HOVZ Stock Market Forecasts

June 29, 2008
Even HOVZ forecasting model is getting scared

All HOVZ Archived Commentary
Links to Other Stock Market Indicators

The past few weeks have been terrible for stock markets. Stocks in Europe and the U.S. are back at 2-year lows. Bloomberg.com called it "the worst June since the Great Depression." HOVZ forecasts long have been projecting a rough patch following the market rebound from this winter's panic. But, recent market trauma has been significantly worse than we expected. High market volatility -- like Thursday's 3%, 358 point drop in the Dow -- said loud and clear that fear is widespread. Gulp!

HOVZ calculations, however, are just too dumb to read the newspaper. With their focus on characteristics of investor herding, HOVZ models still expect the retest to end, leading to some rebound for most stocks. (with the notable exception of anything related to finance or home building). But, overall HOVZ forecasts are less and less optimistic. To see this, watch the animation in the right hand column for our Market Enthusiasm Indicator. It looks weaker and weaker.

Wall Street tends to see itself as the true focus of the world -- much akin to Hollywood's feelings of self-importance. And now, Wall Street seems pretty well convinced that Armageddon has arrived. Last winter -- after denying that it had been building a huge house of cards for years -- the Street woke up and found itself insolvent -- bankrupt. So much of the wondrous and highly profitable financial engineering of the past few years was suddenly seen as a sham that had ignored the probability of risk. Packages of Subprime loans with teaser rates, no-doc loans, Structured Investment Vehicles, highly leveraged corporate buyouts, hedge fund mania, Credit Default Swaps and so many other fascinating and highly leveraged financial tinker toys all began to fall apart. The investment banks were smacked by the surprise conclusion that they would be stuck holding much of the bag.

According to International Monetary Fund and UBS estimates, total financial sector losses will reach roughly $945 billion. John Paulson, founder of the Paulson & Co hedge fund is estimating $1.3 trillion in losses. So far, though, only about $400 billion has been announced. More finance industry losses are coming. When Ben Bernanke tells banks to get more operating capital, and fosters hedge fund investment in banks, there couldn't be any more obvious signal that more hard financial times lie ahead. Well, maybe the Government staffing up more agents to deal with a large number of anticipated bank failures qualifies as an even more obvious signal.

This past week more losses and financial troubles came out related to many of the big names of the financial world: Merrill Lynch , Citigroup, Royal Bank of Scotland, AIG, HBOS, ....

More reported losses will continue to trickle out. For the financial sector as a whole ( XLF) our numerical forecasts are rosy -- but the knife has not stopped falling yet. For now, see only more pain and suffering ahead. The major U.S. averages (SPY, and DIA) also are going to have a hard time because they are heavily weighted toward the major financial firms.

Then, there is the whole rest of the U.S. economy to consider, and that also looks grim. It doesn't really matter if it is a recession yet of not. Consumer confidence is as a 28-year low. The housing bubble is over, and any industry linked with housing has been devastated. Most all big ticket consumer industries like boats have been hit. All of the losses in the financial industry are morphing into a credit crunch several times larger. Consumer wealth has crashed, but somehow consumers keep borrowing more than they earn. The U.S. Dollar is in an intentional multi-year slide causing inflation in all things, but especially in the commodities arena. Commodity speculation to avoid holding dollars may well be making the matter much worse.

None of these major economic gut punches are likely to go away any time soon. We even need to be careful what we wish for. If peace were to suddenly break out in Iraq, the cutback in war spending and returning troops entering the labor market could make things a lot worse for a while.

The U.S. is facing protracted tough times. From the start of the Bush administration we lived in Never-Never Land and spent a ton of borrowed money. The U.S. has been trying to slither away from the debt by devaluing the dollar. Much of the rest of the world has matched our currency inflation in an effort to keep up sales to us. So, the world has largely joined us in inflation and a massive credit and asset price bubble. The massive deleveraging that will deflate these bubbles has probably just started and may run for years. The stream of layoff announcements coming from the financial community shows that is what they believe will happen. Margin Debt  probably will give a good view of the deleveraging progress.

At the very very least, corporate America is facing slower rates of profit growth that are certain to translate sooner or later into lower P/E multiples and hence lower stock prices.

But, "sooner or later" is not the same thing as "next week". The stock market is always looking ahead of the economy and the numbers we read in the press are mainly about the past rather than the future. All the economic problems we face now were talked about in the press since at least 2005, but the stock market didn't react then. So just because more storms loom on the horizon, it doesn't mean that it is going to rain in the next few minutes. Take a look at the long term history of the HOVZ Market Enthusiasm Indicator . If the past is any sort of guide to the future, it appears that a significant stumble while rebounding from a major panic (1987, 1990, 1998, 2002 ) is entirely normal, and is typically fairly short lived. If history is a guide, the world probably won't end in the next few weeks.

So, scared and shaking, we'll try to grab a little solace from our calculations that still point to many stock prices going up over the next few months. Our focus is on stocks that have little to do with the problems in U.S. finance, but that were knocked down anyway in the market panics.

Bottom line:  HOVZ Market Enthusiasm Indicator has been hurting for weeks. Our forecasts expect it soon to be heading back up. Reinvesting for the next half-year is very attractive. Many stocks are back at sale prices! We have been at a 120% investment level, but are now dialing back to 80%.

(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, which is back to the March lows. There may be a huge stock market bubble somewhere -- but it isn't in the bulk of U.S. stocks that Morningstar tracks. We read this graph as saying that stocks are at 'sale' prices. ) 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. 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 24% of stocks are above their 200-day average. In March it hit 17%, a typical bottom. It is again reasonably low, but while prices are falling, the direction is bearish. This is getting near a buying point again. 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 If 'blood in the streets' is a good sign, then this must be betting near a good point 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. Pay close attention to the rate-of-change graph at the bottom of the linked page. It has now turned negative, almost certainly meaning a serious bear market.  We have just stepped over 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 and May. 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 cut taxes and 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 jump 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 sharply, 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.