HOVZ Stock Market Forecasts

January 20, 2008
Like a ball bouncing DOWN the stairs

We find ourselves torn between fear and greed. (So, what else is new?) HOVZ 6-week and 5-month predicted market gains have seldom, if ever, been this good. Check out HOVZ free ETF forecasts. They really are amazingly high, especially the near-term 6-week forecasts. That is not surprising since the market has already fallen so much. On the other hand, the economy, credit markets, and stock market are in non-typical situations, so our statistical models don't have that much to draw on. Fear wins out, as described below. We aren't buying into the market yet. On the other hand, it is probably too late to sell.

Last week Ben Bernake of the Federal Reserve nearly promised more interest rate cuts. Most Interest rate forecasts (thanks to MarketWatch.com -- see the bottom of their page) are for a rate cut of 1/2 percent followed by more later this spring. Also, the President, Congress and nearly all presidential candidates practically fell over each other promising to dump billions of dollars of new stimulus into the economy. By Wednesday afternoon Hillary bid $70 B in stimulus spending. Barak raised the ante to $75 B. Then, in his congressional testimony on Thursday, Ben topped both of them with a $100 B recommendation. On Friday, clearly not wanting to be outbid, George Bush said we needed $140 to $150 billion in joy juice. By Friday evening the market pundits were whining that $150 billion isn't enough. The stimulus bidding pot just keeps growing! It may just be getting started! The problem is that this may be like trying to treat schizophrenia with a leg splint -- just because the splint is handy and it's the only thing the ambulance technician knows how to do.

By way of contrast to this rush to economic stimulus, the stock market in 2000 had been falling for about 8 months in the Dot Com collapse before the Fed instituted its first rate cut of that stimulus cycle. That was a presidential election year too. Makes us think a lot of people are more frightened than they try to let on. We have some thoughts on that below.

Ignoring the promised treats, stock markets world-wide fell dramatically last week. The fall in U.S. markets was minor compared to other markets around the world.

It's an open question as to how well, or when, any new stimulus will turn things around, even if it meets the buzz-word test of being "Timely, Targeted, and Temporary." There are plenty of doubters. This article by Irwin Kellner at MarketWatch.com is downright pessimistic. Here's one from Paul Krugman at NY Times. David Ignatius at Washington Post.com has the same fear. The market has a real credit bubble to face and a physical surplus of up to a couple of million houses built during the boom. It's not just a crisis of confidence. If, as Kellner suggests, housing prices actually need to fall 20% or so, then we haven't even seen the tip of the gigantic economic iceberg we are slamming into. Imagine the political repercussions if house prices did fall that much and almost everyone who bought a house in, say, the last 4 years was financially underwater! Then imagine if they bailed out of their loans!

The real problem, though, is the multiplier effect of leverage. I think a lot of folks secretly smiled when all sorts of large powerful banks announced losses from subprime loan investments. I certainly did! Served them right! Here's the problem -- the losses get deducted from the bank's own capital. But, that capital is just about 7% as large as the money the banks lend out. Call it a 1 to 15 ratio. They have to keep that ratio at about that level in order to be considered credit worthy and solvent. So the net of all of this is that if the banks lose, say, $100 billion from the subprime fiasco, that means they will need to curtail lending of maybe $1.5 trillion. All those loans could potentially end up on the market in a giant fire sale. The losses could start a chain reaction. No wonder bankers are running all around the world trying to get new capital in big chunks from fat cats in the mid east and Asia at unusually high rates and high discounts. They don't have any other choice in this crisis! It is no coincidence that each bank announces its new cash infusion in the same announcement that they announce their most recent quarterly loss. Otherwise their stocks would crash.

There also is a non-zero probability that the credit crunch could get much much worse. At the present time according to this Bloomberg.com article just 7 insurers guarantee over $2.4 trillion in corporate and municipal debt. Approximately $565 billion in bonds are insured by just one of bond insurers, AMBAC. The insurance gives potentially risky bonds more credibility and therefore a higher credit rating and a lower interest rate. Because of the subprime mess, bond insurers are in trouble. They're having to make payouts. As a result their capital stock is disappearing. It must be getting bad. As the article says, one of them AMBAC had its shares decline by over 70% just last week. The article further states that AMBAC's bonds are valued on the market at just 25 cents on the dollar. The greatest market concern is that if the insurers fail, then the insured bonds may lose their AAA credit ratings. The conservative institutions holding those bonds -- like pension funds and conservative bond funds -- may be required to dump them on the market. But if everyone is then afraid to buy the bonds, the market could seize up, creating a financial panic much greater than occurred this past July.

"But wait", like the infomercial says, " There's still more!" We still may be talking small Halloween hobgoblins compared to the real lurking axe murder waiting for us. Jim Jubak of MSN Money writes about the potential for the credit default swaps market -- some $450 trillion to fall apart (yes, trillion). Obviously not wanting to seem alarmist, Jubak doubts that the actual impact would be much more than, say, a measly $27 trillion. That's several times the size of the total U.S. economy. And no one seems to know what the mysterious CDO credit swap market actually is. It's only developed over the past few years. It's never been tested in a recession. And it is not regulated. This all seems to look like a house of cards. So many of them seem to be in question and most any one giving way may bring the whole house crashing down.

Also, the U.S. Current Account deficit -- the untamed and ornery elephant in the room that made it critical in the first place for the Fed to slow the economy and for the U.S. Treasury to inflate/devalue the dollar -- has only improved a tad despite a considerable drop in the value of the dollar. The Euro has risen in value from $0.85 to $1.48 under the Bush administration, but the trade balance has only gotten slightly better. How much more correction is required?

Current Account deficit flows at over 5% of GDP are still way above sustainable levels. As shown in this chart, (thanks to InvestmentTools.com) it is just about the worst balance in the developed world. That kind of spendthrift behavior is normally only expected from third rate dictators about to be overthrown. For improvement to be real, the U.S. Current Account Deficit needs to decline much further to something more near 3% -- either through self restraint (that ain't gonna happen), recession, trade limits or further devaluation. We don't even want to think about how bad things could get if the oil states, China and/or Japan decide to ditch some of their dollar holdings...

As an aside, interest rate increases were not the only factor that came into play to cut economic growth in the U.S. at this particular time in the current business cycle. Note the U.S. Federal Deficit had been in an incredible full-tilt stimulus mode for the Bush years. Just like the Reagan years, the Bush tax cutters and heavy spenders thought that "Deficits don't count!" Now, however, the deficit is actually falling. It's still $200 B, but it is falling. That's bad timing, completely out of sync with the idea of supplying additional stimulus. Wrapping up the Iraq war would further cut stimulus by about $100 B per year. Take one more look at the chart linked above and you can see how it clearly pointed to the end of the Dot Com bull market -- with $200 billion a year being pulled OUT of the economy something had to give way. And it did.

Keeping things a bit in perspective. The $150+ billion new stimulus being talked about is small compared to the $400 billion dollar annual stimulus that the panicked Bush administration dumped on the economy following the Dot Com collapse. And the Fed at 4.25% interest rate is nowhere near the 1% interest rates of 2002. The economy got hooked on the stimulus drug, and it doesn't like tapering off! Also, none of these developments should have come as much of a surprise to anyone, as this David Ignatius Washington Post Op Ed piece demonstrates.

We are NOT witnessing a minor stumble for the economy. The heavy lifting -- or maybe the better phrase is "creative destruction" -- of getting the U.S. economic house in order actually has only just started. It can happen slow or it can happen fast -- that's for the Government to decide. It is debatable if it can be stalled much longer though a lot of people are sure hoping for that!

One way or another the business cycle will get on with its downward sector. The secular business cycle can't be stopped forever. The world's economic imbalances developed over years and are not going to be fixed with just a band-aid. Big, and now fearful, money is stampeding to find a safe place to hide. UBS (link to MarketWatch article) gives a good example of the run to safety. After losing $10 billion last quarter, it's not surprising that they might turn a bit gun shy. This is not penny-ante stock speculators getting spooked, instead it is the whole conservative financial universe that is shaking.

HOVZ Market Enthusiasm Indicator has kamakazied to a level reached only 5 times in the past two decades. (1987, 1990, 1998, 2001, 2002). Take a look at the long term behavior of the HOVZ Market Enthusiasm Indicator to see what we mean. In every case the market began a strong partial rebound within weeks of the conclusion of the primary dramatic plunge in Market Enthusiasm! But here's the rub -- in 3 of the 4 instances the market just kept on falling until well below today's level before turning around. Two of those market declines are remembered un fondly as "crashes." None of those episodes was anything like the colossal economic scale of today's credit bubble. Yikes! As a bit of a surprise, Market Enthusiasm crashed down two weeks ago, but last week, despite a 4% drop in U.S. markets, the indicator hardly budged. Maybe the knife has almost stopped falling?

The stock market typically has two distinct responses to changes in interest rates or spending stimulus. The first reaction is nearly instantaneous -- with news of, or even anticipation of a rate change, the market will usually bounce -- up for a rate reduction or down for a rate increase. The larger reaction of the stock market, however, happens only after the interest rate change has actually affected the real economy a year or more later. Here is a chart comparing interest rates and the stock market over roughly the last decade -- thanks to Bob Bronson at FinancialSense.com. It shows clearly that in the Dot Com bust, the market only got a brief lift with each interest rate reduction and that the rate reductions kept continuing as long as the stock market kept falling. The important thing to see is that lower interest rates did not immediately stop the market slide. It was 2003 before much of the stock market really turned around.

At best, it will take months for the real economy to reflect any stimulus even if it started tomorrow. We find it very likely that stock market confidence will get a quick boost from anticipation and announcement of these stimuli. That's what usually happens. But, we're also prepared for more bad financial news from the credit markets or the real economy before the stimulus works. We're expecting a year or more of depressing housing news, falling U.S. dollar, lower (or slower growing) corporate profits and rising inflation -- especially for commodities and petro products.

It's not just the U.S. that's having problems. Importantly, we also expect other asset bubbles to burst in overseas real estate (e.g. England, Spain) and stock markets (e.g. China, Brazil, Australia). Where the drop hasn't started yet, it is going to soon. The Chinese government, for example, is still ratcheting up its economic constraints convinced that the Chinese market bubble needs to be stopped. How much longer, after all, can their market keep rising at over 100% per year?

As an illustration of the world-wide scope of the asset bubbles, while the SP-500 has nearly doubled since the lows of 2002, the Brazil index fund EWZ has gone up by roughly a factor of 10! Anyway you look at it, that's a bubble. A strong and sustained major bull market is unlikely until these existing bubbles pop and the world has a chance to calm down. This article from Ghassan Abdallah at FinancialSense.com makes a case that emerging markets have already topped.

As said earlier, the sort of collapse in Market Enthusiasm that is underway does not happen very often. As a result our supply of historical predictive data is limited. Therefore we don't dare to place too much trust in our current statistical forecasts. We're afraid that they are too optimistic. We have much more confidence in our forecasts for more frequent smaller downturns.(Also, HOVZ forecasts are for 5 months from now. The scary stuff is happening right now!)

With that caveat, HOVZ now has a large number of very high 5-month gain predictions for both individual stocks and ETFs. The vast majority of these are for shares that have been beaten down over the past 6 months or so -- financials, real estate, home builders, etc. While the prospects half a year away may be statistically wonderful, as far as we are concerned, these knives are still falling. We don't want to touch any of them yet! Someday they will rebound. But we doubt that it's going to happen right now.

Amidst all the truly frightening portents, however, the large capitalization U.S. stock indexes don't look too bad. In 2000 U.S. tech stocks were the heart of the asset valuation bubble, but this time around most still show relatively normal P/E valuations. Check out SPY, DIA, and QQQQ. In each case we rate them with better than normal 5-month gain expectations of about 5%. Also, each has fallen to touch the bottom of their normal channel of expectations. This is a typical turn around point. (Actually, it is pretty amazing that each of these is exactly at the lower edge of the HOVZ expectation channel.)

For a different, financial fundamentals based view of the U.S. large caps, take a look at the Morningstar.Com Market Valuation graph. Morningstar is convinced that the market is already 15% undervalued -- that's getting rather attractive. (Of course in 2002 it got to 28% undervalued.) Also as described in this MarketWatch.com article, Credit Suisse for the first time this decade is recommending its clients to overweight U.S. stocks.

Eventually things will turn around. Just when that's going to happen is the open question. Is it always darkest just before the dawn -- or just before it turns pitch black?

Bottom line:  HOVZ Market Enthusiasm Indicator has been in free fall. but we think the Fed' s next rate cut will prompt a temporary bounce. We fear, though, the risks of further market degeneration are probably greater than the potential gains. We're still out of the market.

. (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 15% undervalued -- down from 12% last week. 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%. But a 20%+ under pricing as in 2001 and 2002 is quite possible. Our bet is that it's likely. 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 17% of stocks are above their 200-day average, getting even better than the typical buying level. 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 (like now), a sharp bullish upswing becomes very likely It's your call as to whether the market will fall more. (Our bet is that for the next couple weeks the fall will continue. For someone with a longer term perspective, the market is already in buying territory.)

NYSE New Highs & New Lows  Now at what is typically a good level for buying. 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  High and/or rising interest rates tend to be bad for corporate profits and stock market prices. The Fed has started to lower short term lending rates and clearly intends to use this stimulus to keep the economy pumped up. Unfortunately, it takes time for this stimulus to start working through the real economy and there is a major concern that moving rates too low could cause the value of the U.S. dollar to go into free fall. The rate inversion that existed most of last year ended up being a good predictor of the market troubles that are occurring right now. The question now is whether the Fed will lower rates as fast as the market wants.

Short Interest Ratio (from InvestmentTools.com) Once again setting 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. In the last bear market this was probably the BEST OVERALL INDICATOR for watching the bear run its course.) 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. Start to pay attention to the rate-of-change graph at the bottom of the linked page. When the rate of change turns negative it will almost certainly mean a serious bear market. 

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. Each month the news just keeps getting worse.

U.S. Leading Economic Indicator  (See graph at bottom of link page.) (Fell in December and 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. A competing an better known leading indicator, the Conference Board Leading Economic Indicator fell sharply in November and again in December-- the fourth time in the last five 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. This is the economic 800 pound gorilla that caused the U.S. dollar to plummet over the past few years. Now, in a major turn-around, 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. This week they decided not to take away this punch bowl. The deficit is going to go up again. The loser will be the value of the dollar. This reduction in the deficit is a significant contributor to the slowing economy. Not surprisingly the politicians are already calling for more stimulus spending to keep the party going.

Effective Federal Funds Rate and Target Interest Rate (from St. Louis Federal Reserve) Negative It was William McChesney Martin, a former Chairman of the Federal Reserve, who first said: "The Federal Reserve's job is to take away the punch bowl just when the party gets going." Right now the Fed has changed course and is lowering interest rates to spike the punch. Eventually this will stimulate the economy, but because of lag times, for the moment is a major contrary signal showing concern by the Fed that probably points to worse bad times ahead. The current MarketWatch.com forecast of interest rates points toward further rate cuts.

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. If this turns up, it probably will be a sign that earnings (right now at historically high levels) have gone to hell. That was much of the story in the 2002 rise of this indicator.

Big Mac Index Economist.com has a truly wonderful (though perhaps not statistically definitive) means to spot if various currencies are correctly valued against the U.S. dollar. It's based on the price of a Big Mac in each country. Right now the european countries appear to be overvalued.