Twin events in the foreign markets impinging upon the ability to invest abroad caused tremors to be felt in the stock market. The reaction was a 15% drop in Thai stocks and a muted protest to China’s new policies. The meaning, however, may prove to be much deeper. The Asian Flu of ’97 started as a currency crisis in tiny markets and morphed into the LTCM crisis of 10/98. That comparisons almost immediately showed up between then and now may be more than coincidence. The free and easy movement of capital has always been an important factor to bull markets around the globe. Anything that impedes the movement of capital is a negative event; anything that impedes international trade is even more so. The news out of Asia was taken by the Street as more of a curiosity than a threat, at least for now. We wonder if a series of seemingly disconnected events such as last week’s trio of sub-prime lenders suddenly blowing up or this week’s retailers reporting surprisingly weak traffic and margins might not be signaling a larger issue for stock investors.  With sentiment at relative highs and surveys showing 89% of the Street believing a recession is now unlikely, the stage has been set.

A very sharp friend noted that sentiment in the NE seems to be gripped with a Malaise. It gives us chills just to hear the term applied to current events. Perhaps the cause is a deficit of construction or a closer relationship to financial markets where indicators seem to keep popping up with disquieting news of emerging chinks in the recovery’s, and therefore the bull market’s, armor. Or perhaps it is because longtime players in the housing market keep using words like ‘unprecedented’ that makes us New Englanders shiver more than the rest. Calls to friends who survived the S&L crisis of the ‘80s reflected the sense that even with housing prices off 10-20% across the nation, ‘things out West are actually going quite well’!

Something appears to be happening in the public perception of housing prices. The national numbers are projecting an image of a stable, albeit off its highs, industry with lots of potential to come back soon. We did some digging and came up with an entirely different scenario. It goes something like this: the actual sale price of a home is reported publicly about 90 days after it closes. The locals may have an idea of actual pricing in the real estate business, but also a negative incentive to report any declines; it’s bad for business! The only way to get reliable data is to trace auctions or to gather the data outside of the traditional channels. Recently some high-end homes were auctioned next to a famous resort. The sellers were expecting at least to get somewhat better prices than the 20% hit the brokers were talking about, hence the PR effort to buoy the final sale price. The results of the auction stunned almost everyone. The prices came in between 40-45% below what was expected, reflecting a much weaker marketplace despite a great deal of favorable attention generated by the event. The lesson to us is a striking one: the true housing prices won't be know for right now until 3 months hence! That means that the real estate industry incents buyers to step up to the plate while the real time prices are plunging, and no one is the wiser at least until after the fact. Sounds like a right profitable scam to us. Next time we buy or sell a house, we’ll check prices a lot more closely!

But the larger implications are troubling. If the US consumer is not fully aware of just how bad their real estate is performing and to the extent that home equity drives spending, then the economy is in big trouble. We just don’t realize it yet. There have been some interesting corroborative events lately to support our dour view of the consumer. Sub-prime lenders failing with no notice is only subsumed in importance in our view to the rash of sellers suddenly cropping up in the secondary market for lending institutions. Barrons wrote just last week about 3-4 ‘motivated’ sellers of sub-prime units. The surprisingly weak results at consumer electronics stores are another big hint. The two main players have both reported weaker margins and softer stales than the Street expected. Other retailers have turned from solid mid-single digit gains for ’07 to like-sized declines shortly after Black Friday. These signs tell us that there may be something to our thesis that mortgage resets and sub-par jobs growth coupled with flat inflation adjusted incomes over the last 3-5 yrs have set up a brewing crisis. If our theories pan out then anything touching the consumer could work out to be a good short, especially housing and construction stocks with potential for another leg down in the next qtr or so.

The huge run in corporate profit margins appears to have peaked and turned down in a cyclical decline that will possibly last for another 3-5 yrs. The last trough came around the end of the ’01 recession and appears to follow the expansion cycle closely which makes a great deal of sense to us. The implications of a profit peak would include a top in the stock market barring any major interest rate cuts or big drops in inflation. The only way profits can peak out is if wages are still constrained while consumer spending isn’t at all. Then with help from modest input prices the bottom lines can soar like they did in ‘05/06 time frames. Stocks usually follow the profit slide that comes next with a recession typically 4-6 months thereafter. We wonder if the timescale might be somewhat different this time because of massive deficit spending and consumers having gone so far out on the solvency limb. But until the market gives us the undeniable signal of a breakaway decline on heavy volume and confirming momentum, the Indian summer effect that has so well characterized the US this fall could continue a bit further. Still there are mounting data points to suggest it could be coming soon.

The inventory data coming out of Fed surveys has shown a consistent trend towards peak levels, something that correlates well with the onset of recessions. Extremely low volatility is another area of interest that historically signals the end rather than the start or middle of a bull run. The SPX has gone for twenty weeks without even a 2.5% correction and a stunning 1378 days without a 9% decline, both representing extremely unusual conditions for the stock market in our experience. The point is that after such a period of a major one-way market, reminiscent of the original nifty-fifty stocks in 1929, the odds of a correction go through the roof as does the probability of the decline being a larger than normal one. With unemployment at such low levels when wage growth has run up to a multi-year high and inventories are spiking despite the unprecedented benefits of Enterprise Software to facilitate Just-In-Time Mfg, anything that smacks of inflation or that shakes confidence in America could quickly become the catalyzing event that precipitates a major correction if not bear market.

By the numbers jobs represent the best recession gauge we have yet found. We took about 90-odd years of history and mapped it against recessions and found that it made an excellent indicator with some modeling and fine tuning. The result suggests that negative jobs growth in the US will shortly lead to a recessionary onset. With 300m people total, the US has over 151.2m workers. With population growth this number gains by 1.9% per year, so the economy has to grow jobs by 2.873m each year or 239k/mo just to absorb new entrants to the workforce. So far in this expansion, and including military reservist call-ups which we believe triple counts jobs created, the economy has added 5.844m and needed to add 10.77m in order to maintain the same level of employment. According to media reports this expansion has created around a net positive 5m jobs and the economy has done a ‘pretty fair’ job of creating employment. Is it any wonder that we question the veracity of the publicly available numbers?

With the markets around the globe reacting by 1-2% overnight and the SPX breaking down a major hourly wedge that was itself comprised of a striking number of embedded wedges, the implication of any sharp declines could be that the game is finally up. Wall Street bonuses are likely to hit records this year and are only 7 days from being locked in, making hedge fund managers twitchy in the extreme. It may not be too late for a correction to get legs in ’06, though the odds favor it in early ’07.

The market pattern from the top looks to us like a wave-1, wave-2 count which means that SPX has only just begun a decline that has violated two key support levels. With sustained prices below 1417 and 1390 and particularly on a fast breakaway with high volume and heavy momentum confirmation, the decline or correction or bear market, whatever one wants to call it, may have begun. The key will be how the markets react over the next 2-3 trading days. With Christmas only days away a decline becomes less likely but more perilous should it actually occur. The S/D charts are turning negative and go operative below 1390. Key data comes out Thursday so stay tuned! This may be interesting.

RTW

SPX has thrown over, reversed and rebounded – and hit retracements spot-on! Fast breakaway moves still needed!!

SPX has retraced 84.5% of the Y2k decline – almost exactly what a wave-1 to wave-2 relationship should be !

Inflation is perhaps in a wave-4 consolidation based on technicals – the risk is for another full leg up even after distortions in CPI

Permits data over LT look dreadful – Housing likely has another down leg ahead!

Home prices just broke trend – but that data is 3 mo old!! Auction data says home prices will fall 40%-45%

If this were a stock – we would be buyers! Inflation looks to us to go higher…

Empire Inv’s spiking higher – follows other Fed surveys higher and into Recession territory

Hourly Sell signal is operative below SPX 1417 on a sustained basis

The rapid decline and depth of momentum suggest further downside after a ST bounce

Every time Inventories have spiked up and turned down a recession has followed !

Daily S/D is very negative for NASD but just turning negative for SPX

Lower lows followed by lower highs points to a larger magnitude decline – SPX 1417 and then 1390 are key

Major turning points are often signaled in advance by an upturn in out New Low model indicator…

Rates have broken out and with confirming momentum – higher rates are now likely !

The dollar below 80 to us means serious trouble – Foreign investors have decreasing incentive to hold US

The LT support for housing doesn’t come into play for another 50%+ decline – suggests more downside ahead!

Weekly S/D lurks at 4-yr extremes – appears to be turning negative – confirmation below SPX 1390

For a new high on VAP, RSI is still weak but gaining – a lower high is a negative signal

Money Supply is now holding steady at moderately aggressive levels – belies Fed tightening…

Certifications and Disclosures

© 2006 Richard T. Williams, CFA, CMT
Editorial Archive

CONTACT INFORMATION
Richard T. Williams, CFA, CMT
ICAP Enterprise Software
Jersey City, NJ
Email