Will the Real Slim Shady Please Stand Up!
By Frank Barbera CMT. June 5, 2007
Another day, another set of stock market NEW HIGHS, as the ticker on CNBC flashes the “points above/below the new record” every few moments. That has been the scene in the market over the last few weeks, with certain market averages, namely the DJIA and the S&P 500, moving to a parade of nominal new highs. We say ‘nominal’ because, with the exception of the Dow, the new highs in the S&P have been really marginal. Consider that the old high for the S&P was set back on March 24th, 2000 at 1527.57, we have seen four days thus far, where the S&P marginally surpassed that record and those were May 30th, last Wednesday, a close of 1530.23, Thursday May 31st, a close of 1530.62, Friday the 1st of June, a close of 1536.34, and yesterday, Monday, June 4th, a close of 1539.18.
Does anyone really get worked up and go running out to buy stocks because the S&P closed a measly 11.61 index points above the old high set SEVEN YEARS AGO? Most of those points evaporated in one day -- today. It just seems so ridiculous, the media barrage of harping on new highs. First, with the DJIA, and now with the S&P, idle prattle and more prattle.
It’s enough to really mislead the average investor who could be forgiven for getting confused amid the barrage of unending media hype. After all, which average do we choose to represent the stock market? Is it the Dow, the S&P or it is the NASDAQ? Back in 2000, a bull would have argued that the first two were relatively unimportant, and that the NASDAQ was the only average that really mattered. So which one really counts, which one is the yardstick for “the market,” which one is the real Slim Shady? Well, maybe one approach would be to look at the action of all three, rather than getting overly worked up about any one index in particular. In the chart below, we have rebased all three of the major averages to a common starting point which shows the bubble excesses of the NASDAQ in 2000, the excessive boom and subsequent bust. In our view, we would argue that despite the substantial move to new all time highs in the DJIA, a thin index of only 30 stocks, the composite of the three stock market indices, is in the zone of strong overhead resistance.
Above: the three major market averages rebased to a starting point at the beginning of 1990.
In the next chart, we take the three major stock market indices and combine them into one index, using an unweighted formula where each of three popular major averages is weighted the same. Perhaps this is the index that we should be focused upon when trying to decide the health and trend of the overall stock market. Perhaps we should include the Russell 2000 as well. In either case, to date, the composite of all three indices has moved back to an approximate .618 fibonacci retracement for the prior decline -- still a good distance from new all time highs.
Above: The Unweighted Market Index Composite and a medium term RSI.
In addition, we took the liberty of plotting a very medium term RSI on this Unweighted Index containing the DJIA, SPX and NASDAQ indices. “Pretty over-extended” would be the term we would use to describe the very high RSI readings seen over the last few weeks. In fact, except for instances as in early 1995 when the Fed began a protracted easing campaign following a growth recession, the stock market has rarely performed well following these kinds of heavily overbought readings.
In addition, while there are those who believe, as I do, that the Fed may be forced into an easing stance later this year, the current cycle is loaded with one-off circumstances that have not been seen in many years. The Housing Bust for example, continues unabated, and remember that Housing accounts for at least a quarter of US Economic growth. At the present time, Home Sales are down over 30% in places like Florida, Arizona, and California, with cancellations running 40 to 50% in some markets. Some took solace in last month's report on New Home Sales which advanced 16% in May. Yet, the historical data clearly shows that quite often months showing a large percentage gain have been reversed out the following month with five out of the last ten double digit gains in New Home Sales evaporating within one or two months. What’s more, the real reason new home sales bounced in May was the fact that builders slashed prices to move out inventories which remain at record levels. In the month of May, New Home Prices plunged by 10.90% to a median price of $229,100, down from $257,600 in March. The decline was the largest monthly price decline seen in many years and leaves the Median New Home Price below the Median Existing Home price for the first time in more than a decade. In addition, the surge in home foreclosures continues, running at a rate 127% higher in May 2007, versus the equivalent period one year earlier.
In our view, home prices are now coming into the cross-hairs of the recession-slow economy gun sites, and could easily begin to move substantially lower as the year 2007 continues to unfold. With that, there risk of rising defaults and derivative issues will come fully into play, as it is estimated that within the CDO Market (Credit Default Market), as much as 20% of the below-investment-grade BBB tranches are already going into default, or into foreclosure. According to Investors Insight, “Fitch data suggests that loans made in 2006 are defaulting in the first 12 months at a rate 50% higher than in 2003, and that the actual loan to value of the defaulting subprime market was 89%. A 10% drop means that most of these owners will be under-water” in terms of the value of their homes to their loans”. Interestingly, while many of the better grade tranches of sub-prime have improved since the March lows, the chart below from Markit.com, shows that the lowest quality paper has barely bounced. In Elliott terms, we see what appears to be a very weak A-B-C upward zig-zag correction in the BBB paper, implying that another serious leg to the downside could unfold in the days directly ahead.
Source: Markit.com — the lowest BBB tranche of sub-prime debt has experience no bounce.
Of course, as the default rates rise, a contraction in credit is all but guaranteed and a phenomenon that by all rights, appears already well underway. In virtually every industry survey, lending has been seen to tighten up, with lower quality borrowers running into the proverbial brick wall. Yet another factor that goes largely undiscussed, is the still inverted Treasury Yield Curve with “2’s” and “10’s” flat near 4.97%. Not a pretty picture for the profitability of the current lending environment, or should we say, “lack of profitability” in the current lending environment. Perhaps for these reasons, we have seen the vast majority of smaller banks ignoring the market advance and quietly moving downward into their own bear market. In our work, we like to follow the American Community Banker’s NASDAQ Bank Index as a proxy for the universe of smaller regional banks. With ticker symbol, ACBQ, the index includes more than 500 community banks with a market cap of over $200 billion dollars. The index does not include any of the major money-center banks and their holding companies which we like because those banks derive a lot of their profits in non-traditional banking practices, prop trading desks, derivatives etc.
Above: the S&P 500 (top clip), Middle: the American Community Bankers Index, and Lower: the 2’s and 10’s Treasury Yield Curve inverted near 1.00.
Historically, small cap community banks have often been a good leading indicator for the direction of things to come, highlighting positive and negative climates based on the conditions in the credit market. In that vein, we note that the NASDAQ ACBQ Banking Index has broken down from a well formed H&S Top in February and March, and has thus far failed to experience any type of significant “post-March” recovery. In fact, if we didn’t know better, we would suggest that the chart is ripe for downside acceleration to new multi-month lows in coming weeks, and that could spell a much wider raft of trouble for the broad stock market which has been doing its level best to ignore and sweep under the rug burgeoning problems in the credit markets. While not as immediately bearish, we also are drawn to the charts of both Lehman Brothers (LEH) and Bear Stearns (BSC), both of which have very oddly lagged behind the brokerage group and the market in general. In fact, not only have they lagged behind, the share prices for these two Wall Street behemoths have been positively atrocious performers since the March lows.
Perhaps someone knows more than we do? To be sure, your guess is as good as mine, but with profits at record levels for the industry and these companies, why are the shares prices still residing in the basement?
Above: Lehman Brothers (LEH)
June 1 — Bloomberg (David Evans): “Bear Stearns Cos., the fifth-largest U.S. securities firm, is hawking the riskiest portions of collateralized debt obligations to public pension funds. At a sales presentation of the bank’s CDOs to 50 public pension fund managers in a Las Vegas hotel ballroom, Jean Fleischhacker, Bear Stearns senior managing director, tells fund managers they can get a 20% annual return from the bottom level of a CDO.” (Source: Bloomberg/PrudentBear.com, Credit Bubble Bulletin by Doug Noland)
Above: Bear Stearns & Co. (BSC)
Within what we see as a developing ‘very troubling’ period directly ahead, there are a number of red flags that continued to be hoisted ever higher with each passing week. In recent days, the Chinese Stock Market has suffered a nasty nearly 20% decline. A major trend break? At the moment, “too hard to tell,” as an upside reversal day on Tuesday lifted the market back above its 50 day moving average. Could the Shanghai Composite be ready to crash directly from here, or could it still make one final run at a new high near 4,600? While we lean toward the idea that this market will end with a classic Double Top, and thus could put on one more final advance, it is way too dangerously close to the edge of the precipice, “tap dancing on the rim of the volcano” which in our mind means only one thing: continue to raise cash.
Above: the Shanghai Composite Index… making an “M” type top? ed. Stick around, got a feeling we will soon find out.
Yes, we know that the other day the S&P shook off an 8% decline in Shanghai, and we know a lot of people think that worrying about this market is much ado about nothing. Perhaps so. But for now, our instincts and hopefully better judgment prevail as in our view, the linkage between an over-extended Chinese market and other over-extended foreign markets along with a super-heated US Cyclical groups just smacks of an ‘accident’ waiting to happen. In recent years, these accidents have come from nowhere, the old overnight contagion routine, and as such leave little time to adopt investment portfolios to the white water of a fast market decline. In this vein, we give you Precision Cast Parts (PCP) as “Exhibit-A”, straight up and vertical, -- now trading an amazing 40% above its long term 200 day average. Or how about Companhia Siderurgica Nacional SA (SID), one of Brazil's leading steel companies and a key driver of the Brazilian Bovespa? One after another, a perusal of names like GGB — Gerdau, Reliance Steel (RS), Harsco (HSC), Commercial Metals (CMC), Hanson PLC (HAN), Martin Marietta Materials (MLM), Foster Wheeler (FWLT), Posco (PKX), ITT, US Steel (X) all hint that a major market reaction is on the immediate market horizon, slated for the summer 2007. In our view, at least for the time being, this is one of the times where it is better to be in the comparative safety of money markets earning a risk free 5%, then having to deal with the end of a China Bubble and the fast markets that will no doubt follow. Perhaps the real Slim Shady is a global recession that will soon Stand Up!
Above: Precision CastParts (PCP) — getting more than a little extended ?
Above: Companhia Siderurgica Nacional SA
Above: Commercial Metals (CMC)
Above: Gerdau SA ads (GGB)
Above: Martin Marietta Materials (MLM)
At the close, the Dow Jones Industrials ended lower on Tuesday by 79.65 index points at 13,596.67, with the S&P 500 also declining to a reading of 1530.98, down 8.23 index points on the day. For technology stocks, the NASDAQ Composite reversed lower, ending down 6.64 at a reading of 2611.65, with the 10 Year Bond Yield finishing the day at a high of 4.95%, up .05 basis points. Gold and Oil prices both edged slightly lower.
© 2007 Frank Barbera