Economy


This week’s edition of “Words from the Wise” is briefer than most as I must answer the call of family to spend a last few days with them before putting shoulder to the 2008 wheel.

My kids have asked me to help them fly a kite, but the wind seems to be a bit too gusty to achieve this with much success. This makes me wonder how stock markets are going live through the various tailwinds and headwinds that will invariably come to blow during 2008.

In the words of market veteran Richard Russell, author of the Dow Theory Letters: “This market cannot make up its mind. The bullish case is strong, the bearish case is strong, and a lot of very big money is very divide on the outlook for the stock market. Thus – we have a very nervous, high volatility market with the Dow jumping over 100 points (up or down) every other day. It’s enough to give an honest man the ‘willies’.”

And in the spirit of the holiday period, David Galland of Casey Research observed: “… we have the US stock market, which, despite the energetic efforts of government on many levels, is stumbling along like a blind drunk after a long and well-lubricated holiday season party. One minute, Mr. Market has a big happy smile on his face, but the next he’s flat on his face. Struggling to his feet, he is barely able to whisper an ebullient toast before tripping over his own shoes and falling back to the ground.”

I will be watching the market carefully as 2007 fades out and the New Year comes in. The market action during the few days of December and January often provides hints regarding the rest of the year. For example, if the so-called “Santa Claus Rally”, which has one more trading day remaining in 2007 and two more in 2008, does not materialize, it typically is a harbinger of a sizeable correction or bear market in the coming year.

The “January Barometer”, stating that as the S&P 500 Index goes in January so goes the year, will also be watched with more than a cursory glance. 

Furthermore, the best years for stock market gains have been years ending in 5, with the second best years being those ending in 8. Since 1891 there have been only two years ending in 8 that were negative, namely 1948 when the Dow was down 2.1% and 1978 when the index declined by 3.2%.

Here’s wishing you a wonderful New Year. May it be truly joyful and exceptionally rewarding on all fronts.

Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the market’s ups and downs on the basis of economic statistics and a performance chart.

Economy
The assassination of Benazir Bhutto, Pakistan’s former prime minister and opposition leader, weighed heavily on markets during the past week, raising the possibility of instability in a volatile region.

An international crisis could not have appeared at a worse time with the global financial system appearing to be an unpredictable black hole. Also, further evidence of worsening economic conditions came in the form of new home sale tumbling by 9% in November to the slowest pace in 12 years and durable goods orders rising a disappointing 0.1% in November. More reassuring data on US mid-west manufacturing activity were largely brushed aside.

All this was piled on top of mounting concerns about more banking write-downs, rising inflation and a deteriorating outlook for economic growth. 
 

Date

Time (ET)

Statistic

For

Actual

Briefing Forecast

Market Expects

Prior

Dec 26

10:30 AM

Crude Inventories 12/21

NA

NA

-7586K

Dec 27

8:30 AM

Durable Orders Nov

0.1%

4.0%

2.2%

-0.4%

Dec 27

8:30 AM

Initial Claims 12/22

349K

345K

340K

348K

Dec 27

10:00 AM

Consumer Confidence Dec

88.6

87.5

87.0

87.8

Dec 27

10:30 AM

Crude Inventories 12/21

-3299K

NA

NA

-7586K

Dec 28

9:45 AM

Chicago PMI Dec

56.6

52.5

52.0

52.9

Dec 28

10:00 AM

Existing Home Sales Nov

NA

NA

4.97M

Dec 28

10:00 AM

New Home Sales Nov

647K

700K

715K

711K

Source: Yahoo Finance, December 28, 2007.

The next week’s economic highlights, courtesy of Northern Trust, include the following: 

Existing Home Sales (Dec 31) – Sales of existing single-family homes are down 31.0% from their peak in September 2005. The consensus is for a steady reading in November. Consensus: 4.97 million.

ISM Manufacturing Survey (Jan. 2) – The Manufacturing ISM survey for December is predicted to fall to 50.3 form 50.8 in November. Indexes tracking new orders, production and employment should be market movers. The employment index fell to 47.8 in November. Consensus: 50.3 from 50.8.

Employment Situation (Jan. 4) – Payroll employment in December is predicted to have risen 40,000 after a gain of 94 000 in November. The gradual upward trend of initial jobless claims suggests that hiring was probably slow in December. The unemployment rate should have risen to 4.8% in December following three monthly readings of 4.7%. Consensus: Payrolls +65 000 vs. +94 000 in November; unemployment rate – 4.8%.

Other reports – Construction Spending (Jan. 2), ISM Non-Manufacturing Survey, and Factory Orders (Jan. 3).

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week. 

whats-hot-and-not.jpg

Source: Wall Street Journal Online, December 30, 2007.

US stock market indexes declined modestly during the past week on the back of increasing economic woes and worries about the situation in Pakistan. The worst casualties were REIT stocks (-2.1%), small caps (-1.8% in the case of the Russell 2000 Index) and financials (-1.2%). Energy (+1.4%), however, brought investors some joy.

The MSCI World Index recorded a gain of 1.1% for the week as a result of the strong performance of emerging markets (+2.6%), and also a small positive contribution from the Japanese Nikkei 225 Average (+0.3%).

On the currency front, the US dollar had its worst week in a year as the poor economic statistics increased expectations of more interest rate cuts, resulting in the US Dollar Index declining by 2.0%. Similarly, sterling hit its lowest level in one-and-a-half years against a basket of currencies after a report of slower growth in house prices raised expectations of interest rate cuts early in 2008. On the positive side, the euro, the Swiss Franc and Chinese renminbi increased strongly.

As far as money markets were concerned, the three-month dollar Libor rate eased to its lowest level since February 2006 and the three-month euro rate was set at its lowest level since November 22. Government bond yields declined during the course of the week, benefitting from more safe-haven buying.

The oil price came within sight of its all-time high after US fuel inventories fell more than expected and in reaction to tension in Pakistan and northern Iraq. Gold, fulfilling its role as a safe-haven investment in times of political uncertainty and a hedge against inflation, jumped by 3.4%. Silver (+2.8%) was in hot pursuit, but platinum (+0.3%) lagged somewhat after having hit a record on Thursday.

Although agricultural and base metal commodities experienced some profit-taking, the Dow Jones-AIG Commodity Index still managed a 1% gain for the week.

Now for a few news items and some words (and graphs) from the investment wise that will hopefully assist to make sense of financial markets’ shenanigans during the shortened week ahead.

John Carney (Dealbreaker): Why Bhutto’s assassination is very bad news
“The reason it’s terrible news is that Bhutto was actually a source of stability for the country. She was a reasonable and relatively US-friendly alternative to Musharraf. With her out of the picture, it’s unclear what direction the opposition to Musharraf will take. But what is clear is that the opposition will most likely strengthen and act with a greater sense of urgency. The world is slightly more dangerous this afternoon than it was when we went to bed last night.”

foto-van-bhutto.jpg

Sources: John Carney, Dealbreaker, December 27, 2007 (text); and Bloomberg, December 27, 2007 (photo).

ABC News: US checking al Qaeda claim of killing Bhutto
“While al Qaeda is considered by the US to be a likely suspect in the assassination of former Pakistani Prime Minister Banazir Bhutto, US intelligence officials say they cannot confirm an initial claim of responsibility for the attack, supposedly from an al Qaeda leader in Afghanistan.   

“An obscure Italian Web site said Mustafa Abu al-Yazid, al Qaeda’s commander in Afghanistan, told its reporter in a phone call, ‘We terminated the most precious American asset which vowed to defeat [the] mujahedeen.’ It said the decision to assassinate Bhutto was made by al Qaeda’s No. 2 leader, Ayman al Zawahri in October. Before joining Osama bin Laden in Afghanistan, Zawahri was imprisoned in Egypt for his role in the assassination of then-Egyptian President Anwar Sadat.

“Bhutto had been outspoken in her opposition to al Qaeda and had criticized the government of President Pervez Musharraf for failing to take strong action against the Islamic terrorists. ‘She openly threatened al Qaeda, and she had American support,’ said ABC News consultant Richard Clarke, the former White House counterterrorism adviser. ‘If al Qaeda could try to kill Musharraf twice, it could easily do this,’ he said.”

Source: Brian Ross, Richard Esposito and R. Schwartz, ABC News, December 27, 2007.

Times Online: Main Bhutto suspects are warlords and security forces
“The main suspects in the assassination are the foreign and Pakistani Islamist militants who saw Ms Bhutto as a Westernized heretic and an American stooge, and had repeatedly threatened to kill her.

“But fingers will also be pointed at the Inter-Services Intelligence agency, (ISI) which has had close ties to the Islamists since the 1970s and has been used by successive Pakistani leaders to suppress political opposition. Ms Bhutto narrowly escaped an assassination attempt in October, when a suicide bomber struck at a rally in Karachi to welcome her back from exile.

“Ms Bhutto said after the attack that she had received a letter, signed by someone claiming to be a friend of al-Qaeda and Osama bin Laden, threatening to slaughter her like a goat. But she also accused Pakistani authorities of not providing her with sufficient security, and hinted that they may have been complicit in the Karachi attack.”

Source: Jeremy Page, Times Online, December 28, 2008.

(more…)

I read a great many reports from investment strategists and other market gurus, but a firm favorite always remains Donald Coxe, Global Portfolio Strategist of BMO Financial Group. I largely share Donald’s investment recommendations as published in the December edition of Basic Points, entitled “Double, Double, Greed and Trouble, CDOs and Housing Bubble”, and have therefore thought it appropriate to republish these eloquently written paragraphs below.

1.

Remain heavily underweight banks, particularly investment banks that have displayed monumental stupidity. Do not assume that a change at the top will automatically convert them into temples of wisdom (unless it is accompanied by demands for the departing to repay bonuses based on bets that turned out disastrously). Better to assume that, like subprime-based DOs, there are layers of rot that can make the entire product dangerous to your financial health.

2.

Remain overweight Emerging Markets, emphasizing those that are oil, gas, and/or food exporters.

3.

Soaring food costs threaten stability for some Third World economies. We have been ardently endorsing India since we returned from our leave of absence a year ago. We are now more cautious, because a weak monsoon could be politically and economically destabilizing at a time of $4 corn and $10 wheat.

4.

Remain heavily overweight gold – both stocks and the ETF. Gold is almost as good a protection against banking problems as SKF – the UltraShort Financials ETF – a security which may not be a suitable investment in some portfolios.

5.

We continue to believe that the Agricultural stocks are the pre-eminent investment class of our time. Farm incomes are rising rapidly and, in the US, farms and farm land are the real estate assets that are rising in value and are virtually immune to foreclosures. That means the leading Ag companies have great pricing power and minimal credit problems. We now hear suggestions that because food inflation has finally made it to the cover of The Economist, it is time to start moving toward the exits. Not so: We think that fine cover story could be the atonement – At Last! – for the magazine’s famous 1999 cover: $5 Oil.

6.

Remain overweight oil and gas producers, including the Alberta oil sands producing companies. As disappointed as we are with the new royalty schemes in that province, Alberta certainly remains more attractive than Nigeria or Angola – and much more attractive than Russia, Kazakhstan or Venezuela.

7.

We think it is time to begin accumulating the refiners that are equipped to handle heavy high-sulfur crude. The collapse of the crack spread has savaged refiners’ earnings, but that will eventually rebound. The Saudis have virtually turned out the Light, and less and less of the oil that the Gulf states will be lifting will be of the most desirable grades.

8.

Retain the base metal stocks that have long-life unhedged reserves in secure areas. Even if there is a global recession caused by global collapses of subprime paper and LBO loans, it will not be deep enough to drive base metal prices back to 2004 levels – but would be worrisome enough to push further mine development even farther into the future.

9.

When borrowing, borrow where possible in dollars. When investing, invest where possible in other currencies.

10.

Stagflation is a bad backdrop for bonds – and for non-commodity stocks. The central bankers could have headed it off had Wall Street behaved with a modicum of morality, but the Fed and its brethren are forced into sustained reflation because of the global solvency crisis. Corporate earnings for most sectors will not meet current optimistic Street forecasts, and rising inflation will reduce the market’s P/E.

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I am spending a few days of the Christmas break at a village alongside the coastline of the Cape Town Peninsula. It is quaint, picturesque and simply an ideal location for enjoying quality time with the family. The only drawback is that it does become quite windy on occasion – at best not a highly predictable event. This reminds me of the erratic behavior of gold bullion – you just never know with what action the yellow metal is going to surprise you next, making it infamously difficult to predict short-term movements.

And true to form, just as traders were bargaining on a quiet Christmas period, gold again startled with a $15 jump, taking the price well clear of the $800-level. (The rally commenced more than a day prior to the assassination of former Pakistani Prime Minister Benazir Bhutto.) Interestingly, gold has never in its history recorded a month-end price above $800 and only closed above this level on two days during its 1980 surge, namely: $830 on January 18, 1980, and $850 on January 21, 1980. That, however, represented a blow-off with the price plunging to $737.50 a day later and falling further to $659 by the end of January.

It would seem that gold bulls may very well have reason to toast bullion next week, saying goodbye to 2007 having achieved the $800 month-end milestone. There is, however, quite an important difference between 1980 and the present situation. In 1980 gold was in a parabolic rise, whereas since the low of $250 in 2001 gold has been rising methodically, mapping out consistently higher lows as shown below.

prent-1.jpg

Source: StockCharts.com

The upside breakout from the pennant consolidation pattern is a bullish technical development and looks well supported by the rising momentum (top section of graph) and MACD (bottom section of graph) indicators.  

The gold price has not only strengthened in US dollar terms, but has in fact been appreciating in most currencies – an indication of increased investment demand. The following graph and table (not yet reflecting the post-Christmas rally) clearly illustrate this phenomenon.

prent-5.jpg

Source: Plexus Asset Management (based on data from I-Net)

GOLD PRICE MOVEMENTS IN VARIOUS CURRENCIES

Gold price in various currencies

2005

2006

2007 (YTD: Dec 24, 2007)

Gold in US dollar

17.9%

23.1%

27.5%

Gold in euro

34.9%

10.5%

16.9%

Gold in British pound

31.3%

8.3%

26.4%

Gold in Swiss franc

35.9%

14.1%

21.1%

Gold in yen

35.5%

24.4%

22.5%

Gold in Aus Dollar

24.9%

13.9%

16.2%

Gold in Can Dollar

14.0%

23.5%

7.8%

Gold in rand

31.9%

37.1%

27.3%

Gold in renminbi

15.0%

19.1%

20.1%

Gold in rupee

22.7%

20.8%

13.7%

Gold in dinar

17.9%

23.2%

21.1%

Source: Plexus Asset Management (based on data from I-Net)

The pressing question is how sustainable bullion’s uptrend is. Although the technical picture indicates a primary bull market, the fundamental situation offers both bullish and bearish arguments.

The arguments in favor of a rising gold price have been well documented and include: the possibility of ongoing pressure on the US dollar, increasing global inflationary expectations, a surging oil price, minimal new mine production, and the fact that central bank sales are capped through the Central Bank Gold Agreement (CBGA II).

The bears, on the other hand, point to: record long speculator positions that have in the past been strongly correlated with gold price corrections, potentially lower fabrication demand from India (as a result of the higher price), and a slowdown in producer de-hedging as the global hedge book diminishes. Additionally, a seasonally weak period is approaching from February to April as illustrated by the graph below.

prent-4.jpg

I have over the past few months often conveyed my bullish stance on gold bullion. Examples of these articles include: “Gold: forwards and upwards” (September 14, 2007) and “Smart money bets on surging gold price” (September 4, 2007). I see no reason to change this position, from both an absolute and safe-haven point of view. I would, however, caution that one should not chase a surging gold price in an attempt to stock up on the various gold-related instruments. Rather bide your time and wait for the short-term corrections that occur regularly, perhaps coinciding with the advent of seasonal weakness in a few weeks’ time.

The final word goes to George Bernard Shaw who said: “The most important thing about money is to maintain its stability… You have to choose between trusting the natural stability of gold and the honesty and intelligence of members of the government. With due respect for these gentlemen, I advise you, as long as the capitalist system lasts, to vote for gold.”

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The commentary for this week’s edition of “Words from the Wise” is somewhat abbreviated as I am trying to finish the report a bit earlier in order to join my family at our beach house at Gordon’s Bay (40 minutes from Cape Town) for a few days over the Christmas period.

I will nevertheless still be following the markets closely as the next few days could see interesting movements. It has been observed by the Stock Trader’s Almanac that “beginning just before or right after the market’s Christmas closing, we normally experience a brief, yet respectable, rally from the last five trading days of the year through the first two of the New Year.” The S&P 500 Index has averaged a 1.5% increase during this seven-day period since 1969 and it is referred to as the “Santa Claus Rally”. However, it is also pointed out by the Stock Trader’s Almanac that “when this reliable seasonality has failed to materialize, it has often been a harbinger of a sizable correction or a bear market in the coming year.” Hence the saying: “If Santa Claus should fail to call; bears may come to Broad & Wall.”

As we approach the end of an eventful 2007 it is appropriate to thank each of my subscribers and readers for your friendship and support in making Investment Postcards such a fulfilling experience. The New Year will bring a new-look blog with a host of exciting features, but more about that in early 2008.

This is also a time for treasuring friends, especially those that are far away. One such friend and business partner is John Mauldin, author of the hugely popular Thoughts from the Frontline weekly e-newsletter. John is also one of five nominees for Motley Fool’s Investor of the Year – along with the likes of Warren Buffett and Carl Icahn. Don’t let the name fool you – this is a serious award. If you have enjoyed and benefited from John’s tireless effort researching and writing his newsletter and books over the years, please consider voting for him by clicking here.

Here’s wishing you a great festive season full of fun, laughter and joy, and a wonderful 2008. (In the spirit of the festive season, click here for a good laugh to see what happens when an investment manager gets “elfed”.)

Before highlighting some of the thought-provoking quotes from market commentators, let’s briefly review the market’s actions on the basis of economic statistics and a performance chart.

Economy
The prevailing mood remained cautious despite massive injections of liquidity into money markets by the world’s central banks. Leading the pack was the European Central Bank (ECB), adding an unprecedented €501 billion of liquidity in its two-week operation.

Markets took some comfort from reports that Temasek, Singapore’s state investor, might buy a $5 billion stake in Merrill Lynch. This would be the fourth time in a month that a US financial institution had raised capital from a sovereign wealth fund.

WEEK’S ECONOMIC REPORTS  

Date Time (ET) Statistic For Actual Briefing Forecast Market Expects
Dec 17 8:30 AM Current Account Q3 -$178.5B -$183.0B
Dec 17 8:30 AM NY Empire State Index Dec 10.3 20.0 21.0
Dec 17 9:00 AM Net Foreign Purchases Oct $114.0B
Dec 18 8:30 AM Housing Starts Nov 1170K 1175K
Dec 18 8:30 AM Building Permits Nov 1180K 1150K
Dec 19 10:30 AM Crude Inventories 12/14 -7586K NA NA
Dec 20 8:30 AM GDP-Final Q3 4.9% 4.9% 4.9%
Dec 20 8:30 AM Chain Deflator-Final Q3 1.0% 0.9% 0.9%
Dec 20 8:30 AM Initial Claims 12/15 346K 335K 335K
Dec 20 10:00 AM Leading Indicators Nov -0.4% -0.4% -0.3%
Dec 20 12:00 PM Philadelphia Fed Dec -5.7 7.0 6.0
Dec 21 8:30 AM Personal Income Nov 0.4% 0.5% 0.5%
Dec 21 8:30 AM Personal Spending Nov 1.1% 0.6% 0.7%
Dec 21 8:30 AM Core PCE Inflation Nov 0.2% 0.2% 0.2%
Dec 21 10:00 AM Mich Sentiment-Rev. Dec 75.5 74.5 74.5

Source: Yahoo Finance, December 21, 2007.

The next two weeks’ economic highlights, courtesy of Northern Trust, include the following: 

Durable Goods Orders (Dec. 27) Durable goods orders are predicted to have risen (+0.9%) after the three consecutive monthly drops. In particular, orders of aircraft may have risen after a reduction in October. A likely decline in bookings of defense items is included in the forecast. Consensus: +3.0% vs. -0.2% in October.

New Home Sales (Dec 28) – The consensus forecast is for a small drop in sales of new homes to 720 000 from 728 000 in November. Sales of new single-family homes are down 47.6% from their peak in July 2005. On a year-to-year basis sales of new single family homes were down nearly 23.0% in October. Consensus: 720 000 vs. 728 000 in October.

Existing Home Sales (Dec 31) Sales of existing single-family homes are down 31.0% from their peak in September 2005. The consensus is for a steady reading in November. Consensus: 4.97 million.

ISM Manufacturing Survey (Jan. 2) The Manufacturing ISM survey for December is predicted to fall to 50.3 form 50.8 in November. Indexes tracking new orders, production and employment should be market movers. The employment index fell to 47.8 in November. Consensus: 50.3 from 50.8.

Employment Situation (Jan. 4) Payroll employment in December is predicted to have risen 40,000 after a gain of 94 000 in November. The gradual upward trend of initial jobless claims suggests that hiring was probably slow in December. The unemployment rate should have risen to 4.8% in December following three monthly readings of 4.7%. Consensus: Payrolls +65 000 vs. +94 000 in November; unemployment rate – 4.8%.

Other reportsConsumer Confidence Index (Dec. 27), Chicago Purchasing Managers’ Index (Dec. 28), Construction Spending (Jan. 2), ISM Non-Manufacturing Survey, and Factory Orders (Jan. 3).

Markets
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week. 

clipboard1a.jpg

Source: Wall Street Journal Online, December 23, 2007.

Christmas Eve is still around the corner, but US stock markets were already in a festive mood towards the close of last week. Despite lingering worries about the US economy and the financial sector, stocks managed to finish a volatile week on a strong note. Small caps (+4.2% in the case of the Russell 2000 Index) charged ahead to pay heed to the so-called “January Effect” of small caps outperforming large caps from the middle of December through the end of January.

Despite the rally on Friday, European and Japanese stocks finished down on the week, whereas emerging markets were also taking a breather.

Central bank action eased money market pressures somewhat, resulting in lower one-month dollar, euro and sterling Libor rates. Despite kicking up a bit on Friday, government bond yields declined during the course of the week, benefitting from more safe-haven buying.

On the currency front, the US dollar was fairly stable against the euro, but recorded a four-month high against the British pound (on the back of expectations of further UK interest rate cuts) and a six-week high against the Japanese yen (as new carry trade positions were opened).

Commodities experienced an excellent week with gains on all fronts. Agricultural commodities surged on the back of tight supplies and strong demand from emerging countries. Solid demand from Asia also resulted in metals making headway, with copper (+4.8%) recovering from a nine-month low. Crude oil (+1.9%) and precious metals (gold +2.3%, platinum +3.7% and silver +3.6%) also performed strongly. The price of gold bullion looks set to record its first ever month-end close above $800.    

Now for some words (and graphs) from the investment wise that will hopefully assist to make sense of financial markets during and beyond the Christmas period, but firstly a cartoon.

 clipboard01.jpg

Source: Jim Sinclair’s MineSet, December 16, 2007.

Eoin Treacy (Fullermoney): Sectoral performance for 2007
“Over the last year, the worst performing sectors have been Homebuilding (-60.69%) Thrifts & Mortgages (52.45%) Real Estate Management (-37.11%), Department Stores (-34.99%), Motorcycle Manufacturers i.e. Harley Davidson (51%) and Regional Banks (-31.2%) This is no secret and real estate related worries have dominated media coverage over the last year.

“However what is less well known is that of the S&P 500’s 147 sector indices, 85 are positive or unchanged for the year. Of these, 7 are up in excess of 50% year-to-date. These were Fertilizer & Agricultural Chemicals (+94.42%), Construction & Engineering (94.24%), Education Services (+84.89%), Coal and Con Fuel (+76.61%) Diversified Metals (71.97%), Internet Retail (64.89%) and Healthcare Services (51.21%. A number of these indices are consolidating their gains and need to sustain moves to new high ground to reaffirm their overall uptrends.

“In the coming year, we can probably expect banks to bottom out and they should perform better than they did this year. So I would be surprised to see them at the bottom of this list a year from now. However with the increase in interest in agriculture, the continued need for infrastructural improvements, not only in the USA, but globally, and the continued secular bull market in all commodities; it is difficult to imagine that the leaders for this year will not be in the upper quartile of performers again next year.”

Source: Eoin Treacy, Fullermoney, December 19, 2007.

Dick Green (Briefing.com): Earnings slowdown dissected

“There is a definite slowdown in aggregate earnings growth. The financial sector is the cause. Other sectors have yet to see a broad slowdown in earnings growth.

“The table below shows the trend in quarterly year-over-year operating earnings growth for the S&P 500 companies in aggregate for 2006 and estimates for the fourth quarter of this year and the first quarter of next year.

clipboard02.jpg

“There is a clear slowdown in profit growth starting in late 2006 and continuing into 2007. Then, of course, profits dropped sharply in the third quarter of this year, and another decline is expected for the fourth quarter. This is why the stock market has hit so much turbulence lately.

“The impact of the financial sector is huge. The drop in third quarter profits is entirely due to the financial sector. Excluding financials, profits were up 10.2% over the third quarter of 2007. The central issue in this debate is that which preoccupies the market – whether the problems in the financial sector (and the associated problems in the housing sector) will lead to a recession. If not, then investors will ultimately find good value among non-financial stocks that have maintained earnings growth.”

Source: Dick Green, Briefing.com, December 17, 2007.

Moody’s Economy.com: Survey of business confidence for world
“Global business sentiment is very weak and fragile. This is particularly true in the US where confidence slumped last week to its lowest level in the five years of this survey, and where it is now consistent with a contracting economy.  Expectations regarding the outlook through mid-2008 are particularly bleak, and responses regarding sales strength, inventory investment, and office space are also soft. Confidence is stronger outside the US, but it has notably weakened across the globe during the past month. While pricing pressures have risen with oil prices near $100 per barrel, they remain notably muted compared to the pressures that prevailed during previous oil price spurts.”

Source: Moody’s Economy.com, December 17, 2007.

(more…)

Why are stock markets not tanking against the background of the sub-prime meltdown and an increasing number of “experts” calling for a US recession? One explanation for this seeming anomaly has been offered by George Friedman, CEO of Stratfor. (Stratfor, short for Strategic Forecasting, focuses on analysis and forecasts of geopolitical, economic, security and public policy issues.)

Although one may quibble with some points, Friedman’s analysis is certainly thought-provoking and worthwhile spending a few minutes on.

“The most bizarre aspect of today’s global economy is what has not occurred. In 1979, oil prices soared to slightly more than $100 a barrel in current dollars, and they are approaching that historic high again. Meanwhile, the subprime meltdown continues to play out. Many financial institutions have been hurt, many individual lives have been shattered and many Wall Street operators once considered brilliant have been declared dunderheads.

“Despite all the predictions that the current situation is just the tip of the iceberg, however, the crisis is progressing in a fairly orderly fashion. Distinguish here between financial institutions, financial markets and the economy. People in the financial world tend to confuse the three. Some financial institutions are being hurt badly. Those experiencing the pain mistakenly think their suffering reflects the condition of the financial markets and economy. But the financial markets are managing, as is the economy.

“What we are seeing is the convergence of two massive forces. Oil prices, along with primary commodity prices in general, have soared. Also, one of the periodic financial bubbles – the subprime mortgage market – has burst. Either of these alone should have created global havoc. Neither has. The stock market has not plummeted. The Standard & Poor’s 500 fell from a high of about 1,565 in mid-October to a low of 1 400 on October 19. Since then, it has rebounded as high as 1 550. Given the media rhetoric and the heads rolling in the financial sector, we would expect to see devastating numbers. And yet, we are not.

“Nor are the numbers devastating in the bond markets. By definition, a liquidity crisis occurs when the money supply is too tight and demand is too great. In other words, a liquidity crisis would be reflected in high interest rates. That hasn’t happened. In fact, both short-term and, particularly, long-term interest rates have trended downward over the past weeks. It might be said that interest rates are low, but that lenders won’t lend. If so, that is sectoral and short-term at most. Low interest rates and no liquidity is an oxymoron.

“This is not the result of actions at the Federal Reserve. The Fed can influence short-term rates, but the longer the yield curve, the longer the payoff date on a loan or bond and the less impact the Fed has. Long-term rates reflect the current availability of money and expectations on interest rates in the future.

“In the US stock market – and world markets, for that matter – we have seen nothing like the devastation prophesied. As we have said in the past, the subprime crisis compared with the savings and loan crisis, for example, is by itself small potatoes. Sure, those financial houses that stocked up on the securitized mortgage debt are going to be hurt, but that does not translate into a geopolitical event, or even into a recession. Many people are arguing that we are only seeing the tip of the iceberg, and that defaults in other categories of the mortgage market coupled with declining housing markets will set off a devastating chain reaction.

“That may well be the case, though something weird is going on here. Given the broad belief that the subprime crisis is only the beginning of a general financial crisis, and that the economy will go into recession, we would have expected major market declines by now. Markets discount in anticipation of events, not after events have happened. Historically, market declines occur about six months before recessions begin. So far, however, the perceived liquidity crisis has not been reflected in higher long-term interest rates, and the perceived recession has not been reflected in a significant decline in the global equity markets.

“When we add in surging oil and commodity prices, we would have expected all hell to break loose in these markets. Certainly, the consequences of high commodity prices during the 1970s helped drive up interest rates as money was transferred to Third World countries that were selling commodities. As a result, the cost of money for modernizing aging industrial plants in the United States surged into double digits, while equity markets were unable to serve capital needs and remained flat.

“So what is going on?

(more…)

The following humorous sketch ended up in my inbox a few days ago:

“Following the problems in the sub-prime lending market in America and the run on Northern Rock in the UK, uncertainty has now hit Japan.

“In the last seven days, Origami Bank has folded, Sumo Bank has gone belly up and Bonsai Bank announced plans to cut some of its branches.

“Yesterday, it was announced that Karaoke Bank is up for sale and will likely go for a song, while today shares in Kamikaze Bank were suspended after they nose-dived.

“Furthermore, 500 staff at Karate Bank got the chop and analysts report that there is something fishy going on at Sushi Bank where it is feared that staff may get a raw deal … “

Source: Hat tip to the person who sent this to me, but I have been unable to ascertain the original source.

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I visited a terminally ill friend in hospital yesterday. It was not a pleasant experience as it was quite apparent that the writing was on the wall. But fading away from life does not mean a continuous deterioration – he still perks up from time to time as glimmers of hope lift his mood. After all, to hope is to be pro life.

This made me think of the complex world of investments – a world where hope unfortunately has no role. Richard Russell, 83-year old author of the Dow Theory Letters, said: “In the stock market hope gets in the way of reality, hope gets in the way of common sense. If the stock market turns bearish and you’re staying put with your whole position, and you’re hoping that what you see is not really happening, then welcome to poverty city.”

Not since buying my first stocks in 1968 have I experienced the stock market outlook to be as murky as we are experiencing today. The fears are well documented and, in short, include lingering concerns about the financial system, a US economy on the doorstep of recession, and mounting inflation worries.

For the first time since starting to write my regular weekly “Words from the Wise” blog post three months ago not a single positive item regarding the US economy/markets made its way into last week’s article. It was not surprising that Nouriel Roubini remarked that it was time to move away from the soft landing versus hard landing discussion and start concentrating on how deep the coming recession would be.

In order to gain some perspective on the outlook for equities it serves a useful purpose to study a long-term graph of the S&P 500 Index (or any other major US stock market index). This chart is based on monthly data which tends to be more helpful than daily or weekly series when trying to identify the stock market’s primary trend.

graph1.jpg

Source: StockCharts.com

There are a number of interesting observations that one can make from this graph:

The MACD indicator (bottom section of graph) has just given a sell signal as evidenced by the blue histogram bars falling below the zero line. These signals do not occur often – the last one, a buy signal, was given in May 2003 and the sell signal before that happened in September 1999.

The more sensitive RSI (internal relative strength) oscillator (top section of graph) has fallen below 70, thereby giving its first sell signal since 1998. (A buy signal was registered four years later in 2002.)

The 20- and 40-month moving averages (middle section of graph) are still intact, but these are lagging indicators and the turning down and crossing over of the two lines typically only serve as final confirmation of turning points in the index.

But what about the argument that multiple Fed rate cuts are supposed to be bullish for stocks, i.e. the maxim “Don’t fight the Fed” (as described by Martin Zweig in his book Winning On Wall Street)? John Hussman points out that in those events where multiple Fed cuts helped the market, stocks had usually firstly experienced a bear market decline of 20% to 40% prior to recovering, and the average P/E on the S&P 500 Index was typically below 14 (compared with a multiple of 19.1 at the moment).

US profit margins, inflated by super-cheap credit in early 2007 (i.e. the lowest spreads ever seen), are clearly unsustainable. As a matter of fact, profits for the Standard & Poor’s 500 companies fell almost 25% on a per-share basis in the third quarter, the biggest year-over-year decline in almost five years. David Wyss, S&P’s chief economist, expects these companies’ earnings to fall as much as 30% in the fourth quarter as companies take more writedowns for bad investments. “The earnings recession has already arrived,” adds David Rosenberg, North America economist for Merrill Lynch.

Goldman Sachs noted that the average fall in the S&P 500 Index over the last nine recessions was 13% from peak to trough. These include 1969 (-18%), 1981 (-23%) and 2001 (-52%). The Index has so far declined by 7.6% since its high of October 9, 2007.

It is no wonder that the message conveyed by the Bullish Percent Indexes, i.e. the percentage of stocks in uptrends, is not exactly comforting with a large proportion of the major indexes in fact in downtrends as indicated below.

graph2.jpg

Source: StockCharts.com

It is impossible to know to what extent stock markets may bounce from time to time, especially with the expiration of options and futures coming up on Friday. (The Dow Jones Industrial Index has rallied 20 times in the past 22 years during the week of the December expiration.) In addition to the long-term graphs looking rather gloomy, the daily chart of the Dow Jones World Stock Index (used as a proxy for global stock markets) has also just triggered a sell signal (see negative MACD histogram bars). (I remain skeptical of world markets decoupling from the US in any meaningful way.)

graph3.jpg

Source: StockCharts.com

Somebody once remarked that “risk is often lowest when it is most visible”. Why do I have a niggling suspicion that a considerable dose of bad news has yet to surface and therefore not yet been discounted by stock prices?

These are unusually treacherous times and any rally should, in general, be used to lighten holdings. And avoid hope, as so eloquently put by Richard Russell above – rather embrace the cold reality of a situation that has possibly not yet seen its darkest hour.

graph4.jpg

Hat tip: Barry Ritholtz, Big Picture, December 16, 2007.

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