HOVZ Stock Market Forecasts

June 22, 2008
We are trying to pretend that the market isn't performing poorly.

All HOVZ Archived Commentary
Links to Other Stock Market Indicators

HOVZ longer term forecast has been great, but our short-term forcast and the market's actual behavior are both negative. So, to deal with the situation, I took a mini-vacation this weekend and tried to ignore things. Anyway, I am just repeating last week's column. As said many times, HOVZ forecasts seldom change quickly,

(Repeat) Sometimes we get it right. As anticipated, the stock market has been weak and volatile, possibly retesting its lows of March (Mark Hulbert article). This is no big surprise as the market had risen unusually fast since March. When that happens there is usually some catch up time needed. HOVZ forecasts point to better times, probably getting underway later in the summer. Time will tell.

In the meantime, all these market ups and downs make us feel kind of seasick. So, as a distraction let's deal with something entirely different: stock market cycles.

Stock market commentary is filled with ramblings and pontifications about all sorts of stock market cycles. Some of this seems downright weird and wacky. Here's a fun sample I clipped from a chat room discussion this week: "Looks like an elongated 5th wave that could be as long as the recent third wave, so what would this bottom look like then. " Huh?

Each cycle theory has its ardent believers. Even the most staid acknowledge the Market Cycle (good Investopia.com entry!) the business cycle, the housing cycle, and the interest rate cycle. Very often, like now, the focus gets to be on how one cycle interacts with another. For example, housing and the business cycle (International Monetary Fund report), today's hot issue.

Some cycle theories seem to have some verifiable credibility like the Presidential Market Cycle, (another link) and the Seasonal Market Cycle (Mark Hulbert article, NY Times) (Sell in May, buy at Halloween, and just before other holidays). Which is to say, these cycle theories work, except when they don't.

Several popular cyclic market theories stray far from normal economic forces, including: Astrology, Kondratiev waves, Elliott Waves, Kress Cycles (Clif Droke article), the Four Year Cycle, and Fibonacci patterns. To their adherents these paradigms are a vital way of understanding what the stock market is up to.

A personal favorite in the cycle world is Didier Sornette's mathematically intensive log-periodic signature cycle as a precursor to market crashes. (Before a crash, markets tend to shoot up exponentially and to become more and more volatile until they are torn apart.) In Why Stock Markets Crash Sornette provides a very readable overview of other attempts to model and forecast stock markets.

HOVZ is not immune from fascination with market cycles. The HOVZ Market Enthusiasm Indicator is a data series that results from our forecasting effort. It oscillates up and down in a somewhat periodic way that is partially predictable. We remain convinced that the forecast portion of the Indicator is the single best guide we have seen of where the stock market is likely to go in the next few months. Its timing accuracy leaves much to be desired, but its general direction has been very helpful to us.

So what? In the end, that's the question that counts. So what? Are stock market cycles real? Or are they all completely bogus? Or what?

At one level, all the stock market cycles we have seen (including our own) are fallacies, fakes, frauds and outright fantasies. Aside from the simple fact that some of the cycle theories have no credible basis in reality whatever, not one of them gives accurate results all of the time. The random complexities of an economic organism as large and open-ended as the stock market are tremendous. The further fact that investors are not purely rational and that seemingly random events of history or nature can have terrific impact put the lie to any possibility for a precisely periodic predictable cycle. The clincher anti-cycle argument comes from the Efficient Market Hypothesis. Put simply, if any cycle theory really worked, then everyone would use it. Then because everyone followed it, the cycle would stop working as a useful source of information advantage.

But, just because some particular cycle theory is bogus or nonsensical, that doesn't mean that it can't be useful. If every aspect of every religion was tested by science and the rules of fact, then in many cases there wouldn't be much left. But maybe with stock market cycles, like religions, there is something 'truer than true', something that has value whether or not it is literally true.

We have some tests to consider when thinking about cycles.

Does the cycle tend to discourage frequent trading? Maybe there are ways to make money in day trading. But, we haven't found them. In the short run the market is a zero sum game -- for every winner there is always a loser, and the bookie\broker always gets his cut. Several studies have shown that stock market success is inversely proportional to the amount of trading -- the more you trade, the worse you do,

On this criteria, most of the cycle theories do fairly well. They concentrate of relatively long term patterns, and as such the natural probabilistic growth of companies shifts in their favor. Over time the stock market is not a zero sum game. Real growth occurs. So a longer holding period inherently adds to the positive aspects of following some particular cycle.

Does the cycle soothe your worries and give peace of mind? In and of itself, there is something beneficial from a cycle theory that gives its followers a sense of understanding, control and direction. It's just nice being able to sleep at night! Calm and confidence tends to encourage longer holding periods.

Does the cycle encourage buying at low points and selling at high points? From a trading standpoint, one of the worst possible strategies is to try to buy when stocks are rising and sell when they start to fall. In practice, far too often the novice buys in when a stock has already risen to dangerous levels. Then when the price plummets, the novice sells out -- usually just before the stock starts a rebound.

From this perspective, most of the cycle theories again fare well. As cycles, or waves they emphasize that stocks inherently rise and fall and that profits can be reaped by buying lower and selling somewhat higher. They also help build the simple faith that when the financial world appears to be on the edge of destruction, there probably will be a brighter day -- given some patience.

Does the cycle theory give a yardstick for evaluation the progress of the market? Suppose your interpretation of the cycle you are following is exactly opposite to what the market is doing. That actually can be very helpful if it causes you to make a major reevaluation and to carefully reconsider your positions. As such it helps you to stay focused on major market directions and major forces moving the markets.

We are now rather agnostic towards most market cycle theories. The actual science or mathematical validity behind any cycle theory has become much less important to us. All of them are really just notions. But, if the cycles lead to patient attentive and careful behavior, then we don't have much against them,

Bottom line:  HOVZ Market Enthusiasm Indicator has stumbled in the past few weeks. Our forecasts expect it soom to be heading back up. The rally for some stocks may have gotten ahead of itself, but the next several months should be good -- IF history is any sort of guide. Reinvesting for the next half-year is very attractive. Many stocks are still at sale prices! We now have a 120% investment level . We may buy more if there is a little more of a dip.

.(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 13% undervalued (8% three weeks ago). Can't hide the fact that stocks have been having trouble. But, this is still much improved from negative 15% in March when the market completed a typical retesting of its 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. A significant amount of upside remains. Click on the 'Maximum' tab for the best view of the Morningstar chart. To us, the direction appears to be up.

% Stocks Trading Above 200-Day Moving Average (The current value is shown at the very bottom of the link page. ) About 29% of stocks are above their 200-day average. In March it hit 17%, a typical bottom. It is still reasonably low and the direction is bullish. 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. For someone with a long term perspective, the market is in buying territory.

NYSE New Highs & New Lows  Typically this is 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 falls from a peak and a 'Sell' indicator occurs near when the number of new Highs peaks. www .InvestmentTools.com. 

Long Treasury Bond versus Discount Rate  High interest rates tend to be bad for corporate profits and stock market prices. For banks the nightmare scenario is when the short term rate they borrow money at climbs higher than the long term rate at which they lend money out. So it is little wonder that the banking world disintegrated in the past 2 years as the Fed cranked rates higher.

Now, the Fed has dramatically lowered short term lending rates creating a major stimulus to keep the economy pumped up. The difference between the short and long rates is seldom greater than it is now. Few economists are expecting another rate cut in the near future.(MarketWatch.com forecast, bottom of linked page). 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. (Hey HOVZ, what do you mean, "could cause?" -- The dollar already is in a serious free-fall.) The rate inversion that existed during most of last year ended up being a good predictor of the market troubles that are occurring right now.

Short Interest Ratio (from InvestmentTools.com) This is really strange -- the ratio never seems to have dropped this far this fast before. We thought it was bad data, but apparently the data is correct. 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. Watch the moving average of this indicator for a very broad look at the anxiety level of the stock market.

Margin Debt  (THIS IS SCARY. It looks like margin debt has sunk below its 20 week moving average -- first time since the last recession, and a rotten long term sign. 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.  We are at the brink!. Here is the NYSE data link.

Building Permits and Housing Starts (Major negative factor seldom worse than it is right now. When the pundits use the phrase "... since the Great Depression..." it's not a really good omen). 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. New home sales sank again in March to levels last seen in the 1990's. (NY Times) Here is a Wikipedia background piece on the U.S. Housing Bubble

U.S. Leading Economic Indicator  May be looking a little better. (See graph at bottom of link page.) The eLEI went up in May .4% -- the best showing in half a year. . A competing and better known leading indicator, the Conference Board Leading Economic Indicator also rose slightly in April. We aren't impressed.

Anxious Index (xls file) (Negative but it does seem to be improving) This article by David Leonhardt in the NY Times a couple of months ago said the Index pointed toward an economic recession. He noted 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. For the past year or so, in a major turn-around, the deficit declined rapidly. It is already $200 B per year better than a couple of years ago. Not surprisingly, cutting back on Federal joy juice the economy started to slump.

Now, jumping to the rescue with fresh liquor for the punch bowl, the new economic stimulus plan is going to send the deficit way up. (Well, screw our kids and grandkids!) The U.S. Dollar has been falling for years. It has looked better recently, but as long at the U.S. balance of payments is so terrible, we just can't believe that the Dollar will jusm up too high..

$58 billion in checks to individual taxpayers that are part of the federal $170 billion stimulus package have now been distributed. But, as Jon Markman at MSN MoneyCentral writes, higher food and fuel prices may suck all that stimulus up. It pales in comparison to the home equity lost in the same period and the companion drop in home equity borrowing.

Effective Federal Funds Rate and Target Interest Rate (from St. Louis Federal Reserve) Negative in the short-term, but soon because of lag times it will become a positive factor. The Fed has rushed like it never has before to drop short-term rates. At 2% there is not much further they can go. The quarter point reduction on 4/30 was a sign that rate cuts are near an end. Recent statements from Chairman Bernanke and other Fed members all point to a freeze on rates for now. Eventually rate cuts 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 no more cuts for while at least.)

Price / Earnings Ratio of the SP-500  (Rising P/E because of falling profits is bad news.) The P/E ratio has spiked up in recent months, a sign of earnings going down shrarply, especially in the previously profitable financial sector. This is a sign of bad economic news.

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 McDonald's 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.