Standing In Front Of A Train
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Standing In Front Of A Train

Week Ending May 8, 2009

Rally blasts up...
Leaders fall behind...
An earnings-deficient recovery?
Construction spending, ISM and jobs improve
Last hurrah, then seven lean years?
Elliott Wave SPX Perspective


Last Week

Quote of the week
"In the U.S., the total market value of housing, commercial real estate, and stocks was about $50 trillion at the peak and fell below $30 trillion at the low.  The original $50 trillion of perceived wealth supported $25 trillion of debt.  This loss of $20-$23 trillion of perceived wealth in the U.S. alone is still enough to deliver a life-changing shock for hundreds of millions of people." 
- Jeremy Grantham in the GMO Quarterly Newsletter May 2009

Rally blasts up...
This rally re-ignited to finish its ninth week of gains pushing the S&P500 up 36% from its March 6 low. More interesting perhaps is the fact that the SPX is showing its first gains for 2009. And stocks are even more overbought than there were last week. 

So why have stocks continued to gain ground despite all the economical problems we face? We discuss one very interesting theory from Jeremy Grantham in our Synopsis this week.

Technically Speaking
Leaders move up...
This week Dan's Monday watchlist included 16 stocks of which 13 were breaking out. They were Apple (AAPL), Blackstone Group (BK), (CYOU), First Solar (FSLR), Goldman Sachs (GS), Google (GOOG), James River Coal (JRCC), Massey Energy (MEE), Peabody Energy (BTU), Potash (POT), S&P Financial (XLF), SL Green Realty (SLG) and (SOHU). That they performed third in the group is bullish for the overall market next week. 

Figure 1 - Five-day performance of Zanger's last Sunday pix (green) compared to the S&P500 (SPX), the Dow Jones Industrial Average (DJX), Dow Transports (DTX), Nasdaq Composite (IXIC), Russell 2000 (RUT) and MSCI Emerging Market ETF (EEM). Data courtesy of The Zanger Report, performance chart courtesy of

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After steadily dropping from March 20 to April 10 then spiking two weeks ago, weekly volumes for the major indexes were above average again this week which combined with the strong move higher must be considered bullish. A rally needs a steady supply of new bulls buying stocks to give it strength and that clearly happened this week and based on the amount of late-day trading, institutions were getting in on the action. 

The Market Volatility Index (VIX) dropped again this week as the VIX closed the week at 32.05, down from 35.30 last week and 36.82 two weeks ago to the lowest level since September 19, 2008.   

Since rebounding off its December 5 bottom, the 19 commodity NYFE CRB Index gained ground again this week to close at 402.37 up from 381.27 last week and 372.50 two weeks ago. The strong move helped pare the loss from the high of 611.51 in July to 34%. As we discuss in our synopsis this week, commodities are clear beneficiaries of the mountains of cash in government stimulus that have been pumped into markets. This index us up more than 25% from its December 5 low.   

But gold has been somewhat of a laggard. After the surge in gold to $1001.10/oz February 20 then dropping, the precious metal moved higher this week to close at $917.20/oz up from $886.50 last week and $913.80 two weeks ago. But volume and open interest remain low which is bearish. It is important to point out that gold has a seasonal low in July and then rallies into year-end. 

Meanwhile, the US Dollar Index took a big hit slipping again to 82.53 from 84.54 last week as inflationary forces of the plethora of stimulus packages have taken root. Since its March 6 peak, the U.S. Dollar Index has fallen 8% with more to come now that US Treasuries are no longer considered a safe haven at any price.  

Crude oil futures joined the commodity party this week as a barrel of crude closed at $59.66 up from $54.06 last week and $51.49 two weeks ago.  Oil is still down nearly 60% from its mid-summer high of $147.20 but that gap will be short-lived as long as economic recovery continues.  

The Baltic Dry Index, an indicator that tracks the cost of shipping dry goods by sea, surged 23% again this week to 2214 from 1806, back to where it was March 11 as shipping demand appears to have also rebounded. This is bullish for both the economy and the price of oil but clearly shows how volatile shipping demand has been during this rebound.

The U.S. bank prime rate and the Fed funds target rate held steady at 3.25% and 0.00% - 0.25% respectively while the effective Fed funds rate slipped to 0.19% (from 0.23% last week). Meanwhile, the 3-month London Interbank Offered Rate (LIBOR*) slipped again to a new 52-week low of 0.9375% (from 1.00688% last week). This compares to LIBOR 52-week high of 4.81875% last October. 

On the mortgage front, Freddie Mac mortgage rates firmed this week to 4.84% (from 4.78% last week) for the 30-year fixed mortgage while the one-year adjustable rate mortgage (ARM) inched up to 4.78% (from 4.77% last week).  

*LIBOR is the benchmark for $900 billion in subprime mortgage loans which typically adjust to it every six months. Corporations around the world have the interest rates on roughly $9 trillion in debt pegged to LIBOR and rates on more than $380 trillion in derivative interest rate swaps also are based on LIBOR. About 6 million U.S. mortgages, including the vast majority of subprime home loans as well as 41% of prime ARMs are linked to LIBOR.

Earnings - The earnings-deficient recovery?
Here is an interesting perspective on earnings. As anyone who has been reading our newsletters for a while now knows, we believe that earnings of the broader market is a more useful metric than for a particular index, since indexes are cherry picked to highlight the best in class - good for investing in but they do not provide an accurate indication on the true state of corporate health. 

The VectorVest Composite is an index consisting currently of more than 8000 stocks. Here we compare the last recovery with this one from an earnings perspective. April 11, 2003 marked the "golden cross" of the price of the VVC moving above its 40-week moving average and the beginning of a 56-month bull market. As the rally was getting underway in March and April 2003, earning growth (GRT in red) was a much healthier 8% and earnings growth had begun improving nearly a year before after hitting a low of 3%.

As we see from the chart, another golden cross occurred again this week. But what is perhaps most interesting is the difference in the Price/Earnings ratio in this rally versus the last one. Last time around PEs peaked at 60.51 on May 16, 2003. Compare this to an incredibly lofty 130.45 this week. The comparisons don't stop there. You will also note that earnings growth is still deteriorating having recently hit just 2%.

Translation?  From a valuation perspective, prices are more than double what they were relative to earnings when the last sustainable recovery began. It is also interesting to note that sustainable recoveries following serious economic meltdowns have rarely occurred from such lofty valuation levels. 

Economic Reports
We learned this week that March construction spending improved month-over-month for the first time since July 2008 for a gain of 0.3% up from -0.9% in February. On a year-over-year basis, construction spending is down 11.1%. Growth was led by private nonresidential outlays while the private residential component fell 4.2% after falling 5.9% in February.

Last week we learned that the Institute of Supply Management manufacturing index moved up to 40.1 in April versus 36.3 in March as the manufacturing sector has shown slow but steady increases over the last four months. On Tuesday we got news that the ISM service index also moved up, to 43.7 which confirms the positive move in manufacturing, proof that the rates of economic contraction appear to be slowing. New orders were especially strong jumping more than 8 points to 47 and employment also improved nearly 5 points to 37. 

Then on Friday, the report the market had been waiting for arrived. Expectation was for a loss of 630,000 jobs. The actual April number came in at -539,000 and so was good news. What was not given much discussion was that the numbers for the last two months were revised downward - March from -663,000 to -699,000 and February from -651,000 to -681,000 for the loss of another 66,000 jobs. This follows another revision in the January number from -655,000 to a newly revised -741,000.

On first blush, the data are encouraging but there is one big caveat. The numbers included more than 60,000 new temporary government jobs that were created to handle the next census that once done, those jobs go away. Remove those from the mix and the actual number would have been a loss of more than 600,000 which isn't much better than -663,000 originally reported in March.

We also learned that the official unemployment figure has now risen to 8.9% from 8.5% in March which is the highest level since November 1983. Official unemployment has now doubled since hitting a low of 4.4% in March 2007. 

Last hurrah, then seven lean years?
In his latest newsletter,  market giant Jeremy Grantham of money management firm GMO LLC proclaimed that he was parting company with his "bearish allies." Why? He identified the Presidential Cycle and "the power of stimulus and moral hazard to move the stock market many multiples of their modest effects on the real economy" as the reason why he had recently turned bullish.

But before we explain, it is important to provide some background. A few years ago, we conducted extensive research into the Presidential Cycle and developed a trading system based on it.  In twenty-eight elections, the four-year cycle low for the Dow Jones Industrial Average was found to occur in September of the mid-term year and the high in November in the year of the election - a period of 26 months. Our simple system bought the Dow in at the end of September two years before each election, held for 26 months then sold the end of November each election year between 1902 and 2006.  

Our results are summarized in the next chart. As you can see, by buying the Dow 2 years before each election and selling at the end of November each election year, the hypothetical investor would have captured 93% of the gains versus just 7% by buying the 2 years following each election and selling the mid-term low. So by owning the Dow for just 26 months or 54% of each 48 month election cycle, earned the hypothetical investor 93% of the gains.

As this chart shows, a strategy that bought stocks two years (26 months) before each election and sold in November of election year would have captured 93% of Dow gains between 1902 and 2006 versus just 7% for one that bought immediately following each election and selling the 2 years (22 months) later.

Pre-election returns were even more pronounced for the Toronto Stock Exchange.  Heavily populated with commodity and resource companies which have strongly benefited from the inflationary effects of pre-election stimulus programs, the TSX enjoyed more than 97% of its gains in the two years leading up to each U.S. election versus a paltry 3% in the two years following an election between 1950 and 2006.

Why? In an effort to get re-elected every four years, the evidence clearly points to a whole bunch of stimulating by governments heading into each election. Both parties were equally guilty. However, once in office governments must get the nasty work out of the way early, making necessary spending cuts in an effort to get the nation's fiscal house in order.

But then like clockwork, as the second year neared an end, the stimulus machine was kicked into high gear as thoughts by the ruling party turned to getting re-elected. Stocks have historically been more sensitive to this stimulus than the economy and resource/commodity stocks more so than industrial stocks.

One problem with this theory is that stimulus heading into the last election did not have the usual positive affect. Instead of enjoying their best gains the four-years, stocks lost a third of their value during the 26-month pre-election period between September 2006 and November 2008.  Something had changed.

But since then, stimulative efforts have clearly been accelerated. At no time in history have governments offered more in the way of fiscal stimulus than during the last 12 months - the total exceeds a whopping $10 trillion if packages from governments around the world are included. And Grantham believes this is having a powerful effect on stocks and should continue to do so for a while. But he also believes this impact will be relatively short-lived. Let's face it, it's been a tough slog.

"In the U.S., the total market value of housing, commercial real estate, and stocks was about $50 trillion at the peak and fell below $30 trillion at the low.  The original $50 trillion of perceived wealth supported $25 trillion of debt.  This loss of $20-$23 trillion of perceived wealth in the U.S. alone is still enough to deliver a life-changing shock for hundreds of millions of people.  No longer as rich as we thought - under-saved, under-pensioned, and realizing it - we will enter a less indulgent world, if a more realistic one, in which life is to be lived more frugally.  Collectively, we will save more, spend less, and waste less.  It may not even be a less pleasant world when we get used to it, but for several years it will cause a lot of readjustment problems.  Not the least of these will be downward pressure on profit margins that for 20 years had benefited from rising asset prices sneaking through into margins."

Grantham also believes that inflation and time, at least seven years, will be required to get us out of the current mess. 

"Now, with the reduced and more realistic perception of wealth at $30 trillion combined with more prudent banking, this [$25 trillion] debt should be cut in half.  This unwinding of $10-$12 trillion of debt is not, in my opinion, as important as the loss of the direct wealth effect on consumer behavior, but it is certainly more important to the financial community.  Critically, we will almost certainly need several years of economic growth, which will be used to pay down debt.    In addition,  we will need several years of moderately increased inflation to erode the value of debt, plus $4-$6 trillion of eventual debt write-offs in order to limp back to even a normal 50% ratio of debt to collateral.  Seven years just might do it."

It seems clear that stocks are now responding with a vengeance to the mountains of cash governments have thrown at the problem and now that the trend has started, it should continue. But Grantham believes this effect will be short lived after which the subsequent recovery will resemble that of Japan.

"The flaky, speculative nature of the current rally bears none of the characteristics that I would expect from a longer-term market recovery."

"What I'm proposing could be known as a VL (very long) recovery in which stimulus causes a fairly quick but superficial recovery, followed by a second decline, followed in turn by a long, drawn-out period of sub-normal growth as the basic underlying economic financial problems are corrected." 

Although no one knows how long the current speculative rally will last, we might as well enjoy it while we can because when it's over, the real work will begin in getting our markets and economy back on to more solid footing once again.

Stories of interest this week...

An interesting bit of research - Are stocks a losing bet [over the long-term]?

The Last Hurrah and Seven Lean Years (Registration required - it's free)  or try

Business Groups Oppose Obama's Budget After Supporting Stimulus

Fed Stress Test Results May Show 10 U.S. Banks Need Capital

Wall Street Firms Will Revert to Pre-Crisis Model, Cohen Says

Libor Falls Below 1% for First Time as Credit Thaws

Short Selling of Banks Accelerates as New Financial Stress Test

‘Great Recession' Will Redefine Full Employment as Jobs Vanish

Taxpayers Lose $328 Million in Build America Profits

Obama Plan on Tax Havens Faces Hurdle in Congress

China Stocks ‘Bubble' Is Almost Over, Galaxy Securities Says

Bonds Show Lehman Fades in History as Spreads Narrow

Rothschild Difference with Madoff Becomes Geneva's Obsession

Working for your wealth,

John M. McClure
John M. McClure, President & CEO
EquiTrend, Inc.

Posted 05-11-2009 10:52 AM by John M. McClure