HOVZ Stock Market Forecasts

March 23, 2008
Intermediate capitulation and retest nearly complete?

All HOVZ Archived Commentary
Links to Other Stock Market Indicators

It appears that nerve wrenching stock market capitulation has been taking place over the past couple of weeks. Panic started to hit last summer, but it may have peaked with the sudden collapse of Bear Stearns last week. Scared investors stampeded to all possible exits. With plenty of evidence, they have been convinced that the financial world is falling apart and the real economy is sliding downhill. The scared have had plenty of press encouragement with articles like this one by Jon Markman from MSN MoneyCentral writing "Sell while the selling is good!" Capitulation took hold as deleveraging gained speed and money flew to supposed safe havens.

On Sunday and Tuesday the Federal Reserve took dramatic and unprecedented emergency steps to restore confidence. Many agreed that the financial system was on the brink of a possible systemic lockup. Thing could have fallen apart in an unthinkable way if the Fed had not acted decisively. The Fed established direct lending to major brokerage houses and further reduced short term interest rates.

The market now needs to figure out how hard it will be for Wall Street firms to stay in business if they can borrow unlimited amounts of money at 2.25% or so with most any sort of weak collateral? That rate is even below the current rate of inflation. None the less, even after the rate cut Standard and Poors still anticipates a 20% to 20% fall in revenue for brokers as a whole.

With the Fed's stimulation and new liquidity, the panic stopped short on Tuesday.

Panic returned on Wednesday but it was of a different sort. Now investors began fleeing the commodities arena, especially oil and gold. Commodities of all sorts had built up to bubble levels with large and small investors seeking shelter from stock market declines and inflation. (MarketWatch story) The capitulation of commodity prices may well signal final despair of market participants. Now, just maybet the stock market will be ready to calm and reevaluate. The Reuters/Jefferies CRB Index of 19 commodities fell 8.3% for the week -- the steepest drop since 1956.

Thursday afternoon, the end of a shortened trading week, saw all the U.S. averages up significantly. For the first time in a while investors weren't afraid to hold stocks over a long weekend. Phew!

As a rule of thumb, any significant interim market bottom gets retested at least once. Hopefully, that is what last week's stock market activity was all about. The volatility -- highest in 70 years according to Standard and Poor's -- has been incredible. Take a look at the long term history of the HOVZ Market Enthusiasm Indicator and see how common retests are.

The immediate collapse of credit and confidence hopefully will wrap up soon. But, the overall problem of a hugely inflated credit/asset bubble remains. The best hope now is for the bubble to deflate in an orderly fashion -- and that probably is going to take several years. Stagflation now looks attractive compared to the other alternatives.

Sadly there is no magic potion or hangover remedy available that can make all things right -- there are no more assets that can be inflated. Consumption -- based on borrowed money -- will be cut back. Now, some high leverage bets have to be withdrawn and some of the borrowed money has to be paid back. And, as everyone knows, paying off a loan is a slow and tedious process -- not near as much fun as taking out the loan in the first place and blowing the money on a new treat.

As we see it, here are some of the most important economic distortions that remain to be worked out -- not over the next few weeks, but over the next few years.

1, Housing affordability must readjust to normal levels
Over several years, 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%.to 30%. Both homeowners and lenders will be hit by this readjustment. This huge drop in wealth has only started to impact the economy. Just considering the resulting decline in consumer spending implies that the growth rate of corporate profits is near-certain to fall for a considerable amount of time putting pressure on stock P/E multiples.

2. Losses must be absorbed and insolvencies avoided
As reported in The Economist, Goldman Sachs now estimates that the direct impact of a 25% reduction of home prices will eventually reach over $1.1 trillion, about 8% of GDP, or something like 3 years of normal GDP growth. That's pretty bad -- perhaps 8.8 million homeowners may find themselves financially underwater. Further losses in the stock market would only make things worse. But, far more serious to the integrity of the financial system is the probable loss to U.S. financial firms of about $300 billion, just over 2% of GDP. That capital now is used as margin reserve by these financial firms to justify highly leveraged borrowing. Assuming rather low leverage of just 10-to-1, the loss of $300 billion capital must either be replaced by new investors (e.g. overseas sovereign wealth funds) or loans of roughly $3 trillion would need to be called in -- something in the order of 20% of GDP. Whatever the outcome, it is sure that credit will be tight, impacts will continue to spread, and more insolvency fears and bad news will continue to flow for years. The days of loose credit are gone for a while.

3, U.S. Current Account must get closer to balance
Following the rising value of the dollar under the Clinton administration, the U.S. balance of payments -- which had been bad already -- went totally out of wack during the Bush years. The flow of dollars to buy oil and way too many goods abroad got out of hand -- nearly 6% of GDP on an annual basis. The Bush administration decided to let the invisible hand of the market solve the huge U.S. current account deficit. i.e. They inflated 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 $1.55. Despite this huge change the current account balance has only improved slightly. The dollar is probably going to fall more. So the wealth of Americans and all those holding dollars will go down. It also makes it less likely that foreign capital will be investing in the the U.S.. The positive side of this is increasingly it should help profits of companies making money outside the U.S..

4, Commodity price bubble must end
In 2000 a gallon of gasoline cost about $0.96. Now it costs about $3.40. That is an increase that is far in excess of the impact caused by a falling dollar. While there are several factors behind the increase in commodity prices, especially fear premiums for oil and increasing worldwide demand for other commodities, some of the increase is a speculative bubble. The bubble has been pervasive, the same sort of increase has occurred with many other commodities such as gold. The flight of capital to the supposed 'safe haven' of commodities has created a major bubble. As confidence comes back to the financial markets and as recession causes demand to subside, the commodities markets could well implode. Departure of the Bush administration might not hurt either.

Bottom line:  HOVZ Market Enthusiasm Indicator had been in free fall. It bottomed, rose considerably and has now retested the lows. 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. (But not in the cyclicals of financials, real estate, discretionary items, or construction.) 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 -- but humbly we admit to having jumped back in too fast and to have lost money as a result.

.(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.' 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 February for the fourth straight month. Here's a Bloomberg story on it.

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 The Fed has rushed like it never has before to drop short-term rates. At 2.25% there is not much further they can go. Eventually this will stimulate the economy. But, because of lag times, for now it is a major contrary signal showing just how worried they are at the Fed. 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.