Saturday, March 10, 2007

Market Week in Review

S&P 500 1,402.85 +1.13%*

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BOTTOM LINE: Overall, last week's market performance was bullish. The cumulative advance/decline line rose, almost every sector gained and volume was above-average on the week. Measures of investor anxiety finished the week at elevated levels. The AAII percentage of bulls fell to 35.80% this week from 36.63% the prior week. This reading is still below average levels. The AAII percentage of bears jumped to 44.89% this week from 39.60% the prior week. This reading is now approaching elevated levels. The 10-week moving average of the percentage of bears is currently 32.25%, 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 currently 37.1%, a very high level seen during only two other periods since tracking began in the 1980s. Those periods were October 1990-July 1991 and March-May 2003, both being near major market bottoms.

Notwithstanding the recent mild pullback, I continue to believe that steadfastly high bearish sentiment in many quarters is mind-boggling, considering the 16.3% rise in the S&P 500 in about nine months, the 90.0% gain for the S&P 500 since the 2002 major bear market lows, the cumulative advance/decline line recently hit a new record high, one of the best August/September/October runs in U.S. history, the fact that the Dow made another all-time high recently and that we are in the early stages of what is historically a very strong period for U.S. equities after a midterm election. As well, despite recent gains, the forward P/E on the S&P 500 is a very reasonable 15.1, falling from 16.2 at the beginning of the year, due to the historic run of double-digit profit growth increases and recent stock pullback. 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, the many market bears see every pullback as a major top and every move higher as just another shorting/selling opportunity. I see few signs of capitulation by the many bears and their crowded ranks are swelling by the day on U.S. sub-prime and emerging market worries. Even most bulls have raised substantial cash of late, anticipating a meaningful correction. Does anyone think the market is done with its recent pullback?

As well, there are many other indicators registering high levels of investor anxiety. The ISE Sentiment Index plunged to an extraordinarily depressed 46.0 on Thursday. Its all-time low was 36.0 in July of last year, right before the market went on a tear. Moreover, the 10-day moving average of the ISE Sentiment Index made a historic low this week of 91.80. The NYSE Arms Index hit 15.98 on Tuesday of last week, the highest level since record-keeping began in the 1960s. The three-day moving average of the NYSE Arms hit an amazing 5.46 last week, also the highest on record. The VIX had its largest one-day percentage increase in history on Tuesday of last week. The CBOE total put/call ratio ten-day moving average is 1.29, the highest since at least 1995 when Bloomberg began tracking the number. Nasdaq and NYSE short interests rose again last month and are very close again to record highs. Moreover, public short interest continues to soar to record levels as odd-lot shorting recently spiked, 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 an 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 U.S. 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 that help pump air into the current U.S. "negativity bubble." A short-sighted day-trading pessimistic mentality has thoroughly permeated the investment landscape. 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 eight months.

Many of the most widely read stories on financial sites are written with a pessimistic slant to gain readers regardless of their accuracy. "Permabears" are more widely followed than ever, despite the market's near-triple digit gain from the major bear market low in 2002. At this major market bottom, "permabulls" had been shunned and chastised for a couple of years. Investment blogger sentiment is bearish at 28.95% Bulls, 42.11% Bears. Finally, the UltraShort QQQQ ProShares (QID) continue to see soaring volume. There is a high wall of worry for stocks to climb substantially from current levels as the public and many professionals remain very skeptical of this bull market and continue to keep "one foot out the door."

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 fresh off an all-time high. 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.

It is hard to believe, after the recent bombardment of pessimism and "crash" calls, that the average U.S. stock is still doing quite well this year. The Value Line Geometric Index, the best gauge of the broad market, is still 1.3% higher in a little over two months. Based on the action so far this year, even more cash has piled up on the sidelines as money market funds hit record levels. I continue to believe that a significant portion of this cash will be deployed into true "growth" companies as their outperformance vs. value stocks gains steam throughout the year. 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 another 4 basis points this week to 6.14%, which is 66 basis points below July 2006 highs. There is still mounting evidence that the worst of the housing downturn is over, despite recent worries over sub-prime lending, and that sales 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 2% of total mortgage loans outstanding are currently problematic. I do not believe sub-prime woes are nearly large enough or will become large enough to meaningfully impact the prime market and bring down the U.S. economy. The Fed’s Bernanke said recently that the prime market is still strong and that he sees no spillover from the sub-prime problems. As well, the Fed’s Poole said recently 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, Plosser, Fisher and Bies all made positive comments recently regarding the prospects for the US housing market. Finally, the ABX-HE-BBB-07-1 Sub-prime Index, the source of much concern, has surged 15.0% from its lows last week.

Mortgage applications jumped 7.3% this week and continue to trend higher with the decline in mortgage rates and healthy job market. The 10-week moving average of mortgage applications is 2.1%, which has been exceeded only once over the last three years. Existing Home Sales, which make up around 85% of the US housing market, rose 3.0% in January, the largest gain since January 2005. The NAHB Housing Market Index came in at 40 in February vs. estimates of 35 and a reading of 35 in January. This is the largest jump since September 2002, notwithstanding the coldest February in 28 years and rising sub-prime worries. Within the NAHB Housing Index for February, the future sales component jumped to 55 vs. 48 in January. The future sales component is now up 49% since its cycle low of 37 in September 2006. It is now only 9 points away from the long-term average of 64. 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. Finally, the House Price Index, which was reported last week, rose 1.1% in the fourth quarter of last year versus a 1.0% gain in the third quarter.

Housing inventories have been trending lower and homebuilding stocks have been moving higher. The Housing Index(HGX) has risen 23.9% from July lows. The Case-Schiller housing futures have improved substantially and are now projecting only a 2.1% decline in the average home price through August, up from projections of a 5.0% decline 6 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 activity 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 16.3% in about nine months and 90.0% since the Oct. 4, 2002 major bear market low. Americans’ median net worth is still 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 and wages are rising at above-average rates. The economy has created 1.38 million jobs in the last eight months. Challenger, Gray & Christmas reported that February job cuts fell -3.9% 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 4.5%, 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 January rose 2.1% 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 to below-average rates. The Producer Price Index for January rose a historically low .2% year-over-year versus the 20-year average of a 2.2% rise. The Import Price Index for January fell -1.2% month-over-month. Moreover, the five-month average of month-over-month import price declines is -0.86%. It has only been lower during three other periods since tracking began in the 1980s. Furthermore, most measures of Americans’ income growth are now almost twice the rate of inflation. Americans’ Average Hourly Earnings rose 4.1% year-over-year in February, substantially above the 3.2% 20-year average. The 10-month moving-average of Americans’ Average Hourly Earnings is currently 4.05%. 1998 was the only year during the 90s expansion that it exceeded current levels. Finally, personal incomes rose 1.0% in January, substantially above estimates of a .3% gain. This rate of income growth has only been exceeded during 13 months over the last two decades.

The benchmark 10-year T-note yield rose 8 basis points for the week on stabilizing global stock markets and diminishing recession worries. In my opinion, many investors’ lingering fears over an economic “hard landing” still seem misplaced. The housing slowdown and auto-production cutbacks impacted manufacturing greatly over the last six months, but those drags on growth are starting to subside. Moreover, for all of 2006, US GDP growth was a healthy 3.1%.

While the drag from housing is subsiding, housing activity will not add to economic growth in any meaningful way this year as homebuilders continue to reduce inventories. As well, recent substantial manufacturing inventory de-stocking will produce below-average growth again this quarter. However, the Fed’s Beige Book report released this week said manufacturing was now “steady or expanding” in most districts. I still expect a smaller GDP deflator, inventory rebuilding, rising auto production, increased business spending and a still healthy service sector to help produce US economic 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 2.8% for the week, which is around average levels. However, retail sales are poised to accelerate. Energy prices are down from this time last year, the job market remains healthy, housing has improved, wage growth has accelerated, stocks are higher and inflation has decelerated to below average rates. Many consumers are chomping at the bit to buy new spring clothing after such a warm fall muted holiday clothing sales. Moreover, automakers reported recently that February auto sales substantially exceeded estimates and analysts said Apple Inc.’s(AAPL) Mac computer sales growth exploded to over 100% in January versus 55% in December. The Conference Board’s Consumer Confidence reading surged to a new cycle high in February. I expect a new cycle high for the Univ. of Mich. Consumer Sentiment Index later this year.

Just take a look at commodity charts, gauges of commodity sentiment and inflows into commodity-related funds over the last couple of years. Net assets invested in the Goldman Sachs Commodity Index rose to almost $70 billion in 2006 from $15 billion in 2003. There has been a historic mania for commodities by investment funds that has pushed prices significantly higher than where the fundamentals dictate. That mania is now in the stages of unwinding. The CRB Commodities Index, the main source of inflation fears has declined -4.0% over the last 12 months and -15.7% 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. As well, this year oil plunged $12/bbl. over the first 18 days of trading. 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 also 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 fell more than expectations as refinery utilization fell. The 10-week moving average of U.S. gasoline supplies is still approaching 8-year highs, notwithstanding recent declines in refinery utilization. Gasoline futures rose for the week, but have plunged 34.8% from September 2005 highs even as some Gulf of Mexico oil production remains shut-in and fears over future production disruptions persist. Crack spreads are now at levels seen last August right before oil fell $28/bbl. in less than six months. The still very elevated level of gas prices will further dampen global fuel demand, sending gas prices still lower over the intermediate-term.

This week the EIA lowered second and third quarter global demand growth for oil by 400,000 barrels per day. The 10-week moving-average of US oil inventories is also 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 January 2004, global oil demand is only up 1.9%, despite the strongest global growth in almost three decades, while global supplies have increased 4.5%, 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. Recently, 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 last year was 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. 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. 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.

Cambridge Energy Research, one of the most respected energy research firms in the world, put out a report late last year 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. and calls for $100/bbl. oil commonplace. 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 less than expectations this week. Prices for the commodity declined as historic investment fund speculation subsided with supplies now 13.5% above the 5-year average and near all-time high levels for this time of year as winter winds down, even as some daily Gulf of Mexico production remains shut-in. Moreover, inventories are still around 77% 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 55.3% 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 slightly on the week on diminishing worries over demand from emerging market economies. Copper rose this week on diminished worries over global demand and short-covering. Copper is now 31.5% lower from euphoric highs set last year. Natural gas, oil, gold and copper all look both fundamentally and technically weak. The US dollar rose on diminished US economic worries and short-covering. The monthly US budget surplus for January was large once again. The US budget deficit is now 1.4% 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. 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. I expect foreign investors’ demand for US securities to remain strong despite last year’s dollar weakness. Steel stocks outperformed for the week on buyout speculation and the perception that fundamentals are improving. HMO shares underperformed on legal concerns.

Current US stock prices are 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 underperform 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 182.3% higher over the last 12 months. Moreover, it is already 54.0% higher this year. Vietnam said recently that it may impose capital controls to curb gains in the dong this month. The country may require overseas investors to hold investments in stocks and bonds for a minimum of 12 months, and withdrawal of funds after the 12-month holding period may require 30-days written notice. 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. The much-hyped BRIC emerging markets(Brazil, Russia, India and China) are already beginning to come under pressure. From their highs, Brazil is down -5.6%, Russia is -8.2% lower, India has declined -12.5% and Chinese shares have dropped -3.7%. 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 18 consecutive quarters, the best streak since recording keeping began in 1936. Notwithstanding a 90.0% total return(which is equivalent to a 15.6% 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 15.1. The 20-year average p/e for the S&P 500 is 23.0.

In my opinion, the US stock market continues to factor in way too much bad news at current levels. 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 record amounts of 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 have seen cash inflows for four out of the last five weeks. 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. 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% and averaged 3.1% illustrates the underlying strength of the economy as a whole. While significant inventory de-stocking has led to a mid-cycle slowdown, I expect inventory rebuilding to begin adding to economic growth next quarter.

While more near-term stock weakness is possible, the historically extreme readings in many gauges of investor angst over the last two weeks shows the US market is cleansing itself of “weak hands” at a extraordinarily rapid rate. I suspect the current healthy pullback will end much sooner than most expect if it hasn’t already. A stronger US dollar, lower commodity prices, election cycle 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 rose slightly again this week and is forecasting healthy US economic activity.

*5-day % Change

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