| TSG Weekly Market Watch August 31, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||
| Sunday, 02 September 2007 | |||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending August 31, 2007TradeSystemGuru.comTopics Discussed This Week:
Election primer = the most powerful market cycle?One topic has become a perennial favorite of The Stock Trader’s Almanac and it's a topic we have discussed before. But given the time of year, we thought it high time to do an in depth recap and update. Perhaps the most powerful short-term cycle, the Presidential or Election Cycle describes the economic impact that governments exert in their efforts to get re-elected. Whether Republican or Democrat, governments have found very inventive and effective ways of putting voters in the best possible mood to get re-elected over the last century or more. While the exact ways in which governments do this is not clear, the effect on stocks is undeniable (see Figure 1). Best Years Figure 1 – Results calculated in Metastock.com To determine exactly how this has impacted the Dow, we designed a trading system in Metastock that bought on the closing day of the first trading day of each period and sold at the close of the last trading day. Our pre-election period was determined by buying following the low of the worst month in the mid-term year (September) and selling following the best month of the election year (November) which was 26 months later. The post-election period was the remaining 22-months of the four-year cycle. Our timeline was 1902 through 2006. Just how powerful is it? If the hypothetical pre-election cycle trader had purchased the Dow two years before each election and sold 26-months later in December he would have capture 93% of the gains over the 104-year period. This compares to a gain of just 7% for the trader who bought in January of the post-election year and sold 22-months later at the end of September of the mid-term year. That works out to a ratio of 93:7 or more than 13:1.
Figure 2 - Results were even more skewed for the Toronto TSX Exchange in Canada. Results calculated by Metastock.com And this phenomenon isn’t limited to American markets. Results were even more skewed for the Canadian Toronto Stock Exchange Index (TSX). Buying the TSX two years before each U.S. election and selling in December of the election year would have yielded 97% of total TSX gains versus just 3% for the two-post election years between 1950 (the inception of the TSX) and 2006. Why? Since the TSX is a resource-based index and since government juicing of the economy is inflationary, commodities have performed very well in the two years leading up to each election. But the similarity doesn’t stop there. In testing a number of international markets, we found that the U.S. election cycle impacted nearly every stock and commodity market from Syndey to Bombay.
Figure 3 - Best years to be in the market. Percentage of total Dow returns over the period for each of the four election years. Results calculated in Metastock.com Best Quarters Figure 4 – Net Dow points gained (and lost) in the best (and worst) quarters between 1902 and 2006. Results calculated in Metastock.com And the best single year to be in the Dow? By only being invested the year before each election, the hypothetical trader would have captured a cool 60% of the total Dow gains. There hasn't been a losing pre-election year since the closing days of the Great Depression in 1939. This was followed by a distant 17% for those only invested in the election year. The worst year was the mid-term year which accounted for just 4% of Dow gains over the period. Next, we looked at the best quarters to be in the Dow. Not surprisingly, the best was Q2 of the pre-election year followed by Q4 in the mid-term year, which incidentally followed the worst quarter to be in the market. Best Months Figure 5 – Comparison of best and worst months in all years versus pre-election years. Results calculated in Metastock.com What about the best months to be in the Dow? Here we broke our periods down to all-years versus just pre-election years. While September has typically been the worst month followed by August, June and February in all-years, pre-election years are different in that September is the only negative month of the year. This time around…As far as pre-election years go, 2007 has so far not lived up to expectations and it has been anything but typical. First, it has already had three losing months and the year is just two-thirds over. But this may be good news. The type of major melts that normally occur in September happened in July and August this year.  Figure 6 – Unlike most pre-election years, 2007 has already had three losing months (August was basically flat) and the year is just eight months old. Results calculated in Metastock.com What does it mean? Unless there is more really bad news regarding the mortgage mess, odds are that the worst of it is behind us. November, December and January are usually the best three months to be in the market in all years. They are also pretty good months to be invested during pre-election years as well and given that 2007 has already experienced three down months, there is a good chance that the best three months will come early this year. Whether the election cycle and the best period to be invested is something that interests you or not, our results make it difficult to argue with one glaring fact. Betting against the government in its effort to get back into the White House is a very bad idea. Being ignorant of this reality can be nearly as damaging. This year has been different for a number of reasons and this will most likely continue. We are nearing the end of the business cycle and if the sub-prime melt is any indication, a number of bubbles percolating around the globe are beginning to unravel. Expect markets to continue to be turbulent accompanied by a high degree of volatility. To make matters worse, a growing number of respected economists and analysts are warning of an impending recession. While the worst of 2007 may well be behind us and with some powerful months ahead, caution is key going forward. There could be some good money still to be made but there are now an increased number of potential ticking timebombs as well. Unless you are a seasoned trader or have access to one, cash could well be the best place to be until the outlook is more promising as we head into the next election. Here is what happened in the markets this week.
Recovery gathers steamAfter strong performances last week, markets took a bit of a breather this week as they awaited word from Benevolent Ben on his intentions regarding the Fed funds rate. His words on Friday were carefully chosen but one thing is clear. Mr. Benranke isn’t ready to give away the plot in his next play just yet. Stocks have advanced but remain well off their July 13 highs but market leaders continued to surge higher so the prognosis for higher prices from here remains positive. Technically SpeakingThe global plunge protection team continued to provide liquidity to markets this week, and that kept them from correcting more strongly. Here is what the technicals are saying. Market Leaders Continue HigherLast week Zanger’s composite of stocks in his Wednesday newsletter led the market with a drop of less than 1% after recovering from a nearly 15% deficit two weeks ago. This week, Dan’s weekly portfolio as of August 29 is again outperforming the market, with a gain of 6.17% in the last month (to August 31) compared to a monthly gain for the S&P Depository Receipts SPYDR (SPY), Dow Jones Industrial Average (DJX) and Nadaq Composite (IXIC) of 1.28%, 1.11% and 1.97% respectively. Dan is again on the hunt for longs – for a second week there were no potential shorts in the mix. His portfolio this week consisted of 10 stocks including past bullish favorites Garmin (GRMN), Baidu.com (BIDU), Crocs Inc (CROX), and Apple (AAPL), Dryships (DRYS) and Oil Holders (OIH) as well as perennial favorites Research in Motion (RIMM) and Google (GOOG). Figure 7 – Market leaders are again outperforming the major indexes including the SPY (proxy for the S&P500), the Dow Jones Industrial Average (DJX) and Nasdaq Composite (IXIC) to the upside which is bullish for the overall market. Data courtesy of The Zanger Report, performance chart courtesy of VectorVest.com. As well as a surge in market leaders, huge volume days two weeks ago bode well for further upside in stocks since they represent capitulation. Such events often mark both termporary and longer-term bottoms. Volumes have since been light, too light except for the fact that it is the last two weeks of the summer and a last opportunity for the smart money managers and traders to take some R&R at the Hamptons. This means that the next two weeks will be pivotal. Upon their return to markets, we will need to see them buying in volume to guarantee that this hobbled rally continues. The Dow Jones Industrial Average, S&P500 and NYSE Index share one trait in common and that is a bullish ‘W’ or catapualt pattern that also often marks market bottoms. This is another bullish sign. A bottom is further supported by the Market Volatility Index (VIX) which surged to another high of 30.67 last week but that has settled down since to close at 23.38 on Friday signalling for a second week more fear has come out of the markets. Commodities also surged this week but remain below both the 2-standard deviation trend channel midline and 50-day moving average as the NYFE CRB Index closed at 413.49 up from 408.65 last week and 403.72 two weeks ago. Gold had a good week as the yellow metal closed at $675.80, up from $671.40 last week and $667.10 two weeks ago. As the market awaited a final decision from the Fed on the funds rates, anticipation for a lower rate did not bode well for the dollar. The U.S. Dollar Index closed at 80.79 on Friday, up marginally from 80.61 last week. However, the dollar is still mired in a strong downtrend that began in 2002 with little end in sight. On a short-term basis, the dollar is also flashing a bearish flag pattern and remains below both its 50 and 200-day moving averages. Meanwhile, NYMEX crude oil (continuous) surged higher this week as another tropical storm threatened the Gulf of Mexico pushing the commodity to close at $74.04/bbl up from $71.09 last week. Emerging markets continued to move higher this week as the MSCI Emerging Market Index ETF (EEM) ended the week at 133.95 up from 127.95 last week. But the index is in a resistance band between 133.75 and 135 so it will be interesting to see if this resistance level is broken and the index moves higher in the coming days. EarningsAs we head into the final stretch of earnings reports and with 3990 companies having reported Q2 earnings (up from 3937 companies last week), earnings improvement dropped slightly to 12% from 13% last week. This compares to an 8% improvement for Q1-07 compared to the same quarter the year before. Economic ReportsHere’s what the charts had to say this week. Existing home sales fall as inventories bulge Chart 1 – Sales of new homes increased 2.8% in July but existing home sales dropped 0.2% in July from the month before according to the National Association of Realtors. July sales were 9% lower than July 2006. But inventories were the real story here as the supply of unsold existing homes bulged 5.1% in July to a 10-month supply – the largest supply of homes since the depths of the last housing recession in October 1991. Surprisingly, the pro-industry group said the median price of an existing home dropped just 0.6% over the last year. Meanwhile, the more reliable S&P Case-Shiller housing price index showed a drop of 3.2% for the second quarter compared to the same quarter a year ago – the worst quarterly decline in the history of the index which started in 1987. Chart 2a – Chart showing monthly changes to the inventory of unsold existing homes across the country over the last year. There are no signs of a levelling in the trend. It is clear that inventories continue to grow and as supplies expand pressure to reduce prices increases. Chart 2b – Here is a longer-term view showing monthly existing home inventories on an annualized basis. No sign of any reduction or levelling trend here either according to data from the National Association of Realtors. Chart 3 – The second preliminary estimate for GDP growth in Q2 climbed to 4% from 3.4% for the strongest growth since Q1-06 thanks to higher business spending and overseas sales. Consumer spending which accounts for 70% of GDP grew 1.4% but it is down considerably from the high of 3.7% in Q1 according to the Wall Street Journal. Even more interesting perhaps is that residential fixed investment, including spending on housing, fell 11.6% in Q2 which was bigger than the previous drop of 9.3%. An annual quarterly drop in excess of 10% generally precedes recessions according to Hugh Moore of Guerite Advisors and is therefore an important metric to watch. And this is not the first time the RFI has registered an annual drop of more than 10%... But more about that in our synopsis. Chart 4 – This chart of personal income and spending is saying that both are basically flat over the last two years according to the trendlines of both. Not all that interesting except that while both have dropped modestly over the last two years, income appears to be falling faster in line with a slowing economy but spending has held up reasonably well. What is surprising is that the sub-prime maelstrom has yet to have a measurable impact on the ability of consumers to borrow for spending.
Chart 5 – We stopped including the University of Michigan’s consumer sentiment and the Conference Board consumer confidence indices a few months ago since they are indicators of essential the same metric, the emotional status of the consumer. But as you see, they are still heading in opposite directions – the Confidence Board index shows consumer confidence increasing while the U.Michigan data shows a slow steady decline in sentiment. The U. Mich indicator is certainly more in-line with other economic data. One has to seriously question government sanctioned or quasi-government economic indicators, especially given that we are heading into an election and governments have a bad habit of putting a positive spin on the data in an effort to get re-elected. Next WeekHere are the economic reports we’ll be watching in this upcoming holiday-shortened week. - Tuesday, July construction spending (previous -0.3%), August ISM Manufacturing Business Index (previous 53.8).- Wednesday, August Challenger layoffs (previous -23.0%), July pending home sales (previous +5.0%).- Friday, August nonfarm payrolls (previous 92,000), August unemployment rate (previous 4.6%).SynopsisWrapping up…First let’s sum up the shorter-term perspective. While this week was positive, there remains one potential fly in the ointment and that is the lack of commitment as evidenced by the light volume. But there are more signs that the bottom two weeks ago was in fact a bottom of sorts. Looking at the bigger picture however, the outlook is a little more muddled. Over the last month markets have reeled from fallout that may well represent the first serious hole in the Greenspan bubble. Hissing from real estate bubble evidenced by surging inventories, falling prices and rising foreclosures is growing louder. Merger and acquistions have also dropped off as has the carry trade. That is not to say that they won’t resume again, which appeared to be the case this week with the carry trade as the yen gave way to high-yielding currencies like the New Zealand and Australian dollars. But the first holes are showing. Chart 6 – Chart of the Guerite Indicator going back to 1960 showing when their indicator flashed red and recessions (cyan bands). Chart courtesy of GueriteAdvisors.com Other troubling signs include calls from respected economists like Merrill’s David Rosenberg who now puts the chances of recession at 65%, up from 25% a few short months ago. As evidence he points to consistently falling car sales, a slow but steady rise in the unemployment numbers (up 25 basis points) and slowing economy. The next discussion Rosenberg says will be whether it will be a mild or severe one. A number of other indicators have been flashing a recession warning for a while. First, the yield curve turned negative in June 2006. The Guerite Indicator has also been flashing high risk for the better part of a year (see Chart 6). This indicator has 12 moving parts and has provided accurate advanced warning of the last seven recessions. It is looking more and more likely that it will again prove accurate. In the final analysis even though we are in a pre-election year, if these indicators are right it will get progressively tougher for everyone to make money in markets going forward. Although we have already had some tough months this year and the worst may be behind us, we are also about to begin the first trading week in September which has been the worst month to be invested over the last century. Last Minute News…Just after our newsletter went out, we received an email from Hugh Moore of Guerite Advisors with their latest chart of residential fixed investment (RFI) to GDP.
Chart 7 - The latest chart of RFI to GDP from 1960 through 2007. Hugh's comments that accompanied the chart were very interesting. “The gist of the indicator is not so much a year over year drop, but rather an absolute drop from a peak. As you can see, (except for the “mini-recession” of 1967) each time the RFI to GDP has fallen by more than 10% from a peak, the economy has ended in recession. These peak-to-troughs have taken, on average, 28 months. “The mid-decade slowdowns of the 1980’s and 1990’s reduced RFI to GDP by less than 10% or, 5% and 8%, respectively. The recession of 2001 was an anomaly and clearly a “business recession” since consumers continued borrowing...and spending...and building houses right through that recession. “Nevertheless, neither of these are the case currently. RFI to GDP has fallen 23.4% from its peak in 4QTR05 and is showing no signs of bottoming, yet. (My guess is that we are about two-thirds of the way to the bottom, which would yield a peak-to-trough fall in RFI to GDP of about 35%+/- and a bottoming date sometime in mid-2008+/-.) Unless things are REALLY different this time, the economy will continue to weaken into a recession.” ------------------------------------------------------------------------------------------------------ If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be added). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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