Good Evening: Many investors had their eyes trained on the Dow Jones Industrial average today. This venerable index has been in retreat for most of 2009 and market participants openly wondered whether it could hold the closing low it set back during the dark days of November. Dow 7500 saw none of the white-knuckle angst that was so apparent on November 20; the VIX, for example, actually declined today. But instead of putting up a fight, Charles Dow’s creation simply surrendered and set a new closing low for this bear market. In so doing, both the industrials and transports have now flashed a renewed “Dow Theory” sell signal by setting new cycle lows at the same time. Whether the S&P 500, NASDAQ, and Russell 2000 follow suit cannot be known in advance, but investors should be alert to the very real possibility that the 2007-2009 bear stock market may be entering the despair/capitulation phase.
Heading into today’s session, U.S. stock index futures were indicating a mildly positive bounce at the opening bell. Few clues could be found in the economic data, which were a mixed bag. On the negative side, jobless claims remained mired above the troublesome 600K mark, while the Philly Fed survey virtually collapsed (see below). PPI and leading indicators both surprised to the upside, however, though it must be said that most analysts viewed both of these results with skepticism. Even with a 14% rise in crude oil today (due to a surprisingly low inventory figure), it’s hard to make the case that either inflation or economic growth will be blasting off any time soon. Aside from some earnings results (WFMI, CVS, and S reported upside surprises, while HPQ disappointed), the only other corporate news of note came in the form of a ratings downgrade for Prudential Financial that resulted in PRU’s dismissal from the Fed’s commercial paper program (see below). The insurers were all weak in response, causing more than one pundit to wonder how soon the insurance industry will head to Washington in search of a spot in the bread line known as TARP. The warm feeling for equities at today’s open proved to be short-lived. After jumping 1% or more within the first 15 minutes of trading, the major averages put in their highs and then spent the rest of the session easing lower. Yesterday’s lows were tested by lunchtime, and when they held, a brief rally ensued. This pop could only regain the unchanged mark, and the indexes then slid to new lows at the closing bell. There was little discussion about the hard-to-see “silver lining” for housing spied by BAC/MER’s David Rosenberg (see below). An original housing bear, Mr. Rosenberg is happy to finally see the homebuilding industry “get it” by cutting back on new home construction. Before you get the sense that Mr. Rosenberg may be crawling out of hibernation, a thorough read of his piece reveals that working down the inventories in housing will take not weeks but months (and perhaps years). The final damage for equities ranged from the S&P 500’s 1.2% decline to the Dow Transport’s 2% loss, and the Dow Industrials set a six year low in the process.
Surprisingly, the fixed income markets couldn’t rally on the weak showing by equities. Almost every sector, from Treasurys to High Yield, retreated today. Treasurys face a large amount of supply in the weeks ahead, and yields rose between 3 bps and 12 bps as the yield curve steepened. The dollar was also weak, dropping against all but the yen. The attached piece from Societe General makes a pretty solid case for further yen weakness, too. Analyst Albert Edwards points out that almost no country has been hit harder by the drop off in global economic activity than Japan. Furthermore, he thinks the yen’s strength until earlier this month has been the result of global risk aversion causing many to unwind the “yen carry trade”. Since Japan’s economy is very sensitive to currency movements, and since it’s far easier for a government to trash its own currency than to support it, I agree with Mr. Edwards that the yen could head a lot lower. Whether China then feels compelled to devalue in response is a harder call, but gold and maybe even the U.S. dollar should benefit in the interim. Of course, in the long run the dollar and all fiat currencies will be reduced to confetti. And speaking of gold, the yellow metal headed lower today as the worries continue over its recent rise. Despite the drop in precious metals, the CRB was pulled higher by firmer crude prices and the index finished with a gain of 2.2%.
Like grief, bear markets are famous for a progression through various stages before a peaceful acceptance finally sets it. I’ve seen definitions of these stages run from as few as two to as many as five. The most common number of stages for bear stock markets is three: 1) denial, 2) concern & fear, and 3) despair & capitulation. From the time two Bear Stearns hedge funds blew up in mid 2007 until the time Bear Stearns itself was subsumed in March of 2008, I think the evidence points to our markets being in phase one — denial. Heck, the Dow even managed to set a new all time high in between those two dates, and the crisis known then as “subprime” was already in full view. After a spring rally last year, the second phase hit during the summer when Fannie and Freddie were hastily ushered into the Treasury Department’s version of the Federal Witness Protection program. The concern on display even into September of last year became abject fear when Lehman Brothers went the way of the Woolly mammoth. This phase of concern and fear peaked on November 20 and 21, coinciding with the lows in the Dow and Dow Transports that, until today, marked the bottom.
After what turned out to be a small (20%) and short (6 weeks) rally into early January, today’s new lows for the Dow Industrials and Transports, in addition to flashing a classic “Dow Theory” sell signal, may mean we are entering the final stage of the bear market — capitulation. I say this not as a prediction but to provide food for thought for serious investors to consider. This hypothesis could prove null and void if a rally of substance soon takes hold, or if the decline under way accelerates (i.e. a resumption of the concern/fear stage). And even if we are in the final and capitulatory phase of the great bear market of 2007 – 2009, there are no hard and fast rules for how low prices can go or how long the decline can last. For visual evidence of just how grizzly can a bear market become, please click on the link below that will take you to a chart of the Dow Industrials from 1920 to 1940. You won’t be able to help yourself; your eyes will be drawn to the massive drop from 1929 to 1932. Although I don’t expect a replay of this horror show (both the amount of financial leverage and governmental policy responses have been larger this time around, enough so to cloud even the best crystal ball), I do think Mr. Market will suffer another beating by the time the capitulatory phase of this bear market plays out. To repeat: I’m not sure the stock market is entering the capitulation phase. I am sure, however, that some day our grandchildren will be almost as frightened by the 2007 – 2009 chart as the grandchildren of the Great Depression are today when they gaze upon the one from 1929 – 1932.
— Jack McHugh