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BOTTOM LINE: Overall, last week's market performance was mildly bearish. The advance/decline line fell slightly, most sectors declined and volume was above-average on the week. Measures of investor anxiety were mostly higher. The AAII percentage of Bulls fell to 46.2% this week from 46.3% the prior week. This reading is still at average levels. The AAII percentage of Bears fell to 30.0% this week from 30.5% the prior week. This reading is still slightly above average levels. The 10-week moving average of the percentage of Bears is currently 34.3%, an above-average level. The 10-week moving average of the percentage of Bears peaked at 43.0% at the major bear market low during 2002. Moreover, the 50-week moving average of the percentage of Bears is 36.8%, a very high level seen during only two other periods since tracking began in the 80s.
I continue to believe that steadfastly high bearish sentiment in many quarters is mind-boggling, considering the S&P 500's 19.0% rise in about eight months, one of the best August/September/October runs in U.S. history, the fact that the Dow made another all-time high this week, the macro backdrop for stocks is improving and that we are in the early stages of what is historically a very strong period for U.S. stocks after a midterm election. As well, despite recent gains, the forward P/E on the S&P 500 is a very reasonable 15.8, falling from 16.2 at the beginning of the year, due to the historic run of double-digit profit growth increases. The S&P P/E multiple has contracted for three consecutive years. It has only contracted four consecutive years two times since 1905. Each point of multiple expansion is equivalent to a 6.6% gain in the S&P 500. Bears still remain stunningly complacent, in my opinion. As I have said many times over the last few months, every pullback is seen as a major top and every move higher is just another shorting/selling opportunity. I see few signs of capitulation by the many bears. Even most bulls have raised cash of late, anticipating a correction after the recent surge.
As well, there are many other indicators registering high levels of investor skepticism regarding recent stock market gains. The 50-day moving average of the ISE Sentiment Index just recently crossed above the 200-day moving average for the first time since November 2005 and is already rolling over. The ISE Sentiment Index plunged to a depressed 97.0 on Monday. Nasdaq and NYSE short interests are very close again to record highs. Moreover, public short interest continues to soar to record levels, and U.S. stock mutual funds have seen outflows for most of the last year, according to AMG Data Services. The percentage of U.S. mutual fund assets in domestic stocks is the lowest since at least 1984, when record-keeping began. There has been a historic explosion of hedge funds created with absolute return, low correlation or negative correlation U.S. stock strategies that directly benefit from the perception of a stagnant or declining US stock market. Commodity funds, which typically have a low or negative correlation with stocks, have been created in record numbers. Research boutiques with a negative bias have sprung up to cater to these many new funds. Wall Street analysts have made the fewest "buy" calls on stocks this year since Bloomberg began tracking in 1997. "Buy" calls have been trending lower for seven months through most of last year's rally. Many of the most widely read stories on financial sites are written with a pessimistic slant to gain readers. Investment blogger bullish sentiment is still bearish at 32.3% Bulls, 38.7% Bears. Finally, the UltraShort QQQQ ProShares (QID) continues to see surging volume. There is still a high wall of worry for stocks to climb substantially from current levels as the public remains very skeptical of this bull market.
I continue to believe this is a direct result of the strong belief by the herd that the U.S. is in a long-term trading range or secular bear environment. There is still overwhelming evidence that investment sentiment by the general public regarding U.S. stocks has never been this poor in history, with the Dow registering all-time highs almost weekly. This is serving to further widen the so-called “wealth gap.” I still expect the herd to finally embrace the current bull market this year, which should result in another substantial move higher in the major averages as the S&P 500 breaks out to an all-time high to join the Dow and Russell 2000.
Only in a "negativity bubble" could Wall Street strategists' consensus predictions of a 7% gain for the S&P 500 this year be characterized as "very bullish" by the many bearish pundits. The historical average gain for the S&P 500 is 8.3%. A recent UBS investor sentiment survey hit a three-year high and was characterized as “very bullish,” yet only 37% of respondents expected a gain in the DJIA this year. Moreover, of those 37% that expected a gain, only 11% thought the DJIA would rise over 10%. As well, many of the so-called “bullish” U.S. investors are only "really bullish" on commodity stocks and U.S. companies with substantial emerging markets exposure, not the broad U.S. stock market. Finally, how many investors are bullish on "growth" stocks? There are very few true "growth" investors even left after six years of underperformance. Based on the action so far this year, I suspect even more cash has piled up on the sidelines. I continue to believe significant portion of this cash will be deployed into “true growth” companies as their outperformance versus “value” stocks gains steam throughout the year. Finally, I still believe the coming bullish shift in long-term sentiment with respect to U.S. stocks will result in the "mother of all short-covering rallies."
The average 30-year mortgage rate fell 6 basis points this week to 6.28%, which is still 52 basis points below July 2006 highs. There remains mounting evidence that the worst of the housing downturn is over, despite recent worries over sub-prime lending, and that activity is stabilizing at relatively high levels. About 12% of total mortgage loans are sub-prime. Of those 12%, another 12.6% are delinquent. Thus, only about 1.5% of total mortgage loans outstanding are currently problematic. I think the fact that bonds didn't rally much, the dollar remained firm and stocks barely fell on this week’s housing-related news was telling. I do not believe sub-prime woes are nearly large enough or will become large enough to bring down the U.S. economy. As well, the Fed’s Poole said this week that, “there is no danger to the economy from sub-prime loan defaults.” There are just too many other positives that outweigh this negative. Moreover, the Fed’s Hoenig, Lacker, Fisher and Bies all made positive comments recently regarding the prospects for the US housing market. Mortgage applications fell .2% this week, but continue to trend higher with the decline in mortgage rates and healthy job market. The Mortgage Bankers Association said at year-end that the US housing market will “fully regain its footing” by the middle of this year. Moreover, the California Building Industry Association recently gave an upbeat forecast for housing, saying production would be near last year’s brisk levels.
Housing inventories have been trending meaningfully lower and homebuilding stocks have been moving higher. The Housing Index(HGX) has risen 29.5% from July lows. The Case-Schiller housing futures have improved substantially and are now projecting only a 1.9% decline in the average home price by May, up from projections of a 5.2% decline a few months ago. Considering the median house has appreciated over 50% during the last few years with record high US home ownership, this would be considered a “soft landing.” The overall negative effects of housing on the US economy and the potential for significant price drops are still being exaggerated by the many stock market bears in hopes of dissuading buyers from stepping up, in my opinion. Housing and home equity extractions had been slowing substantially for almost 2 years and the negative effects were mostly offset by many other very positive aspects of the US economy.
Home values are more important than stock prices to the average American, but the median home has barely declined in value after a historic run-up, while the S&P 500 has risen 19.0% in just over seven months and 94.4% since the Oct. 4, 2002 bear market low. Americans’ median net worth is still very close to or at record high levels as a result, a fact that is generally unrecognized or minimized by the record number of stock market participants that feel it is in their financial and/or political interests to paint a bleak picture of America.
Moreover, energy prices are down significantly, consumer spending remains healthy, unemployment is low by historic standards, interest rates are low, inflation is below average rates, stocks are surging and wages are rising at above-average rates. The economy has created 1.23 million jobs in the last seven months. Challenger, Gray & Christmas reported last week that January job cuts plunged 39.1% from year-ago levels. As well, the Monster Employment Index is just off record highs. The 50-week moving average of initial jobless claims has been lower during only two other periods since the 70s. Finally, the unemployment rate is a historically low 4.6%, down from 5.1% in September 2005, notwithstanding fewer real estate-related jobs and significant auto production cutbacks. The unemployment rate’s current 12-month average is 4.6%. It has only been lower during two other periods since the mid-50s.
The Consumer Price Index for December rose 2.5% year-over-year, down from a 4.7% increase in September of 2005. This is meaningfully below the 20-year average of 3.1%. Moreover, the CPI has only been lower during four other periods since the mid-1960s. Many other measures of inflation have recently shown substantial deceleration. The Producer Price Index for December rose a historically low 1.1% year-over-year. Furthermore, most measures of Americans’ income growth are now almost twice the rate of inflation. Americans’ Average Hourly Earnings rose 4.0% in January, substantially above the 3.2% 20-year average. The 10-month moving-average of Americans’ Average Hourly Earnings is currently 4.0%. 1998 was the only year during the 90s expansion that it exceeded current levels.
The benchmark 10-year T-note yield fell 4 basis points for the week on better-than-expected productivity and lower-than-expected unit labor cost readings. In my opinion, many investors’ lingering fears over an economic “hard landing” seem more misplaced than ever. The housing slowdown and auto-production cutbacks impacted manufacturing greatly over the last six months, but those drags on growth are subsiding. However, growth is likely unsustainable at the fourth quarter’s pace. 4Q GDP came in at 3.5% versus the long-term average of 3.1%. For all of 2006, US GDP growth rose an above-average 3.4%. While the drag from housing is subsiding, housing will not add to economic growth in any meaningful way this year. Slowing global growth, muted real estate-related activity and a smaller GDP deflator will likely result in US growth of around 3% for the year.
Manufacturing accounts for roughly 12% of US economic growth, while consumer spending accounts for about 70% of growth. U.S. GDP growth came in at a sluggish 1.1% and 0.7% during the first two quarters of 1995. During May 1995, the ISM Manufacturing Index fell below 50, which signals a contraction in activity. It stayed below 50, reaching a low of 45.5, until August 1996. During that period, the S&P 500 soared 31% as its P/E multiple expanded from 16.0 to 17.2. This was well before the stock market bubble began to inflate. As well, manufacturing was more important to overall US economic growth at that time. Stocks can and will rise as P/E multiples expand, even with more average economic and earnings growth.
Weekly retail sales rose an around average 2.9% for the week. However, retail sales are poised to accelerate. Energy prices are down from this time last year, jobless claims have taken another dip lower of late, housing has improved, wage growth has accelerated, stocks are higher and inflation has decelerated to below average rates. Both main consumer confidence readings are now very near cycle highs and many consumers are chomping at the bit to buy new spring clothing after such a warm fall muted holiday clothing sales. I expect new cycle highs for both measures of consumer sentiment over the next few months.
Just take a look at commodity charts, gauges of commodity sentiment and inflows into commodity-related funds over the last couple of years. There has been a historic mania for commodities. That mania is now in the stages of unwinding. The CRB Commodities Index, the main source of inflation fears has declined -9.4% over the last 12 months and -16.5% from May highs despite a historic flood of capital into commodity-related funds and numerous potential upside catalysts. Oil has declined $18/bbl from July highs. Last year, oil rose $2.05/bbl. on the first trading day of the year and $7.40/bbl. through the first three weeks of trading as commodity funds, flush with new capital, drove futures prices higher. I suspect, given the average commodity hedge fund fell around double-digits last year as the CRB Index dropped 7.4%, that many energy-related funds saw outflows at year-end. The commodity mania has pumped air into the current US “negativity bubble.” Talk of runaway inflation, drought, world wars, global warming, a US dollar collapse, recession/depression and global pandemics, to name a few, has been fueled by the mania in commodities. In my opinion, that is why it is so easy for most to believe that US housing was in a bubble, but then act shocked when commodities plunge. I continue to believe inflation fears have peaked for this cycle as global economic growth slows to 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 again as refinery utilization rose. U.S. gasoline supplies are at very high levels for this time of the year, notwithstanding declining refinery utilization. Gasoline futures rose slightly for the week, but have plunged 44.5% from September 2005 highs even as some Gulf of Mexico oil production remains shut-in and fears over future production disruptions persist. The still very elevated level of gas prices will further dampen global fuel demand, sending gas prices still lower over the intermediate-term.
The 10-week moving-average of US oil inventories is still approaching 8-year highs. Global demand destruction is pervasive. Oil consumption in the 30 OECD countries fell last year for the first time in over two decades. Since December 2003, global oil demand is only up 2.6%, despite the strongest global growth in almost three decades, while global supplies have increased 5.7%, according to the Energy Intelligence Group. The EIA recently forecast that bio-fuels should rise to the equivalent of more than five million barrels of crude oil production a day within four years. Recenly, Energy Secretary Bodman said the US will likely remove tariffs to boost bio-fuel imports, which should reduce fears over a potential corn shortage. As well, OPEC said recently that global crude oil supply would exceed demand by 100 million barrels by the second quarter of this year. Worldwide oil inventories are poised to begin increasing at an accelerated rate over the next year. There is a very fine line in the crude oil market between perceptions of "significantly supply constrained" and "massive oversupply." One of the main reasons I believe OPEC has been slow to actually meet their pledged cuts has been the fear of losing market share to non-OPEC countries. Moreover, OPEC actually needs lower prices to prevent any further long-term demand destruction. I continue to believe oil is priced at elevated levels on 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 for consumers and businesses. Amaranth, a multi-strategy hedge fund, lost about $6.5 billion of its $9.5 billion under management in less than two months speculating mostly on higher natural gas prices even as they plunged. I continue to believe a number of other funds will experience similar fates over the coming months after managers “pressed their bets” in hopes of making up for recent poor performance, which will further pressure energy prices as these funds unwind their leveraged long positions to meet rising investor redemptions. This appears to already be happening with copper. Moreover, the same rampant speculation that has driven the commodity mania will work against energy as downside speculation increases and drives down prices even further than the fundamentals would otherwise dictate.
Recently, Cambridge Energy Research, one of the most respected energy research firms in the world, put out a report that drills gaping holes in the belief by most investors of imminent "peak oil" production. Cambridge said that its analysis indicates that the remaining global oil base is actually 3.74 trillion barrels, three times greater than "peak oil" theory proponents say and that the "peak oil" theory is based on faulty analysis. I suspect the substantial contango that still exists in energy futures, which encourages hoarding, will begin to reverse over the coming months as more investors come to the realization that the "peak oil" theory is hugely flawed, global storage tanks fill and Chinese/US demand slows further.
Global crude oil storage capacity utilization is running around 98%. Recent OPEC production cuts have resulted in a complete technical breakdown in crude futures, notwithstanding the recent bounce higher. Spare production capacity, which had been one of the main sources of angst among the many oil bulls, rises with each OPEC cut. As well, demand destruction which is already pervasive globally will only intensify over the coming years as many more alternative energy projects come to the fore. Moreover, many Americans feel as though they are helping fund terrorism or hurting the environment every time 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 plunge further from current levels, as I expect. If OPEC actually implements all their announced production cuts, with oil still at very high levels and weakening global growth, it will only further deepen resentment towards the cartel and result in even greater long-term demand destruction.
I continue to believe oil made a major top last year during the period of historic euphoria surrounding the commodity with prices above $70/bbl. Falling demand growth for oil in emerging market economies, an explosion in alternatives, rising spare production capacity, increasing global refining capacity, the complete debunking of the hugely flawed "peak oil" theory, a firmer U.S. dollar, less demand for gas guzzling vehicles, accelerating non-OPEC production, a reversal of the "contango" in the futures market, a smaller risk premium and essentially full global storage should provide the catalysts for oil to fall to $35 per barrel to $40 per barrel this year. I fully expect oil to test $20 per barrel to $25 per barrel within the next three years.
Natural gas inventories fell slightly more than expectations this week. Prices for the commodity rose again as historic investment fund speculation remains rampant despite the fact that supplies are now 19.2% above the 5-year average and at all-time high levels for this time of year, even as some daily Gulf of Mexico production remains shut-in. Moreover, inventories are still around 84% of their pre-season capacity. Usually natural gas supplies are down to 58% at this point in the year. Furthermore, the EIA recently projected global liquefied natural gas production to soar this year, with the US poised to see a 34.5% surge in imports and another 38.5% increase in 2008. Natural gas prices have collapsed 50.7% since December 2005 highs. Notwithstanding this severe decline, natural gas anywhere near current prices is still ridiculous with absolute inventories poised to hit new records this year. The long-term average price of natural gas is $4.63 with inventories much lower than current levels.
Gold rose again on the week as weakening demand from India, the world’s largest buyer of the metal and decelerating inflation readings were offset by historic investment fund speculation and higher energy prices. Copper rose this week on short-covering. Copper is now 38.1% lower from euphoric highs set last year. Natural gas, oil and copper still look both fundamentally and technically weak. The US dollar was about even on more hawkish Fed comments and decelerating unit labor costs. The monthly budget statement for December was significantly better-than-expected once again. The US budget deficit is now 1.5% of GDP, well below the 40-year average of 2.3% of GDP. I continue to believe there is very little chance of another Fed rate hike anytime soon despite the current modest acceleration in economic activity. An eventual rate cut is more likely this year as inflation continues to decelerate substantially. An eventual Fed rate cut should actually boost the dollar as currency speculators anticipate faster US economic activity relative to other developed economies. Moreover, last month’s net long-term TIC flows report showed foreign investors’ demand for US securities remains strong despite last year’s dollar weakness. Utilities stocks outperformed for the week on better-than-expected earnings reports and a decline in long-term rates. Homebuilding shares underperformed on profit-taking and rising worries over the sub-prime lending market.
Current US stock prices are still providing longer-term investors very attractive opportunities, in my opinion. 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 CSFB report late last year confirmed this view. The report concluded that on a price-to-cash flow basis growth stocks are cheaper than value stocks for the first time since at least 1977. The entire decline in the S&P 500’s p/e, since the bubble burst in 2000, is attributable to growth stock multiple contraction. Many “value” investors point to the still “low” price/earnings ratios of commodity stocks, notwithstanding their historic price runs over the last few years. However, commodity equities always appear the “cheapest” right before significant price declines. 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 as global growth slows to more average rates.
The emerging markets’ mania, which has mainly been the by-product of the commodity mania, is likely nearing an end, as well. I am keeping a close eye on the Vietnam Stock Index(VNINDEX), which has recently dwarfed the Nasdaq’s meteoric rise in the late 90s, rocketing 217.0% higher over the last 12 months. Moreover, it is already 37.1% higher this year. The bursting of this bubble in Vietnam, which I suspect will begin very soon, may well signal the end of the mania for emerging market stocks. I continue to believe a chain reaction of events has already begun that will result in a substantial increase in demand for US equities.
S&P 500 profits have risen at double-digit rates for 17 consecutive quarters, the best streak since recording keeping began in 1936. Another double-digit gain is likely for the fourth quarter despite a number of pundits proclaiming the end of the historic streak earlier in the reporting season. Notwithstanding a 94.4% total return(which is equivalent to a 16.5% average annual 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 15.8. The 20-year average p/e for the S&P 500 is 23.0.
In my opinion, the US stock market is still factoring in way too much bad news at current levels, notwithstanding recent gains. One of the characteristics of the current US “negativity bubble” is that most potential positives are undermined, downplayed or completely ignored, while almost every potential negative is exaggerated, trumpeted and promptly priced in to stock prices. “Irrational pessimism” by investors has resulted in a dramatic decrease in the supply of stock. Booming merger and acquisition activity is also greatly constricting supply. Many commodity funds, which have received a historic flood of capital inflows over the last few years are likely now seeing redemptions as the CRB Index continues to languish near bear market territory. Some of this capital will likely find its way back to US stocks. As well, money market funds are brimming with cash. There is massive bull firepower available on the sidelines for US equities at a time when the supply of stock has contracted.
A recent Citigroup report said that the total value of U.S. shares dropped last year, despite rising stock prices, by the most in 22 years. Last year, supply contracted, but demand for U.S. equities was muted. While overall US public sentiment is still depressed given the macro backdrop, I am seeing some signs that irrational pessimism is lifting a bit. US stock mutual funds saw the largest cash inflows in recent memory last week. This should make the many bears very nervous as keeping the public excessively pessimistic on U.S. stocks has been one of their main weapons. Furthermore, the “shoot first” mentality that has dominated trading for a number of years is developing cracks as several high-profile stocks were recently punished severely in after-hours trading on supposed “weak” earnings reports only to surge substantially higher by the close of trading the following day. Moreover, for the first time in several years I am seeing numerous violent upside reactions to “positive” earnings reports. I suspect accelerating demand for U.S. stocks, combined with shrinking supply, will make for a lethally bullish combination this year.
Considering the overwhelming majority of investment funds failed to meet the S&P 500's 15.8% return last year, I suspect most portfolio managers have a very low threshold of pain this year for falling substantially behind their benchmark once again. The fact that last year the US economy withstood one of the sharpest downturns in the housing market in history and economic growth never dipped below 2% illustrates the underlying strength of the economy as a whole. A stronger US dollar, lower commodity prices, seasonal strength, decelerating inflation readings, a pick-up in consumer spending, lower long-term rates, increased consumer/investor confidence, short-covering, investment manager performance anxiety, rising demand for US stocks and the realization that economic growth is poised to rise around average rates should provide the catalysts for another substantial push higher in the major averages this year as p/e multiples expand significantly. I expect the S&P 500 to return a total of about 17% for the year. "Growth" stocks will likely lead the broad market higher, with the Russell 1000 Growth iShares(IWF) rising a total of 25%. Finally, the ECRI Weekly Leading Index fell slightly this week and is still forecasting modestly accelerating US economic activity.
*5-day % Change
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