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Rally on hold...

Week Ending June 19, 2009

Rally on hold...
Leaders not heading higher
'Earnings-less' recovery continues
Builder optimism stutters, starts surge and Treasury sales fall
Wall of Worry climb takes a break or...?
Elliott Wave SPX Perspective


Last Time

Quote of the week
"The government played chicken with the bond market and it lost. If they were able to keep it up long enough, the housing market would heal and the rest on the economy could start its recovery. What has happened, however, is that the bond market called their bluff." - Randy Johnson, president Independence Mortgage Co., California.

Rally on hold...
Stocks took a break this week and volumes were noticeably lower as many traders began their summer vacations. But investors remain bullish and continue to ignore or at least discount bad news for the most part and that alone speaks volumes about this market.

But are investors being overly optimistic? After all the fundamentals are certainly nothing to write home about and earnings, as we will see, remain moribund.

Technically Speaking
Leaders not leading higher...
In his Sunday June 14 newsletter, Dan Zanger opined that a break below 920 for the S&P500 would suggest that the market was going to retrace some of this massive run up. That is exactly what happened this week. None of the stocks on his 11 stock watchlist were breaking to new highs, even over the short-term which is bearish.

Although weekly volumes for the major indexes were below average again this week, they were higher than last week and since this occurred on a drop in prices, is mildly bearish. A rally needs a steady supply of new bulls buying stocks to give it strength. Any increase in volume on falling prices shows bears coming to the party in growing numbers and the higher the volume, the more bearish it is. It is important to point out that summer has begun for traders and volumes are generally lower. Momentum has been falling and now the prices are down week-over-week for the first time in five weeks (SPX). But even with the drops this week, the S&P500 Index remains above both its 50 and 200 day moving averages so technically speaking, the up-trend is still in play.

Meanwhile, the Market Volatility Index (VIX) has continued to fall and this week it closed at 27.99 down slightly from 28.92 May 29.  Fear continues to leak out of markets and while still higher than average, the fact that the VIX is falling is bullish.     

Since rebounding off its December 5 bottom, the 19 commodity NYFE CRB Index has almost steadily gained ground that is until this week when the index fell to 401.70 from 417.04 May 29. However, the ongoing stimulation in the form of cash from governments should continue to have a positive effect on commodities but when it doesn't any longer, look out below.  Even with the drops this week and last, the CRB index is still up nearly 25% from its December 5 low.   

After the surge in gold to a high of $1001.10/oz February 20, the precious metal slipped for the third week to close at $934.9/oz from $959.30 May 29 after which it peaked at $992 during the first week of June. A chart of gold reveals that each time the metal has approached $1000 in the last 18 months, it has been rebuffed.  Volume and open interest continue to look anemic and that is bearish. Gold normally has a seasonal low in July and then rallies into year-end but there are factors at work, namely government generated inflation, that are more powerful this time around.

Meanwhile, the US Dollar Index has struggled since March, closing at 80.35 this week, which is no surprise given the fiscal irresponsibility world-wide with nearly $20 trillion being pumped into economies and more than $12 trillion in the US when all stimulus programs are added up. A steadily weakening dollar is bullish for commodities, interest rates and U.S. multinational corporations with a larger share of their revenues derived from overseas sales. 

But oil has continued to buck the commodity weakening trend as crude oil futures held relatively firm at $70.02/bbl this week amid hopes for a stronger economy and a rallying Baltic Dry Index (see below).  This is up from $66.31/bbl May 29.  Oil is still down more than 50% from its mid-summer 2008 high of $147.20 and the rapid drop has had a negative impact on supply which is bullish for prices.

And speaking of the Baltic Dry Index, an indicator that tracks the cost of shipping dry goods by sea,  it continued to surge since the end of May as the index jumped another 13.6% this week to close at 4070, up from 3494 May 29.  This is bullish for both the economy and the price of oil and is further confirmation of growing inflationary pressure trickling into the economy.

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 firmed to 0.25% (from 0.19% May 29).  
Meanwhile, the 3-month London Interbank Offered Rate (LIBOR*) continued to fall closing at 0.61188% another new 52-week low and down from 0.65625% May 29. This compares to LIBOR 52-week high of 4.81875% last October.  

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On the mortgage front, Freddie Mac mortgage rates firmed again this week to 5.38% (up from 4.91% May 29) for the 30-year fixed mortgage while the one-year adjustable rate mortgage (ARM) firmed to 4.95% (up from 4.69% May 29).  

*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-less' recovery continues
On May 29 the average Price/Earnings ratio for the 8,011 US stocks of the VectorVest Composite Index (VVC) hit another new all-time high of 151.45 thanks to rising prices but no increase in average earnings. That trend continued June 5 as PEs rose to another new high of 155.58 on rising prices but then prices began to drop and earnings for the broad range of companies showed their first signs of improvement rising from $0.13 to $0.15 per share. This pushed PEs down to an average 131.21.  However, the rate of earnings growth (GRT in red) was cut in half from 2% to 1% this week as the ‘earnings-less' recovery continued.

At the beginning of the last recovery, 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. VVC PEs peaked at 60.51 in mid-May 2003. 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%.

Looking even further back to the lofty prices in March 2000, we see the PE although high, was a much more benign 32 times and earnings growth was running at 11%. 

Figure 1 - Chart showing prices, average PE and earnings growth (GRT) for 8011 US stocks tracked by VectorVest. As the chart shows, the average PE for the broad range of publicly trading companies is in uncharted territory and well above any previous rally or recovery high.

This week we also took a look at earnings for stocks of the Canadian Toronto Stock Exchange (TSX). VectorVest currently tracks 2,969 stocks on the TSX exchange which rose more than 40% from March 6 to June 12, 2009 thanks in large part to the commodity rally. Earnings peaked at an average $0.73 per share in September 2005 and have steadily fallen since. By the week of March 6, 2009 they had fallen to $0.16/share and on June 12 they were negative $0.02. In other words, Canadian stocks rallied 40% during a period in which earnings dropped more than 100%! When earnings get this bad, there is no point in looking at PEs - recently they went from +1000 to -1000 in the space of a week!

So are US and Canadian stocks overprices now? You can judge for yourselves but either we have entered a new paradigm in which earnings don't matter or the market is betting that earnings are about to take off like a thoroughbred on steroids. Clearly prices have gotten way ahead of themselves!

Economic Reports
Builder sentiment drops, permits and starts rise, sales of US Treasuries fall
The National Association of Home Builder's Index of builder sentiment fell 1 point in June to 15. The survey made up of three components scored as follows in June - present buying was unchanged at 14, traffic through show homes/projects was unchanged at 13 and the outlook for buying six months out fell from 27 to 26.

The financial media buzzed this week with news that housing starts jumped 17% to 518,000 in May. However, not widely reported was the fact that permits which generally lead starts were up only 4%. Year-over-year, permits are down 47% while starts are down 46%. Since peaking in January 2006 both permits and starts have fallen 77%. Has the housing market bottomed? At this point, it is far too early to know.

Monthly net Treasury international capital flows registered the third drop in four months as foreigners sold net $53.2 billion in April versus a net purchase (revised) of $25 billion in March. A further breakdown of the April number showed that net foreign private flows were negative $58.4 billion, and net foreign official flows were $5.2 billion. Monthly net TIC flows is the most comprehensive category contained in the monthly Treasury report and includes non-market flows, short-term securities and changes in banks' dollar holdings. Foreign holdings of dollar-denominated short-term U.S. securities, including Treasury bills, and other custody liabilities decreased $39.4 billion and foreigners sold $44.5 billion of Treasury bills in April.

Why is this important? With a looming deficit north of $2 trillion, the US Treasury will have to sell approximately $200 billion in government bonds per month just to pay the bills, a level that is far higher than currently levels of investment in US capital assets. Unless the Treasury is able to attract new levels of foreign investment, there will be growing upward pressure on interest rates and rising rates are bad for housing and nearly every aspect of economic growth.

We got some good news from the current account deficit as it dropped in Q1-09 to $101.5 billion versus $154.9 billion in Q4-08.  But the improvement reflected a drop in domestic demand for imported products thanks to the recession. According to Bloomberg, the gap has narrowed to 2.9% of GDP, the lowest rate in 10 years.

The Wall of Worry climb has clearly taken a break but from a technical perspective, is too early to tell if it has come to an end or just taking a break. From a fundamental perspective, especially in relation to earnings, prices seem to have gotten way ahead of themselves but lofty PEs could also indicate the beginning of a longer-term rally. But without the anticipated growth in earnings, would indicate an overblown rally.

On the lighter side...
Trouble strikes in series of threes, but when working around the house the next job after a series of three is not the fourth job -- it's the start of a brand new series of three.                                                                  Avery's Rule of Three

Stories of interest this week...

Obama Aid Signals Deal With ‘Devil' as Bankers Get New Rules

Obama Plan Gets Wary Reception From Banks, Lawmakers

Obama Mortgage Refinancing Program May Expand, Lockhart Says

Obama Seeks to Show Health-Care Revamp Is Affordable

Fed Unveils Lending Details After Lawmaker Pressure

‘Swine' Bankers Shun Jet Loans, Leave $36 Billion Gap

Rosy thoughts on U.S. economy clash with reality

U.S. Home Prices May Fall for Years, Shiller Says

U.S. homes recovery distressingly slow: Reuters/UMich

Bank Rescue Costs EU States $5.3 Trillion, More Than German GDP

Dollar's Reserve Status May Deteriorate, Roubini Says

Working for your wealth,

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

Posted 06-22-2009 11:56 AM by John M. McClure