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BOTTOM LINE: Overall, last week's market performance was neutral. However the Dow Jones Industrial Average made another new all-time high and closed above 12,000. The advance/decline line was even, sector performance was mixed and volume was above average on the week. Measures of investor anxiety were mostly lower. The AAII percentage of bulls rose to 54.20% this week from 48.98% the prior week. This reading is now above average levels. The AAII percentage of bears fell to 29.77% this week from 37.76% the prior week. This reading is now slightly above average levels. The 10-week moving average of the percentage of bears is currently high at 36.03%. 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 the recent rally and the fact that the DJIA is making new all-time highs. Bears still remain stunningly complacent, in my opinion. As well, there are many other indicators registering high levels of investor skepticism regarding recent stock market gains. The 4-day NYSE Arms reading is at levels last seen at the July market lows. Short interest on the NYSE and Nasdaq is still at all-time highs. Moreover, the 50-day moving-average of the ISE Sentiment Index is still near all-time lows. Domestic stock mutual funds continue to see outflows. There remains a very high wall of worry for stocks to climb substantially from current levels over the coming weeks.
I continue to believe this is a direct result of the strong belief by the herd that the US 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 US stocks has never been this poor in history with the DJIA registering all-time highs. Due to the extraordinarily divisive political climate and 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. 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 expect the herd to finally embrace the current bull market next year which should result in another meaningful move higher in the major averages.
The average 30-year mortgage rate fell 1 basis points to 6.36%, which is 44 basis points below July highs. I still believe housing is in the process of stabilizing at relatively high levels. Former Fed Chairman Alan Greenspan said recently he believes the “worst may well be over” for the housing slowdown. Mortgage applications have turned higher recently with the decline in mortgage rates. The Case-Shiller housing futures are still projecting a 5% decline in the average home price over the next 7 months. Considering the average 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 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, energy prices have plunged, consumer spending remains very healthy, 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 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.
The benchmark 10-year T-note yield fell 2 basis points on the week as numerous inflation measures showed meaningful deceleration and economic slowdown fears resurfaced. 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 3.5% 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 5.2% over the last 12 months and is down 16.3% from May highs, approaching bear market territory. The average commodity hedge fund is down 13.8% for the year. 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 as refinery utilization dropped substantially. U.S. gasoline supplies are still at extraordinarily high levels for this time of the year. Unleaded Gasoline futures were unchanged for the week and are 49.70% 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 is estimated to rise .8% this year versus a 20-year average of 1.7% demand growth. Moreover, distillate stocks are 17% above the five-year average for this time of the year as we head into 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, which will send gas prices still lower over the intermediate-term.
US oil inventories are back at 7-year highs. Since December 2003, global oil demand is only up 1.5%, while global supplies have increased 5.9%, 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 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 positions to meet investor redemptions.
Oil has clearly broken its uptrend and is now in its seasonally weak period. 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. An OPEC production cut with oil at still 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 suspect oil will eventually trade at levels that most investors deemed unimaginable just a few months ago during the next meaningful global economic downturn.
Natural gas inventories rose more than expectations this week, however prices for the commodity soared amidst another bout of record speculation by investment funds. Supplies are now 11.1% 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 54.1% since December 2005 highs. It is quite possible US natural gas storage will become full sometime over the next few weeks, creating the distinct possibility of a “no-bid” situation for the physical commodity, notwithstanding recent price gains. Natural gas futures will enter their seasonally weak period over the next few weeks.
Gold fell on the week despite US dollar weakness, more North Korea nuclear test threats and unconstructive comments from Iran. The US dollar fell on declining inflation worries. 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.
Airline stocks outperformed for the week on falling oil prices and earnings optimism. Semiconductor stocks underperformed on some disappointing earnings reports and lingering inventory worries. With 32% of the S&P 500 reporting, profit growth for the third quarter is coming in a very strong 16% 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. Despite a 83.9% total return(which is equivalent to a 16.2% 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 15.7. The 20-year average p/e for the S&P 500 is 24.4. The S&P 500 is now up 11.3% and the Russell 2000 Index is up 14.3% year-to-date. The DJIA made another new all-time high this week and closed slightly above 12,000. I still expect the Dow to break convincingly above 12,000 over the coming weeks.
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 and emerging market funds, which have received huge capital infusions this year, will likely see significant outflows at year-end. 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, the November election, 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 rose this week and is forecasting healthy US economic activity.
*5-day % Change
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