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BOTTOM LINE: Overall, last week's market performance was just slightly bearish as stocks consolidated recent sharp gains ahead of significant political uncertainty. The advance/decline line fell, most sectors declined and volume was slightly above average on the week. Measures of investor anxiety were mostly higher. The AAII percentage of bulls fell to 43.75% this week from 52.17% the prior week. This reading is now slightly below average levels. The AAII percentage of bears surged to 36.88% this week from 30.43% the prior week. This reading is now 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 was 43.0% at the major bear market lows during 2002. I continue to believe steadfastly high bearish sentiment is mind-boggling considering stocks are coming off one of their best Aug./Sept./Oct. runs in US history and the fact that the DJIA just recently made an all-time high above 12,000. This thick skepticism is a huge positive for stocks and bodes very well for further gains.
Bears still remain stunningly complacent, in my opinion. The barrage of “major top” calls of late only solidifies my views on their complacency. As well, there are many other indicators registering high levels of investor skepticism regarding recent stock market gains. The NYSE Arms reading has been at above-average levels quite frequently of late. The 50-day moving-average of the ISE Sentiment Index is still near all-time lows. Nasdaq and NYSE short interest made record highs again this month. Moreover, public short interest continues to soar to records. U.S. stock mutual funds have seen outflows for months, according to AMG Data Services. Finally, investment blogger sentiment is still bearish. There remains a very high wall of worry for stocks to climb substantially from current levels. The recent pause in the market's upward move is allowing the bears to reload without doing any technical damage to the major averages. In my opinion, the market's resiliency into significant political uncertainty illustrates its underlying strength.
I continue to believe well-entrenched investor skepticism 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. I strongly disagree with this assessment. There is overwhelming evidence that investor sentiment regarding U.S. stocks has never been this poor in history with the DJIA just off all-time highs. Due to an extraordinarily divisive political climate and the explosion of absolute return strategies, there has likely never been a time in US history when more market participants perceived they directly benefited from a stagnant or declining US economy and stock market. This is the main reason for the overwhelmingly negative commentary in the financial media today, in my opinion.
The bears' abuse of George Soros' Theory of Reflexivity(the theory basically states that the future outcome of an event can be altered by changing current perceptions regarding such an event) during the last few years has left most investors substantially underexposed to US equities, specifically growth stocks, and many traders heavily leaning the wrong way. I still expect the herd to finally embrace the current bull market next year which should result in another meaningful move higher in the major averages as the S&P 500 breaks out to an all-time high to join the DJIA and Russell 2000.
The average 30-year mortgage rate fell 9 basis points to 6.31%, which is 49 basis points below July highs. I still believe housing is in the process of stabilizing at relatively high levels. Former Fed Chairman Alan Greenspan reiterated his belief recently that the “worst may well be over” for the housing slowdown. Mortgage applications have begun trending higher with the decline in mortgage rates. As well, Housing inventories have been falling. The Case-Shiller housing futures are still projecting a 5% decline in the average home price over the next 7 months. 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 are currently being exaggerated by the bears, in my opinion. Housing and home equity extractions have been slowing substantially for well over a year and have 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, energy prices have plunged, consumer spending remains healthy, unemployment is low by historic standards, interest rates are low, stocks are rising and wages are rising, just to name a few. The unemployment rate fell to a historically low 4.4% last month from 4.6% the prior month, notwithstanding fewer real estate-related jobs. Consumer spending is still above long-term average levels and looks poised to strengthen into the holiday shopping season.
The Consumer Price Index for September rose 2.1% year-over-year, the smallest increase since early 2004 and down from 4.7% in September of 2005. This is substantially below the long-term average of around 3%. Moreover, the CPI has only been lower during 4 other periods since the mid-1960s. It was lower during 1986, late 1998-early 1999, late 2001-late 2002 and late 2003-early 2004. Many other measures of inflation have recently shown substantial deceleration. Most measures of Americans’ income growth are almost twice the rate of inflation.
The benchmark 10-year T-note yield rose 4 basis points on the week on the decline in unemployment, significant upward revision to prior estimates of job creation and strong ISM Non-manufacturing report. The economy has created almost half a million jobs in the last three months. 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. Weekly retail sales rose an above-average 3.4% for the week. 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 optimism. The CRB Commodities Index, the main source of inflation fears, has now declined 3.5% over the last 12 months and is down 15.2% from May highs. The average commodity hedge fund is down 13.8% for the year. Oil has declined $20/bbl. I continue to 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 fell more than expectations even as refinery utilization rose. U.S. gasoline supplies are still at extraordinarily high levels for this time of the year. Unleaded Gasoline futures fell for the week and have plunged 48.3% from September 2005 highs even as some Gulf of Mexico oil production remains shut-in and fears over future production disruptions persist. Gasoline demand is estimated to rise .8% this year versus a 20-year average of 1.7% demand growth. Moreover, distillate stocks are 12.3% above the five-year average for this time of the year as we enter the winter heating season. The still elevated level of gas prices, related to crude oil production disruption speculation by investment funds, will further dampen global fuel demand, sending gas prices still lower over the intermediate-term.
US oil inventories are near 7-year highs. Since December 2003, global oil demand is only up 1.5%, despite booming global growth, while global supplies have increased 5.9%, according to the Energy Intelligence Group. Moreover, worldwide oil 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 mostly 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 long positions to meet investor redemptions.
Oil has clearly broken its uptrend and is now in its seasonally weak period. The commodity continues to trade very poorly despite numerous potential catalysts. A major top in oil is likely already in place as global crude oil storage capacity utilization is running around 95%. Recent OPEC production cuts will likely result in a complete technical breakdown in crude over the coming weeks. Demand destruction is already pervasive globally. 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 continue to plunge. OPEC production cuts, with oil still at very high levels and weakening global growth, only further deepens resentment towards the cartel and will 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. I still believe oil will test $50/bbl. before year-end. I suspect oil will eventually fall to levels that most investors deemed unimaginable just a few months ago during the next meaningful global economic downturn.
Natural gas inventories fell less than expectations this week, however prices for the commodity rose as investment fund speculation in the commodity remains near record highs. Supplies are now 8.7% above the 5-year average and at record high levels for this time of year, even as some daily Gulf of Mexico production remains shut-in. Natural gas prices have collapsed 50.1% since December 2005 highs. Natural gas futures are now entering their seasonally weak period. I suspect natural recently made another meaningful top.
Gold rose on the week on US dollar weakness and rising investment fund speculation. The US dollar rose on short-covering and stronger economic data. I continue to believe there is very little chance of another Fed rate hike anytime soon. An eventual cut is more likely next year as inflation continues to decelerate substantially.
Gold & Silver stocks outperformed for the week on the rise in precious metal prices. HMO stocks underperformed on earnings concerns. With more than 80% of the S&P 500 reporting, profit growth for the third quarter is coming in a booming 21% versus a long-term historical average of 7%, according to Thomson Financial. This would mark the 17th 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 fourth quarter. Just a few months ago many investors expected profit growth to fall to the low single digits this quarter. Despite an 83.4% total return(which is equivalent to a 16.0% 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 15.6. The 20-year average p/e for the S&P 500 is 24.4. The S&P 500 is now up 11.0% and the Russell 2000 Index is up 13.0% year-to-date. Historically, if the S&P 500 is up at least 10% going into the final two months of the year, it continues to climb the last two months 84% of the time.
Current 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 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. The entire decline in the S&P 500’s p/e, since the bubble burst in 2000, is attributable to growth stock multiple contraction. 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, notwithstanding recent gains. 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, trumpeted and promptly priced in to stock prices. Furthermore, this “irrational pessimism” by investors has resulted in a dramatic decrease in the supply of stock as companies bought back shares, IPOs were pulled and secondary stock offerings canceled. Commodity funds, which have received huge capital infusions this year, will likely see significant outflows at year-end. Some of this capital will likely find its way back to US stocks. I continue to believe there is massive bull firepower available on the sidelines for US equities at a time when the supply of stock has contracted.
An end to the Fed rate hikes, lower commodity prices, seasonal strength, an end to political uncertainty, decelerating inflation readings, a strong holiday shopping season, 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 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 expand further. I still expect the S&P 500 to return a total of at least 15% for the year. The ECRI Weekly Leading Index fell slightly this week and is still forecasting healthy US economic activity.
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