strong volume that shows investors entering the market in increasing numbers. That has yet to happen.

Elliott Wave Perspective

This week, we shift back to the S&P500 Index. As we see from the 1-hour chart, the highest probability Elliott Wave pattern remains a Double Zigzag with highest probability target between 1120 and 1150. However, the next highest probable pattern shows a retracement to between 920 and 960 on the SPX before the index moves to above 1000.

On the lighter side…

More market definitions…

STOCK SPLIT — When your ex-wife and her lawyer split your assets equally between themselves.

FINANCIAL PLANNER — A guy whose phone has been disconnected.

Stories of interest this week…

House Votes to Add $2 Billion to ‘Cash for Clunkers’

http://www.bloomberg.com/apps/news?pid=20601087&sid=aZQsGa9XbZGY

Chinese bubble fears as funds flow into IPOs

http://www.ft.com/cms/s/0/26b99f12-7c6c-11de-a7bf-00144feabdc0.html

I've been an optimist on China. But I'm starting to worry

http://www.ft.com/cms/s/0/42d38b2c-7bd6-11de-9772-00144feabdc0.html?nclick_check=1

Real Yields Highest Since 1994 Aid Record Debt Sales

http://www.bloomberg.com/apps/news?pid=20601087&sid=awNyge.080yI

European Consumer Prices Fall Most in 13 Years

http://www.bloomberg.com/apps/news?pid=20601068&sid=a46.Gr5RgP94

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