| TSG Stock Market Letter September 21, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||
| Sunday, 23 September 2007 | |||||||||||||||||||||||||||||||
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TSG Market LetterWeek Ending September 21, 2007TradeSystemGuru.comTopics Discussed This Week: Chart TalkMaking sense of the monetary and market muddleThis week, lots happened and we have been busily working behind the scenes to chart what it all may mean. This week’s move to drop the Fed funds rate by 50 basis-points has received tons of media attention with analysts weighing in as either pro (the majority) or con. We will examine what the drop means to the overall economic picture so you can judge for yourself whether it was the right move. There is lots to cover so let’s get started. Housing bubble update from six miles upIt was a busy week for housing reports with the release of the National Association of Home Builders Housing Market Index (HMI – Chart 1), housing starts and housing permits (Chart 2). We thought it a good time to step back, see how the new data impacts the picture from 30,000 feet and update our Case-Shiller home price indices (Figure 1 and Chart 3). With foreclosures mounting each month and no end in sight, how bad will it get? According to HUD Secretary Alphonso Jackson, two million homeowners now face bankruptcy in the next few years. He says that if legislation introduced recently by the Bush Administration is passed, that should prevent approximately 25% of those now facing foreclosure from having to take that route. So the best case scenario is that at least 1.5 million homeowners face foreclosure – and that assumes home prices don't fall further and interest rates don’t rise. If either occurs, more homeowners will be motivated or forced to walk since they will owe more than their home is worth (thanks to the proliferation of no-money down mortgages and under the table cash payments that became popular which means that many homeowners have little or no money of their own invested). In assessing the long-term situation, Robert Shiller’s inflation adjusted home price index is very useful. Using data going back to 1890, the last index low of 109.6 occurred in 1997 following the last bubble high of 127.5 in 1989. As we see from Figure 1, thanks to the low interest rate policies of Alan Greenspan and company, real estate has done extremely well since 2000 supercharged by 50-year low interest rates which drove the index up to 202.8 in 2006 or 60% higher than it had ever been in the past after adjusting for inflation. It a nutshell it seems that the majority of economists now believe that more of what created the bubble in the first place will prevent the bubble from popping proving the wisdom of the age-old adage, hope springs eternal, holds especially true in the ivory towers of high finance today. When one takes a serious look at the chart, it becomes painfully obvious what we should expect next after experiencing the largest real estate price bubble in history. Research by highly-respected money manager Jeremy Grantham, who has studied the major financial bubbles throughout history, showed that in every case and without exception, prices following the bursting of each bubble reverted to their historic median or mean at a minimum. More commonly, prices fell well below the mean. Looking at Figure 1, a reversion to the long-term median price which is very close to the average price (purple dashed line) implies that prices have another 47% to fall! But even if home values only revert back to the last bubble high (a correction this mild has no historical precedent) still implies another further 37% drop in national home prices.
Figure 1 – It’s at times like now that one appreciates the work of such visionaries as Dr. Robert Shiller in his home price index (HPI) of inflation-adjusted real estate prices over the last two hundred years. Chart by Robert Shiller from his book Irrational Exuberance The dollar and the damage done… I’ve seen the needle and the damage done. Markets, over the last twenty odd years, have become addicted to good times and the Fed has been only too willing to comply. Let’s take a look at how historic Fed action combined with economic performance has impacted our portfolios and our buying power.
Figure 2 – The Dow Jones Industrial Average priced in gold. Not a pretty picture – the Dow is still down 60% from its 1999 high priced in gold. Chart by Metastock.com And what about the Dow in terms of oil prices?
Figure 3 – It looks even worse when we look the Dow Jones Industrial Average priced in crude. The investor buying the Dow in 1999 has seen his investment fall 80% versus the investor who bought and kept oil futures. Chart by Metastock.com Conclusion? U.S. stocks have been a poor refuge against the forces of inflation over the last seven years thanks to our habit of playing now and paying later. How have U.S. stocks performed when priced in euros?
Figure 4 – Similar picture for the S&P500 priced in euros which reflects how European investors have fared by investing in the SPX. As we see, they are still well down and have recovered less than half the losses from 2000 through 2002. Chart by Metastock.com Here is how the dollar has performed compared to some major world currencies.
Figure 5 – How are Americans doing in terms of the value of the dollar compared to some of their major trading partners? The greenback has lost 78%, 66%, 60%, 52% and 44% versus the Australian dollar, euro, Canadian dollar, Swiss franc and British pound respectively in the last six years. Chart by Metastock.com On average, our dollar is now worth less than half of what it was in 2001 compared to other major currencies. No matter which way you measure stock performance, U.S. indexes are still well off where they were in 2000 in real terms. But what can we expect going forward? Last time around…This weeks’ FFR drop put in perspectiveThe drop in the Fed funds rate (FFR) this week was the first significant drop in more than six years. Last time the Fed began cutting rates in earnest was in the first week of January 2001. Both the S&P500 and Nasdaq Composite had peaked in March 2000 but it wasn’t until 10 months later that the Fed began to drop the funds rate from 6.5% to 6%. Stocks responded by rallying with the S&P500 gaining more than 4% over the next three weeks. But then stocks resumed their free fall, losing nearly 50% over the next 22-months and even with rates being cut by nearly two-thirds to 1.5%, stocks continued their fall. We now know that the drop to 1% in 2003 was far too generous and was responsible in a large part to the bubbles that we struggle with today. But at the time, it seemed like a good idea.
Figure 6 – The last time the Fed began to seriously cut interest rates in the first week of 2001, it began with a 50 basis-point cut in the effective rate from 6.5% to 6%. Chart by Metastock.com Fast forward to today…But there are a number of differences between then and now. First, 2001 marked the end of a longest-running bull market and stock valuations had become unwieldy. The internet bubble had gotten out of control. Business models no longer mattered – stock price had become the ultimate raison d'être for corporate insiders and traders alike. Irrational exuberance reigned supreme. It was also a post-election year, one of the toughest for stocks since markets were created. No matter what the Fed did with rates, once started the correction would not be denied. This time around, stock valuations remain tame by comparison. Instead property prices have lost touch with reality. But falling property prices won’t necessarily drag stocks down. We are also in a pre-election year which has historically been the best for stocks. Between 1902 and 2006 the pre-election year has been responsible for more than 60% of all Dow gains over the period (see http://electionomics.com/bestyears/ ). There has not been a losing pre-election year in 68 years since the sombre days of the Great Depression! So statistically at least, chances of the stock drops we experienced the last time the Fed began to seriously cut rates are slim at least from an election cycle perspective.
Figure 7 – Bailout Ben and company cut the target Fed funds rate by 50 basis-points but the real or effective rate which had risen above the target rate to 5.33% the day before the September 18 surprise Fed announcement, fell below the new 4.75% target rate to 4.74% the day after it as the Fed resumed throwing money at the problem. Chart by Metastock.com The other big difference has been the manner and speed in which the Fed acted this time around. It moved aggressively and pre-emptively to cut both the discount and effective rates (see Chart 1 below) weeks before the Fed funds rate. But there are no free lunches. Ignoring real inflation and dropping rates will continue to hurt the dollar and thereby increases the risk that markets will drive real rates higher (watch the LIBOR see http://tradesystemguru.com/content/view/84/58/#Libor ). Rising rates would be nothing short of disastrous for beleaguered mortgagors and consumers. Here is what happened in the markets this week.
Fed plays to the crowd and the quadruple witchThe financial world held its breath on Monday and then on Tuesday it happened. To the relief of the majority of money managers, investors, brokers and economists, Bernanke gave them what they all desperately wanted – the 50 basis-point Fed funds rate cut. Stocks took off with the Dow soaring 335.97 points for its biggest daily percentage gain in four years. As we see from the table above however, that represented the lion’s share of weekly gains. Homebuilders and mortgage lenders were some of the largest beneficiaries of the cut this week as the Philadelphia Housing Index ($HGX) jumped 5.9% on Tuesday. But it quickly gave back most of the gains Wednesday and Thursday as smart traders used the opportunity to dump shares on the rise. Even after the jump, the $HGX is still down 44% from its June 2005 high. And if the Fed decision didn’t add enough turmoil, it was quadruple witching week as a pile of futures, stock and bond options expired this week causing traders to reshuffle holdings for Q4. During witching weeks, longer-term forces driving markets are lost in the pandemonium of this reshuffling. Technically SpeakingLast week we discussed that the average effective Fed funds rate (EFFR) was 5.26% for July and dropped to 5.02% in August but the daily EFFR then jumped to 5.33% on the eve of the Fed target rate announcement. But the reality is that the Fed had already dropped the rate before the announcement – the average effective Fed funds rate between August 1 and September 17 was just 5.04%. Even after the target rate was dropped to 5 %, the Fed continued pumping cash into the cracks, dropping the effective rate another 24 basis points below the target (see Chart 1). While the world awaited word from the Fed on Tuesday, those with a keen eye on the numbers watched the Fed continuing to pump cash at the problem.
Figure 8 –As we see from this chart, the effective funds rate hit 5.41% on August 9 just before more bad credit news erupted spurring the Fed to pump large amounts of cash into the market over the next two weeks – a habit that continues after the drop. Here is what the technicals are saying.
Market leaders take off again…Indexes performed well this week, but Dan Zanger’s composite of market leaders listed in his Wednesday newsletter did even better – nearly three times better with a weekly gain of 9% compared to 2% for the S&P Depository Receipts SPYDR (SPY), 2.8% for the Dow Jones Industrial Average (DJX) and 2.7% for the Nadaq Composite (IXIC). Dan remains still bullish and opting for long trades only. His leaders this week consisted of 13 stocks including past bullish favorites Baidu.com (BIDU), Dryships (DRYS), Oil Holders (OIH), National Oilwell (NOV), Apple (AAPL), Transocean Inc. (RIG), MasterCard (MA), Google (GOOG), Wynn Resorts (WYNN) as well as Schlumberger (SLB), Freeport (FCX) and Southern Copper (PCU). This bodes well for the market going forward.
Figure 9 – Weekly performance of Zanger’s market leaders compared to the SPY (proxy for the S&P500), the Dow Jones Industrial Average (DJX) and Nasdaq Composite (IXIC). Data courtesy of The Zanger Report, performance chart courtesy of VectorVest.com. Trading volumes remained surprisingly low this week (just below average) considering that it was quadruple witching. As we have said over the last two weeks, not much has changed regarding the technical outlook for the Dow Industrials, S&P500, NYSE still engaged in bullish catapult or ‘W’ patterns except that stocks got a powerful boost from the Fed. And after surging to a multi-year high August 17 the Market Volatility Index (VIX) settled down further this week to 19 versus 24.92 last week. This indicates that fear continues to come out of the market and is positive for stocks. Not surprisingly commodities surged again this week to well above the 2-standard deviation (2 sigma) trend channel top-line and far beyond 50-day moving average as the NYFE CRB Index closed at 442.91, up from 428.54 last week and 413.49 three weeks ago. But this also means that the chances of a pull-back have increased since the CRB is extremely overbought. Gold also had another good week as the yellow metal surged to $732 up from $711.00 last week and $675.80 three weeks ago. It jumped from $719 after the Fed dropped the Fed funds rate 50 basis points on Tuesday. And no surprise that the dollar again got hit after Bernanke’s 50 basis-point Fed funds rate drop. For the first time in 15 years two weeks ago, the U.S. Dollar Index fell below significant support at 80. It fell further this week to 78.48 and also hit a new all-time low against the euro. Still mired in a downtrend that began in 2002 and there are still no indications either technical or fundamental (with the possible exception of a volume capitulation spike as trading hit a new all time high last week) that this trend will reverse soon. Pushed higher by a falling dollar, NYMEX crude oil (continuous) again surged this week closing at $81.62 up from $78.09/bbl last week. And more than doubling the weekly performances of the Dow and S&P500, the MSCI Emerging Market Index ETF (EEM) gained nearly 6% as it ended the week at 145, up from 137.17 last week as the smart money sought refuge in other currencies and markets. It now has strong support between 133.75 and 135. EarningsA total of 4121 companies have now reported Q2 earnings (up from 4092 last week) and earnings improvement dropped back to 12% from 13% last week. This compares to an 8% improvement for Q1-07 versus the same quarter the year before. Economic ReportsHere’s what the charts had to say this week. Same old story for homebuilders Chart 1 – The National Association of Home Builders housing market index (HMI) hit yet another low of 20 in September – the lowest reading since January 1991 when the market was in recession. It was the seventh consecutive monthly decline in this leading indicator and shows that builders continue to grow more pessimistic about the current and the future state of their industry. Separately, the NAHB condo index fell to 18 – the lowest level since that index was created five years ago. Home builders are surveyed on three different aspects of the new home market: current single family home sales, sales expectations for the next six months and prospective buyer traffic through show homes. Two out of three categories declined in September – sales expectations for the next six months registered a five-point drop to 26 while the index measuring the traffic of prospective buyers held steady at 16. The index measuring current single-family home sales fell two points to 20. All four regions in the country fell in September with the West registering the largest decline – from 22 in July to 18 in August according to the National Association of Home Builders. Starts and permits confirm builders’ pessimism
Chart 2 – Meanwhile, housing permits and starts registered further declines in August. As reported in the financial news, starts (the more widely followed metric) fell 2.6% but less widely followed even though they leads starts, housing permits fell nearly 6%. On a year-over-year basis, permits are down 19.6% and starts down 19.1% from August 2006. As we see from the chart, there are no signs of any levelling in this trend as both permits and starts continue their rapid descend down the slippery slope following the peak of the new home market two years ago. Looking at the bigger picture, permits are now down more than 42% and starts more than 38% from their September 2005 peaks. It is interesting to note the new home market, which led existing homes by twelve months in correcting, has now reverted below mean or median historic levels and looks like it is far from over. We will see what this means for general housing prices in our next chart. Home prices experienced an unprecedented rise from 2000 to 2006 powered in large part by Alan Greenspan’s easy money policies that created the only global real estate market bubble in history (not to mention bubbles in many other areas). This means that if history is any guide (and it always is) we should expect the biggest correction ever.
Chart 3 – John Mauldin included this Conference Board chart in his weekly e-letter from Dennis Gartman showing historic housing starts with recession periods (gray). He noted that recessions have accompanied periods when starts dropped below 1 million. As we see, sub 1-million periods occurred during recessions with one exception – 1966 but that was the beginning of an ugly bear market that was to last another 12 years through three recessions. It is also interesting to note that starts remained well above 1-million in two recessions – 1960 and 2001. In July, housing starts hit a 10-year low and in August starts hit a 14-year low of 1.33 million and permits, which lead starts, were 1.3 million. At the current rate of decline (~20% per year), the 1-million threshold for permits will be breached in roughly 18 months with starts not far behind.
Chart 4 – Not given as much coverage in the media as the National Association of Realtors (NAR) and Office of Housing Enterprise Oversights’ (OFHEO) median home price data, the S&P Case-Shiller 20 city composite home price index (HPI) fell again in June (the latest data available). As the market is learning the hard way, this index is far more accurate for a number of reasons – the most important of which is that median prices are now being buoyed by the tendency in a falling market for higher-end property sales and prices to lag since the luxury market is generally the last segment of the market to roll-over. This characteristic has the effect of skewing median prices upwards and thereby giving those who follow it (including Ben Bernanke) a false sense of security. This skew is further exacerbated by generous incentives being offered by both builders and home sellers fighting each other to sell to a shrinking number of buyers. Since the Case-Shiller HPI only tracks repeat or paired sales, it is less prone to this major weakness in median price tracking. On a year-over-year basis the HPI is now down 3.5% from June 2006 and the Chicago Mercantile Exchange Housing Composite futures (Nov 2008) are projecting that home prices will fall by that time 9.3% from where they were in June 2007. As we see in the lower chart in Chart 3, there is still no sign of slowing in the rate of change in home price declines. If prices only revert to the mean (or median) price in this chart since 1987 shown by the purple dashed line in this chart prices still have another 58% to fall! It provides valuable insight into why the Fed and government have such a strong incentive to inflate their way out of this problem. Unfortunately the last time this was tried under the reign of the “Bubble King,” it solved one problem by creating an even larger one. Inflation tamed? – Yeah right…
Chart 5 – We don’t normally publish this chart but thought it worthwhile this week. Team Fed no doubt used the seemingly tame CPI data in August (0.1% drop) to further justify a 50 basis-point drop in the Fed funds rate. Traders in the crowd however have learned that this and other Fed inflation indicators have been in effect “reverse engineered” to justify a course of action that ignores real inflationary pressure, especially when elections loom. Ditto for the index of leading economic indicators (LEI), which shows inflationary pressure near a four year low. Meanwhile, with commodity prices soaring, gold at a 30-year high, the dollar hitting historic lows and home prices higher than they have ever been after adjusting for inflation, which inflation indicators are you going to believe? Next WeekIt’s a much anticipated week for economic reports, especially Tuesday. Here are the ones we’ll be watching. · Tuesday, August existing home sales (previous -0.2%).· Wednesday, August durable goods orders (previous 6.0%).· Thursday, Q2-07 final GDP (previous: +4.0%, August new home sales (previous 2.8%).· Friday, August personal income (revious 0.5%), August personal spending (previous 0.4%), September Chicago PMI (previous 53.8), August construction spending (previous -0.4%).SynopsisDeath Takes a HolidayBased on a 1934 screenplay written by Maxwell Anderson, the film Death Takes a Holiday made that same year is a phantasmic fantasy in which Death takes on the human form of Prince Sirki, played by Frederic March, and comes to earth to escort the aged Duke Lambert to the netherworld. But in the process, Prince Sirki (Death) becomes fascinated by the people he meets, especially by the beautiful Grazia (played by Evelyn Venable) because she is the only person who is unafraid of him. Sirki falls in love with Grazia but in the process neglects his macabre duties. Wars rage, accidents continue but no one and nothing dies – victims suffer and flowers wither as if in suspended painful purgatory. The duke, who recognizes Sirki for who he really is, begs him to resume his tasks but Death is torn between his responsibilities and the love he feels. If this sounds familiar to those who didn’t see the original film, the 1998 remake Meet Joe Black starring Brad Pitt and Anthony Hopkins did an admirable job sticking to the plot while putting it in a modern context. What does this have to do with stocks and the current fate of the dollar? The last recession (2001-02) was the first in history in which private debt actually increased. Like death, recessions serve a very useful purpose. They remove the excesses and inefficiencies that build up through the good times like the mineral deposits in a water pipe. Economies are like pipes, if these excesses (including excess debt) are not removed (through bankruptcy and foreclosure) they choke the economic engine so that it no longer functions properly. Like death, recessions are a painful but necessary part of the economic cycle allowing the proper demand-supply relationships to return so that markets can operate unfettered once again. After the longest running bull market in history (1982-2000) there should have been a more severe recession. But thanks to the easy money policies of the Fed in dropping interest rates to 50-year lows, much of the pain was avoided. Yes, stocks did correct but the correction was short-lived. But while stocks corrected, the real estate and other assets including commodities began a new bull market. However, there was a price to pay for this monetary manipulation. It spawned a new string of bubbles that rage today – the most obvious is the real estate bubble if Figure 1 is any guide and has decimated the purchasing power of the greenback. And in its most recent action, the Fed has shown that it is again pulling out all the stops to avoid a meltdown even if it is at the expense of the dollar. As we see from the charts, the price we have so far paid is high. The value of our dollar has been cut in half since 2001. Energy, food and shelter costs have skyrocketed no matter what personal consumption expenditures and the consumer price index are saying. Real stock returns have also been significantly impacted. And now at least 2 million homeowners and possibly a lot more face losing their homes. Excesses were not removed during the last recession; they were simply transferred from one asset class to a number of others. Death has been on holiday for the last five years but one day, he will resume his necessary economic duties. But now instead of just stocks, a broad range of asset classes will feel his blade. There will come a time when this outcome will be unavoidable. Just look at Japan. Interest rates there have remained at or near zero for years yet they still struggle with economic malaise and moribund markets. We face a ‘good news – bad news’ situation. When the Fed gives with one hand, it takes with the other. Each time more cash is pumped in to address liquidity problems, the dollar is worth less. At what point do the foreigners who now finance the lion’s share of our debt get tired of taking our depreciating IOUs? When that time comes, look for interest rates to climb closer to the real rate of inflation. While no one knows for sure when it will come one thing is certain. The longer we put off the inevitable, the more severe the eventual outcome will be. ------------------------------------------------------------------------------------------------------ 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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