Tuesday, May 18, 2010

Morning Update/ Market Thread 5/18

Good Morning,

Equity futures are higher this morning, below is a snapshot of the DOW futures on the left and S&P futures on the right showing the overnight action. There is a potential rising wedge outlined, but being that it developed in after hours, it may not be a valid formation:

There was a small change in the McClellan Oscillator yesterday so I do expect a large move to be likely today.

Yesterday’s action produced what appeared to be a topping candle in the U.S. Dollar and a potential bottom candle in the euro, and indeed, you can see that the dollar is lower, euro higher this morning:

Note that neither are back inside of their channel. If the Euro reenters, I would be more short term bullish on the Euro and therefore more short term bullish on equities. I think the negative sentiment on the Euro got pretty high and I think it may need a period of consolidation before the decline resumes. Don't forget that the move yesterday pierced overhead resistance and triggered a huge 112 bullish target for the dollar.

It could be a short period of consolodation, however, as it is possible to count the prior down move in equities as wave 1 of 3 down, this would be potentially a wave 2 bounce with 3 of 3 to follow. If that’s occurring then the bounce should not go too much higher and we should get a very large decline in the next few days. There are alternative counts, so it will be important to track over the next couple of days.

Bonds are higher this morning, that’s not the direction you would expect for a significant bounce in equities. Oil is higher this morning, if you’re looking at the /QM futures, the front month contract rolled over, so the bounce is not nearly as high as depicted on that chart. Gold is continuing its correction this morning but is still above the $1,200 mark.

The headline on the mainstream media says, “New Home Sales Spike 41%!” LOL, yes, year over year from last year’s disaster. Month over month new home sales rose 5.8%, up to 672,000, with 650k expected, 626k the prior. It is near peak season, and not in the headlines is the fact that permits plunged from 685k to 606k, a drop of 11.5% in the month, double the increase in sales over the same month!

And the bottom line is that inventory is NOT what the housing market needs. Here’s Econoday’s spin:
The recent spike in home sales has boosted new construction, but according to permits, homebuilders are still cautious about a likely dip in sales now that special tax credits for homebuyers expired in April. Housing starts in April advanced 5.8 percent, following a 5.0 percent gain in March. The April annualized pace of 0.672 million units topped analysts' forecast for 0.650 million units and was up 40.9 percent on a year-ago basis. April's gain was led by a 10.2 percent increase in single-family starts, following a 2.1 percent rise in March. The multifamily component fell 18.6 percent after a 24.4 percent surge the month before.

By region, the April gain in starts was led by a 23.9 percent boost in the Northeast with increases also seen in the Midwest, up 16.7, and the South, up 7.0 percent. The West declined 13.3 percent.

Given the expiration of special tax credits in April, homebuilders are not rushing to the courthouse to pay for new building permits and are actually dialing back a bit. Housing permits declined 11.5 percent, following a 5.4 percent boost in March. The April pace of 0.606 million units annualized was up 15.9 percent on a year-ago basis.

Overall, the April starts report shows homebuilders benefitting from recently robust home sales but being rationally cautious about future strength. Nonetheless, housing appears to be slightly better than believed ahead of the report. Markets were little changed on the news but futures were up on mostly favorable company news.

The PPI fell .1% in April. Year over year it is up 5.4%, but that is down from March’s 6.1% increase.
Headline inflation came in better than expected but higher auto prices boosted the core rate. Overall PPI inflation eased to down 0.1 percent in April from a 0.7 percent spike in March. The April number came in below the consensus forecast for a 0.1 percent rise. Declines in both food and energy helped pull the headline figure down. At the core level, the PPI came in with a 0.2 percent increase, following a 0.1 percent uptick in March. Analysts had expected a 0.1 percent bump in core prices. The key factor behind the boost in the core was cuts in discounts by auto dealers.

The dip in the headline PPI was led by a 0.8 percent decline in energy costs, following a 0.7 percent increase in March. Gasoline dropped 2.7 percent in the latest period after gaining 2.1 percent the month before. As expected, food prices slipped 0.2 percent on lower prices for fruits and vegetables as the impact of severe winter weather fades. Egg prices also fell significantly.

At the core level, the boost was led by a 0.6 percent jump in passenger car prices after declining 1.1 percent in March.

For the overall PPI, the year-on-year rate decreased to 5.4 percent from 6.1 percent in March (seasonally adjusted). The core rate firmed to 1.0 percent from 0.8 percent the month before. On a not seasonally adjusted basis for April, the year-ago increase for the headline PPI was up 5.5 percent while the core was up 1.0 percent.

Markets had little reaction to the PPI report. Generally, the core topping expectations would get market attention but worries over sovereign debt in certain European countries, related austerity measures, and declines in commodity prices has markets more worried about potential deflation than blips in the core from off and on discounts on autos. However, equity futures are up largely on mostly favorable company news.

With oil down sharply in the past month, look for the May report to be substantially lower.

In what I would normally consider to be a contrary indicator, I was shocked to read a Fortune article on CNN news this morning that went like this:
2010's coming stock market crash: 1987 all over again

(Fortune) -- In two tumultuous weeks in October 1987, the stock market shed nearly one-third of its value in perhaps the second most notorious crash in U.S. history. It could happen again. Don't be deceived by the rebounding economy, any more than the bulls should have been misled by the balmy climate during the late Reagan years. Right now, stocks are extremely vulnerable to the same scenario. The reason: The market is even more overpriced than when thunder struck on that distant Black Monday.

That doesn't mean that a giant correction is inevitable; far from it. But the quasi-bubble that followed the big selloff in late 2008 and early 2009 makes the probability of sudden downward swing far more likely. And today's high prices make it practically certain that investors can, at best, expect extremely low returns in the years ahead.

Let's gauge where the market stood just before the shock of October '87. For this analysis, we'll use the price-to-earnings multiples developed by Yale economist Robert Shiller, who smoothes the erratic swings in profits by calculating PEs based on a 10-year average S&P earnings, adjusted for inflation.

In the fall of 1987, stocks were on a tear. The Shiller PE had doubled to 18.3 in just four-and-a-half years. That's far above the historical average of less than 14 (though pales in comparison to recent giant PE numbers). The dividend yield was also an extremely narrow 2.6%, well below the norm of around 4.5%. That's important to remember, because over long periods, dividends are by far the biggest source of investor returns from equities. Then the bottom fell out of the stock market.

When the carnage ended, the PE had dropped to 13.3, around its 60-year average, and the dividend yield was approaching 4%. In other words, the fall hardly made stocks a bargain. But with brutal speed and efficiency, it chopped valuations to levels that made sense.

The slow crash of 2008-2009: a temporary return to sanity
From early 2008 until March of 2009, stocks suffered a steep decline that echoed the 1987 correction, though over many months versus a few days. During that period, PEs fell from the low 20s to 13.3, precisely their level following the '87 crash. Once again, dividend yields approached 4%. For a few brief weeks, it appeared that sanity had returned to the capital markets. Suddenly, equities--overpriced for 20 years-- looked like a good buy, just as they had in at the close of 1987.

But the rational interlude didn't last. By early May of this year, the PE had soared back to almost 22, shrinking the dividend yield to 1.8%. In recent days, stocks have dropped over 7% amid giant gyrations. That decline isn't nearly enough to restore equities to anything like their fair value. So what do the current, extremely price PEs tell us about the future of stock prices?

The best bet is always that equity values, like most investments, "revert to the mean." So following a bubble or bubblette, PEs and dividend yield will inevitably fall back to their historic averages. The big question is how long it will take. In 1987, it took a few days. In the 1990s and early 2000s, stocks remained overpriced for years.

The problem is that the returns investors can garner at today's lofty valuations are just too low. They're also too low to last. If PEs stay constant, the total return to investors is the dividend yield plus the growth in earnings per share, with an added bump for inflation.

Today, the yield is 1.8%. Earnings per share typically grow at a "real" rate of around 1.5%, way below the pace that Wall Street advertises. So the total gain from investing at today's prices is 3.3% or so, plus around 2.5% for inflation, for a total of between 5.5% and 6%.

That's not enough. Stocks are far too risky for investors to accept those puny rewards, as the wild swings of the last two years, and last two weeks, make abundantly obvious. The only way for future returns to rise is for PEs to fall.

How far must prices fall to get back to basics? For the S&P to return to a PE of around 14, the index would need to drop by around 33% to less than 800, its range in early 2009. That would substantially raise dividend yields, and raise future real returns into the high single digits, where they belong.

The drop is going to happen. Here's how:
Here's how I see the odds. The chances are about one in three that we suffer a huge, wrenching correction in the next year or two similar to the one in 1987. That possibility is so high because stocks are so startlingly expensive. Another high probability event is that markets go on a long sideways grind, with smaller drops along the way. What's extremely unlikely is that the market rises substantially from current levels and stays there for any extended period.

Whatever happens in the next couple of years, the odds are overwhelming that investors who buy stocks today will reap puny returns for 10 years. For example, if you'd purchased shares at today's PE of 22 in early 2003, you would have gotten a return of around 3% a year, barely enough to compensate for inflation, let alone buy the blood pressure medication you'd need to survive the scary ride of stock ownership.

Now let's look out a decade or two. The evidence is extremely strong that price matters, and matters a lot: except in rare cases, buying stocks when they are pricey -- when the Shiller PE exceeds 20 -- leads to puny returns ten years later.

Not that you'd ever know that from the happy talk from Wall Street. So screen the noise out, and follow the numbers. They'll eventually get better for investors. But to get back there, we may revisit October of 1987.

Wow, I’m very surprised they put that into print. Making crash calls is almost never a smart call, nor is betting on one, at least with money you cannot afford to lose. The valuation point of the article, however, is correct and the markets are certainly overvalued, not that I am a fan of Schiller’s smoothing technique. And reading mainstream articles about crashes tells me that there may be too much fear for a crash to occur now – although with a potential wave 3 of 3 looming (one count possibility), it’s not out of the question either.

Here’s an interesting update and photo of the oil spill. This photo comes from Dr. Jeff Masters' WunderBlog, an interesting article discussing this satellite photo showing the subsurface movement of the oil spill:

The oil beneath the surface is being pulled southeast and is being picked up by the “loop current.” A good thing or a bad thing? I guess we’ll find out over time, it’s certainly a crying shame no matter where that oil eventually lands.

That's not the only crying shame as this morning we needlessly lost another 5 of our troops to a suicide bomber in Afghanistan...

Question Mark & The Mysterians - 96 Tears: