The fundamental case for a bear market we outlined last week (please see archives on left) is being increasingly supported by the deteriorating technical picture. Both the Dow Industrials (DJIA) and S&P 500 have carved out ominous-looking eight-month head and shoulder tops. While both indexes peaked on October 11, the NYSE breadth index topped out in June and has made successively lower peaks on rallies. This is confirmed by the unweighted NYSE index, which made its high in July. Only 32% of all NYSE stocks are above their 200-day moving averages, indicating that two-thirds are already in their own bear markets. The Dow Transportation average reached its high in July and was down 11% at the October high in the DJIA and S&P 500. Both the Russell 2000 and Philadelphia Semiconductor indexes peaked in July.
In addition the number of new daily annual highs on the NYSE topped out in May and has decreased on every subsequent rally, indicating that fewer stocks have been participating in any upward moves. Upside volume peaked in August, with the October peaks in the averages corning on sharply lower volume. Overall there has been higher volume on down days in the market and lower volume on up days, while late-day selloffs have been a distinguishing feature. All of this is typical of a bull market peak, particularly when supported by the fading credit and economic situation.
The housing and credit picture continues to worsen and is spreading to the rest of the economy. Building permits are at a 14-year low, housing starts at a 15-year low and new home sales at a 13-year low at the same time that the supply of new homes is at a 17-year high. The NAHB Buyer Traffic index fell to an all-time low of 14 in December, below the previous record of 16 in December 1990. There have now been six consecutive monthly readings below 20, exceeding the previous record of three in the 1990-1991 recession. The Case/Shiller 20-city composite of home prices is down 6.1% from a year earlier, the highest since the index began in 1988.
A recent study by one former and two present Federal Reserve economists continues to be gloomy on future home prices. Based on the ratio of annual rents-to-home prices from 1960, home prices would have to drop 15% over the next five years while rents were rising 4% annually just to bring the ratio back to normal. Substantial further home prices declines would place more homeowners in a negative equity position and lead to more defaults with increased asset declines for those holding the mortgages.
At the same time the rest of the economy continues to deteriorate with softness in retail sales, employment, capital spending, autos, trucking and new orders for durable goods. The ISM manufacturing index fell to 47, below the no-growth threshold of 50. It was the sixth consecutive monthly decline, the most since 2000-2001. Two of the key index subsets—production and new orders—were down to their lowest levels since November 2001. The year-over-year growth in chain store sales is the lowest since the last recession. The ECRI Weekly Leading Index has now been falling at a rate similar to past periods preceding recessions. Foreign economies have been showing signs of a slowdown as well. The global PMI for manufacturing has declined both in developed and developing nations. The EU coincident indicator is clearly down while the Baltic freight index had dropped 20%.
Corporate earnings estimates have also started to come down. First Call is now estimating that fourth quarter S&P 500 operating earnings will be down 9.4% versus an estimate of plus 10.4% as recently as October. First quarter earnings are estimated at plus 5.7%, down from the 10.4% forecast of October. Once earnings have turned it is almost certain that the downward revisions are not over, and that there is far more to come.
As if to give emphasis to our negative outlook, it has been announced that tomorrow (Friday) President Bush will, for the first time, meet with members of the President’s Working Group on Financial Markets to discuss the current financial and economic situation. This is the formal name for the so-called Plunge Protection Team that was formed by President Reagan following the 1987 market crash. Its stated purpose was to prepare to deal with a serious credit or market crisis that could significantly impact financial institutions and the economy. While we understand that the team has met periodically with no announcement, we are unaware of any president ever meeting formally with the group. We think they view the current financial and economic situation with alarm—and so should you.
NOTE: If you go to the archive search section on our site and type in "plunge protection" you will be directed to past comments with more details on the group.
