NOTE: This Maarket Commentary alert was originally emailed to subscribers at Ritholtz Research & Analytics on Tue 10/06/2006 3:28 PM EDT;
This is posted here not as investing advice, but
rather as an example of a trading call for potential subscribers. We
expect to post future advisories in a similar manner — after the call,
but in the correct chronological location on the blog.
>>>
Given the new Dow highs hit this week, we thought we would take a look at some of our favorite technical and monetary indicators to see where we are in the current cycle.
Despite all the recent CNBC hoopla, it must be pointed out that 1) the Dow has still underperformed cash since the 2000 highs; and B) The much broader Wilshire 5000 Index remains a full $1.2 Trillion below its 2000 first quarter value.
Our review of the technical and monetary components strongly suggest that caution is well warranted. Further, our advice that it is too early too early to short continues to remain in effect. Patience is the key in placing shorts, and we know far too many who trade from that side of the desk who have been carried out on their shields. Our favorite example is Jonathan Cohen, the Merrill Lynch analyst who correctly stated that Amazon.com — then priced at $80 — should be a single digit stock. He was eventually correct, but only after Amazon went to $400+ (and after Henry Blodget took his job).
However, we are considerably bit closer to being ready to start to putting on short positions than we were a month or even a week ago.
Let’s get into the details:
Monetary Policy: A large portion of the present rally rests on the probability of the Fed cutting rates in 2007; We went back and looked for when in the past the Fed has cut rates when the Dow was near 52 week highs — or all time highs. While it has happened on occasion, its not common Fed practice, with July 1995 as the most recent Fed easing when the Dow was near a 52 week high.
Our assumption for this is that the Fed doesn’t cut when stocks are near highs, because stocks don’t get near highs without some degree of underlying economic strength that translates into revenue and earnings. However, stocks can and do overshoot to the upside — but the market should catch itself and correct the excess long before the Fed is cutting rates again.
Another thesis has been that "we are slowing to a Goldilocks economy" — not hot enough to cause inflation and Fed tightening, and not cool enough to cause a recesssion.
We remain unconvinced.
Another thesis has been we are slowing to a "Goldilocks economy" — not hot enough to cause inflation and Fed tightening, and not cool enough to cause a recession. We remain unconvinced. The only true soft landing was 1994; As rust belt industries went south, it nearly caused a recession. But the underlying strength in several new industries — the Wireless build-out, the PC upgrade cycle, and the early expansion of the Internet — was more than enough to make up the slack. That is missing in the present environment as housing cools.
Goldilocks proponents keep suggesting that commercial real estate can take its place, but we are doubtful; Last year, Residential Real Estate was an over $700 Billion dollar sector; Commercial was a little more than one third of that. Additionally, commercial construction does not generate the same equity withdrawal that has powered so much of consumer spending over the past few years.
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Technical Underpinnings: Anyway, several technical indicators are suggesting that our caution is well warranted:
– Market Breadth remains poor, with only the biggest stocks participating (see chart below); This is not how healthy markets behave, and is more typical of what we see near market tops.
– Despite the drop in Oil prices, the Transports are not participating in the rally — this suggests the economy is significantly slowing;
– The number of stocks making new highs on the NYSE is barely positive; Its hard to reconcile this with the Dow at new highs;
– Sentiment has been very bullish, with the finacial media bordering on giddy.
The bottom line: The price action has been good, the volume okay, and the internals weak. This is not what is typically observed at the beginning of a new Bull cycle.
Bullish Percent (red and black) ; S&P500 (green)
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Upside Targets: One of our subscribers pointed out to us
that our upside targets had been hit this week. In the beginning of the
year, we participate in several market forecasts by major media. We do this despite our longstanding believe that "Forecasting is Folly."
Through what can only be referred to as Dumb Luck, two of our upside
targets have been reached. In December of 2005, we forecast the Dow
hitting 11,800 before reversing, the S&P500 hitting 1350, and the
Nasdaq reaching 2,600. This took longer than "mid-year" we
guesstimated.
So too has the reversal. That’s part of the reason why predictions
are so perilous — no one consistently anticipates exactly when markets
top or bottom and reverse; (there are simply too many variables to
control for). Its also why investors should not rely on these long term
guesses. Sure, they make for a good double issue filled with lots
advertising — but they are not a basis for intelligent portfolio
management.
-Barry Ritholtz
October 6, 2006
