HOVZ Stock Market Forecasts

March 16, 2008
Successful retest of market lows?? Or free fall??

All HOVZ Archived Commentary
Links to Other Stock Market Indicators

The collapse and bailout of Bear Sterns put financial panic back on the newspaper front page. If any further panic confirmation is needed, here is Jon Markman from MSN MoneyCentral writing "Sell while the selling is good!" However, there now is also a contrarian argument like this article by Clif Droke at FinancialSense.com indicating hat fear has been overworked and is losing its edge.

As a rule of thumb, any significant market bottom gets retested at least once. Hopefully, that is what last week's stock market activity was all about. The volatility was incredible. Take a look at the long term history of the HOVZ Market Enthusiasm Indicator and see how common retests are.

I'll stick with my opinion of last week that the market is in a retest and that the broader stock market is likely to stage a significant rebound over the next several months -- the entire financial system is not in immediate and complete collapse. Unfortunately, I think the market recovery is probably going to be partial and temporary. Over the next couple of years, stock market prospects will generally be poor for many companies -- until the huge credit bubble largely deflates.

It is very old news that the U.S. Housing Bubble burst and that cascading damage has spread. Credit markets locked up and collapsed. The stock market got slammed. Major financial firms went broke and turned belly up or had to be saved by major cash infusions. And now the economy is in a tailspin. Millions of people have been hurt and many millions more will be.

None of this is good. HOVZ models expected a market downturn for some time. When it actually came it was later and more severe than anticipated. All of this still could turn very very bad as the market is rightfully fearful and has been gripped by panic. Both Housing Starts and the Anxious Index (xls file)show that we are in the spike-leading edge of a typical recessionary panic.

All of this is still playing out as an investor panic -- refusals to make loans, panic selling of stocks, fire sales of assets, massive currency flows, and deleveraging in the normally staid long term lending markets. It's been a crisis of confidence like a giant worldwide run on all the banks. Few think the process is over. The media did its job spreading the story, spreading the panic. Pretty much everyone over the age of 20 knows most of this by now.

The fact that this is now 'old news' is important to us. Panics seem to have a typical pattern and a normal life span. When fear becomes old then confidence and later optimism can slowly begin to return. A successful retest of market lows is a major confidence builder.

We don't see much of a lasting rebound happening any time soon in anything related to banking, brokers, real estate, housing or big ticket consumer discretionary items. Very predictable bad news should just keep flowing for the foreseeable future -- even after more short term interest rate cuts by the Federal Reserve. Rather than allowing the economy to correct itself with a short and painful recession, it appears that the Government has chosen to embark on several years of stagflation as a slow moving way for the economy to come back to historic norms.

Norm 1: Housing affordability must readjust to historic levels
The speculative housing bubble took house prices way above their normal relation to incomes (a relationship that has been amazingly consistent for many countries over decades). Several estimates say that house prices need to fall back to roughly 2004 levels, a reduction of about 20%. This amounts to a huge drop in wealth. The housing market is not going to rebound quickly -- it can't anymore, now that the bubble has been pricked. It is political suicide, however, to let the readjustment happen too fast. The obvious solution is to stretch out the solution and allow inflation to bring prices back into line.

Norm 2: U.S. Current Account must get closer to balance
With the rising value of the dollar under the Clinton administration the U.S. balance of payments got out of wack. The U.S. began to buy way too many goods abroad -- nearly 6% of GDP. The Bush administration decided to let the market solve the huge U.S. current account deficit by inflating the dollar -- with enough reduction in value of the dollar, eventually the foreign trade deficit would self correct. When Bush came into power a Euro cost about $1.00. Now a Euro costs about $1.54. A gallon of gasoline cost about $0.96. Now it costs about $3.40. Despite this huge change the current account balance has only improved slightly. Either petroleum consumption needs to be reduced -- which is not politically acceptable -- or the dollar needs to fall further -- further inflation and an increase in oil prices.

It seems a shame, though, that it will be the innocent incoming U.S. President who will get blamed for the mistakes of the Bush administration-- reminiscent of Jimmy Carter's lot in office.

The falling dollar, however, makes it harder to quiet the credit markets. A large number of conservative international investors now want to flee risky U.S. markets and investment in a falling currency. Credit is disappearing.

Eventually though, credit markets will calm. (The alternative is a repeat of something like the Great Depression.) As credit markets calm, we are expecting at least a temporary rebound in any non financial stocks that didn't deserve to be dragged down in the stampede of panicked investors.

Bottom line:  HOVZ Market Enthusiasm Indicator had been in free fall. It bottomed, rose considerably and has again gone skydiving. Is this an intermediate bottom? We think it is, but we could easily be wrong. Reinvesting on a fairly short-term basis is very attractive. Every day the odds keep improving. Compared to October, many great stocks are now at 20% to 30% off sale prices! We now have a 100% investment level.

.(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 -- even worse than the 14% undervalued level of January. Hopefully the market is experiencing a typical retesting of lows. 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.

% 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. That is VERY LOW. 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. ( For someone with a long 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 peaks. 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 dramatically lowered 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) Back near an all-time high. This has proven to be a good short range market predictor over the past year -- doesn't look good for the next few weeks. 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  (The incredibly high level of margin debt is at least partially a sign of high leverage in the markets. The fact that the growth rate has fallen for months may be a sign of a longer term deleveraging. 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 persistently 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 for the past few years 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. 

At the same time, it would probably be wrong to read too much into the predictive powers of margin debt levels according to this Mark Hulbert column from MarketWatch.com. Here is the NYSE data link.

Building Permits and Housing Starts (Major negative factor seldom worse than it is right now). 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. Here is a Wikipedia background piece on the U.S. Housing Bubble

U.S. Leading Economic Indicator  (See graph at bottom of link page.) (The leading indicator dropped again in February -- some big surprise? ) 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 in January for the fourth straight month.

Anxious Index (xls file) (Long term negative) This article by David Leonhardt in the NY Times says the Index now points toward an economic recession. He notes this Survey of Professional Forecasters maintained by the Philadelphia Federal Reserve hasn't missed calling a recession or called a false positive in the years since 1968 when it was started. Updated quarterly.

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. This week they decided to refill the punch bowl. The deficit is going to go up again. The loser will be the value of the dollar. For the moment, the reduction in the deficit is a significant contributor to the slowing economy. The federal $170 billion stimulus package that became law this week will not impact the economy for several months.

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 now it is a major contrary signal showing concern by the Fed that probably points to worse 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 reasonably 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. We're hoping this will tell us where we can afford to take our next foreign vacation.