TSG Weekly Stock Market Letter

Week Ending April 27, 2007

TradeSystemGuru.com

• Countdown to the great bust, but first Dow 26,000?
• Dow surges past psychological 13,000 resistance level.
• Dow Transports drops on rising oil prices.
• Existing home sales drop to four-year low.
• Leading industry performance report card 2003 – 2007.

Last time we looked at the Canadian Toronto Stock Exchange Index (TSX) and how it has reacted to U.S. government inflationary stoking of the economy leading into each election. This week we discuss another much longer cycle revealed in an interesting albeit highly controversial book that explains why economic booms and busts have occurred and what we can look forward to next.

Of bubbles, busts and PE ratios

The Great Bust Ahead by Dan Arnold is just 54 pages in length and it puts forward a supposition almost as simple as the title. In a nutshell, Arnold believes that booms and busts in the last century were driven by demographics – specifically by those in their maximum earning and spending years, the 45 – 54 year olds. When this group represents a large segment of the population like it is now and like it was in the roaring twenties and mid-sixties in the U.S. and late eighties in Japan (before their crash of 1990), economies and markets boom. The more gray-wavers there are, the greater the boom. Conversely, the fewer of them there are following it, the more severe the downturn. Arnold believes the next peak will be in 2013 after which a “rapid, relentless and catastrophic” fall will occur until 2025.

According to Arnold there are more than 100 million baby-boomers in America and they will start hitting retirement age in 2011 leading to what he believes will be “the greatest depression in U.S. and U.K. history – much worse than the Great Depression of the 1930s.” It seems too simple to be true. How can plain demographics explain complex economic relationships?
 
“I dismissed this initially as being too simple,” commented Louis Paquette in his April Emerging Growth Stocks newsletter. “Since then I can find no reason to why not to incorporate it into the game plan. I am not bothered by the fact that the author is a complete outsider from the financial sector. With an army of financial analysts and commentators out there, wouldn’t it be ironic if it took an outsider to find the answers.”

Simple as Arnold’s theory seems, it relies on one very powerful relationship and that is that of the consumer to the economy. U.S. consumer spending accounts for 71% of gross domestic product and so it follows that  where the consumer goes the economy and markets are sure to follow. If the biggest spending demographic does begin to decline in 2011, there is no doubt that it will have a sizeable impact.

 
Figure 1 – Chart from The Great Bust Ahead showing inflation-adjusted Dow Industrial performance (blue line) versus demographic profile of the gray-wavers (red histogram). The cyan line shows projected Dow performance based on this demographic cycle. Chart www.thegreatbustahead.com

The good news is that between now and then Arnold says the Dow will at least double to 26,000 with a maximum based on the demographic data of 32,000 as this rally continues. One caveat is that in 2003 he predicted a Dow at 13,000 by the end of 2004 (see Heading for a Meltdown link below) which didn’t occur until last week so he was nearly 2.5 years early, highlighting the challenges of market forecasting.

But Arnold’s past peaks and cycles are confirmed by work done by Yale economist and author of Irrational Exuberance, Dr. Robert Shiller. Dr. Shiller constructed historic price/earnings ratio charts but instead used trailing ten year earnings versus the usual trailing twelve months. He found this statistic to give him a more accurate representation of what was going on.

According to Shiller’s data, the first PE trough (not shown) was 1914 as World War I began. Figure 2 shows the next troughs at 1948 and 1984 approximately 35 years apart. This corresponds nicely with to the bottom of the economic cycles. This puts the next low at 2020, nine years after Arnold’s forecasted market peak that if true means that the bottom will come more quickly than in past cycle bottoms. Average time from peak to trough averaged 17 years over the last 100 years. If peak wavelengths in Shiller’s data remain relatively unchanged we can look forward to the next peak around 2035.

However, it Arnold’s hypothesis is correct and the Dow hits his minimum target of 26,000 by 2013, it means there will be another PE peak north of the 44 hit in 1999. If this happens, it will be the first time in history that PEs have re-accelerated to new highs without putting in years of below average reversion to the mean performance.  

 
Figure 2 – Chart of price/earnings data from Robert Shiller’s book Irrational Exuberance website showing PE peaks and troughs.

The other possibility is that another event may intercede before 2013 and we have already seen the best PE levels. As we see from a comparison of Figures 1 and 2, PE and demographic peak relationships while close are not lockstep. The Dow (and PEs) peaked in 1965-66 even as the demographic trend continued to advance before peaking in 1968. The Dow dropped nearly 30% from a high above 1000 in February 1966 to 740 later that year. Over the next eight years it was nearly cut in half to close at 570 in December 1974.  Also notice that even though the demographics in Figure 1 continued to decline to 1935, the Dow began to recover early, thank Arnold says to Roosevelt’s New Deal government programs that had a positive impact on earnings and spending.

It is interesting to note that while government intervention can have a positive impact, it can also have a negative one. There is evidence that the Smoot Hawley Act of 1930 was the cause of the stock market crash of 1929 according to Jude Wanniski who is credited with giving Arthur Laffer the idea for the famous Laffer Curve developed in 1974. The Smoot Hawley Act began as legislation designed to protect the American farmer from the effects of about 20 European agricultural imports. However, by the time it wound its way through an overly patriotic and vitriolic Congress, it levied duties against more than 20,000 imported goods from around the world starting a global trade war that resulted in a nearly 70% drop in trade over the next two years. In the process, it greatly exacerbated the economic impact of the crash and Great Depression that followed. To read how this could have initiated a crash that occurred nearly a year before the Act was passed into legislation read the link to Wanniski comments on Smoot Hawley impact in the 1929 crash below.

There is also evidence that misguided government legislation caused the 1987 crash. Here is how McGill University's Farad Saberi explained it on his website.

"Mark Mitchell and Jeffry Netter presented evidence in 1989 that the large decline in the U.S. market from October 14 through 16 was largely a rational reaction to an unanticipated tax proposal by the House Ways and Means Committee limiting the deductibility of interest expense on corporate debt, especially in takeovers. Between Tuesday, October 13, when the legislation was first introduced, and Friday, October 16, when the market closed for the weekend, stock prices fell more than 10 percent -- the largest 3-day drop in almost 50 years. In addition, those stocks that led the market downward were precisely those most affected by the legislation. This explanation certainly explains the temporal problem; why markets started to decline in mid-October. But why would a proposal concerning American markets affect prices in Australia and Hong Kong to a greater degree than in New York? Though a negative American reaction to proposed U.S. tax change might be rational to Mitchell and Netter, expecting us to believe that the remarkably negative response of non-U.S. markets to the same news event seems a stretch."

For the full discussion please see link below. Given the emotions currently riding roughshod through Capital Hill, could the Smoot Hawley type of legislation see the light of day again? What if the Democrats succeed in killing the Bush tax cuts? Given where markets are today, any legislative or geopolitical wrinkle could generate a strongly negative reaction.

Parabolic Peak Projection

In this week’s excellent e-letter entitled the Last Bear Standing, John Mauldin discussed comments by famed Wall Street money manager Jeremy Grantham who manages $150 billion (including some belonging to Dick Cheney). In his client newsletter, Grantham said that he now sees bubbles everywhere “from Indian antiquities to modern Chinese art from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it's bubble time!” In other words he sees a worldwide bubble affecting all asset classes.

But rather than an imminent melt, Grantham believes that the short but dramatic exponential phase of this bubble is yet to come. He has studied 28 bubbles with an average periodicity of 40 years and each takes a similar form – and in every case, price reverted back to the mean.

How high could the Dow go? In this newsletter, Mauldin mentions a number that surpasses even Arnold’s most optimistic number: Dow 36,000. All this of course assumes that there is no downturn in the meantime caused by myopic government meddling or some major and devastating geopolitical event.  

The point is that Arnold's theory has support from two of the best minds in America – one financial and one economic. It is further supported by the human psychological behavior when the emotions of fear and greed take over. The highs and lows that inevitably result defy the ability of even the most talented of the mere mortals who try to forecast them.

Wanniski comments on Smoot Hawley impact in the 1929 crash

 http://tinyurl.com/2kvhfn

Evidence that legislation was to blame for 1987 crash

http://tinyurl.com/24y8tx

See Dan Arnold’s 2003 article entitled Heading for a Meltdown

http://tinyurl.com/2be269   


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

Summary

With the exception of the Dow Transports, this was the fourth consecutive week of gains for the major indexes as the Dow moved above the psychological 13,000 level. Earnings also continued to improve this week with a few companies handily beating analyst estimates.

Technically Speaking

Stock momentum increased this week as the Dow hit breached 13,000. The NYSE Index, Russell 2000 S&P500 and Nasdaq Composite are at multi-year highs.   

The Philadelphia Housing Index (HGX) rally continued this week as the index closed at 232.53 up from 228.42 last week and 217.85 two weeks ago even as the housing industry news continued to deteriorate (see Economic Reports).

Commodities corrected this week as the NYFE CRB Index closed at 403.70 down from 405.32 last week.

Gold dropped in four out of five days this week, closing at $684.50 on Friday.

NYMEX crude oil (June07) closed Friday at $66.46 up from $64.11 last week.

Meanwhile the dollar continued to weaken as the U.S. Dollar Index closed at 81.35 from 81.64 last week. Next stop is the December 2004 low of 80.53 followed by the 1995 low of 80.05 then the 1992 low of 78.33. Below that is uncharted dollar territory. The dollar hit an all-time low against the euro on Friday. The euro rose again on Friday and is now up nearly 9% against the U.S. dollar in a year.

A weakening dollar continues to push the MSCI Emerging Market Index ETF (EEM) that represents a basket of foreign currencies higher as it closed at 123.26 up slightly from 123.16 last week. This shows that the Shanghai market drop last week has done little to shake global investor complacency.

Earnings

As of April 26, 1505 have reported (up from 770 last week) and average earnings versus the same quarter last year improved to 8% up from 4% last week and 2% two weeks ago. However with Q4-2006 improvements coming in at an impressive 33%, Q1-2007 earnings still have a lot of catching up to do. 

Economic Reports

Here’s what the charts had to say this week.

Chart 1 – March existing homes figures released this week showed a bigger than expected drop to -8.4% in sales. Existing homes dwarf new homes with 85% of total annual sales in the U.S. It was the biggest drop in four years. Last week we learned that the National Association of Home Builders housing market index dropped again in April to 33 the lowest level since December and March housing starts rose 0.8%.

 
Chart 2 – Meanwhile, March new homes sales came in better than expected this with a gain of 2.6% however, the February number was revised downward from -3.9% to -4.2%. Housing construction fell 17% on the quarter with little change expected going forward.

 
Chart 3 – Preliminary Q1-07 GDP also disappointed the street coming it at an anemic 1.3% versus the consensus 1.8%. It was a double whammy since one of the major inflation measures, the Personal Consumption Expenditures (PCE) deflator is now up 4% annually, well ahead of the Fed’s target of 1 – 2%. PCE rose by 3.4% in Q1-07 versus a decline of 1% in Q4-06 highlighting how rapidly inflation pressure has grown.

Next Week  

A busy week for economic reports next week. Here are the ones we’ll be watching.

-    Monday, March personal income (previous 0.6%), March personal spending (previous 0.6%), April Chicago PMI          (previous 61.7) and March construction spending (previous 0.3%).
-    Tuesday, March pending home sales (previous 0.7%), and the ISM Manufacturing Business Index (previous 50.9).
-    Wednesday, April Challenger layoffs (previous -41.7%) and March factory orders (previous1.0%).
-    Thursday, Q1-07 preliminary productivity (previous 1.6%).
-    Friday, April non-farm payrolls (previous 180,000) and April unemployment rate (previous 4.4%).

Synopsis

I did some searching this week for indications of where the current rally may be in the overall scheme of things. I was specifically looking for signs of parabolic rises that generally mark the final stage of a rally. As we see from chart 4, the top five industries over the last four years have done very well. Leading the pack was Home appliances. After gaining nearly 1900% to 2004, the industry dropped till 2006 when it got another shot in the arm. In an attempt to keep sales going electronics retailers have been offering no money down and no payments for a year borrowing no doubt from similar mortgage market strategies used to drum up more business but that ultimately got homebuyers into so much trouble.

However, if the top performer Home appliances was eliminated, there were indications of parabolic run-ups in industries two through six (the sixth not shown in Chart 4 was Chemical – fertilizers). For example, Steel – alloy gained roughly 350% from the beginning of 2003 to the start of 2006. Over the next 15 and a half months it was up more than two and a half times or 984%. Similar moves occurred in Food – meat products and Steel – basic.   

 
Chart 4 – Top five industries over the last four years with Home – appliances the volatile leader with a 4-year gain of 1555% followed by Steel – alloy (984%), Food – meat products (684%), Steel – basic (651%) and Machinery – construction/mining (354%). Chart by www.VectorVest.com

Certainly not convincing evidence that a parabolic blow-off has taken hold just yet.
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