Bulls Zen Bears

EVIDENCE FROM A WHOLE HOST OF INDICATORS SUGGESTS THAT EQUITY MARKETS HAVE HIT BOTTOM AS A FULL BLOWN RECESSION BECAME FACTORED INTO CURRENT PRICES. STILL WAITING FOR SIGNS THAT A NEW DYNAMIC UPTREND HAS BEGUN, BUT IT IS TIME TO BUY

The trend of US equity markets turned into an elevator shaft as 2008 began. By mid-January, the TSX and other global markets could no longer hold their own and succumbed to the selling pressure. The reason for this sharp sell-off was a change in the sentiment of investors – they reacted to statistics indicating that we might enter a recession (two quarters of declining growth). The market decline reached a climax last Monday when many global markets fell approximately 5%. (Perhaps it was exacerbated when Societe Generale was forced to unload what could be over $50 billion worth of stocks bought by a rogue trader.) This finally prompted Ben Bernanke to discard his peashooter and bring out the canon by announcing a .75% cut in interest rates in between normally scheduled meetings. This was the biggest cut since 1984. The markets recovered on Tuesday and staged a stunning reversal on Wednesday, enabling the TSX to close the week with a gain of 1.24% while the SP 500 gained .41%. This should not have surprised the readers of this update.

Research from a prominent Canadian strategist shows that equity markets typically decline 17% from the peak during a recession. At the lows last week the markets were down almost 20%. In a normal recession, earnings decline an average of 14%, which would reduce the PE multiple of stocks down to 14.2 times earnings for the SP 500. Last week the SP 500 Index was trading at 12.2x forward earnings. This all implies that investors have priced in a full-blown recession for stocks. Even though a recession seems to have been ‘baked into the cake’, no one knows whether or not we will indeed experience such a slowdown.

I attended a talk by Alan Greenspan in Vancouver on Jan. 24, who is probably the best person to shed some light on future prospects. He believes there is a 50/50 chance that the US economy will enter a recession. He also stated that he thought that the US would enter a recession after the 1987 Crash and the terror attacks of Sept. 11, 2001. The US economy surprised him by defying historical precedents and avoiding a recession after both of those events. His conclusion was that the strength of the US economy should not be under estimated – it is very resilient.

Whether we enter a recession or not, almost every technical tool such as the TRIN, Volatility Index, Insider Selling, the extent of media coverage and the oscillators I use suggest that the selling last week reached an extreme level typically seen at a major market bottoms such as 1987, 1990, 1998 and 2002. Remember, once fear reaches an extreme and everyone that wants to sell has sold, the markets rise. Investors have therefore likely seen the worst of the selling. When the indicators show more signs of heavy buying and reduced selling pressure, we can declare that a new dynamic uptrend that could last for the rest of the year is in place. The long-term oscillators have turned up for the US financial and banking sectors, which usually lead the markets. However, the oscillators for the market averages have not quite turned up yet, but, like I said last week, that could happen at anytime. Bernanke might still bring out a bazooka at the Fed meeting Jan. 30. While our natural reaction to sudden market declines like this is to focus on the risk, it is after times like this that the gains tend to be the greatest – especially after the Fed has been reducing rates for some time. Although it may take some time for the markets to get going, this is the time to buy. Hang on for the ride!

Bonds, Commodities and Currencies – As forecast in last week’s letter, the trend for other assets reversed as the downtrend in equity prices reversed. Please see charts and comments for bonds, commodities and currencies below.

 

After giving a rare false signal in December, the long-term oscillators for the US Financial Services Index and Banking Index have turned up from very oversold levels. This should lead the markets higher as they did when these oscillators turned up on Aug. 20.

 

The reversal has not been enough to enable the long-term oscillators for the market averages to turn up. They turned up on Aug. 27, 2007 one week after the financials did an a 10 days after the Aug. 16 lows so perhaps it will take another week this time too.

 

The TSX has reversed and seems poised to rise at anytime after giving a rare false signal in December. It turned up 10 days after the Aug. 16 low as well.

 

Bond prices are likely peaking, as they should if equities have bottomed. The oscillator looks like it is ready to roll over.

 

Gold has been very strong and may be overbought after a big six-month rise. Gold stocks could out perform bullion now.

 

Oil prices have stabilized but the oscillator is still declining. More time is required to clarify if oil prices will increase from here.

 

The US$ likely peaked last week along with investor fear as the money which gravitated to the US$ for a safe haven flows out. The CAD$ likely experienced a multi-month low last week and is ready to rise.

 

According to this chart, the Euro has also bottomed and started a new uptrend.

Data supplied by

Equities – In my update of June 25, I said that the equity markets should be okay because falling bond yield should support stock prices. Well, by Wednesday morning it looked like I was going to be dead wrong as the TSX was down 500 points for the week. However, at the time of writing today the TSX is actually up 48 points since last Monday and the US markets are up approximately 1.5%, so I think that qualifies as "okay." On Friday, June 29 I wrote a special update suggesting that the markets should have a short term bounce since the short term oscillators turned up and that bounce is happening as we speak. However, the long term oscillators still have not turned up. This needs to happen if the markets are to move higher. Markets typically have a peak in mid-July and late August before declining into October so we could see a longer rally this time compared to after June 13. Often these rallies move the markets higher but fewer and fewer stocks participate in the rise. This is a sign of weakness and potential trouble ahead. Rising interest rates around the world, the longest rise ever in the US markets without a 10% correction and problems with sub prime mortgages are serious concerns. In fact, it appears that Standard & Poors Bond Ratings have purposely not updated the ratings on these sub prime loans to reflect the deterioration in quality. This would temporarily protect the hedge funds and financial institutions from further problems such as Bear Stearns experienced. Eventually this is likely to lead to heavy losses when prices are adjusted to reflect their true, reduced value. Tread carefully!

Bonds – US 10 year bond yields dropped to 5.03% Friday so the buy signal given by the long term bond oscillators weeks ago has been accurate. This trend could continue for some time.

Gold and other commodities - Gold and some other metals are very oversold and could begin a new rising trend in a week or so.

Gold stocks – Long oscillators for the TSX Gold Index turned up two weeks ago and has had a rare double bottom, delaying a new up trend.

Canadian dollar – Still appears to be peaking. The Loonie is highly correlated to the price of oil so high oil prices could keep the CAD dollar strong.

 

The long term oscillators for gold, copper, and aluminum turned up today from very oversold levels that typically produces a new up trend lasting from three to six months. The oscillator for the TSX Gold Index (gold stocks) turned up several weeks ago but did not make much headway. This should light a fire under them. This is positive for resource companies and the TSX Index.

 

One week ago, I wrote that investors should "go for the gold" since the long term oscillator turned up from a very oversold level. This also occurred in 2003 and 2005 which were followed by major rises. The gold stocks have had trouble getting started and as you can see the oscillator has had a rare double bottom. No indicator is perfect and this does happen from time to time. The signal is usually accurate, it just takes a little more time to consolidate before the move take place. Gold bullion and many other metals are now oversold and could turn at any time so perhaps they will move up together. Time will tell.

 

The long term oscillator for most all equity market averages look similar to this one for the TSX – declining from an overbought level. As you can see by looking at the past history, the markets can stay overbought for some time. The oscillator frequently turns up once or twice before dropping all the way to a fully oversold position. If these oscillators do not turn up, short rallies could fizzle and the risk of a longer/more severe decline increases significantly.

 

In the update of June 29, I included a chart showing that the SP 500 short term oscillator had turned up the way it did on June 13. Immediately after the June 13 update the markets experienced the biggest rise since March. On June 29 I mentioned that the TSX oscillator had not turned up yet but it usually follows the lead of the US markets. As you can see that happened today. While US markets were down slightly Friday they rose close 1% today and the TSX rose 191 points on Friday. (The TSX was closed today for Canada Day.) These upturns suggest that the markets should have a bounce for at least three days or so. If the long term oscillators do not turn up then this rally could eventually fizzle. The recent market action is typically of what often occurs at the end of a long market rally we have just experienced. One should be careful if the long term oscillators do not confirm this rally.

Green = up trend

Red = risk

Going through a long bear market is perhaps the most stressful aspect of being a money manager. To have a discipline for selling can help to reduce the negative effects of a major decline. You can see that this chart was green throughout 1999 and most of 2000 catching most of the gains before turning red in the Fall of 2000. This marked the beginning of the longest bear markets in recent history. This was a clear sign of higher risk had caused extreme over valuation in many stocks. Even though there were strong four to six week rallies in January 2001 and April 2001 as the US Federal Reserve lowered interest rates, this chart stayed red, indicating that these were just rallies within a long term decline. The indicator finally turned green again seven weeks after Sept. 11, 2001 before turning red again in the Spring of 2002 as the last major decline of the bear market unfolded. It turned green briefly before 2003 before turning red for the last time as the US prepared to attack Iraq. As the markets rose after the invasion, it turned green and stayed positive for a year. No indicator is perfect. However, using this indicator as a selling discipline along with the other indicators I use, have enabled me to avoid a serious decline and have a strong conviction about the trend of the markets. This is the best indicator for selling that I have discovered in my 26 years of research.

SP 500 and SP/TSX - Up trend is still intact according to all indicators except the long term Volatility Index chart. I am concerned about what might happen in the July to October time frame.

Gold stocks - Gold stocks are very oversold and could be close to a turning point even though there is no such evidence for bullion prices. Gold stocks had a 3% up day on May 31.

Bonds – It looks like Canadian bond yields may have reached some sort of peak. US bond yields could be close to peaking in the coming weeks. That should be positive for equity prices and should add strength to any rally in Canadian bonds.

Currencies - The US$ vs. euro chart shows that the US$ still appears to be in an up trend versus the euro (since it gave a buy signal several weeks ago) even though progress is slow. The Canadian dollar is overbought versus the US$. With CIBC predicting parity by the end of this year, the oscillator shows no signs of turning yet, meaning that the up trend is still intact. Keep in mind that by the time this oscillator turns the CAD$ could already be 2% or so off of the highs.

POSITIVE AND NEGATIVE FOR EQUITIES

Positives

• Massive buyouts are shrinking for supply of stocks
• Companies are buying back their own shares instead of bringing new issues to the market
• China has close to a trillion dollars it wants to invest in companies around the world
• SP 500 earnings are double what they were when the index was at the same level seven years ago
• Third year of a Presidential cycle usually produces good returns
• Short positions for US markets are at an all-time record high

Negatives

• At 1,578 days this rise is the longest bull market ever without a 10% correct. 1,344 days was the previous record before the Crash of 1987.
• Markets usually follow a cycle where there is a major decline every four years. Exceptions are after the 1929 – 1932 bear market that peaked in 1937 before declining and after the 1981 – 1982 bear market the also rose five years to 1987 before falling. Currently, since the 2000 – 2002 bear market, stocks have been rising four and one half years into 2007. Interesting pattern of years ending in 2 and 7!
• According to Ron Miesels of Phases and Cycles Inc., ever since 1887, years ending in 7 have an unblemished record of providing bad news and bad surprises
• Extremely high insider selling for many months
• A one year 206% rise in the Chinese stock market has created an investment frenzy among inexperienced investors to the point that it is causing labor shortages. For example, 10% of all maids in Shanghai have quit their jobs because they are making more money investing than they can by working.
• Seasonally, the markets are usually the weakest between July and October.

We are likely closer to a market decline than a new bull market. The decline could be serious. Successful investors require a discipline for selling. I will do my best to use the tools I have shared with you to guide us through the months ahead. This is probably a time to be aware and alert, not complacent!

 

The oscillator has turned up without reaching the fully overbought range as it did in the spring of 2006. So far the other VIX indicators I watch have not confirmed a change in trend but we will have to watch this closely to see if this is suggesting that the rally might be over.

 

The oscillator is still rising suggesting that the up trend is continuing.

 

This oscillator is still in a clear downtrend some distance from the oversold level. While the price of gold rose $10 or so last week, I like to wait for this to turn up before investing in gold itself. Gold stocks, however, can move up ahead of the gold price and they also rose over 3% May 31, so this will be interesting to watch in coming weeks.

When the SP/TSX and other market oscillators (including the US Financial Services Index oscillator) turn up from an oversold level it almost always signals the beginning of a new up trend. Usually the VIX oscillator peaks and turns down at the same time confirming a change in trend. This occurred in: October 2002 making the end of the long bear market, March 2003 near the start of the Iraq War and SARS virus, in May 2004, in May 2005 after the Spain train bombing correction, again in October 2005 after Hurricane Katrina, at the end of June 2006, at the end of September 2006 after the resource sector ended a correction and again on Apr. 2, 2007. In 2006, the TSX corrected in the fall as the US markets kept rising so the TSX oscillator was the only market oscillator to become oversold at that time. By April 2007, the markets and oscillators were moving in sync again. In all other periods the TSX and US market oscillators turned up at the same time.

When the SP 500 and other market oscillators (including the US Financial Services Index oscillator) turn up from an oversold level it almost always signals the beginning of a new up trend. Usually the VIX oscillator peaks and turns down at the same time confirming a change in trend. This occurred in March 2003 near the start of the Iraq War and SARS virus marking the end of the long bear market, in May 2004, in May 2005 after the Spain train bombing correction, again in October 2005 after Hurricane Katrina, at the end of June 2006 (after which the US markets had one of the longest rises without a 2% or greater correction) and again on Apr. 2, 2007.