HOVZ Stock Market Forecasts

December 30, 2007
Blahs for the New Year, and one glimmer of hope

The Santa Claus market rally flopped. Though the market recovered a bit, the HOVZ gage of investor optimism kept falling. We are closing our long positions. Potential market risks appear to outweigh likely gains. We don't see much that's bright on the horizon until maybe spring. Even then, things don't look all that wonderful.

So, what comes next? With all the storm clouds overhead it's hard to think 2008 will be a great year for the market. Worse, there's a significant chance that things could quickly turn really bad. The big question appears to be whether the world's multiple asset/credit bubbles unwind smoothly and calmly? Or will panic take over and produce a quick crash? Much depends on how the Federal Reserve manages interest rates. Will the Fed cut rates enough to reduce the number of housing foreclosures and forestall panic repricing of houses and a tremendous drop in consumer wealth? But, if the Fed continues to cut rates, will that lead to a run on the U.S. dollar and a stampede away from U.S. denominated assets?

HOVZ forecasts are not based on economic fundamentals, but on models of the herding behavior of investors. Right now that herding mentality is a primary market driver. Since July the market has been near panic and investor confidence has been in free fall. HOVZ models tell us that the market remains near panic. The Fed has used its powers skillfully, but the investing herd has not settled down.

HOVZ does not see the stock markets as entirely logical and efficient. In our view the subjective emotions of market leaders are terrifically important to short term market gyrations. We feel most market action comes not from small independently minded investors, but from shifting positions of multi-billion dollar investment pools. There are also herds of smaller investors that collectively follow a relatively small number of influential gurus and stock rating services. These investment Elephants are so big they can't turn on a dime and they leave tracks. More important still, they tend to travel in a herd. That's what we follow and try to forecast.

The HOVZ models are still being tested -- that testing has been the whole point of this web site for the past 4 1/2 years. The models rely heavily on past experience which may or may not shed worthwhile light on likely future moves of the market. At best the models tell us what is most likely to happen.

HOVZ models tell us that one thing is certain. The stock market is already in the middle of a major decline in investor enthusiasm. As we track it, Market Enthusiasm tends to rise and fall on roughly a yearly basis. The scale of behavior that is happening now, however, is much bigger than the typical yearly swing and only happens every 8 years or so. Because this kind of major market move is not very common, we don't have a huge amount of data to draw upon for this event magnitude. That makes the forecasting value of our models especially uncertain right now. Take a look at the long term behavior of the HOVZ Market Enthusiasm Indicator to see what we mean. Our hunch is that in a major downturn our models will be giving us more optimistic forecasts than they really should.

Currently our models point to an extended late winter case of the Blahs. That seems to fit with the basic economic picture painted by the gurus quoted in the headlines. This article by Jon Markman at MSN Money is a good example. Stagflation -- combined economic stagnation and rising inflation -- looks like the most probable economic alternative for the next couple of years. The combined overhangs of too many houses built over the past few years and all priced to unaffordable levels is going to take years to work off.

The U.S. stock market seems determined to keep falling. HOVZ 6-week forecasts are generally dismal.

We are not all that concerned about most U.S. large cap stocks, particularly those companies with significant foreign sales. This is especially true considering how much the dollar has fallen in value. After accounting for the falling dollar, the U.S. stock market didn't rise in real terms at all in 2007. Take a look at the Morningstar.Com Market Valuation graph. Morningstar is convinced that the market is already 7% undervalued. Considering that in a downturn there will likely be a flight to quality stocks, we doubt that there will be overall terrible damage to U.S. large caps averages in the coming year.

The stock market is already showing a major divergence which is typical of the late stages of a bull market. Though the overall market hasn't broken down, some parts of the stock market already have been declining for months-- basically anything related to housing. Generally our forecasts see either continuing declines or weak performance in this part of the market.

On the other hand, the herd has not given up yet on a number of star performers, especially certain technology heroes and the emerging market funds. We see the most risk in these investor favorites that have risen in value several hundred percent over the past few years. It is very difficult to forecast accurately when the last big pockets of nvestor euphoria will turn to panic, but HOVZ is relatively confident that the break will happen at some point in the next year -- probably in response to some triggering event such as a popping of the China stock market bubble.

We do see one ray of hope, a chance for optimism to suddenly turn around. The hope we see is that in the spring it will be increasing clear who is likely to be the next U.S. President. That makes a difference. Remember that the Dot Com bubble broke in April, 2000 at exactly the point where George Bush took the lead in presidential polls. It was clear even then that big international investors were afraid of Bush and they pulled their money accordingly. They proved to be correct. Our hope for the New Year is that the likely next President will inspire trust and confidence. Remember what that felt like?

Bottom line:  Market Enthusiasm has been in free fall. It may or may not have stopped. We have become discouraged with many stocks performing below our expectations, so we have closed all positions. It appears that a number of high flying emerging market funds are in the process of breaking down. These are the few remaining places where investor optimism has been holding on. Our concern is that emerging market shares have risen so much over the past few years that they now have a lot to lose.

. (This column is not investment advice, YOU need to figure out what's best for you.)

Links to Other Stock Market Indicators We tend to focus our market timing attention on the HOVZ Market Enthusiasm Indicator which follows a roughly annual cycle. Several other popular market indicators are listed below.  

Morningstar.Com Market Valuation graph  (Shows market to be 7% undervalued. There may be a huge stock market bubble somewhere -- but it isn't in the bulk of U.S. stocks that Morningstar tracks.) This graph is a fundamental financial analysis / accounting calculation based on long-term projected returns for the 1,800 stocks Morningstar tracks.  Typically in the past couple of years the trend has gone from undervalued to somewhat overvalued at 5% to 10%. The current trend is NOT up!

% Stocks Trading Above 200-Day Moving Average (The current value is shown at the very bottom of the link page. ) About 30% of stocks are above their 200-day average -- up from 29%. As a general rule, when a stock's price is above its 200-day moving average, the stock is in a long-term price rise. So, an increasing percentage of stocks priced above their 200-day moving average is generally a good sign. However, when 80% to 90% of stocks are trading above their averages it is usually a signal that euphoria has gotten out of hand and a market correction is due. Similarly, when only 20% to 30% of stocks are trading above average, a sharp bullish upswing becomes very likely It's your call as to whether the market will fall more.

NYSE New Highs & New Lows  Looks like a good time to Buy. The graph of new lows tracks fairly closely with our HOVZ Market Enthusiasm Indicator.  A 'Buy' indicator occurs when the number of Low values peaks and a 'Sell' indicator occurs near when the number of new Highs heads past a peak. www .InvestmentTools.com. 

Long Treasury Bond versus Discount Rate  (Neutral) High and/or rising interest rates tend to be bad for corporate profits and stock market prices. Long-term interest rates have finally started to rise, but the Fed has lowered short term lending rates. The interest rate inversion did well in predicting this summer's market tumble.

Short Interest Ratio (from InvestmentTools.com) Right near an all-time high. This has proven to be a good short range market predictor over the past year. Right now it points to near term weakness. This number derived from NYSE data is the dollar value of total outstanding short positions divided by the value of an average day of trading -- essentially, how many days would it take to close all short positions. The last time the ratio was anywhere near this high was at the broad stock market top of 1998-1999. Watch the moving average of this indicator for a very broad look at the anxiety level of the stock market.

Margin Debt  (This may just be a sign of the growth of hedge funds. We still find it worrisome for the coming year.) People who borrow money to buy stock (i.e. "buying on margin") fall into two groups. First, they might be optimists, convinced that the market is going up. On the other hand they can be hedgers, confident that they can borrow money to go long on 'winners' and short 'losers.' These people are arrogant. A rising level of margin is a good sign of a confident Bull market.  A falling margin level is a clear sign of a Bear market -- the optimists get frightened and the hedgers flee the scene. This chart from www.InvestmentTools.com shows that we have been is a very strong period of rising margin, possibly too strong. The total amount of margin borrowing has surpassed the historic high reached in 2000. "Deleveraging' could be a major multiyear process -- but hopefully not right now. 

Building Permits and Housing Starts (Major negative factor). Housing related activity -- not just construction, but including all factors such as new appliances -- constitutes roughly 20% to 25% of the U.S. economy, so it is much too big to ignore. These linked charts from the St. Louis Federal Reserve provide a way to watch the slow moving collapse unfold. Housing tends to lead the stock market by approximately one year. If so, that is very bad news.

U.S. Leading Economic Indicator  (See graph at bottom of link page.) (Rose slightly in November but it has been weak for months. ) The link is from e-Forecasting.com. Since the stock market is itself a big component of composite leading economic indicators, it's questionable how much this can really tell you about what is going to happen next in the market. Look at the bottom of the link page to see how the other components are doing. An alternative indicator, the Conference Board Leading Economic Indicator fell sharply in November -- the third time in the last four months.

U.S. Federal Deficit (from St. Louis Federal Reserve) Be careful what you wish for! To recover from the Dot Com market crash and the 2001 recession the Federal Government spent lavishly. The deficit moved from a $200 B per year surplus to a $400+ B deficit -- a net difference of roughly 1/2 trillion dollars per year. Not chump change. Now the deficit is rapidly declining. It is already $200 B per year better than a couple of years ago. Wrapping up the Iraq war could make another huge cut in federal spending. That fiscal improvement bodes well eventually for strengthening the dollar, but in the meantime it is a huge amount of spending stimulus being removed from the economy. It's like someone taking the keg of beer away from the party! This is a significant contributor to the slowing economy.

Price / Earnings Ratio of the SP-500  (To us this does not indicate a significantly overvalued market.) Except during short and intense recessions the composite P/E ratio of major corporations provides a general indication if the stock market is priced high or low.