| TSG Weekly Market Watch October 19, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||
| Monday, 22 October 2007 | |||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending October 19, 2007TradeSystemGuru.comTopics Discussed This Week:
Market action and reports highlight growing recession riskWith the ominous market melt on Friday, we thought now was a good time to review our recession indicators. We have discussed these indicators individually in the past and this is the first time we are bringing them together. As I get ready to post this on the website, reports on advance of market opens Monday morning (October 22) in Hong Kong and Japan look downright ugly. One analyst is projecting that the Hang Seng will drop 1,000 points! (See Gremlins make surprise early appearance for more.) Charts worth a thousand forecastsRisks of recession are rapidly increasing so we deemed it prudent to bring together some of the more important indicators we and others have been tracking.
Figure 1 – Monthly chart of the National Association of Home Builders housing market index (HMI) advanced 12 months versus the S&P500 with the growing correlation between 1996 and 2006 then mysterious divergence. In his August 21, 2006 newsletter, Merrill Lynch economist David Rosenberg provided us with a new indicator. He had been tracking the S&P500 and the National Association of Home Builders (NAHB) housing market index (HMI) advanced 12 months and found an interesting relationship. He found that the HMI led the S&P 500 by 12 months and with a near-80 percent correlation – a correlation that had strengthened over time owing to the growing influence that the real estate market has exerted on the overall economic and financial landscape over the past five years. Between 1985 and 1995 the correlation was limited at best but the increasing correlation over time on the chart is clearly evident. Between 1996 and 2006 the relationship strengthened. But while the HMI began collapse in 2006 in Figure 1, the S&P500 continued to advance. Does it mean that the relationship is dead? More likely it signals an increasing lag due to the importance that housing played in the economy, the incredible excesses that built up in housing markets thanks to the flood of cash that became available thanks to easy if not downright irresponsible credit lending practices. This has been compounded by the current state of denial of the consumer who continues to wrack up debt as the economy weakens. What Figure 1 is telling us is that the S&P500 has the potential to experience a drop in the coming year (or so) that will surprise even the most aggressive bears. It is interesting to note that David Rosenberg has upgraded recession risk from 25-30% then to 65% recently. Next is a chart of 10 year minus 2 year U.S. Treasury yields showing that each time since 1977 that the relationship turned negative, a bear market and recession followed – the longest lag from negative to recession was 28 months. Although the relationship last turned negative in January 2006 and while the curve has since turned positive, this in no way minimizes risks going forward.
Figure 2 – Monthly chart of 10 year Treasury yields minus 2 year yields. Gray boxes show bear markets with corresponding drops in the Dow Industrial Average. Next we look at an indicator that has taken on increasing importance when housing was a large contributor to economic growth. Put together by Hugh Moore of Guerite Advisors, this chart of residential fixed investment (RFI) to GDP shows that each time 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. As of this latest chart from late August, RFI had fallen 23.4% from its peak in Q4-05 and is showing no signs of bottoming according to Moore.
Figure 3 – Residential fixed investment to GDP showing past recessions in cyan. The drop in 2000 before the last recession was slight indeed compared to the most recent drop. In this next chart from Guerite Advisors, Moore points out that while lagging, year-over-year changes to non-farm payrolls provides a valuable recession warning. Payrolls have not yet fired a recession warning signal but as we see from Figure 5, it looks to be only a matter of time.
However, factor in temporary services employment changes year-over-year and we get further confirmation of recession risk. The major drawback is the temp services employment published by the Bureau of Labor Statistics, is a relatively new indicator with a short history but as the chart shows, drops into negative territory have lead non-farm payrolls in the last two recessions.
Figure 5 – Relatively short but strong relationship between temporary services employment and non-farm payrolls showing past recession warnings.
Figure 6 – Chart showing year-over-year changes to real equipment and software fixed investment (RESFI) since 1960 and past recessions in orange. According to Moore, Real Equipment and Software Fixed Investment (RESFI) in Figure 6 measures corporate America's willingness to invest in additional productive capacity. Since 1960, RESFI has been an excellent barometer for the general economy and recessions in particular. Each time the year-over-year increase in RESFI has fallen below zero, a recession has followed, with two exceptions. The two exceptions were the "mini-recession" of 1967 and the mid-decade slowdown of the 1980's. Both periods produced shallow and short-lived signals. The current RESFI reading has been negative for two quarters and shallow like the two exceptions noted above. A prolonged or increasingly negative signal would indicate a very high-risk of recession.
Figure 7 – Chart of the year-over-year change to total household debt which averaged More than $112,000 per family in May. Every recession since 1960 has been preceded by a 40% or greater drop in total household debt with two exceptions. As we see from Figure 7, the 61.6% drop in 1967 was not followed by a recession and the recession on 2000 was marked by an increasing in total debt – but this was the first time in history this occurred. As of the latest figures, total household debt has fallen nearly 40% from its peak but given the current mortgage and credit crisis, the challenges are just beginning. If history is any guide, this does not bode well for the health of the economy over the next 12 to 18 months.
Figure 8 – Chart showing peaks and the percentage declines going back to 1959 showing that each time housing starts have declined significantly, a recession has followed with one exception and that was in 1967.
Figure 9 – Another chart that compared total construction with residential construction showing that with one exception (1966) recessions have been preceded by significant declines in residential and total construction. We are again in negative construction territory. As we see from the chart, construction never went negative in 2001 thanks to the cheap money policies of Allan Greenspan and the Fed. Finally, here is the granddaddy of indicators published by Moore that incorporates 12 different metrics into one showing past success at predicting a recession. As we see, it has been very accurate in the past but the amount of advanced warning varies widely. It began to flash red in May 2005 so the signal is already more than two years old. The longest warning on record was the signal that fired in 1966 followed by the 1970 recession. While there is a chance things will be different this time, given the number of warnings, chances are it won’t be.
Figure 10 – Guerite Advisors recession indicator plotted with the S&P500 going back to 1960 with recessions marked in cyan that began flashing red May 2005. Here is our market summary for the week as well as key indicators to follow. It looks like it could be the beginning of a brutal week if early indications from Asia are any guide…
Gremlins make surprise early Halloween appearance…Halloween may still be a week away but that didn’t stop investors from getting an early surprise spook and based on the reaction, they didn’t like it one bit. Off came the rose colored glasses that had become a fashion statement on Wall Street and on went the dour masks as players ran for the shadows. A triple witching week as three types of options and futures contracts expired added further volatility to the mix. By the close on Thursday it had already been a gut wrenching week. Stocks had fallen Monday and Tuesday with quintessentially resistant emerging markets taking it hardest. But then stocks began to recover Wednesday and Thursday with the Nasdaq almost getting back to even. Then came Friday with the Dow, S&P500 and Nasdaq dropping more than 2.6% while the MSCI Emerging Market ETF (symbol EEM) dropped 4.3%. Investors and analysts have clearly underestimated how sub-prime and credit derivative excesses will impact the economy as both continue to unravel. Oil hitting a new high north of $86/bbl was another depressive factor. Technically SpeakingEven market leaders take it on the chinVolatility is the hallmark of Dan Zanger’s frisky puppies, and his composite of 9 market leaders listed in his Wednesday newsletter was certainly that. Down 1% by Tuesday, the composite came back over the next two days but then gave most of it back on Friday for a weekly gain of just 0.42%. Although better than the 4% drops for the S&P500 and Dow Industrials and 3% for the Nasdaq Composite, master Zanger is not optimistic about the performance of his favorites going forward. In a telephone conversation with him after market on Friday he admitted that the going had been tough over the last few weeks. October and the seventh decennial year (years ending in “7”) both have nasty reputations which they lived up to this week according to Dan. (For more of his comments please see the Synopsis.) Stocks covered this week included past picks Research in Motion (RIMM), Apple (AAPL), Excel Marine (EXM), Garmin (GRMN) and Google (GGOG) as well as First Solar (FSLR), iSHaresFTSE China (FXI) and Aluminum China (ACH). Gone were the likes of Baidu (BIDU), Las Vegas Sands (LVS), Holders Oil Services (OIH) as well as miners Southern Copper (PCU) and Freeport-McMoran Copper & Gold (FCX). What is surprising is that the composite held up as well as it did but Mr. Zanger has turned bearish again and is not looking for a quick broad market recovery anytime soon. 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 9 – 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. 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). Last week we discussed Dow Theory and that for a trend to be confirmed, both the Dow Transports and Dow Industrials must be going in the same direction. A recovery by the Industrials has yet to be confirmed by the Transports have struggled. In looking back and comparing charts of both, the last time a similar situation occurred on the weekly charts was in late 1999 and early 2000. With the change in Wall Street weather this week, this is just one more reason for caution going forward. Volatility as indicated by the Market Volatility Index (VIX) jumped again this week to 22.96 from 17.73 last week and 16.91 two weeks, a sign that fear is again creeping back into the market. Commodities this week surged higher as the NYFE CRB Index closed at 450.56 up from 446.44 last week and is still above its upper 2-standard deviation (2 sigma) trend channel. Gold again surged higher as it closed at $768.6 from $753.80/oz last week. It is due for a rest but has been doing double duty as credit market turmoil continued to escalate. Further declines in the dollar also helped propel it higher. And after its dead-cat bounce last week the U.S. Dollar Index dropped again to close at 77.37 down from 78.16 last week and in the process put in another all-time low. A weaker dollar, concerns following the assassination attempt on Bhuto in Pakistan and remaining hurricane fears helped drive the NYMEX crude oil (continuous) contract to another new high close this week of $86.95/bbl up from $82.74 last week. As mentioned the MSCI Emerging Market Index ETF (EEM) had a tough week as the index dropped 4.6%. However, it remains well above its 2 standard-deviation upper trend channel line means that it remains overbought. The index ended the week at 152.20 down from 159.50 last week. Two year U.S. Treasuries rose the most since September 11, 2001 as investors sought the relative safety of bonds amid the spreading turmoil pushing yields lower in the process. In Meanwhile, the 3-month London Interbank Offered Rate dropped slightly to 5.15% from 5.22% last week offering minimal relief to stressed mortgagors looking to renew in the coming weeks and months. LIBOR is used in computing mortgage rates and has yet to fall significantly in the wake of the Fed funds rate cut. EarningsWhat a difference two weeks makes. Last week we reported that for some unknown reason no Q3-07 earnings improvement data had been published by the Wall Street Journal. This week, those reports resumed and with a total of 760 companies having reported Q3-07 earnings, improvements over the same quarter averaged a drop of 8%. This compares to a 9% improvement with 384 companies having reported two weeks ago. Economic ReportsLong-term readers of this newsletter know that we track numerous econometric indicators and reports in an effort to help us understand what may lie ahead in markets. We came to the conclusion long ago that the majority of economic indicators were at best coincident but most lagged the market. In other words, they have been pretty much useless in helping anticipate a market reversal, bear market or recession. As a case in point, we updated our Reuters/University of Michigan Consumer Sentiment Index and Conference Board Consumer Confidence Indexes to see if they helped provide any warning of a slowing economy and change in outlook by the consumer.
Chart 1 – Conference Board index showing consumer confidence.
Chart 2 – Chart of the Reuters/University of Michigan showing consumer sentiment over the last two years. As we see from the charts, they give us no guidance on what to expect. Of greater concern is the fact that these two indexes that basically track the same metric are telling us very different stories. But here is what some very useful indicators today are saying. Ignore them at your peril! U.S. Treasuries experience panic selling in August
Chart 3 – Treasury released net capital flows for August showed a whopping exodus of $163.0 billion during the credit mayhem. In other words investors dumped $163 billion in Treasuries in August for the largest withdrawal in at least two years. According to the U.S. Treasury, net foreign purchases of Treasuries totaled -$69.3 billion which means unlike the previous two years, foreigners were big net sellers in August. It was the largest dumping of Treasuries by foreigners since 1990 according to Financial Times. As concerning if not more so was the net selling of $60 billion from July in corporate stock investment. These figures are revised regularly so it will take time to tell whether this is simply a temporary blip or a trend in the making. If this is the start of a new trend, it has ominous implications for interest rates given the U.S. dependence on foreigners to finance total debt. The U.S. must borrow $2.1 billion per day just to finance the trade gap which totaled 5.5% of GDP in Q2-07. Then there is the budget deficit, corporate and consumer borrowing…etc. What is perhaps more interesting is that this concerning statistic was given little coverage in the financial media when it was released on Tuesday when we constructed this graph. In retrospect, it is clear that more people should have been paying attention. Builder’s sentiment and future outlook hit record low Chart 4 – We also learned on Tuesday that the NAHB housing market index (HMI) fell for the eighth consecutive month to 18, the lowest reading on record since records began in January 1985 according the NAHB data. It shows that builders continue to grow more pessimistic about the future of their industry. A reading below 50 denotes shrinking demand. Two of the three components of the index, namely new single family home sales and prospective buyer traffic, both declined to 18 and 15 respectively while sales expectations over the next six months was unchanged at 26. The West accounted for a “substantial portion” of builders decline in confidence with a four point drop to 14. It has now been more than two years since home builders peaked in Q2-2005. Chief NAHB economist David Seiders tried to put a positive spin on the report saying that builder expectations for the next six months held steady. However, any optimism assumes we don’t enter a recession, the probability of which has steadily increased over the last six months. With building permits and starts currently running around 1.2 million, they still have a long way to fall. Housing starts hit 1993 low
Chart 5 – Builder’s fears expressed in the negative NAHB report were confirmed on Wednesday with the release of housing permits and starts for September. Starts dropped 10.25% from August to a seasonally adjusted rate of 1.19 million while starts fell 7.3% to 1.22 million. Starts dropped to their lowest level since 1993 and permits were also below 1994 levels. On a year-over-year basis, permits are down 29.93% and starts are down 30.8% from September 2006. At the current rate of decline, both are projected to be down 50% from their peak in September 2005 by December 2007. Next WeekIt’s a busier week for economic reports. Here are the reports we’ll be watching with important ones emboldened. Existing and new home sales will be ugly, the question is how ugly?
SynopsisEarnings highlight growing stress and recession probabilityIf this week is any indication, the credit turmoil has started to seriously impact the broader economy and the markets are feeling the pain. Optimistic investors were severely knocked on their backs this week and it’s a drubbing they won’t soon forget. That previously resilient emerging markets are now hurting indicates that the contagion is spreading around the globe. In going back over our earnings reports through 2005, we found no weeks in which improvements were negative so this week was a multi-year first. Strong earnings improvements have been a major pillar of the rally that began four years ago but it became obvious this week just how rapidly this situation can change. Caterpillar, an important barometer of U.S. economic health, startled analysts and investors this week with a gloomy forecast for North America that drastically lowered its full year earnings guidance in its Q3-07 report that included the mention of an approaching recession. Surprisingly, the company attributed a large part of the earnings knock largely to weaker manufacturing operations in the U.K. according to the Wall Street Journal. Caterpillar blamed lower earnings on weakness in several key industries it services that included housing, non-residential construction, coal mining and trucking. Also interestingly the company does not expect interest rate cuts to substantially benefit the industries it serves in 2008. Other negative surprises included Standard Pacific Corp, a home builder in eight states that dropped on concerns that mortgagors will have an increasingly hard time repaying loans. In the financial sector, Citigroup, the biggest U.S. bank said defaults will plague the financial industry for years. Its stock dropped 12% on the news. MGIC Investment Corp., the largest U.S. mortgage insurer, posted its first quarterly loss in 16 years and fell 33% for the steepest decline in the S&P500 according to Bloomberg news. The lowest housing starts in 14 years brought more negative attention to bear on builders prompting DR Horton to report that sales orders fell another 39% in its Q4-07 which knocked the stock down another 15%. This poster child of homebuilder success in 2002-2005 has seen the value of its stock decline more than 70% from its July 2005 peak. Lenders who took part in the “wild and woolly wholly, reckless abandon” lending fest to everyone and anyone looking for a mortgage aren’t far behind. However, it became crystal clear this week that contrary to legions of analysts and economists who claimed the sub-prime hemorrhaging would be contained, it is anything but. The credit turmoil roiling markets and a rapidly deteriorating U.S. economy is beginning to show up on the bottom line of companies outside the financial and real estate sectors if the Caterpillar report is any indication. Here are some numbers to ponder. The value of U.S. mortgages outstanding equaled somewhere between $9.5 to $10.5 trillion in April according to Federated Investors fixed-income manager Randall Bauer. (Add other household debt and the total hit $12. 8 trillion in May 2007 according to USA Today.) About 15% of current mortgage debt is subprime. An even larger percentage today is adjustable rate Alt-A loans. Total residential housing value in the U.S. stood at just under $22 trillion in Q2-2006. You don’t need a degree in math to calculate the losses to household wealth if 10% of mortgages go into foreclosure or if home prices drop by the same amount, estimates that are conservative given the current momentum to home price declines and spreading economic risks. Is the rally wave hitting the beach?We mentioned negatives in the market last week that included that lack of confirmation in the Dow Industrials upturn by the Transports, bearish indicators including negative divergence between the Relative Strength Index (RSI) and Dow Industrials, NYSE Index and S&P500. Low volumes have been replaced with increasing downside volume and that is even more bearish. For the first time in nine weeks, volume on the NYSE Index rose above the 10 week moving average – the result of increased selling. Until now, the market has discounted credit woes because the consumer has remained oblivious. But businesses have not been so sanguine. Now it is only a matter of time before consumers are forced to wake up and smell the boiling coffee. Can the fall in their spending, so critical to economic health, and more earnings disappointment be far behind? Dan Zanger put this week’s performance in perspective. “It is reminiscent of 1987 and 1997. In both years, the Dow peaked in August then rallied to lower highs in October before falling out of bed in the third week of the month. This year, it put in a high in August followed by a higher high in October before dropping Friday,” he said. “But it is important to remember that big October Friday drops have been followed by even bigger drops on Mondays,” he warned. That stocks have rallied higher in October than in both previous “7” years means that they have further to fall this time around. Zanger cited the big intraday drops in some of his recent favorite high-fliers like Apple, Research in Motion and Baidu.com as three more good reasons to be bearish. Whether or not the negative decennial year performances are repeated, both fundamental and technical reasons for caution have dramatically increased. While Zanger goes short and adopts other strategies that hedge downside risk at such times, putting more money in cash may not be a bad idea for longer-term investors. It is a trader’s market and playing it requires fast reflexes and an ability to take small losses quickly without asking why. The reasons behind a stock or index plummet will only become clear after the fact. If stocks resume the rally on good up-volume, it’s easy to jump back in. But for longer-term investors and traders alike, discretion is the better part of valor in this market. Here are links to some stories this week that you will find interesting. Article links Behind the Subprime Woes, A Cascade of Bad Bets (WSJ online – free 7 day access) G-7 says global growth will slow after ‘market’ rout Taxpayers on the hook for $59 trillion ------------------------------------------------------------------------------------------------------ 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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