Gold? Yes, but not yet.

January 31, 2010

The S&P500 stumbled last week, dropping 1.6% on growing volume, the third consecutive week of losses.  So far, the turning point appears to be gaining strength.  And with the S&P closing at 1074, a minor level of support was clearly broken.  The next major level of support, at 1020, will now become the big test.  If the S&P approaches and then crosses this level, then we could easily witness a major drop into the mid 900’s as stock owners rush for the exists and bears pile on with short selling.

The economic data mixed, which is a bad omen for the stock market, because it sold off even when good news was announced.  Existing home sales and new home sales were much lower than expected; this should not be a surprise to those who correctly saw through the temporary nature of government gimmicks (tax credits) to boost home demand.  Consumer confidence and consumer sentiment were both better than forecast.  Durable goods orders disappointed, and initial claims were also weaker than anticipated.  The first estimate for Q409 GDP came in better than expected, but revisions will likely trim this figure, and more importantly, many economists expect that the growth rate for 2010 to drop meaningfully.

Technically, the S&P is slightly oversold on the daily charts.  A small bounce back rally would not be surprising.  On a weekly basis, the long-term topping formation is just about complete; if the S&P falls another 40-50 points over the next several weeks, then a strong correction will be in effect.  The monthly charts are still maintaining the 2+ year downtrend; so far, the 9 month rally has been a cyclical bounce in a secular bear market.

Gold, on the other hand, is in a secular bull market.  And given the massive monetary and fiscal programs deployed by much of the developed and developing world, many investors are rightfully worried about all fiat currency and its ability to be a store of value. 

Yet gold has acted as a strong alternative to paper currencies.  Although gold does not yield a cash flow (interest or dividend), it has risen several hundred percent in the early 2000’s, far outpacing the appreciation of the S&P500’s near zero growth over the same time period.

But gold has jumped a lot over the last four months–from about $900 per ounce to over $1200 per ounce, only to fall back to about $1080 as of last week.  Is this a good time to buy?

Not yet.  At $1080, gold has fallen back to a major resistance level, while the U.S. dollar has soared over the last two months.  If the dollar continues to rise–and any global shock, such as a debt crisis in Greece, will surely push the dollar higher–then gold will come under severe downside pressure.  And because gold is sitting at technical resistance levels, a slide just below these levels would mean that it could then fall much further.  The next resistance level would be at the $1030 level, and if it breaks below that, then it could fall much more–into the low $900’s or even into the $800’s.

The good news is that the long-term uptrend line for gold is now around $700.  So gold could fall all the way down to $750 per ounce and NOT break its multi-year uptrend.

The bottom line:  there is a good chance that gold will drop further over the next several months, offering investors a much better buying opportunity.  If the price falls, investors should consider buying.

The lower prices may not return for years, if ever.

Is the Equity Market Rally Over?

January 23, 2010

The S&P500 fell almost 4% this week on strong, but not huge volume.  The VIX (or fear) index, however, went ballistic; it jumped over 52%.  The rise in volatility suggests that the complacency that dominated the fall and winter might be coming to an end.  Even though prices did not collapse, traders were willing to pay much higher insurance premiums to protect against further price drops.  A lot of folks got scared all of a sudden.

The economic data were mostly weak, as usual.  Housing starts fell–a lot more than expected.  Producer prices were mostly flat to slightly higher, suggesting that upstream prices could eventually push up prices for goods and services.  Initial claims spiked well above than the consensus estimate, and continuing claims (when adding in extended and emergency claims) approached a stunning 12 million.  Leading indicators were better than expected, while the Philly Fed survey came in below expectations.

Technically, the S&P500 broke some critical new ground this week.  For example, the uptrend that began in March 2009 was broken decisively, on the weekly charts.  The next major level of support, below Friday’s close, will be at the 200 day moving average; this is about 1010, or 7% lower.  The daily charts are also strongly pointing to more downward movement over the next two weeks.  On the monthly charts, the last two consecutive down weeks are adhering to the top of the two year old downtrend line that began in November 2007.  If prices fall again over the next two weeks, then this downtrend will have successfully reasserted itself.

So what happened to cause the sudden change in sentiment?  And how do we determine if this is a minor pullback, or the start of something larger?

Dozens of pundits can throw up dozens of differing causes of the change.  One of the most compelling explanations is the reversal of the key driver of the prior rally–the Federal Reserve’s liquidity program is coming to a close, and the markets are bracing themselves for the withdrawal of the Fed’s purchases.  After pumping almost $1.7 trillion (of newly created money) into the capital markets, the Fed has become a major buyer in several of the largest credit markets–the MBS, the agency debt, and the U.S. Treasury markets.  Without any doubt, the Fed’s purchases have boosted prices across most asset classes AND they have lowered volatility.

Naturally, the shutdown of such a massive buying program will cause prices to stop going up so steadily and with low volatility.  Without even SELLING any of its newly acquired assets, the markets will pull back from the otherwise higher anticipated prices. 

But will this be a minor pullback, up to 10%, or the something more severe, say 10% to 20%?

It’s impossible to know with certainty.  But the major “test” will be the market’s ability to bounce up from resistance.  If the S&P does NOT fall through the 200 day moving average of 1010, and then bounces up from there, then the bulls will probably cheer and start buying again.

But if the 200 day is broken, then there’s a lot of room to fall to the next level of support–first near the 900 mark, and then near the 800 mark.

If the Fed keeps its promise and shuts down quantitative easing–and the political message generated by the Massachusetts senate election will make it much more difficult for the Fed to keep printing money–then the chances of a more meaningful correction rise. 

Soon, we will be able to see exactly how much of the rally was driven purely by the Fed’s printing presses running on overdrive.

The Age of Austerity

January 17, 2010

The S&P500 slipped 0.8% last week on moderate volume.  The VIX (or fear) index also fell as it touched levels not seen in more than a year and a half.  Complacency seems to be setting in, and investors search for clues that will dictate the direction of the equity markets.

Unfortunately, as usual, the fundamental economic data did not support the bullish case.  The U.S. trade deficit widened more than expected, primarily due to the soaring cost of oil.  Retail sales missed badly; they fell 0.3% when they were expected to rise 0.4%.  Initial claims rose more than forecast, and total continuing claims were still near record highs.  Consumer prices increased modestly, as expected.  Corporate earnings season kicked off on a down note–Alcoa missed. 

The equity markets are looking for signs that the one-time cyclical inventory bounce in the second half of 2009 will lead to sustainable organic growth, growth that will not wither away once the government stimulus evaporates.  Given that we are suffering from a balance sheet recession stemming from a financial crisis, such a quick resumption of sustainable growth would be a first in modern economic history.  I’m not holding my breath.

So what happens in an economy that doesn’t bounce back? 

The Economist highlighted a recent McKinsey Global Institute report that examined the ways in which dozens of other countries, with huge ratios of total credit market debt to GDP, deleveraged and the effects of the deleveraging process.

In all cases, countries took one of three paths.  Some defaulted.  Others inflated away their debt.  But in half the cases, nations went through a long period of “belt-tightening, where credit grew more slowly than output”.  And more grimly, the deleveraging actually began two years after the onset of the financial crisis, and it lasted for six to seven years.  In almost every case, economic output fell in the first few years of the deleveraging.

What’s worse in the U.S. today is that the level of debt is higher than the average level in the report.  So the deleveraging will be more painful.  And since so many of the world’s nations are afflicted, the individual nations can’t boost exports to help pay down debt; in the past, other nations were able to boost exports more easily.  Also, today’s debt-laden nations have also hugely expanded public sector borrowing, so that after the private sector winds down its deleveraging, the public sector will need to go through its painful debt reduction process.

And finally, if investors lose confidence in the government debt markets before the private sector completes its deleveraging, then all debt might need to be reduced at the same time.

In every scenario, including the default and inflation cases, the nations that were overlevered suffered a prolonged period of austerity.  After decades of living beyond their means, their tabs had to get paid. Paying down the debts was always painful, and it always lasted about a decade.

This time will be not be different.

Secular Bull Market? Not a Chance

January 9, 2010

The positive momentum continued to push the S&P500 higher in the first week of 2010.  The index rose 2.7% this week.  Complacency in the equity markets also rose; the VIX (or fear) index fell to its lowest level in more than a year. 

Yet, as prices pushed higher, the economic data took a turn for the worse.  Construction spending was lower than expected.  ISM Manufacturing was better than estimated; ISM Non-Manufacturing was lower.  Pending home sales took a nosedive, falling 16% month-on-month.  Jobless claims were slightly better than forecast, yet continuous claims (when combined with extended and emergency claims) reached all time highs of 11.3 million.  Non-farm payrolls stunned forecasters by dropping 85,000 jobs, when they called for an increase of 10,000 jobs.  The headline unemployment rate remained unchanged, but only because 661,000 discouraged job-seekers left the workforce; had they continued looking, the unemployment rate would have jumped to about 10.5%.  More alarmingly, the percentage of unemployed who’ve been out of work (and looking) for more than 27 weeks soared to 40%, an all-time record.  Only 20% a year ago, this figure shows how deeply rooted the unemployment problem has become; the longer folks remain jobless, the more likely they will never find comparable work again.  Finally, consumer credit fell by a shocking $17.5 billion last month; analysts were calling for only a $5 billion drop.  Clearly, the economy cannot recover on its own if consumers (who make up 70% of GDP) are slashing their means (credit) of consuming.

But in spite of the gloomy economic picture, the equity markets continue to melt upward.  Could this be the beginning of a secular bull market, one that lasts for 15 – 20 years?

David Rosenberg, of Gluskin Sheff and formerly Merrill Lynch, used simple historical analysis to answer this question.  He measured key metrics at prior secular bull market inceptions.  Then he measured these same metrics at the start of the equity market run up in March 2009.  If these metrics, in both former and current periods, were roughly the same, then he could safely conclude that a new secular bull market has begun.

David zeroed in on the most recent secular bull market that began in 1982.  Here are his findings:

Fed funds rate:  Then–18% and can only fall.  Now–0% and can only rise.

10 year yield:  Then–15% and falling.  Now–3.8% and rising.

Budget deficit:  Then–3% and improving.  Now–10% and not improving.

Household debt to income:  Then–62% and rising.  Now–123% and falling.

Inflation rate:  Then–10% and falling.  Now–0% and rising.

Savings rate:  Then–10% and falling.  Now–4% and rising.

Unemployment:  Then–10.8% and falling.  Now–10% and rising.

Highest tax rate:  Then–69% and falling.  Now–35% and rising.

Global trade barriers:  Then–high but falling.  Now–low but rising.

Corporate profits:  Then–6% with room to rise.  Now–10% and not rising.

P/E ratio (1 year trailing) for S&P500:  Then–8.0x.  Now–20.0x 

Price-to-book for S&P500:  Then–1.0x.  Now–2.2x 

Dividend yield for S&P500:  Then–6.0%.  Now–2.0%

Demographics:  Then–young workforce investing.  Now–old workforce spending.

Put it all together and you get a dramatically different picture in 2009 than you did in 1982.  And the picture is not positive.  Unlike the equity markets in 1982, the equity markets in 2009 are not only NOT in a secular bull market, but they are most likely OVERVALUED.

If anything, this picture looks like a sign with the warning: “Danger Ahead”.

The Outlook for Housing

January 2, 2010

The S&P500 fell 1.0% last week, with most of the loss occurring in the final 30 minutes of the final trading day of 2009.  Volume was light and the VIX, or fear, index jumped higher.  The last minute plunge was noteworthy because it seemed as though the computerized trading was simply turned off.  The concern is that automated trading is now such a large percentage of the total equity market volume (60%+) that violent downside risks are extremely high, yet under appreciated.

The economic data were mixed during the holiday shortened week.  The Case-Shiller index was slightly weaker than expected.  Consumer confidence was also a bit lower than forecast.  The Chicago PMI was stronger than expected, but the employment component was still showing contraction.  Initial claims were better than expected, but the short week makes this number less meaningful.  Continuing claims, when combined with extended and emergency claims, was still at record highs.

The technicals are still toppy on a daily basis.  The slight rise in prices over the last four weeks occurred on some of the lightest volume of the year, giving the rise very little conviction.  The weekly charts also pointing to a stalled rally that has very little gas left for strong upside movement.  With a close at near the 1,100 level, the S&P500 is still conforming to the two-year downtrend that began in late 2007.

Since the asset bubble in housing was the most important factor in sparking the onset of the Great Recession, it would make sense to assess where the housing market stands, today and going forward.

As of November 2009, the Case-Shiller 20 city index logged a 29% drop from peak in housing prices in the U.S. 

Where does that leave us historically?  Well, prices between the late 1990’s and 2006 soared roughly 100% above the 100 year trendline, according to the Case-Shiller index.  To simply revert back to the trendline means that they’d need to fall almost 50%.  With a 29% decline already booked, prices would need to fall another 30%–from today’s levels–to revert to trend.

And this additional drop does NOT consider the fact that prices tend to undershoot the trend as often as they tend to overshoot the trend.  If so, then prices could fall even more than 30%.

What are some of the forces that could push prices down some more?

On the supply side, banks–with the encouragement of the administration AND the cheap financing from the Fed–have been withholding enormous amounts of home inventory from flooding the market.  Banks have been slow to foreclose and after foreclosing, banks have been slow to sell.  This supply restriction appears to be set to reverse itself.  As the Fed withdraws its easy money policies in early 2010, banks will have less ability to hold onto homes that do not generate cash flows.  Supply should rise.

On the demand side, buyers have enjoyed a major stimulus.  First, they have been encouraged to buy homes because of the government’s tax credit. This pushed up demand especially during the second half of 2009.  The tax credit will expire, finally, in April 2010.  Second, and more importantly, the Fed has shoved down mortgage rates through its quantitative easing program.  This pushed up demand for most of 2009 because it provided buyers historically low mortgages, often below 5%.  This Fed intervention will expire by the end of March 2010, and most economists expect 30 year mortgage rates to rise about 1 full percentage point–from 5% to 6%.

Put it all together and you get a grim outlook for housing prices–soaring supply and crumbling demand will BOTH put severe downward pressure on home prices for 2010 and beyond.

The good news?  Most everyone who wants to buy a home will benefit.  Homes will become more affordable.  And homes will return to prices that will be more in line with long-term trends.  This will make the downside risk of buying a home melt away so that buyers will be able to buy homes more confident that the prices paid will be less likely to fall further.

The bad news?  Millions of more foreclosures will mean that millions of households will be going through the painful process of moving to a rental property.  The banks and investors that hold the mortgages on these properties will be forced to REALIZE their losses.  This means that potentially another $1 trillion of losses will need to be booked.  The implication is that credit available to new borrowers will be much harder to get, and it will be more expensive.  All borrowers will be affected–households, corporations and local, state and federal government. 

The end result is that the U.S. economy will get dragged down in the short run, so that it can lay a stronger foundation to grow in the future.  So at the very end, the bad news will ultimately lead to good news.