So, You Want To Know The Future?
Hey, me too! In all seriousness, for those of you that don't tune into the Market Monitor during the day, tonight's article will be another installment of me donning my "Great Carnac" hat and gazing into my crystal ball. I received an email requesting just that this afternoon, and when I inquired in the Monitor about whether there was any interest, the response was overwhelming. Wow! I fell like Sally Field, "You like me, you really like me!" HUGE GRIN
The nature of the question I received is "What do I see for the markets, looking out over the next 3-6 months, assuming the Iraq conflict goes according to "script", whatever that means. That seemed like a good question to me, as the markets have lately been locked into the All-Iraq, All-The-Time theme. Economics, earnings, and anything other than geopolitical news is being ignored. We all know that fog will clear in the very near future -- at least we hope it does. And our job is to try to look out past the Gulf conflict to try to determine where our beloved markets are headed next.
So let's get to it shall we. Never mind the chanting in the background, that's just me entering my predictive trance. Alright, enough bad jokes. Here we go.
First, let's start with some background. The last time I delved into this topic was on January 6th, when I started a two-part discussion on my prognostications for the coming year. If you missed those articles, then feel free to take a look at those articles at the links below.
'Tis The Season, Part II
In that discussion (for those that don't want to take the time to read the old stuff), was my prediction that the broad markets would actually avoid the dreaded 4th consecutive down year. Additionally, I pointed to the likelihood that the NASDAQ would perform better than the rest of the market, due in large part to the fact that most of the punishment has already been meted out to Technology stocks, while there is still a fair amount of excess to be wrung out of the rest of the market.
That second point has certainly turned out to be true over the past couple months, as the NASDAQ Composite (COMPX) bottomed last week well above its October lows, finding support at the 1260 level once again. A simple relative strength chart comparing the COMPX to the S&P 500 (SPX.X) bears this out quite clearly.
Relative Strength Chart of the COMPX vs. SPX
See how the RS chart bottomed in December of last year at a significantly higher level than that seen in October? That looks very good for my premise of outperformance for the Technology sector of the market. We can get another view of this strength by just looking at the chart of the COMPX, shown below.
Daily Chart of the NASDAQ Composite - COMPX
As you can see, the COMPX is still mired within the descending channel (red lines) that has been building for nearly two years now. But isn't it interesting how this index has been consistently finding support above the center line (gray line) of that channel for the past few months? Add in this week's breakout over both the 50-dma and the 200-dma and the COMPX looks like it might have some room to run if it can clear near-term resistance in the 1400-1425 area.
So does this mean we can just go out and buy LEAP calls on the QQQ and let it ride into the end of the year? Maybe, but I have a lot of reservations. You see, the COMPX looks bullish on a technical basis right now, but the technicals are only one part of this equation. A big reason the COMPX looks so good right now is that it (and the rest of the market) are in the process of rebounding from a severe oversold condition. So what are the other components we need to pay attention to, when trying to divine the direction of the market? Fundamentals and Sentiment.
First, let's deal with the issue of sentiment. Since the middle of January, the market has been fixated on the looming war in Iraq, with a tremendous amount of uncertainty being priced into the market. That has created the oversold condition that we are now recovering from. Over the past week, this oversold condition has been unwinding rather rapidly, as traders have attempted to front-run what they expect will be a powerful post-conflict rally, using the 1991 Gulf War as the template. So you see, while technicals have certainly played a role, the decline and subsequent rally since early December has been predominantly driven by changing sentiment -- first pessimistic and now optimistic.
Here's the big potential problem though. The current rally in the market is predicated on a relatively smooth operation in Iraq. In my opinion, that means a conflict that is measured in the 2-4 week timeframe, with the absence of large numbers of U.S. casualties and Saddam not resorting to the use of weapons of mass destruction. That is the scenario that is currently priced into the market, along with the unspoken assumption that after the war is out of the way, the economy will recover smartly into the end of the year. Aaahhh, now there is that pesky issue of fundamentals that we've avoided up to this point in our conversation. This is also the part of the equation that is currently being ignored by the market in hopes that it will get better after the war is over.
If I was to detail my thoughts on the state of the economy (which is really what fundamentals for the market boil down to right now), I could probably fill another 15-20 pages, discussing things like the trade balance, currency concerns, interest rates, unemployment, inflation vs. deflation, the housing market, the retail environment, the price of oil and the outlook for gold. Fortunately for me, I don't need to write that thesis, as Buzz Lynn has done an excellent job of that over the past couple months. Buzz and I don't necessarily agree on everything, but we are pretty much on the same page with respect to the economic outlook both here in the U.S. and for the global economy. If you haven't read his series, I highly recommend it. Here are the links for your convenience.
To Inflate or Deflate - That is the Question
To Inflate or Die - That is the Second Question
Real Estate 2003 - Boon or Bubble?
Now that you're back from reading that dissertation on the state of the economy, let's look at where we are right now. Interest rates are still at multi-decade lows and unlikely to move up any time soon. In fact the economic picture is so uncertain that at this week's FOMC meeting, Alan Greenspan declined to even issue a statement on the economic risks. I think there are two possibilities here: either the Fed chief doesn't know what to make of the current economy (i.e. doesn't have a clue) or sees something ugly on the horizon that he doesn't want to disclose to the public as the country heads to war. Neither option sounds very encouraging to me.
I find the recent developments in the Housing market to be interesting too. On numerous occasions over the past year, Greenspan has forcefully stated that the housing market is NOT in a bubble like that which the equity markets are still dealing with. So isn't it curious that with sharp declines in the housing reports for the past two months, the Fed chief warned that we should expect weakness in the housing and refinancing markets this year? It doesn't take a genius to see that the economy has been propped up over the past couple years by the cycle of refinancing, the proceeds of which have been used to fund consumption. But with interest rates at multi-decade lows, and not likely to go much lower, the incentive for another refi is dramatically reduced. Translation: the gravy train that has been propping up the economy in the vacuum left behind when businesses stopped spending looks like it has run its course.
The trade imbalance is looking uglier by the month, auto sales are falling and unemployment is rising. Even after the pullback in the past several days, energy prices are still quite elevated. This equates to a direct tax on both the consumer and business. For every extra dollar the consumer has to pay for energy, that's a dollar that is unavailable to drive economic growth. Similarly, that increased fuel cost increases the cost for energy-intensive businesses to produce what they produce. In a normal economic environment, companies would simply raise prices to maintain profit margins. But they can't do that right now, as there is a glut of supply and a shortage of demand. So what we have is a consumer with fewer dollars to spend on products produced by Corporate America, intensifying the competition (read: price competition) for those discretionary dollars that are in circulation. This competitive cycle in the business world is global, and China is exporting deflation to the world, due to its ability to produce "stuff" cheaper than anyone else. The weakness in the dollar just feeds that cycle, as China's currency is tied to the dollar. So as the dollar weakens, China's goods are cheaper on the global market, intensifying the pricing pressures on domestic companies. I could go on and on about this topic, but what it boils down to is there is not a definable engine for growth in the economy, either in the U.S. or worldwide.
So what does any of this have to do with the imminent war in Iraq? Actually nothing, but what is key is that market participants have been ignoring all the economic problems over the past week in the hope that when the smoke clears in Iraq, consumers and businesses will go back on a spending spree. Call me a cynic, but I say that dog won't hunt. Record levels of debt (for consumers, businesses and governments) mean that more and more revenue is being used to service that debt. That means it isn't going to be used to fuel economic growth. Investors seem to be dancing to the 1991 game plan, where the markets embarked on a strong rally following the start of the first Gulf War. But I see the underlying conditions as very different this time around.
Even if the conflict in Iraq goes smooth as glass, when it is all over, investors will be confronted with an S&P 500 P/E ratio (based on core earnings) of about 40, and a dividend yield of less than 2% in a stagnant economy. Those numbers for P/E ratio and dividend yield are typical of bull market tops, not bear market bottoms. There are only two ways to bring those two metrics in line with what is typical near a bear market bottom - earnings and dividend payouts need to rise or stock prices need to fall. I think I've made a pretty good case above that growing earnings over the next year is going to be a Herculean task for most companies, as there just isn't anything to drive growth to the bottom line.
Six weeks from now, we'll be looking at the April earnings cycle in the rear-view mirror and while it may not be a disaster, it isn't likely be strong enough to usher in a new bull market -- not even a cyclical one. At the same time, early May will usher in the "bad" 6 months of the year (May-October) that are usually least kind to stock market bulls. I've made no secret of my opinion that we haven't seen the bottom of this bear market, by any stretch of the imagination. But I think it is going to be a very interesting path between here and the bottom.
Over the near-term, we're likely to continue the rally that is currently underway, provided there aren't any nasty surprises related to the war effort. The bullish percent charts will likely continue their trek from oversold territory, back up to overbought and we'll be ready to repeat the process. I've frequently referred to the descending channel that the SPX has been mired in for the past few years. That channel shows no signs of being broken anytime soon, in large part because there isn't a sufficient fundamental catalyst to get the job done. The top of that channel is at the 950 level right now, which is very near the highs in both November and January. I expect the top of that channel to once again deflect this rally downwards, if it gets that far.
Therein lies the problem with my prognostication from January, though. You see, if you project this channel out to the end of the year, the top of that channel will be at 750!! There's certainly no way the SPX can remain in the channel AND close positive for the year, now is there? So either, it has to break out of that channel, or my guess for a positive close for the year is WAY off. I think before we ring in another new year, the SPX will indeed break and hold above the top of that descending channel, but the path isn't going to be pretty. My view is that after the fog of war has been cleared from our collective viewscreen and we once again focus on the economy, the market will have no choice but to head back to the south, breaking below the October lows in the process. We ought to find a bottom on that decline near the 700 level, probably sometime in the latter part of the summer. I'm basing my timeframe on the latest cycle from low to high to low, which took just about 5 months. Five months from now will have us closing in on the end of August. It isn't an exact science, by any stretch of the imagination, but I think it ought to work for the purposes of our discussion. Note that at the end of August, the center line of that descending channel will have fallen to about 675, and we will really need to see it hold as support, for the subsequent rebound.
If the SPX actually trades that low, I think the spring will actually be coiled tightly enough to propel the SPX out of its channel and we should be in the process of actually starting to build a bottom. A couple of other metrics that we'll want to start watching for at that time will be for the 50-dma and 200-dma to bottom, then turn up, and for the 50-dma to cross above the 200-dma. Once the SPX pushes through both of these upturned moving averages, I'll be happy to chant "The bulls are back in town". It may not be the start of a new Bull Market (I expect that event is still a few years off), but it could be time for a serious advance that results in the upside break of that channel.
For a picture of what that will look like, all you have to do is look at the COMPX daily chart up above. Actually, the COMPX isn't quite there yet, as both moving averages are still pointed south. But with price now over both averages, we can start the process of at least flattening them out...with enough time. The process of turning those moving averages around will help to break the COMPX out of its descending channel, just like we expect at a later date from the SPX.
Let's summarize based on the three major factors I mentioned above. Sentiment is in control right now, more appropriately termed, "fear of missing the next rally". When the war fades from our view, we'll be forced to confront the reality of our economy for what it is. Without some earth-shaking good news in the April earnings cycle, investors are going to lose their appetite for being long stocks. Then the technicals will come into play with a vengeance, just like at the end of each of the prior bear market rallies, and we'll get another big drop. I feel the action in the VIX will be particularly interesting, but we just don't have the time to go into it tonight.
So if you're bearish, don't fret. There will be another major rollover in the market that we can play for all it's worth. And for the bulls, my recommendation would be to focus your efforts in the NASDAQ stocks, as that is where the relative strength currently is. The blow-by-blow of what to expect each week will be dependent on the developments in the bullish percents and the technical price action. But more up, then more down and finally a big push up at the end of the year, is where I see this great game shaking out. It may not be enough to prove me right on a positive close for the year, but I'm willing to bet the COMPX will close well into the 'plus' column.
That's all the Great Carnac has for tonight. Have a great evening and we'll talk again over the weekend.