See the Forest for the Trees

Volume 2, Issue 7

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THE BIG PICTURE — A SNAPSHOT OF REAL ESTATE, CREDIT MARKETS, EQUITIES AND THE ECONOMY. BASE-BUILDING IS FRUSTRATING, BUT IT IS A CHARACTERISTIC OF A BOTTOME BEFORE A RISE. INFLUENTIAL FINANCIAL STOCKS ARE SHOWING SIGNS OF TURNING UP.

In this issue, let us take a look at the bigger picture. Careless lending and borrowing caused a bubble in the real estate prices, especially in the US and the UK. The swift decline in real estate prices which followed caused world credit markets to seize up. This caused fear and reduced business transactions, resulting in a sharp decline for global stock markets and economic activity everywhere. We know that almost no one saw this financial crisis coming. It only stands to reason that very few ill likely see the recovery coming either. Therefore, let us look at some of the indicators that showed signs of trouble to see how they are acting now.

North American equity markets are approximately 10% higher than they were at the Nov. 21, 2008 low, but they have already made no progress since the end of November. This is very frustrating for investors because there is little confidence that the markets will not decline to lower lows at anytime. History can provide some guidance here. A sharp decline followed by a quick rise (known as a V-bottom) is characteristic of a rise in a longer-term decline. A double bottom and/or a period of base-building such as we are enduring, is just about always a sign of a market bottom before a rise, not the precursor of a decline. See examples of V-bottoms and a base-building bottom below.

Toll Brothers is one of America’s biggest home-building companies. You can see that the share price peaked in 2005 before US real estate price peaked. The share price has been hovering around the $20 level for over a year even though new home sales and prices keep dropping. This could be a sign that the worst-case scenario for home prices has already been factored into equity prices. The US Homebuilding Index (XHB) only goes back to 2006.

It is also interesting to look back to see what history can teach us about what usually happens after severe economic recessions and stock market declines. The worst recessions and bear markets in recent history occurred in 1973 – 1974 and 1982. Those were also the only times that stock prices were as undervalued as they are now. In 1980, commodity prices and inflation seemed to be rising out of control in North America. By late 1981 the inflation rate was approaching 2,000% per year in South America. In a desperate effort to break the back of inflationary psychology, US Federal Reserve Chairman Paul Volker increased US interest rates higher than 15% in late 1981, the highest rate in history. North American banks and the IMF had loaned billions of dollars to Brazil and Argentina, which could not be repaid due to the collapse of the commodity bubble. In spite of the doubt at the time, monetary police was successful once again.

Now, the collapse of the housing bubble has caused massive losses for US banks and deflation as the concern. There is little confidence that a monetary policy of zero percent interest rates can jolt global economies back to life. Paul Volker has become one of Obama’s Economic Advisors. After 1974, it took 15 months for US markets to come close to record highs again. In 1982, it took less than 6 months. Signs of economic improvements came many months after stock prices turned up. History shows that appropriate US monetary policy works over time.

Technical indicators changed very little this week. However, the long-term oscillators are showing signs that the influential financial stocks could be bottoming and on the verge of turning up longer-term. Usually a government announcement is the catalyst for a strong rise in equity markets. Hopefully that will happen soon.

Bonds - Government bonds are weak as money flows into corporate bonds. This is positive action.

Commodities - Gold is overbought but still positive. Oil might be forming a double bottom.

Currencies - The euro and CAD$ have also been base-building for months. The CAD$ is looking a little more positive compared to the US$. Equities, commodities, and currencies will likely move together.

 

The TED Spread is the rate that banks charge to lend to each other. You can see that it has declined from 5.22% in October to 0.93%, which is very close to the normal rate of 5%. Credit conditions have improved.

 

This is the difference between the interest rate on US 10-year government bonds and corporate bonds. This rate has declined from 6.22% on Dec. 20 to 5.02% now. Over $75 billion of new corporate bonds were sold in the first 6 weeks of 2009 compared to only $23 billion for December. This shows that confidence is returning to the corporate debt markets. The credit crisis is definitely easing.

 

US stock prices have been marking time for four months since the Oct. 10 lows. No more new lows since Nov. 21.

 

After spiking over 80 on the October and November lows, the Volatility Index is now down to 43. It is down to where major market bottoms have occurred before (marked by the arrows). It is now at more normal extremes of investor fear. There is still much room for improvement for the VIX and equity markets.

 

This gives us an indication of the cost to ship raw materials to ocean vessels. After skyrocketing and collapsing along with commodity prices, rates have now tripled from 665 in December to a more normal 1,900. This is a good sign of the economy. China’s $581 billion stimulus program appears to be working.

 

V-bottoms occurred during the bear market in 2001 and July 2002 as marked by the arrows. The double bottom in October 2002 to slightly lower lows marked the end of the declining phase. After all, many investors believed that an invasion of Iraq was coming. When that happened in March 2003, the new bull market started. Markets have recently experienced double bottoms. What will be the catalyst this time?

 

The DJIA declined 45% during a severe recession in 1973 and 1974. To the surprise of most experts and investors, the DJIA recovered almost all of its losses 15 months after the double bottom on Dec. 6, 1974.

 

In 1981, the commodity bubble burst and a severe recession began. By the spring of 1982, banks were on the verge of collapse as 15% interest rates destroyed businesses. Lower rates brought markets to record highs by the end of 1982. Do not underestimate the power of monetary policy and interest rates, even if it takes time.

 

Coming back to the present, a recovery by the US financial stocks helped the markets recover after the long-term oscillators bottomed and turned up on Nov. 24, 2008. After the oscillator turned down again in early January, US financial stocks fell 35% and held the equity markets back. The oscillator for the financial sector is showing signs of bottoming and turning up once more. A rise by this sector would greatly help the equity markets. This could hurt gold prices. Note the higher lows for the oscillator since July 2008.

 

The long-term oscillator for the DJIA has been declining along with the financials since early January. However, each low on the oscillator is higher than the previous low. This is another indication that this base-building stage should be resolved by a move to the upside.

 

While the euro is still weak relative to the US$ and the yen, the CAD$ is showing signs of improvement vs. the US$. The oscillator is staying positive. Higher oil prices would be very helpful to help move the CAD$ out of its trading range. Brazil, Canada, and China seem to be in the best position to recover from this crisis.