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Week Ending March 30, 2007

o    Quarterly report card and seventh anniversary of index peaks.
o    Sub-prime mayhem spreading to million-dollar mortgagors.
o    Stocks challenged as Iran plays fools poker with British…
o    And oil rallies back above $66/bbl.
o    U.S. fires first shot in a potentially damaging trade tariff battle.

Last week we talked about naked shorting and the fact that $6 billion in trades fail in the U.S. daily because share certificates fail to get delivered. We will be coming back to that issue in the next couple of weeks but this week we will be looking back in markets examining the seventh anniversary of index peaks and what they mean today.

Figure 1 – Weekly chart of the S&P500 showing the pre-election and election years (between green dashed lines), the March 2000 high. The index is still more than 7% below its all-time high.  Chart by www.VectorVest.com

Nearly twelve years ago, on July 17, 1995 the Nasdaq Composite Index closed above the 1,000 mark for the first time ever. The S&P500 reached the same milestone on February 2, 1998 when the index closed at 1001.27. The next few years would be good for both with the Nasdaq jumping more than 400% over the next 56 months to hit a high of 5.132.52 (March 10, 2000) while the SPX added another 50% over the next two years hitting a high of 1,527.46 on March 24. By this point the Dow Industrials had already seen its best day recorded to that point, closing at 11,722.98 on January 14.

Figure 2 – Meanwhile this weekly chart of the Nasdaq Composite Index showing pre-election and election years (green dashed lines) is still more than 52% off its all-time high. Chart by www.VectorVest.com

Like, 2007, 1999 was a pre-election year which has historically outperformed the other years in the four-year election cycle by a wide margin. Election years are the next best year but 2000 failed to live up to expectation as both indexes lost ground. It would prove to be the start of a 2-year bear market that would see the Nasdaq lose nearly 80% of its value by October 2002 while the SPX was nearly cut in half.

But true to form, the next two years leading up the Presidential Election 2004 did not disappoint. March 2003 was the official beginning of a rally that lasted not only through the next two years but with one major hiccup, is still in play. 

There were large differences between the two previous pre-election periods. In 1999-2000, the market had been engaged in a bull market for 18 years that was capped off by an exuberant blow-off rally that pushed indexes into the stratosphere before they fell off a cliff. The next pre-election period coincided with the end of the recession and an ensuing economic recovery. But as we move into the latest pre-election period, the rally is getting long in the tooth. The economic recovery is also facing growing headwinds that include a mortgage bubble that promises to get worse before it gets better.

There is now growing evidence that unlike a hoped for soft housing landing, sub-prime and alt-A problems are the tip of an iceberg that will put a much wider group of homeowners than originally thought under increasing pressure. In spite of what industry cheerleaders with a vested interest in keeping optimism alive have been saying, the news just keeps getting worse.

According to a new report by the Center of Responsible Lending, 91% of sub-prime loans made nationwide since 1998 were used to refinance existing mortgages affecting 2.4 million Americans and they estimate that 1 million of them could lose their homes. According to the Mortgage Banker’s Association, lenders started foreclosure proceedings against more than one in 200 homeowners in 2006 and Florida, the nation’s real estate hotspot until recently, now leads the nation in foreclosures with California running a close second.

Contrary to what many analysts have regularly repeated, the problem is not limited to those with shaky credit histories buying lower priced homes. The article Mortgage crisis hits million-dollar homes highlights this problem. It should surprise no one that exotic no-money down and negative amortization mortgages with low introductory rates and terms also enticed the well-heeled to purchase their dream homes. Now folks with million-dollar plus mortgages, like their sub-prime brethren, are running into trouble paying new and often drastically higher payments.  Getting in over our heads became a national past-time and no one was immune.

Getting back to the main point, it’s no longer a matter of if but when this problem (and the many mortgage CDO portfolios held on Wall Street) begins to seriously impact stock prices. Based on history, government minions will do their level best to keep happy faces firmly glued on all they can influence and the consumer merrily spending as the election looms. And like just about every other pre-election period in history, these efforts have so far been successful.

So how long can stocks keep the drive alive in the face of the increasing powerful downdraft? In 2000, it began to peter out early in the election year. If the correction doesn’t come in the fourth quarter this year, it will be increasingly challenging to keep this balloon aloft even into mid-2008; that is unless Ben Bernanke makes good on this treat to throw money out of helicopters.

Now let’s check in on what happened in the stock market this week.

Summary

This marked the fifth week of manic market mood moves as the index light board has swung from one extreme to the other – this time back to red. Action was highlighted by growing tension in the Gulf when Iran kidnapped 14 British military personnel in the first move in a potentially dangerous chess game with the West.  That combined with oil prices back above $66 and some troubling economic numbers teamed up to push stock prices lower.

Technically Speaking

Not a lot has changed this week from last except that the Dow Jones Industrials Average, S&P500, Nasdaq Composite, NYSE Index and Russell 2000 some of which had broken their 50-day moving averages as they rallied higher for the most part have dropped below them. But all, with the possible exception of the Nasdaq, are still in up trends while the Dow Transports Average sits on trend line support. Another important gauge of market health, the Philadelphia Housing Index (HGX), has seriously broken down and struggled and failed this week to keeps its head above the 200-day moving average.

Commodities continued to trend higher this week as the NYFE CRB Index closed at 407.45 up from 405.34 and 399.02 two weeks ago.

After rallying for six consecutive days and then taking a breather, gold managed to close at $663.10 up from $657.30 last week and $653.90/oz two weeks ago. With growing protectionist pressure building on Capital Hill, gold should continue to be relatively strong as the dollar is put under double pressure of a contracting economy and a brewing US-Chinese trade battle (see Synopsis).

NYMEX crude oil jumped this week to close at $65.87 (continuous contract) after briefly cavorting above $66 from $62.28 last week and $58.33 two weeks ago. In the process it decisively broke through its resistance band at $62-$64.   

It was another challenging week for the greenback, especially following news Friday that the US would levy tariffs on some paper Chinese goods.  The U.S. Dollar Index closed at 82.66 down from 83 last week. 

Emerging markets held their ground for the most part this week as the MSCI Emerging Market Index ETF (EEM) settled to 116.50 from 117.03 last week.

After hitting a high of 20.41 on March 5, the Market Volatility Index (VIX) settled and then moved back up to 14.64 on Friday. Given the high readings combined with a extreme bearish sentiment of the options put-call ratio (normally a contrarian indicator), the chance of a bounce from here again cannot be discounted.

Earnings

We reported last week that with 3946 companies having reported for Q4-06 (up from 3793 companies the previous week), average earnings improvements over the same period last year was a respectable 34% from 29% two weeks ago.  Now that earning season is nearly over, earnings strength will add lift to the market at least until earnings shows signs of weakening.

Economic Reports

It was relatively week for economic reports this week. Here’s what the charts had to say.

Chart 1 – Following in the wake of a weaker than expected March NAHB housing market index reading, February new home sales also disappointed this week dropping 3.9% to the lowest number of sales in seven years versus an expected gain of 6.7%.

 

Chart 2 – Overall durable goods grew 2.5% in February but orders for nondefense capital goods excluding aircraft, an indicator of business investment, fell 1.2% for the fourth decline in five months. 

 

Chart 3 – After a drop of 0.8% in January, construction spending turned positive with a gain of 0.3% in February. 

Chart 4 – Final Q4-06 GDP moved up from 2.2% last estimate but was down from the first estimate of 3.5%. Annual growth for 2006 was 3.3% thanks to 5.6% growth in Q1. As the trendline shows however, GDP growth has steadily declined over the last two years. Even more concerning was the drop in productivity, a trend which began in the late 1990s when it peaked at an annual growth rate of 2.6% and has continued in spite of a recovery in the stock market hitting just 1.4% in Q4-06, the lowest level since the early 1990s. Finally, consumer spending grew 0.6% in February as the consumer showed their spunk in spite of the growing mortgage problems and slowing growth.

Next Week 

It’s another average week next week for economic reports with three key housing reports to watch.

-    Monday, March ISM manufacturing business index (previous 52.3).
-    Tuesday, Feb pending home sales (previous: -4.1
-    Wednesday, March Challenger layoffs (previous 33.4%) and February factory orders (previous -5.6%).
-    Friday, March non-farm payrolls (previous 97,000), March unemployment rate (previous 4.5%) and February consumer credit (previous $6.4B).

Synopsis

A risk we didn’t discuss in our introduction is the growing potential for a trade war. Certain politicians have been looking to ingratiate themselves with voters by using the Chinese as scapegoats. A bill that would have placed a 27.5% tariff on Chinese goods luckily never saw the light of legislative day but that hasn’t stopped them. Now the Bush Administration under growing Senate and House pressure has agreed to put tariffs on a small range of goods impacting just $224 million of China’s more than $200 billion in goods it exports to the U.S. annually. But with an election looming, Democrats (and some Republicans) will use every opportunity to enlarge this short list to gain the approval of their constituents at home.

Most of us are too young to remember what happened in the early 1930s when the Herbert Hoover government enacted the Smoot Hawley Act that also started innocently enough; that time to protect American farmers from a few European agricultural imports. But by the time it wound its way through an excited and vitriolic Congress, the Act included 20,000 dutiable items, turning the small-scale dispute into a full-blown trade war that caused a 66% decline in global trade. While it may not have been the initial cause of the Great Depression, the drop in trade was responsible for exacerbating an already grave economic situation that took a full decade and a second world war to finally heal.

Given the trend toward a weakening economy and the usual 6 to 12 month lag in employment impact, jobs losses will become an increasingly important issue and the calls for protection will grow louder. Could Smoot Hawley type legislation get passed again? The difference is that this time around, China has been acting as America’s banker and their tireless buying of U.S. Treasuries at any price and yield has been largely responsible for keeping borrowing rates low. Should this trend stop, it would put strong upward pressure on interest rates as Congress competed with the private and corporate sector for funds in its struggle to raise the $600 billion plus it needs annually to finance spending.

The last thing America needs right now, especially in the face of a growing perfect storm in the lending industry and cooling economy, is higher rates or a trade battle. China has already said that it is unhappy with this new course but no one yet knows what they will do about it. But if the fallout has only one-tenth the impact that Smoot Hawley had in 1930, lookout!

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All material presented herein is believed to be reliable but we cannot attest to its accuracy. All material represents the opinions of Matt Blackman. Opinions may change without notice and readers are urged to check with their investment counsellors before making any investment decisions. Matt Blackman may or may not be invested in any investments cited above.