Are equities getting long in the tooth?

In This Issue:

Are equities getting long in the tooth?
The pros and cons of owning gold
Bulk dry shipments and rail traffic trending lower but...
Economic charts show improvement... that is except employment
Carry trade update
Chinese stocks still weak
Market overview
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Interesting Stories...

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Quote of the month

"So, in order to earn 6% for clients after inflation, fees and taxes, these financial planners will somehow have to pick investments that generate 11% or 13% a year before costs. Where will they find such huge gains? Since 1926, according to Ibbotson Associates, U.S. stocks have earned an annual average of 9.8%. Their long-term, net-net-net return is under 4%."Why Many Investors Keep Fooling Themselves, WSJ January 16, 2010

Are equities getting long in the tooth?

Last month, we discussed the importance of the Santa Claus rally in the last five trading days of the year and first two of the New Year. Although the last five days of 2009 were negative for the S&P500, the rally was saved thanks to strong performance in the first two trading days of 2010 helping the index post a net gain of 1.4% over the seven-day period. As we mentioned, a positive Santa rally bodes well for a positive close in 2010.

Our next indicator one the Stock Trader's Almanac 2010 calls the First Five Days indicator. "S&P gains in the first trading five days of the January preceded full-year gains 86.1% of the time." This is also good news since the S&P this year as it gained 2.7% during this period.

Another important Stock Trader's indicator is the January Barometer which says that as goes January, so goes the rest of the year with a batting average of 0.746. Its accuracy is lower this mid-term election year (2010 is a mid-term election year) at 0.666 in that it forecasted the outcome in 10 of the last 15 mid-term years. It is interesting to note that down Januarys since 1950 have predicted down years 100% of the time so we'll be watching this month closely.

Figure 1 – Weekly chart of the S&P500 showing the peak in October 2007 and rally off the March 2009 low. A bearish wedge chart pattern is still building that is much longer in duration than usual. Note that volume has continued to drop, especially lately which is bearish. Chart by

Historically, stocks have struggled in the two post-election years (of the four-year election cycle) and markets have traditionally bottomed around September of the mid-term year. But this time has certainly been different so all bets are off for the usual election cycle performance this time around given the amounts of money global governments have thrown at the credit crisis. Between 1902 and 2006, the S&P500 has registered 93% of its gains in the two pre-election years and only 7% in the two post-election years.

But there are technical and fundamental reasons for concern. Since bottoming in March 2009, volume has steadily declined and volume was especially weak during the Santa Claus rally (see red arrow in volume sub-graph). Rallies on low volume are generally suspect as this demonstrates a lack of broad-based investor participation.

Fundamentally, this rally has been driven in large part due to unprecedented government stimulus programs prompting the trillion-dollar question. What happens when governments either voluntarily remove stimulus or are forced to due to declining Treasury demand?

Gold pros and cons

Last month we discussed the weakness in gold and what it and dollar strength meant for stock performance. Lately there has been a negative correlation between the SPX and the dollar – one that is highly negative at -92.5%, down slightly from -95% last month. We saw the two factors work against stocks in the latter part of December. Lately, the dollar has started to weaken again and that has provided another lift to stocks.

But the dollar has continued to drop and is now down more than 85% in terms of gold since 2001 in spite of the recent weakness in gold. Two articles in the Interesting Reading section below offer opposing views on gold.

A deflationary view that trashes gold is understandable for those who support government and Fed policies. The opposing camp advocating the purchase of gold or other precious metal is a vote against government monetary policy and the incredible increase in cash printed and put into circulation (monetary base). It is a monumental battle between gold bugs – those who oppose the fiat paper currency trend versus the government pundits – those who promote Treasury bond purchases who are betting against inflation and a strong dollar.

Unfortunately, the history of fiat paper currencies and the aftermath of banking crises do not support the latter or current government policy. As Ken Rogoff and Carmen Reinhart point out in their excellent 2009 book entitled This Time is Different (which I recommend if only because an ignorance in the lessons of history dooms us to repeat them), the three years following banking crises saw government debt soar an average 86% and high government debt (north of 90% of GDP where it is today in the U.S.) has been historically negative for economic growth. Unfortunately, the most popular governmental solution has been to inflate its way out of the problem, especially when domestic debt levels were high, like they are today in the U.S.!

(For more on this be sure to read the articles entitled High debt? Say goodbye to growth and Growth in a Time of Debt in Interesting Reading.)

Figure 2 – Daily chart of gold showing the 80% gain from October 2008 through December 2009, followed by the 12% drop and 5% resurgence to start the New Year. However, technically speaking the uptrend from the 2008 low is still very much alive and well. Chart by

Gold peaked in early December at $1227/oz and then suffered a 12% decline over the next three weeks. Since then, gold has come back somewhat clawing its way back toward $1150/oz on a slow but steady increase in volume, which is bullish.

A deflation argument (against owning gold) is also a vote against the stock rally – rallying gold prices generally equate to a weakening dollar and that is usually good for stocks. So as long as gold rallies, stocks should do the same.

What defies logic is how deflation proponents do so in spite of the fact that the monetary base has more than doubled in the last year. Exactly how can doubling the dollars in circulation result in deflation? A deflationary belief requires an incredible leap of faith in the ability of government policy makers – one that is simply not justified based on past performance.

But logic and history aside, the camp that gets this argument right stands to earn significant gains!

Dry goods shipments and rail traffic trending lower but...

One useful measure of transport demand is the Baltic Dry Index that tracks shipping rates for dry goods transported by sea and since it is not traded on an exchange is less subject to speculation and manipulation. It is therefore a good indicator of real demand for goods and commodities used in manufacturing a wide variety of products around the world, as well as an economic bellwether. Although the BDI is up 500% from its lows in December 2008, it has continued to be weak since its last peak in mid November.

Another useful indicator of economic demand is railcar traffic published by the Association of American Railroads (AAR). When the index goes up, it shows increasing demand for goods and commodities as factories and outlets gear up to meet consumer spending.

As the next chart shows, the first six months of year have traditionally seen strong transport demand and as the dashed sloping trendline shows at the right of the chart, the uptrend is still alive. But if this index breaks down strongly in the coming weeks, it will be bearish so bears watching.

Figure 3 – Daily Baltic Dry Index showing typically strong performance in the first six months of the calendar year.

The next two charts show composite North American railcar demand. Again, notice the tendency for increasing demand in the early part of the year except that railcar demand tends to pick up in Q2 (see yellow boxes).

This chart also shows that demand tends to drop into year end.

Figure 4 – Railfax chart showing railcar demand between 2005 and 2009.

However, the bigger picture in the next chart shows that railcar demand is well down from the previous three years, and according to the AAR rail traffic is back down to 1988 levels.

Will both dry goods and rail traffic show their traditional New Year pickup through Q2 this year? An increase in both would bode well for the economic recovery.

Figure 5 – Comparison of annual U.S. railcar traffic. Note that no matter how bad the year, traffic tended to increase for the two-thirds of the year then dropped to year-end. The big difference is how much traffic has dropped in the last twelve months.

Economic charts show continued improvement except employment

Here are the most recent economic charts from the Cleveland Fed (see with more positive signs for the economy.

However, one very noticeable exception has been employment or more correctly the lack thereof. In this next chart that come courtesy of Calculated Risk, we see the comparison of recoveries past and present and the present is most certainly different than the past as the chart shows.

Figure 6 – Comparison of jobs losses through recoveries from 1948 to present. Source: Calculated Risk Blog.

Carry trade update

The carry trade continues to be important to markets as it provides much needed cash to buy assets in attractive markets. This month we update our chart of the NZD-JPY (New Zealand dollar – Japanese yen) which has shown a very high correlation with the S&P500 in the past year. Note the continued negative divergence between the NZD-JPY and the SPX in the next chart, which given the high correlation between the two is another bearish sign for stocks. However, a return to a rally in the NZD-JPY would be good for stocks as would weakness in the USD. But this is all contingent on interest rates remaining low in both the U.S. and Japan.

Figure 7 – Weekly chart of the New Zealand dollar-USD (top), the S&P500 Index (middle) and the 50-week correlation between the two (bottom). Chart by

Chinese stocks still weak

Although U.S. and other national indexes are back on the rally trail, Chinese markets are another story. Next is our updated weekly chart of the four major markets we have been following and how they have moved since our last newsletter. Although economic growth continues to outperform most other global economies, Chinese stocks are another story and this is a concern. We are seeing similar weakness in the iShares FTSE/Xinhua China 25 Index (FXI).

Figure 8 – Weekly chart of the four major global indexes we've been tracking, the Shanghai Composite (SSE) in red, the S&P500 (SPX) in blue, the Indian Nifty Index (NFTY) in green and German DAX (GX) in magenta. The SSE and SPX peaked within a week of each other in October 2007 with the SSE leading the SPX, NFTY and GX lower from January through October 2008. Then the SSE bottomed well ahead of the other indexes. Chart courtesy of

Market overview

All in all, the prognosis for this rally to continue at least in the short-term is good. But given its importance in anticipating yearly performance, what happens in January for the SPX will tell us much about what to expect in 2010.

Equally important is anticipating stock movement from here will be strength in gold/weakness in the USD as well as continuing fuel to drive stock purchases by way of the carry trade. Overall economic performance will be in effect held hostage by high debt levels and high unemployment levels. It would be foolhardy to expect any sustainable improvement without a steady supply of new jobs, and a reduction in debt levels.

In the meantime while government coffers remain open and with it the steady supply of newly minted greenbacks courtesy of the current policy of quantitative easing (another term for the creation of new money) stocks could continue to rally for a number of weeks or even months.

As investment manager John Lynch cautioned on Bloomberg last week, "We can't overlook the positive impact of two-thirds of the government stimulus programs that kick in over the next two quarters."

This, if nothing else, will provide a lift to stocks in lieu of any further major financial bombshells.

Daily updates

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If you have a question or comment, please email it to me at the following address:

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Interesting Stories:

High debt? Say goodbye to growth

Growth in a Time of Debt - Rogoff, Reinhart

Weekly Summary and a Look Ahead - Charts of unemployment, rental vacancies etc

The Ultimate Guide To 2010 Investment Predictions and Outlooks

Why Many Investors Keep Fooling Themselves

Employment from Big Picture - Charts

BLS: Near Record Low Job Openings in November

US mortgage originations seen plummeting - MBA

U.S. Now a Renters' Market

Apartment Vacancy Rate Highest on Record, Rents Plunge

LA Area Port Traffic in December

Point-Counterpoint on gold

Money Magazine article trashes gold


Taking on the Fed – What the deflationists are missing


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Posted 01-21-2010 2:20 PM by Matt Blackman