| TSG Weekly Market Watch October 12, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||
| Sunday, 14 October 2007 | |||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending October 12, 2007TradeSystemGuru.comTopics Discussed This Week:
Rally returns after Thursday spook…It was back to a bad news, good action week for the most part as investors chose to look at the data through rose-colored glasses. That the Dow rallied 120 points after the release of the Federal Open Market Committee minutes on Tuesday that gave little if any guidance going forward and instead cautioned on credit market and economic risks ahead, is a case in point. But then along came Thursday, and the market rallied into new territory but then something happened. A sobering “most read” article in the Wall Street Journal that day entitled “Data Show Bad Loans Permeate U.S.” (see link at end of newsletter) combined with the fact that JP Morgan cut its quarterly revenue estimate and downgraded Chinese internet high-flyer Baidu.com (BIDU) didn’t help. By the end of the day BIDU had fallen 10% dragging down other tech plays such as Apple, Amazon and Google and cutting the Nasdaq 39 points and the Dow 64 points. On Friday, the bulls returned using the opportunity to pick up stocks at a discount and the Dow rallied 78 points while the beaten down Nasdaq bounced back 33.5 points. Technically SpeakingMarket leaders bob and weave their way higherIn a definite déjà vu of last week’s action, Dan Zanger’s composite of 10 market leaders listed in his Wednesday newsletter took a hit Thursday dropping from a gain of 5% to just over 1%, then recovered nicely on Friday for a weekly gain of nearly 4% compared to barely positive for the S&P500 and Dow Industrials and 1% for the Nasdaq Composite. This group included past picks Research in Motion (RIMM), Apple (AAPL), Baidu.com (BIDU), Wynn Resorts (WYNN) as well as First Solar (FSLR), Las Vegas Sands (LVS) plus miners Southern Copper (PCU) and Freeport-McMoran Copper & Gold (FCX). But Thursday’s big drop showed that while the high fliers have been streaking through the stratosphere, they have further to fall when panic strikes.
Figure 1 – Weekly performance of Zanger’s market leaders compared to the S&P500 (SPX), the Dow Jones Industrial Average (DJX) and Nasdaq Composite (IXIC). Data courtesy of The Zanger Report, performance chart courtesy of VectorVest.com . We got a question last week about how the composite of Dan Zanger’s market leading stocks is computed. First, the term “market leaders” is ours not his based on my observations over the last two years that stocks he is watching tend to lead the market. The composite is computed in VectorVest by charting the performance of the watchlist of stocks he covers every Wednesday for the week. The idea is to provide insight into whether these stocks are leading higher. When they break down and stay down its time for caution. I have found that when these stocks falter, the broader market isn’t far behind. Figure 2 shows how the stocks he covered on July 25 (picked at random) have done over the last 2 ½ months through the melt. They broke down harder than the rest of the market but they also recovered more quickly as well. Simply buying all seven stocks he discussed July 25 (of which NOV, RIMM, APPL, and BIDU were in his newsletter this week) the following day and without employing any stops, money management or margin and not including commissions, would have returned the hypothetical trader 35% as of Friday’s close. It is important to point out that we do not recommend stocks and are just using this composite as a proxy of overall market strength.
Figure 2 – In this chart from July 26 though October 12, we see how the composite of stocks from Dan Zanger’s July 25 newsletter has performed compared to the major indexes. After taking a 13.4% hit from August 8 – 16, they have gained 35%. As mentioned last week, trading volumes have been below average since the third week in August and NYSE volumes fell again for the fourth consecutive week and were up only modestly for the Nasdaq. But although the Dow Industrials remains above its upper 2-standard deviation trend channel, it underperformed the other major indexes with the exception of the Dow Jones Transports Average (DJT). That brings up an interesting technical point. Dow Theory states that for a trend to be confirmed, both the Dow Transports and Dow Industrials must be trending in the same direction. Although the Industrials have recovered all the territory lost since the July melt, the Transports have struggled. This week the Transports lost ground while the Industrials ended slightly higher. Until they both are heading in the same direction, the trend is in question. And after falling since September 14, the Market Volatility Index (VIX) jumped this week to 17.73 from 16.91 last week as volatility (and fear) crept back into the market. But both stock and currency traders have shown an ability to recover fast if stock performance and the resumption of the carry trade (traders sell low yield currencies like the Japanese yen to purchase instruments in high yielding countries like the New Zealand dollar) are any indication. After falling last week, commodities recovered this week as the NYFE CRB Index closed at 446.44 up from 442.73 last week and its back to its upper 2-standard deviation (2 sigma) trend channel. Gold continued to surge higher as it closed at $753.80/oz up from $747.4/oz. last week. And after its dead-cat bounce last week the U.S. Dollar Index dropped again to close at 78.16 down from 78.24 last week but still above its an all-time low of 77.63 in late September. However, there are still no technical or fundamental signs yet that the current downtrend is set to reverse anytime soon and volumes have remained subdued. NYMEX crude oil (continuous) surged again this week to close at $82.74, up from $80.62/bbl last week. And for its eighth consecutive week, the MSCI Emerging Market Index ETF (EEM) continued to power higher and remains well above its 2 standard-deviation upper trend channel line putting it in extremely overbought territory. The index ended the week at 159.50 up from 157.07 last week. The 3-month London Interbank Offered Rate held steady at 5.22% this week 48 basis-points above the Fed funds target rate. The US bank prime rate was 7.75% and the 30-year Freddie Mac mortgage yield was 6.26%. As the LIBOR is used in computing mortgage rates and has not fallen in the wake of the Fed funds rate cut, mortgage borrowers have yet to see any benefit from the drop in the way of lower rates. EarningsThere were no new Q3-07 earnings improvement data published this week by the Wall Street Journal. Last week a total of 384 companies had reported, and improvements over the same quarter averaged 9% compared to a final 13% improvement in Q2-07. Chart 1 presents a longer-term earnings improvement trend to Q2-07.
Chart 1 – Chart of annual change in earnings improvements from more than 4000 companies published by the Wall Street Journal showing final 13% improvement in Q2-07 up from 9% in Q1. However, the trend still shows a steep decline. Economic Reports Here’s what the charts had to say this week. One benefit of falling dollar emerges
Chart 2 – One advantage of a declining dollar is that imports become more expensive while your exports become cheaper. The net result is to push the trade deficit lower which is what has happened over the last three months. However, the fact that the China’s trade surplus surged to $23.9 billion, a 56% increase in September from a year ago, will stick in the craw of trade protectionist politicians and shows that the falling dollar isn’t curbing Chinese imports into the U.S. much at all. Chinese exports totaled $112.48 in September, up 23% from September 2006 according to the Wall Street Journal.
Chart 3 – Meanwhile, import prices continued to decline in September with another 0.4% cut which may indicate that exporters are eating the declines in the dollar to maintain sales rather than increase prices in an increasingly price sensitive market. But it also shows that demand for imported goods is dropping. Retail sales for the month of September registered a bigger than expected increase of 0.6% showing that while the demand for imported goods has been falling, consumers are ignoring the sub-prime problems and continuing to borrow to spend as evidenced by a surge in car buying which offset declines in housing-related sales. But fourth quarter highlighted by the all important retail spending number may be a different story especially as the number of mortgage resets climbs. In a separate report, food and retail sales (ex-autos) rose 0.4% but the chart shows a steady decline over the last two years. Next WeekIt’s a busier week for economic reports. Here are the reports we’ll be watching with important ones emboldened.
SynopsisReactive, not proactive Fed…On Monday and Tuesday, the market waited for the latest Federal Market Open Committee minutes from the Fed ivory tower for any hint of its interest rate intentions. What we got instead was a rather banal justification for the 50 basis-point drop on September 18. But other than expressing the already painfully obvious – a concern of more credit market turmoil and its effect on the economy – there was little to provide guidance of what to expect from the Fed going forward. What is becoming clear is that Mr. Bernanke has been guilty of a number of errors in judgment. He failed to see the housing meltdown coming for a number of reasons. They include a mistaken reliance on median home price data showing that prices remained stable well after we had credible data to the contrary, a lack of understanding of how ballooning inventories would impact prices, a failure to grasp the importance housing played and the effect declining new home sales would have. He also completely discounted the importance of mortgage equity withdrawals (MEWs) on consumer spending. Even the great Bubble King, Allan Greenspan warned publicly of the importance MEWs had come to play in maintaining the status quo. But Bernanke threw such caution to the wind and like most on Wall Street, was caught like a deer in the headlights by the housing melt and subsequent credit crunch. As a result, he now finds himself in reaction mode, trying to play catch-up with his latest discount and Fed funds rate cuts. It seems clear from the latest FOMC minutes, that he and Team Fed are in full reaction mode and either have no plan or are keeping it to themselves. Unfortunately, the dollar is taking the fall. These latest Fed actions constitute a dramatic and unexpected paradigm shift from fighting inflation (as evidenced by seventeen consecutive rate hikes) to fretting about the health of the economy. By his actions and comments, Mr. Bernanke has shown that he is squarely in the middle of the crowd instead of leading it. Failure to recognize significant warning signals of trouble ahead then reactively cutting both the discount and Fed funds rate 50 basis-points is troubling. Some have lauded his quick response but his reactions also indicate a worrying case of econometric myopia. These swift cuts and Fed liquidity pumping conger haunting memories of his callous remarks about why deflationary concerns are groundless as long as there are printing presses and helicopters from which to throw money. If Mr. Bernanke thinks his latest actions will solve our problems, I wonder if he’s had a chance to learn from the experiences of Michael Blumenthal, G. William Miller and Paul Volker? They were the Fed Chairs in the latter years of the Carter Administration – a period plagued first by runaway inflation then stagflation. Miller had been appointed by Jimmy Carter in 1978 to replace Michael Blumenthal after the latter was dismissed. Barely a year after his appointment, Miller was replaced by Paul Volker in what was one of the shortest Fed Chair tenures on record. Messrs. Blumenthal and Miller had both tried to control inflation by cranking up the Fed funds rate from 4.6% in 1977 to more than 10% in 1978 but to no avail. After taking over the Fed helm in 1979, Paul Volker subsequently pushed the FFR to 17.6% in April 1980 but the US Dollar Index hit a multi-year low of 80 in July 1980. After dropping the FFR to 9% in July only to see stagflation re-ignite, Chairman Volker again cranked the rate to over 19% on two separate occasions in 1981 before finally taming the beast. Unfortunately, it came at a terrible cost in the way of a serious recession accompanied by a drop in housing prices of as much as 50% in some regions. It was also a period of abysmal stock market returns. After rising to nearly 1000 in 1966, the Dow did not significantly break that level until 1983. In short, an inability to control inflationary pressure led to dismal stock returns over a 17-year period. Factor inflation into the equation and you get real returns in negative territory. Between 1971 and 1980 alone, the Dow dropped more than 25% in dollar terms. Inflation had run out of control in the early 1970s only to be replaced by its evil twin, stagflation in the late 1970s, leaving Mr. Volker with little room to maneuver. In the final analysis his actions, while highly unpopular, proved necessary. The recession cleared out the excesses and inefficiencies that accumulated over the prior two decades – excesses and inefficiencies that had kept markets and the economy in a steady malaise until 1983. As we learned later this action helped clear the way for the longest running bull market and a period of unparalleled economic prosperity. We are again being told that inflation is under control, so much so that any efforts to rein it in have gone the way of the Dodo bird. But is it that simple? Surging commodity prices, the growing wave of labor discontent, rising wages and spiraling real costs in everything from art to corporate acquisitions would suggest otherwise. I wonder if Mr. Bernanke will have the stomach to “do the right thing” when the time comes knowing that it will cause howls of protest from politicians and the general populace alike? Or like his predecessor, will he take the easy but infinitely more costly way out? The price we paid for this last error in judgment by Mr. Greenspan is the bubbles that endure today and a dollar worth less than half of what it was five years ago. Although hard to believe, this cost may pale in comparison to what another such error in judgment will cost. As we learned more than 30 years ago, the stagflation trap can’t be fixed by throwing money out of helicopters. Is it any wonder that gold bugs are again hording their favorite metal? In today’s dollars, the 1980 peak in gold exceeded $1,400. With gold above $750 and climbing, it has become a confidence proxy for international (and domestic) investors about the job Bernanke is doing. Since the Fed’s surprise 50 basis-point cut in the discount rate August 17, gold has jumped 14%. Watch this trend to continue, especially if the Fed cuts rates again in the October 30 meeting. Still surfing the cash wave…Looking at the short-term picture, our market leaders continue to lead higher but there are clouds growing on the horizon. While they continue to point up, these high beta stocks are really taking it on the nose when an event (like this week’s downgrade of tech flyer Baidu.com) shocks the bulls out of their rally reverie. When shocks are absent, the masses continue to view down days as a buying opportunity and that is bullish. On the negative side at least over the shorter-term, our concerns are mostly technical. The Dow Transports are still in the dumps and have yet to confirm the strong reversal by the Industrials. Technical indicators like the Relative Strength Index (RSI) have diverged lower on the Dow Industrials, NYSE Index and S&P500 which can be bearish but that is not the case on the Nasdaq Composite where the RSI is neutral. Given that a number of indexes are at or above their 2 standard-deviation trend channel top lines, the next correction could come at any time. Volumes also remain low and there has yet to be the flood of new buyers entering the market that normally accompanies – and confirms – a sustained rally. Article links Data Show Bad Loans Permeate U.S. (WSJ online free link) ------------------------------------------------------------------------------------------------------ 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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