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BOTTOM LINE: Overall, last week's market performance was bullish. The advance/decline line rose, most sectors rose and volume was above average on the week. Measures of investor anxiety were mostly lower. The AAII % Bulls rose to 51.32% this week from 47.75% the prior week. This reading is above average levels. The AAII % Bears fell to 32.89% this week from 34.23% the prior week. This reading is still above average levels.
The 10-week moving average of the % Bears is currently a high 39.1%. The 10-week moving-average of % Bears was 43.0% at the major bear market lows during 2002. The only other times it was higher than these levels, since record keeping began in 1987, were the significant market bottom during the 1990 recession/Gulf War and in October 1992. The persistent negative sentiment towards US equities is amazing and, considering the DJIA is only 71 points from an all-time high, still provides a wall of worry for stocks to climb. As well, there are many other indicators registering high levels of investor skepticism regarding recent stock market gains.
Short interest on the NYSE and Nasdaq is at all-time highs. The ISE Sentiment Index has bounced around depressed levels for months. The OEX Put/Call ratio has been elevated during this time, as well. Domestic stock mutual funds are still seeing outflows. I have heard a number of pundits recently state that investor complacency is high and used anecdotal evidence to back up their view. I strongly disagree. I doubt investor sentiment has ever been this poor in U.S. history with the DJIA about to break to new record highs. This bodes very well for a continuation of the recent rally.
The average 30-year mortgage rate fell another 9 basis points to 6.31%, which is 49 basis points below July highs. I still believe housing is in the process of slowing to more healthy sustainable levels. Mortgage rates have likely begun an intermediate-term move lower, which should help stabilize housing at relatively high levels over the next few months. The Case-Shiller housing futures are still projecting a 5% decline in the average home price over the next 9 months. Considering the average house has appreciated over 50% during the last few years, this would be considered a “soft landing.” The overall negative effects of housing on the US economy are currently being exaggerated, in my opinion. Housing has been slowing substantially for 14 months and has been mostly offset by many other very positive aspects of the economy. Americans’ median net worth is still very close to or at record high levels, unemployment is low, interest rates are low, stocks are rising and most measures of income growth are almost twice the inflation rate, just to name a few.
The benchmark 10-year T-note yield rose 4 basis points on the week on profit taking and diminishing economic growth concerns. In my opinion, investors’ continuing fears over an economic “hard landing” are misplaced. Consumer spending is very important to the health of the US economy. Spending is poised to remain strong on plunging energy prices, low long-term interest rates, a rising stock market, healthy job market, decelerating inflation and more consumer optimism. The CRB Commodities Index, the main source of inflation fears, has now declined 8.7% over the last 12 months and is down 16.4% from May highs, approaching bear market territory. The average commodity hedge fund is down 13.8% for the year. I believe inflation fears have peaked for this cycle as global economic growth moderates to around average levels, unit labor costs remain subdued and the mania for commodities continues to reverse course.
The EIA reported this week that gasoline supplies rose substantially more than expectations even as refinery utilization fell. U.S. gasoline supplies are now at the highest level since 1991 for this time of the year. Unleaded Gasoline futures bounced for the week, but are still 46.6% below September 2005 highs even as refinery utilization remains below normal as a result of the hurricanes last year, some Gulf of Mexico oil production remains shut-in and fears over future production disruptions persist. Gasoline demand rose .6% this week and is estimated to rise .8% this year versus a 20-year average of 1.7% demand growth. Moreover, distillate stocks are 18% above the five-year average for this time of the year as we head into the winter heating season. According to TradeSports.com, the percent chance of a US and/or Israeli strike on Iran this year has fallen to 9% from 36% late last year. The still elevated level of gas prices related to crude oil production disruption speculation is further dampening fuel demand, which will send gas prices back to more reasonable levels.
US oil inventories have only been higher during one other period over the last 7 years. Since December 2003, global oil demand is only up .7%, while global supplies have increased 4.8%, according to the Energy Intelligence Group. Moreover, worldwide inventories are poised to begin increasing at an accelerated rate over the next year. I continue to believe oil is priced at extremely elevated levels on fear and record speculation by investment funds, not fundamentals. The Amaranth Advisors hedge fund blow-up is a prime example of the extent to which many investment funds have been speculating on ever higher energy prices through futures contracts, thus driving the price of the underlying commodity to absurd levels. Amaranth, a multi-strategy hedge fund, lost about $6.5 billion of its $9.5 billion under management in less than two months speculating on higher natural gas prices. I suspect a number of other funds will experience similar fates over the coming months, which will further pressure energy prices as these funds unwind their leveraged positions to meet investor redemptions.
Oil has clearly broken its uptrend, notwithstanding that this is the seasonally strong period for the commodity. A major top in oil is likely already in place. However, a Gulf hurricane or OPEC production cut could lead to a temporary bounce higher in price over the next couple of weeks, accelerating demand destruction, resulting in a complete technical breakdown in crude. Demand destruction is already pervasive globally. Moreover, many Americans already feel as though they are helping fund terrorism or hurting the environment everytime they fill up their gas tanks. I do not believe we will ever again see the demand for gas-guzzling vehicles that we saw in recent years, even if gas prices continue to plunge. An OPEC production cut with oil above $60 per barrel and weakening global growth would only further deepen resentment towards the cartel and result in even greater long-term demand destruction. Finally, as the fear premium in oil dissipates back to more reasonable levels, global growth slows and supplies continue to rise, crude oil should continue heading meaningfully lower over the intermediate-term, notwithstanding OPEC production cuts.
Natural gas inventories rose less than expectations this week, however prices for the commodity fell again. Supplies are now 12.2% above the 5-year average, a record high level for this time of year, even as some daily Gulf of Mexico production remains shut-in. Natural gas prices have collapsed 64.4% since December 2005 highs. It is very likely US natural gas storage will become full sometime this month, creating the distinct possibility of a “no-bid” situation for the physical commodity. Colorado State recently reduced its forecast from three to two major hurricanes for this season versus seven last year. The peak of hurricane season was September 10. Natural gas made new cycle lows again this week despite the fact that the commodity is in its seasonally strong period.
Gold rose slightly on the week on short-covering and a bounce in oil. The US dollar rose on diminishing worries over slowing economic growth. I continue to believe there is very little chance of another Fed rate hike anytime soon. An eventual cut is more likely at this point as inflation continues to decelerate.
Energy stocks outperformed for the week on quarter-end short-covering. Airline stocks underperformed on the bounce in oil and profit-taking. S&P 500 profit growth for the second quarter came in a strong 16.3% versus a long-term historical average of 7%, according to Thomson Financial. This is the 16th straight quarter of double-digit profit growth, the best streak since recording keeping began in 1936. Moreover, another double-digit gain is likely in the third quarter. Earnings pre-announcements are running below average levels so far. Despite a 79.3% total return for the S&P 500 since the October 2002 bottom, its forward p/e has contracted relentlessly and now stands at a very reasonable 15.3. The 20-year average p/e for the S&P 500 is 24.4. The S&P 500 is now up 8.5% and the Russell 2000 Index is up 8.7% year-to-date. The DJIA is only 71 points away from its all-time high reached on January 14, 2000. I expect the Dow to breach this level convincingly during the fourth quarter.
Current stock prices are still providing longer-term investors very attractive opportunities in many equities that have been punished indiscriminately during the latest correction. In my entire investment career, I have never seen the best “growth” companies in the world priced as cheaply as they are now relative to the broad market. By contrast, “value” stocks are quite expensive in many cases. A recent CSFB report confirmed this view. The report concluded that on a price-to-cash flow basis growth stocks are now cheaper than value stocks for the first time since at least 1977. Almost the entire decline in the S&P 500’s p/e, since the bubble burst in 2000, is attributable to growth stock multiple contraction. The p/e on value stocks is back near high levels. I still expect the most overvalued economically sensitive and emerging market stocks to continue underperforming over the intermediate-term as the manias for those shares subside and global growth slows to more average rates. I continue to believe a chain reaction of events has begun that will result in a substantial increase in demand for US stocks.
In my opinion, the market is still factoring in way too much bad news at current levels. One of the characteristics of the current “negativity bubble” is that most potential positives are undermined, downplayed or completely ignored, while almost every potential negative is exaggerated and promptly priced in to stock prices. Furthermore, this “irrational pessimism” by investors is resulting in a dramatic decrease in the supply of stock as companies buy back shares, IPOs are pulled and secondary stock offerings are canceled. Commodity and emerging market funds, which have received huge capital infusions this year, will likely see significant outflows at year-end. As well, how many times earlier in the year did we hear investment managers talk about the mid-term election cycle decline they expected and that they were already positioned for it? Historically, the average bottom for mid-term election cycle lows is Sept. 30. There is massive bull firepower available at a time when the supply of stock is contracting.
Over the coming months, an end to the Fed rate hikes, lower commodity prices, seasonal strength, the November election, decelerating inflation readings, lower long-term rates, increased consumer/investor confidence, rising demand for US stocks and the realization that economic growth is only slowing to around average levels should provide the catalysts for another substantial push higher in the major averages through year-end as p/e multiples begin to expand. I still expect the S&P 500 to return a total of at least 15% for the year. The ECRI Weekly Leading Index fell this week and is forecasting healthy, but decelerating US economic activity.
*5-day % Change
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