TSG Stock Market Letter

Week Ending June 22, 2007

TradeSystemGuru.com

• More on the Morgan Stanley “full house sell signal.”
• A look at what some powerful technical indicators are saying.
• Even though bonds have bounced, stock investors still gun-shy.
• Housing market index hits another low.
• Best months to be in the market in pre-election years.

Given the volatility lately, this week we’ll take a look at some key market indicators to determine what they may be trying to tell us about the health of stocks going forward.

On June 6, Morgan Stanley made a big splash in the media when it issued a “full house sell signal” based on a basket of three leading indicators – bond yields, Institute for Supply Management new orders and a metric they call valuation and risk. This sell signal has only occurred five times since 1980 and equities have dropped an average 15% over the following six months.
 

Figure 1 – Chart showing a comparison of the S&P500 (red) with NYSE short-interest (gray). Provided by GaveKal.com

However, according to one analyst, cautious sentiment can negate the sell signal. As we see from Figure 3, sentiment was certainly not bullish but even though not perfect, the sell signal has so far been correct. The Dow hit an all-time high of 13, 690 on the day the call was made (June 6), a number which has yet to be topped. Was the Morgan Stanley call prophetic and is this the beginning of a major correction or are we just experiencing the normal malady that impacts markets at this time of the year known as the summer doldrums? 

On June 1 we discussed extreme short-interest levels on the NYSE (which hit a high not seen since 1931) and what that might mean for markets. In Figure 1, we see the historic relationship between the S&P500 Index (red line) and NYSE short-interest (grey histogram) showing the recent short-interest spike. O(ver the last decade short-interest highs generally occurred near lows in the S&P500 and have been a good historic contrarian indicator.

 Another heavily followed contrarian market indicator is the put/call ratio. Put options are purchased by investors who either believe the market will drop or who are hedging current long positions as insurance. Call options are purchased in hopes of profiting when a stock moves higher (or an insurance in short positions). As we see from Figure 2, the ratio of puts to calls has historically been highest following a major drop in the market and usually precedes a rally. The ratio hit a new high at the end of February 2007 following the last global market meltdown (which turned out to be a great time to buy).

Figure 2 – Chicago Board Options Exchange Put/Call ratio (blue) compared to the S&P500 Index. Provided by GaveKal.com

Bullish sentiment (Figure 3) is more bearish than bullish at present and since this is also a contrarian indicator, it also points to higher prices ahead. 

The final indicator is implied option volatility (Figure 4) which is telling us that volatility is increasing. This means that the tight trend bands that most major indexes have traded in over the last few years are widening. This doesn’t necessarily mean a reversal but that the market is transitioning from a trending to a trading range market (as often occurs during summer doldrum markets).

Figure 3 – Chart of the AA All Net Bullish Sentiment, another contrarian indicator. Note that when investors have been the most bearish has been the best time to buy the S&P500 and when they are most bullish is the time to sell. The current low levels would seem to suggest that the current stock correction is a minor one, if the last decade is any guide.  Provided by GaveKal.com

Figure 4 – Another characteristic of market over the last four years is the trend toward falling volatility as this chart shows. However, the market meltdowns in May 2006 and February 2007 have been accompanied by spikes in volatility suggesting that the low volatility trending markets are changing. Provided by GaveKal.com

Bond Signals

However, one important market is flashing a potential reversal signal and that is the bonds. In our June 8 newsletter , we discussed the stock meltdown that occurred thanks to actions by the European Central Bank and the Reserve Bank of New Zealand to raise rates due to higher inflation pressure. New Zealand has the second highest interest rates of the Western world behind Iceland and mortgage rates have risen to 10% and above. But the flow of hot money thanks to the carry trade (global investors borrow money in Japan at rates as low as 0.25% to invest in high interest rate jurisdictions like Iceland and New Zealand) has been spurring inflation putting pressure on central banks to raise rates. The problem is that this has created a self-fuelling problem – hot international money flows into high interest rate nations, which in turn raise rates to cool their economies, which in turn attracts more capital… The side effect of the second highest rates in the industrialized world has been to lift the New Zealand dollar (kiwi) to a 22-year high which over the short-term decreases the cost of imported goods and further contributes to domestic inflation. 

Figure 5 – Updated 30-year T-Bond chart showing June 6 breach in long-term trendline compared to the last two breaches. T-Bonds have now been below trend for 2-1/2 weeks compared to a 4-1/2 week breach in December-January 2000 and a one-day breach in October 1987. Chart by GenesisFT.com   

Unlike in the past however, the international interest rate hikes triggered a major sell off in bonds in the U.S., helping to drive yields higher. This widened the gap between two and ten year yields to 0.09%, which was the largest in a year as the yield curve moved from inverted to flat. The rate hikes were also good for the U.S. dollar and triggered a flight to safety as currency investors sought the refuge of the greenback.

But the bad news is that the trend to higher rates will put added pressure on U.S. borrowers already struggling with high mortgage and credit card debt as well as take the shine off stocks. Last Friday, the interest rate for a 30-year fixed mortgage was 6.65%, up from 6.35% in May according to the Wall Street Journal, which while below the average rate of 8.2% through the 1990s, when combined with a bank prime rate now sitting at 8.25% makes it increasingly more difficult for buyers to qualify for loans. Recent hikes combined with the a tightening by lenders in the wake of the sub-prime meltdown has prompted a growing number of economists re-evaluate their earlier assumptions of a soft landing and quick recovery in home prices. 

Another factor contributing to higher rates was revealed in data released last week showing that for the first time since October 2005, China had become a net seller of U.S. Treasuries in April as it unloading roughly $5.8 billion according to GaveKal. May and June data will confirm whether this is the start of a trend or a limited event. The move follows the declaration China made a few months ago that it was diversifying into higher risk and non-OECD (Organization for Economic Cooperation and Development) investments.  Falling demand from Asian central banks will push rates higher on longer-term U.S. rates.    

However, one thing is clear. This recent string of events has spooked investors if the 185 point Dow drop on Friday is any indication. It was the fifth daily 100+ point drop for the Dow this month, the most in a month since May 2006.

The good news is that after peaking June 6, longer-term bond yields have been trending lower. Only time will tell if this is but temporary relief or that higher rates are now behind us but a falling dollar is not only inflationary exerting further upward pressure on rates, it will decrease the attractiveness of U.S. bonds and stocks to foreigners making matters even worse.

Finally, unless you have been holidaying in deepest Africa or the Australian Outback for the last couple of months, you’ve probably have heard Jeremy Grantham’s famous quote about the state of the global economy, “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!” We found a link to the article at http://tinyurl.com/278nvb#bubble  For those who’d like to read Jeremy’s Q1-2007 newsletter in which the article appeared or any of his past newsletters, they are available free by registering at http://www.gmo.com   

Now let’s check in on what happened in stock markets over the last two weeks. 

One Week Performance to June 22

Two Week Performance

Summary

Last week it was green across the board for the major indexes but not so this week. The net result is that over the last two weeks, the market was mostly lower after Friday’s Dow drop 185 points. Even though it dropped 1.4% this week, only the Nasdaq Composite closed higher than it did two weeks ago.

Technically Speaking

With the recent series of down days some interesting chart patterns have shown up. After surging to an all-time high in early June, a correction and another rally, the Dow Industrial Average has put in a double top with a neckline at 13,270. A 90 point Dow drop would confirm the bearish pattern. Such a break would also fracture the up trendline from March. Friday also marked the third break in the DJIA 50-day moving average in the last three weeks. A similar double top pattern exists for the S&P500 with neckline at 1490 except that the index closed right on its 50-day moving average.  Of the majors, only the Nasdaq Composite and NYSE Indexes closed above their 50-day moving averages this week.  

Although commodities rallied last week, this was a tough week for the the NYFE CRB Index as it dropped from 417.94 to close at 408.41 Friday up from 403.93 June 8.  

Rising rates have taken their toll on gold. After hitting a high of $678 June 5, the metal has been in a downtrend and closed at $657.10 on Friday.

While the second week in June was initally good for the greenback thanks to the flight to quality, this was a tough week for the dollar. After closing at 82.58 last Friday, the U.S. Dollar Index dropped to close at 82.11 this week.  

To make matters worse for stocks, NYMEX crude oil (continuous) surged to close at $69.14 this week.  

But as U.S. stocks struggled, emerging markets remained amazingly strong in the face of rising yields and this is bullish for global stock markets. The MSCI Emerging Market Index ETF (EEM) looks to be in the process of putting in a bullish flag pattern closing at 131.44 on Friday up from 126.10 two weeks ago.   

Earnings

With a total of 4194 companies (up from 4084 two weeks ago) having reported earnings for Q1-2007, the improvement versus the same quarter last year dropped to 8% from 9%.

Economic Reports

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

Chart 1 – Retails sales (including autos) jumped the most in almost a year as the May number beat estimates. As we see from this chart ex-autos, food and retail sales jumped 1.3% in May, which is the largest jump since July 2006. In the process, the two-year trend tilted from negative which it has been since February 2006, to flat showing that consumer spending has remained robust.

Chart 2 – Import prices registered a 0.9% increase in May again thanks to strong consumer demand.       

Chart 3 – But it was another kick in the pants for the housing bulls on Monday this week as the May National Association of Home Builders Housing Market Index dropped to a new 16-year low of 28. A reading below 50 is bearish which is where the index has been now for 13 months. In all, 409 builders were surveyed and the three components came in as follows: single family home sales fell to 29 from 31, prospective buyer traffic dropped to 21 from 22 and sales expectations six month out dropped from 41 to 39. One glimmer of good news was that the inventories of new homes that hit a record high of 8.1 months supply in April dropped to 6.5 months in May. But with the benchmark 30-year mortgage rate climbed to an average 6.74% recently up from 6.16% two months ago and the number of homeowners facing foreclosure hit an all-time high for Q1-07 according to a report last week from the Mortgage Banker’s Association. Foreclosure filings jumped a whopping 90% in May from a year earlier according to RealtyTrac and the toll of sub-prime lender failures rose from approximately 30 last month to at least 50 recently. Regionally, the NAHB index declined in the West, Midwest and South, while it rose in the Northeast. New and existing home sales figures are released next week and they come following a report from the National Association of Realtors that existing home inventories have risen 25% in the last to an 8.4 month supply at current sales rates, double that for 2004 and 2005. 

Chart 4 – Chart comparing housing permits to housing starts showing that both are now back down at 1997 levels (seasonally adjusted). Both have fallen off a cliff since August 2006 but in May, permits rose 3% thanks to stronger demand for apartment buildings for the commercial market while housing starts dropped 2.1%. As we see on the chart, starts are much more volatile than permits and while the latter peaked in September 2005, starts didn’t peak until January 2006 but rapidly dropped over the next year. May permits (privately-owned housing units) are down 22% and starts down 24% since May 2006 according to the Census Bureau.

Next Week 

Here are the economic reports we’ll be watching. 

-         Monday, May existing home sales (previous -2.6%).

-         Tuesday, May new home sales (previous 16.2%).

-         Wednesday, May durable goods orders (previous 0.8%).

-         Thursday, 1Q-2007 GDP final (previous 0.6%).

-         Friday, May personal income (previous -0.1%), May personal spending (pevious 0.5%), June Chicago PMI (previous -61.7), June U. Mich Consumer Sentiment Index, May construction spending (previous 0.1%).

Synopsis

On June 8 we discussed the best months to be in the market in all years. But as this is a pre-election year and very different from the other years in the cycle, we ran some tests on the Dow Jones Industrial Average between 1902 and 2006 to determine the differences in monthly performance in all years compared to pre-election years. What we found was interesting. 

Chart 5 – A comparison between monthly performance in all 104 years between 1902 and 2006 versus the 25 pre-election years that occurred over the period. 

In all years, November was the best month followed by April, December and October. By only being invested during the best four months of the year the investor would have captured 145% of the Dow’s annual gains.  September was by far the worst month to be in the Dow losing 46% or nearly 4 times as many points as the next runner up loser – August.

In comparison, April was the best performing month in pre-elections years, followed by December, March and June. November was relegated to number seven. 

But individual performance for the winning months was also reduced in pre-election years. Returns for the best four pre-election months totaled 84.5%. But loses were also more muted with September losing about one-third as much as it did in all years. It was also the only losing month during pre-election years. 

As we discussed on June 8, June has not been a good month to be invested in all years losing an average 9%. But as we see from this research, this isn’t true in pre-election years where June gained an average 11%. 

Given the lackluster performance in June so far, does this mean that July and August will also perform below average? Will September be worse than average or will the worst have already come and gone by then? Stay tuned!
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