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Today's Market WrapUp 02.28.2007 Mon Tue Wed Thu Fri Puplava Archive
The market yesterday seemed to answer the question to last week’s article entitled, “Bad Moon Rising?” as I wrote about a few developments that pointed towards a market correction. I wanted to update the figures presented last week and put forth a few more that point towards economic weakness ahead, which is likely to weigh on the markets going forward. First off, last week I presented Westpac Strategy Group’s economic surprise indices that have a great track record of turning prior to or at least coinciding with turns in the S&P 500. I showed last week how both the percent surprise index and the size of surprise index had both turned lower and hinted at a coming market correction. The updated versions are provided below. Figure 1
Figure 2
Both indices have descended further and will likely continue to fall as more economic data is surprising to the downside. The data in the figures above are weekly data, which is why the S&P 500 (black line) does not show yesterday’s correction. Moving on, I also pointed towards an up tick in the consumer staples relative strength ratio (XLP/S&P500) as possibly hinting at a market correction as it turned up sharply prior to the May 2006 correction. After yesterday’s close, the ratio has turned sharply higher with the S&P 500 falling in dramatic fashion. The consumer staples relative strength ratio has been a pretty reliable indicator of market tops and bottoms as S&P 500 market tops coincide with consumer staples relative strength bottoms and vice-versa, as seen by the opposite pointing red and black arrows below. Figure 3. Consumer Staples Relative Strength and S&P 500
The consumer staples relative strength ratio also has a fairly strong directional correlation with the Volatility Index (VIX) as rising volatility typically indicates fear, and when fear is rampant, investors rotate into defensive sectors such as consumer staples that lead to a rise in the consumer staples relative strength ratio. What I would like to point out below is that the multi-year downtrend seen in the consumer staples relative strength ratio was decidedly broken during last year’s May correction as was the downtrend in the VIX. The consumer staples relative strength ratio now appears to have shifted direction and is displaying an upward trending path. This is significant as this has not occurred since 2000, the year the stock market entered into a bear market (Figure 5) and saw the consumer staples relatives strength ratio soar until topping in late 2002, the year the S&P 500 bottomed. Figure 4. Consumer Staples Relative Strength and VIX
Figure 5. Consumer Staples Relative Strength and S&P 500
Negative Economic Trends Point Toward Continued Economic Deceleration The recent trend reversal behind consumer staples is likely to continue as more economic data is pointing towards continued deceleration in the economy, an environment defensive sectors thrive in due to sector rotation. Transportation data has been corroborating the slowdown in U.S. GDP and questions the rebound in the Dow Jones Transportation Average, which is likely the result of falling oil prices, not a turnaround in economic activity. Truck tonnage in shipments continues to move south on a year-over-year (YOY) basis as it has prior to recessions and mid-cycle slowdowns in the past. Figure 6
The Cass Information Systems data for both freight expenditures and shipments is warning of economic weakness, possibly a recession. Both indices have turned sharply lower, something that was not seen in the 94-95 mid-cycle slowdown. The indices turned sharply lower prior to the last two recessions and the recent trend is not an encouraging sign. Figure 7
Not only is trucking data pointing towards continued economic weakness but so is railcar data. Railcar shipments peaked in late 2003 and 2004 on a YOY basis and have continued to decelerate since then, turning negative in the middle of 2006. There is a fairly strong directional correlation between the consumer discretionary relative strength ratio with railcar shipments as seen below. As trucking data questions the strength in the Dow Jones Transportation Average, so does railcar shipping data question the recent relative strength in the consumer discretionary sector. Who’s telling the right story -- investors or economic data? My belief is in the latter. Figure 8
Looking at retail sales and retail employment would indicate that investors are on the wrong side of the trade by buying into the consumer discretionary sector as both are moving in the same direction (down) as railcar shipments, indicating a likely sell-off ahead in the consumer discretionary sector. Figure 9
Figure 10
The trend in Figure 10 not only points a bleak picture for the consumer discretionary sector but also the economy as a whole. The last two times the YOY rate in retail employment turned negative resulted in a recession. We are well below the levels of the 94-95 mid-cycle slowdown, and thus question the reality of a soft landing and adding support to a likely recession. The transportation data above as well as retail sales and employment data support economic cooling ahead and begin to raise the possibility of a recession. This then questions the likely sustainability in the markets and raises the potential for a severe market correction. The S&P 500 displays a strong correlation to the durable goods and nondurable goods inventory to shipments ratio (I/S). A rising I/S ratio indicates economic slowing as sales decelerate and inventories begin to build, and a falling I/S ratio indicates economic strength as inventory levels can’t keep up with rising shipments. As the markets reflect and discount economic reality, it’s understandable how the S&P 500 would have directional similarity to the I/S ratio where the movements are inversely related in which the S&P 500 rises with a falling I/S ratio and vice-versa. To show the correlation between the S&P 500 and the I/S ratio, I have inverted the I/S ratio for both durable and nondurable goods below. Figure 11
Investors correctly predicted a mid-cycle slowdown in 94-95 as the S&P 500 (black line, left axis) rallied despite a rising (inverted in figure) I/S ratio in both durable and nondurable goods. Investors were also right in selling prior to the 2001 recession as the S&P 500 corrected sharply in 2000. Was the rally since last June the start of a mid-cycle slowdown rally, or was yesterday the start of a recessionary sell-off? One very large deciding factor to this question is the direction of the Fed in setting interest rates. Retail sales contracted in both the last two recessions and last two mid-cycle slowdowns. Retail sale's YOY levels are currently at levels near the last two mid-cycle slow downs and have the potential to fall further unless interest rates are lowered by the Fed soon, which would greatly support the ailing housing market as adjustable rate mortgages reset. The Fed pays close attention to the level and direction of retail sales as the figure below demonstrates the strong relationship seen between them. Figure 12
Retail sales in Figure 12 was advanced and hints that the Fed should be lowering interest rates soon. More support for the Fed to lower interest rates is declining capacity utilization, which declines sharply prior to or coincides to every recession in the past four decades. The unemployment rate has strong inverse directional similarity to capacity utilization as unemployment rises with falling capacity utilization as seen by Figure 13 (unemployment rate inverted). Figure 13
Though capacity utilization has not contracted sharply, nor unemployment risen significantly, the recent trend change in capacity utilization may be hinting at what is to come, and will bare watching closely in the months ahead to determine whether the Fed has more support for lowering interest rates in addition to sharply contracting transportation, retail, and housing data. If the Fed remains on pause, the risk for a market correction continues going forward with some market technicians already calling for a top. Technical Work by Frank Barbera Frank Barbera, who writes the Tuesday WrapUp (Archive/Bio), called a market top in his February 20th WrapUp entitled, “Changes on the Margin,” with his commentary and figure provided below. Figure 14
As can be seen in the chart above, the rally of the last few months for the S&P 500 appears to be in its final phases, with a clear-cut ‘five-wave’ pattern evident from the July 18, 2006 lows. With a bit of closer inspection, we see that the recent rally has sub-divided several levels down during the third wave advance. Using a very conservative and generous interpretation, the evidence points to some type of “fifth” wave rising wedge completing in this time frame. Note also that internal momentum within the advance appears to be diverging, signaling the prospect for a potentially more important trend reversal. As stated over the last several weeks, the 1,400 area for the S&P remains an initial support boundary and should be expected to hold during any first assault. (Yesterday’s close = 1,399.04, pretty spot on!) Yet, the rally appears to be maturing, and against the backdrop of these broader concerns, one cannot help but wonder what unknown problems await for both the market, and for the safety of investors' capital when the vast uncorrected financial machinery of the past few years goes into reverse on the other side of a major top. Frank sent out an update to subscribers of his GST MarketFax newsletter this morning and I was given his permission to include it below to give readers a possible scenario as to what may come in the S&P 500. The S&P 500 has just completed the classic “overshoot” of the H&S neckline typical of these patterns in the development stage. From here, we look for a fast rally back over the next one to two days toward the 1430 to 1440 zone (mid-range target of 1435). At that point, Minor Wave (A) to the upside should complete and should be followed by a slower pace, but still relatively brisk decline back down to the 1405-1400 zone. This will retest the neckline which resides at 1405.00. At that point, we look for another rally back up toward 1430 and then another decline toward 1410.00. The odds are overwhelming that following the initial peak for Minor Wave (A) at 1430-1440, that a five wave triangle (a,b,c,d,e) will develop forming out Minor Wave (B). When complete, which should be very late March, there will likely be one final upward thrust for Minor Wave (C) back up to a slightly higher high in the 1440 to 1445 range. At that point, the high right shoulder of the top will be completing, and the danger will be increased for the beginning of the next intermediate move down. While the H&S pattern is my preferred view, there is a chance that a full scale double top could be seen in late March/early April at 1460 which would not change the overall outlook for the market, but would simply allow the market to hold up into quarter end.
I had been 10% short in my portfolio’s for the last 8 days, and we unwound all shorts and went long the S&P in the early going this AM. I will be unwinding longs on the S&P above 1435 over the next few days. Gold Stocks are bottoming along with energy names, all set for a nice recovery. TODAY'S MARKET - Economic Reports Gross Domestic Product (GDP) – 2006 Q4
Source: Bureau of Economic Analysis From the table above, what can be seen is a negative housing trend (fixed residential investment) that began in the fourth quarter of 2005 that continues to worsen. There was a lag of two quarters before the contraction in housing led to negative levels in total fixed investment (Q2 2006), which also continues to fall at a current negative 8.5% annualized rate. Furthermore, what is even more troubling is that fixed nonresidential investment has turned negative at a 2.4% annualized rate, with both residential and nonresidential fixed investment weighing on total fixed investment.
The last time all three were negative was in the fourth quarter of 2001, near the end of the recession. Prior to 2001, all three were in negative territory just prior to the 1990 recession. Notice the similarity between current readings and those in the 1990 recession. We are currently going through a major housing correction which was seen in the 1990 recessionary environment. With all three measures near pre-1990 recession levels (and in terms of residential fixed investment, greater than 2001 recession levels), are we really going to dodge the bullet with a soft landing?
The tell-tale sign will be the consumer (no surprise there). It wasn’t until the personal consumption expenditures (PCE) fell to a 1% contribution to GDP and were unable to offset the negative contribution of gross private domestic investment to GDP that a recession resulted. Any weakening ahead in PCE will likely result in a recession as gross private domestic investment continues to fall. With ARMs resetting at higher rates and with a negative savings rate, weakening in PCE is to be expected as consumer’s feel the pinch on their wallets. MBA Mortgage Applications Survey – Week of 02/23/07 Mortgage demand rose 3.2% last week, mainly the result of a 2.5% rise in purchase applications, while refinance applications rose a smaller 3.2% rate. The contract rate on the 30-year FRM decreased 3 basis points to 6.16% with the 1-year ARM moving in the opposite direction, rising 11 basis points to 5.92%.
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