Blue Skies or Rough Waters Ahead, Which Is It?

Keeping an Open Mind

By Chris Puplava, March 7, 2007

To be completely honest, who knows? The recent sell-off in every single asset class globally could be a healthy correction much like what was witnessed last May or the start of something more ominous. Since the initial plunge on Tuesday last week, many financial pundits have given their take on the meaning of the correction and what lies ahead. A prudent course at this point is to have an open mind to both the bull and bear case and to have an investment plan for each outcome, letting the market tell investors where it’s headed and not the other way around.

Many analysts make conviction calls as to the direction of the market prior to a market turn. Many times their predictions do not pan out, with a great multitude of "perma-bears" calling for a bear market for years now with those shorting the markets getting crushed as the market or individual stocks make an about face after breaking some form of support. Martin Goldberg, who writes the Thursday WrapUp, pointed out the risk of being a bear in his June 8th, 2006 article with the following comments:

The market's character has imparted a rhythm upon the stock market that has been profitably used by a many alert technicians who were buying pullbacks. The pullbacks have had similar sentiment internals, characterized by high put to call ratios, volatility spikes, bearish sentiment indicators, negative fundamental news, and oversold conditions. The rallies off of the pullbacks have been steep, making long positions profitable in a short amount of time. All the while, longer term market internals and momentum have been weakening. But the frequency and dependability of the periodic rallies always trumped these weakening market internals. Over an approximate 2-1/2 year time frame, it has been almost financial suicide for traders to sell into weakness and apparent breakdowns of technical support levels.

Mr. Goldberg also devoted a whole Market Observation exclusively to this topic entitled, "Whipped Again Suggests More Life in the Bull & Long-Term Bull Market Views." I would highly recommend readers take the time to read his analysis and chart examples of the pain that can be witnessed by being a bear and shorting this market too soon without definitive signs that the bull is dead with the bear awakening from hibernation.

Part of the source of the financial suicide in shorting the market stems from the abundance of liquidity where all the money being printed globally has to go somewhere, and some of it is creating a bid under financial markets. The explosion in derivatives leading to low volatility that I commented on back on January 24th ("A Return to Volatility?") also has the potential to create a high degree of volatility from the unwinding of leverage in the global financial market system. Whether this is a simple correction or the start of a bear market has a great deal to do with whether the great credit cycle has ended or is inflated ever higher. Neither of which is known at this time, and to make a judgment on either case is presumptuous as hindsight, not foresight, is 20/20.

The point being, there are risks for making investment decisions prior to conclusive evidence provided by the markets that there is a change in the wind, which is why it is important to have both an investment plan for a bullish and bearish case, and knowing what signals to rely on to tell you which case is panning out.

In looking at the bullish and bearish case scenario and keeping an open mind, Mark Zandi, chief economist and co-founder at Moody's Economy.com, provided excellent analysis on last week's sell-off, which is provided in part below: (Click here for article link)

Yesterday's global financial market sell-off will likely turn out to be a garden-variety correction. However, the odds are measurable that the correction could devolve into a more serious decline in asset prices with substantial economic fallout.

Having made the case that yesterday's selling will ultimately turn out to be the start of a garden-variety correction, it is worth considering that it could instead be the start of something more serious. It seems clear that a flood of liquidity has been driving global asset markets, and that this now-ample ocean of liquidity is beginning to dry up. Global central banks are nearly universally tightening monetary policy. The European Central Bank, the Bank of England, the People's Bank of China, the Reserve Bank of India, and even the Bank of Japan, have all tightened policy in recent weeks. The Federal Reserve is on hold, but a 5.25% funds rate target is consistent with a somewhat restrictive monetary policy. The carry trades, where investors borrow money in low interest rate countries, such as Japan, and invest in higher-yielding assets elsewhere around the globe, are increasingly in jeopardy of short-circuiting.

If indeed global liquidity is at an inflection point, however, then yesterday's correction may eventually intensify and be more prolonged. A global financial crisis could ensue. Moreover, this crisis could turn out like no other, in that capital may not flow into the U.S. looking for a safe haven, but may instead flow out, as the U.S. could very well be the source of the problem for investors. In the late 1990s crisis Asia and Russia were the sources of the problem, and capital flooded into the U.S. the dollar soared, import prices plunged, inflation moderated, real incomes rose and the U.S. economy was off and running.

Capital could flow out of the U.S., or at least not come in at the same rate, leading to a fall in the dollar and an increase in import prices, weighing on real incomes and consumer spending. This would have real economic consequences.

Yesterday's global sell-off will most likely turn out to be a correction that costs investors some gains, but won't cost the U.S. economy any jobs. It does highlight a number of challenges, however. Global asset markets are very closely linked and problems anywhere in the world can immediately reverberate to U.S. financial markets and the economy.

A day after the market sell-off, Chairman Ben Bernanke addressed a member of the House Budget Committee�s question if the global sell-off had changed the Fed's thinking. This was his response:

"There is really no material change in our expectations for the U.S. economy since I last reported to Congress a couple weeks ago. If the housing sector begins to stabilize, and if some of the inventory corrections that are still going on in manufacturing begin to be completed, there is a reasonable possibility of strengthening of the economy sometime during the middle of the year."

Jim Jubak from MSN Money provides his reaction to Chairman Bernanke's comments and his own feelings regarding last week's sell-off in his article, "Drowning in cheap money," with highlights provided below.

The Pyramid Could Crumble

What's more important is what Bernanke didn't say: that this time, the biggest potential danger isn't from a slowdown in the U.S. or Chinese economies. It's from the pyramid of leverage in the debt markets created by traders and speculators using cheap money from around the globe, and in particular from Japan. The sell-off of Feb. 27 demonstrated how a panicked unwinding of that pyramid of debt could send financial markets into chaos.

His answer on Feb. 28 was reassuring to the markets in the short term, but I worry that all it does is extend the complacency about risk piled on risk in the debt markets that got us into this fix in the first place.

Let me first run through the evidence from the market action on Feb. 27 that shows that the problem is in the financial markets and not in the economy.

• Just about every asset sold off. Emerging-market stocks down. Developed market stocks down. Commodities down. Some of those assets are normally good hedges against declines in other asset classes. Gold often goes up when stocks fall, for example, but not this time. The coordinated sell-off was evidence, I believe, that speculative buying had driven up the price of just about every asset class. And prices fell across all classes as traders unwound those speculative trades.
• Why did a 9% plunge in a small and unimportant market like Shanghai, largely off-limits to any but domestic Chinese investors, set off a global sell-off? Leverage. If you're using borrowed money -- lots and lots of borrowed money -- to buy assets, you can't wait to see if prices will stabilize. If you've borrowed 10 or 20 or even 50 times more money than your actual capital, very few investors are willing to bet the future of their company on the hope that a manageable 1% decline won't turn into a disastrous 3% retreat. Of course, all the automatic computerized selling programs designed to cut an investor's losses just trigger more selling, which, in turns, sets off more selling. The result is the kind of downside cascade that swept the New York Stock Exchange on Feb. 27.
• While everything else, except for safe U.S. Treasurys, fell, the Japanese yen rallied by about 2%. The most likely explanation is that the traders and speculators who had borrowed in Japan at 0.5% interest rates to invest in everything from New Zealand bonds to U.S. stocks were selling those assets in local currencies and then buying yen to repay their loans. The move on Feb. 27 certainly doesn't mark the end of what's called the yen carry trade, but it does illustrate the role of cheap money in the current rally in all kinds of assets and the increased volatility of a market where "everybody" has the same bet on.

When and Where? Who knows?

I can point to this evidence and these big trends and say "danger ahead," but I can't tell you what catalyst will trigger a turn or on what schedule. India seems likely to hit its tough patch later this year. The Japanese yen carry trade could be unwinding now -- thanks to a legion of currency traders who all read the same technical charts and who have all started to get nervous because the charts show the yen at major support against stronger currencies and in an over-sold condition.

But despite my inability to call the timing of this shift, I think you ought to be preparing for it now. The risk is high enough, and the reward of staying the current course low enough, that I think that getting cautious now is just prudent. No need to panic. No need to undo all your positions. I think there's still a good chance that the Shanghai sell-off will turn into a bounce and then a limited, seasonal rally running into the spring. I think this advice from my Feb. 20 column, "Don't jump ship on this rally yet," still stands: "If I can't find bargains right now, I'd be perfectly comfortable selling into this rally whenever a stock hits my target price. I'd certainly like to have some cash on hand as we head into the second half of the year."

Notice I haven't said a word about the economy. Currently it's the least of my worries. I just wish Fed Chairman Bernanke would take some time off from reassuring investors about the economy and the short run and start flagging some of the growing longer-term risks from cheap money and complacency about risk. The Fed could even do something about the problem before it bites us all.

As Mr. Jubak points out, risks are high and the reward for staying invested is low enough to become cautious. Before getting overly bearish, a look at the market's internals is warranted and points to last week's sell-off as a healthy correction instead of the start of a bearish trend. There were signs long before the correction last May that a correction was overdue and likely as market internals deteriorated. Lowry's Reports Inc. had been warning of a market correction long before it was witnessed last year as they saw selling pressure increase at the same dime buying power (demand) was falling. A chart of their data for buying power and selling pressure is provided below, showing buying power peaking in the summer of 2005 at the same time selling pressure bottomed. Buying power remained in a downtrend throughout the first half of last year indicating the markets were rising on weaker investor demand, and the rising trend in selling pressure indicating investors were selling into strength. The market correction last May came as no surprise to Lowry's as they warned their subscribers in advance.

Source: Lowry's Reports Inc

What is significant is the fact that the negative downtrend in buying power and the positive trend in selling pressure reversed course and broke their respective trends last September, pointing to new life in the aging bull market that began in 2002. Weakening internals prior to last Tuesday's dramatic sell-off were absent as Lowry's buying power index was reaching confirmatory new highs, and the selling pressure index was reaching confirmatory new lows, both healthy conditions for a bull market advance. Lowry's weekly commentary report for the week ending 03/02/07, used with permission, is provided below:

As pointed out in last Friday's report, the internal condition of the NYSE market just before Tuesday's decline was healthy, with none of the classic warning signs that typically precede major market declines. Our Buying Power Index had been at a 9-month high just three days earlier. Our Selling Pressure Index, which is usually in strong uptrend pattern for months in advance of important market tops, had been at a 9-month low just three days earlier. Our cumulative totals of Net Points Gained and Net Upside Volume were just slightly off of new all-time highs. The Adv-Dec Lines for our OCO universe of NYSE-listed stocks, as well as for the S&P 500, 400 and 600 components, had been at new all-time highs just days earlier. The % of stocks above their 30-day moving averages had been at a very healthy 82% level. And, our Average Power Rating, based on the relative strength of 1,000 key stocks, was at an 11-month high. In brief, since there were no significant signs of weakening Demand and no notable signs of expanding distribution, the probabilities drawn from our 74 year history suggest Tuesday's sell-off did not mark the start of a major market decline.

It was Tuesday's intensity that will go into the record book. Downside Volume equaled 99.1% of the sum of Upside plus Downside Volume, and Points Lost equaled 98.7% of the sum of Points Gained and Points Lost, qualifying as an official 90% Downside Day. Our 2002 award-winning paper on 90% days, titled Identifying Bear Market Bottoms and New Bull Markets was essentially a study of panic selling, which takes one of two forms in the stock market. The first occurs after many months of declining prices and deteriorating investor psychology (bear markets) when investors finally "throw in the towel to avoid losing everything". A second form of panic selling occurs when some piece of unexpected bad news triggers a sudden nervous reaction, much like the back-fire of a car on a dark street. Once it is realized that the panic was an over-reaction, most people tend to return to what they were doing before the scare. In the present case, there was no evidence of a prolonged deterioration of investor psychology. Past experience shows that 90% Downside Days occurring near the market highs with no warning signs of a major market top, are typically part of short term corrections, and thus eventually provide an opportunity to buy stocks with strong Power Rating patterns at the time of the next short term buy-signals, for a resumption of the primary market advance.

- Paul F. Desmond & Richard A. Dickson, Lowry's Reports, Inc
(Weekly Market Trend, 03/02/07)

As mentioned by Mr. Desmond and Mr. Dickson, Lowry's impressive 74 year history suggests that last week's sell-off was likely a healthy correction within the context of a bull market and not "the start of a major market decline." With Lowry's Reports Inc.'s reaction to last week's correction, along with Jim Jubak's comments that he still stands by his advice from his February 20th column, "Don't jump ship on this rally yet," investors should not be quick to call an end to the current bull market and put on their bearish hats just yet.

That being said, with subprime mortgage lenders blowing up daily and a possibility of the yen carry trade unwinding, investors should remain cautious as Mr. Jubak also advises. One technician that did call for the top in the S&P, as mentioned previously, is Frank Barbera who writes on Tuesdays. There is the possibility of the market to turn further south after a corrective bounce and Frank comments on the possible bearish case in his WrapUp from yesterday entitled, "Markets Hit Bottom: But Will It Last?," with his comments and charts given below.

In our view, a classic trend change pattern is now unfolding before our very eyes. It is a pattern that all should pay heed to do because if I am right, it is leading us into the beginning of the next bear market. In truth, on a secular basis, the real bull market ended in 2000, and what we have seen since has been, and likely will be, a series of alternating cyclical bull and bear moves not unlike the 1970's. You remember "That 70's Show," don't you? A long secular bull market lasting 24 years from 1942 to 1966 followed by 16 years of "giant sideways" activity, which for the Dow took the shape of a side swinging trading range between 1000 and 500?

On the very long-term trend of the stock market, the 1966 peak really exhausted the growth phase that had been intact for two decades. What followed was essentially one ongoing bear market that had alternating phases of smaller "bull and bear" cycles. Sure the market managed to make token new all time highs in the Dow in 1968 and 1973, but did that really amount to much? In the ensuing bear markets of 1969-1970, 1973-1974, investor portfolios were decimated, with the gains of the cyclical bulls entirely and utterly gone. Could we be on the path to a repeat performance in the years ahead? Well, we certainly saw a sustained 25 year bull market from 1975 to 2000, and while the DJIA has recently gone to a nominal new all time high, most averages like the S&P and NASDAQ fell way short. There is an ugly divergence of sorts that hints at a larger stock market "turn."

As market internals were strong prior to last week's sell-off, it could be premature to call an end to the aging bull market. Likewise, risks for a more serious and prolonged correction turning into a bear market are also rising, and being a "perma-bull" can have its consequences just as being a "perma-bear" can. Thus, investors should keep an open mind to either possibility and let the market tell them where it’s headed, and not the other way around.

TODAY'S MARKET - Economic Reports

MBA Mortgage Applications Survey - Week of 03/02/07

Mortgage demand rose 7.3% last week fueled by a drop in interest rates that led to a 15.0% surge in refinance applications, while purchase applications witnessed a smaller rise, up 1.0%. The contract rate on the 30-year FRM decreased 12 basis points to 6.04% with the 1-year ARM declining even more, falling 13 basis points to 5.79%.

Source: Moody's Dismal Scientist
Data: Mortgage Bankers Association of America

Oil & Gas Inventories - Week of 03/02/07

Crude oil inventories fell 4.8 million barrels last week, a dramatic contrast and in the opposite direction to expectations of a 2.0 million barrel rise. Gasoline inventories also fell greater than expected, declining 3.8 million barrels while expectations were calling for a 1.4 million barrel decrease. Distillate inventories fell 1.3 million barrels, below expectations of a 2.5 million barrel drawdown. All three energy levels are below last year's levels, with distillate inventories down the greatest (-8.4%) followed by crude oil (-5.1%) and gasoline (-3.9%). Refinery activity decreased slightly from the prior week's level of 86.0% to 85.8%.

Source: Energy Information Agency (EIA)

Source: Moody's Economy.com/EIA

As seen above, crude oil inventories have been in a declining trend since the end of summer last year as demand for crude oil delivered to refineries from late 2006 into this year has remained at levels above late 2005 to early 2006, seen by the chart below.

Source: Energy Information Agency (EIA)

Not only is current demand for crude oil above the 2005 to early 2006 levels, but so is gasoline demand. Looking at the balance of supply and demand for gasoline in terms of days of supply shows that we are approaching summer with lower gasoline inventories than we had in the past two years despite higher production levels This will have bullish implications for gasoline prices going forward if this trend continues, something cash-strapped consumers will not be looking forward to.

Source: Energy Information Agency (EIA)

Source: EIA, �This Week In Petroleum,� 02.28.07 Release

Also worth mentioning, the Energy Information Agency (EIA) said that between the first of the year and March 2, 2007, East Coast distillate fuel inventories (diesel and heating fuel oil combined) declined by 21.9 million barrels compared to the 5-year average decline for January-February period of 12.8 million barrels. That corresponds to a 71% increase in distillate demand. Had it not been for early mild winter weather that helped push distillate inventories to above average levels, prices for distillates would have soared.

Source: Moody's Dismal Scientist/ EIA

Consumer Credit - January

Consumer credit increased by $6.4 billion in January to $2.4 trillion, below expectations for an increase of $8.5 billion. The increase was primarily from non-revolving credit, which increased at a 4.4% annual rate while revolving credit increased by only a 1.1% annual rate.

Source: Moody's Dismal Scientist/ Federal Reserve

The Markets

The markets continued the theme of volatility as they were mostly down in early morning trading before staging a rally into early afternoon. That faded going into the close to erase the rally attempt to finish near the day's lows. The Dow, S&P 500, and NASDAQ were all down with the Dow posting a loss of 15.14 points to close at 12192.45, the S&P 500 shed 3.44 points to close at 1391.97, and the NASDAQ fell 10.50 points to close at 2374.64. Investors purchased Treasuries today with the 10-year note yield at 4.497%, falling 3.1 basis points. The dollar index was also down on the day, falling 0.29 points to close at 83.75. Advancing issues represented 49% and 41% for the NYSE and NASDAQ respectively, with up volume representing 49% and 28% of total volume on the NYSE and NASDAQ.

Energy prices recovered today based on the bullish inventory data with WTIC oil rising 1.86%, gasoline rising 2.17%, and the biggest move coming from spot Henry Hub, up 2.45%. Precious metals were mixed with gold rising $2.40/oz to $648.90/oz (+0.37%) and silver finishing up $0.08/oz to close at $12.975/oz (+0.62%). Base metals were mixed with nickel showing the greatest strength on the day (+2.68%) while aluminum displayed the weakest performance (-0.87%).

Overseas markets were mostly up with the Chinese Shanghai index recovering from last week's dramatic decline, rising nearly 2% on the day. Latin markets were the day's weakest indices with Brazil's Bovespa and Mexico's Bolsa indices down 1.28% and 0.65% respectively.

Selling was broad based today as nine out of the ten S&P sectors were down, with energy the only positive performance on the release of the bullish inventory report. The telecommunications sector (-1.31%) and financial sector (-0.66%) put in the weakest showings on the day.

Chris Puplava

© 2007 Chris Puplava

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