Words from the (investment) wise for the week that was (Oct 26

Rewind the movie to before the stock market lows of March 9: stocks down, corporate bonds down, commodities and gold down, emerging-market currencies down, safe havens in fashion, including the US dollar and government bonds. In short, risky assets closed sharply lower over the past few days as concerns mounted over the outlook for central bank policy and the sustainability of the global economic recovery, with investors only warming momentarily to the US emerging from recession as shown by the Q3 GDP report (announced on the 80^th anniversary of Black Tuesday, October 29, 1929).

Cameron Brandt, senior analyst of fund tracker EPFR Global, said (via the Financial Times): “Good corporate earnings - viewed in recent weeks as fuel for a sustained recovery - are currently being regarded as ammunition for policymakers looking to close the fiscal and monetary stimulus taps.”

Adding to the economic uncertainty, Chuck Butler of the Daily Pfennig, highlighted a study by Peter Bernholz (Professor of Economics in Basel) in which he analyzed the world’s 12 most important periods of hyperinflation and discovered that the tipping point occurred when deficits amounted to 40% of the expenditures. “For the United States we have arrived at exactly that point. The deficit of $1.5 trillion amounts to 41.7% of the $3.6 trillion in expenses,” said Butler.

The CBOE Volatility (VIX) Index is a measure of the implied volatility of S&P 500 Index options, with very low numbers indicating extreme bullishness and very high numbers severe bearishness. It is also referred to as the “fear gauge” of US stock markets and is used as a contrary indicator as it moves inversely to equity prices. As shown below, it is noteworthy that the VIX has surged by 48.3% during the past seven trading sessions to its highest level since early July.

The past week’s performance of the major asset classes is summarized by the chart below. The numbers indicate an all-change pattern in the performances from the past few months as risk aversion re-entered financial markets and investors moved money from stocks and commodities into government bonds and the US dollar.

A summary of the movements of major global stock markets for the past week, as well as since the October 19 peak and various other measurement periods, is given in the table below.

The MSCI World Index and the MSCI Emerging Markets Index declined by 4.1% and 5.5% respectively during the past week, resulting in the World Index being down 1.8% for the month of October and the Emerging Markets Index recording a zero return. As far as individual markets are concerned, Sweden and New Zealand were the only major markets closing the week in the black. However, a number of markets (mostly emerging) managed to see the month out with positive returns.

The US indices closed down for the second consecutive week, yo-yoing during the course of the week, but with a particularly ugly close (on steep volume) on Friday, marking the worst day in the case of the Dow Jones Industrial Index and the S&P 500 Index since the beginning of July. The benchmarks recorded their first loss-making month since February, with the exception of the Dow Jones Industrial Index that was unchanged from September.

Top performers among stock markets this week were Ecuador (+4.2%), Sweden (+1.2%), Bangladesh (+1.2%), Kenya (+1.1%) and Uganda (+1.0%). At the bottom end of the performance rankings countries included Peru (-9.5%), Ghana (-8.9%), Ireland (-8.9%), Cyprus (-7.9%) and Argentina (-7.9%).

Of the 99 stock markets I keep on my radar screen, only 15% recorded gains, 84% showed losses and 1% remained unchanged. (Click here to access a complete list of global stock market movements, as supplied by Emerginvest.)

John Nyaradi (Wall Street Sector Selector) reports that, as far as exchange-traded funds (ETFs) are concerned, the winners for the week included ProShares Short Emerging Markets (EUM) (+7.7%), ProShares Short Russell 2000 (RWM) (+6.5%) and ProShares Short Financial (SEF) (+6.5%). Besides short funds, CurrencyShares Japanese Yen Trust (FXY) (+2.3%) and PowerShares DB US Dollar Bullish (UUP) (+1.2%) also performed well.

On the losing side of the slate, ETFs included SPDR S&P Emerging Europe (GUR) (-11.0%), Market Vectors Solar Energy (KWT) (-11.0%) and Claymore/MAC Global Solar Energy (TAN) (-10.9%).

Referring to the massive Wall Street bonuses, the quote du jour this week comes from Allan Sloan in The Washington Post (hat tip: The King Report). He said: “What do the record-high Wall Street bonuses have in common with the record-low yields for savers? Answer: They show yet another way that prudent people, especially those living on fixed incomes, are being cheated by the government’s bailout of the imprudent.

“Here’s the deal. The government is spending trillions to keep interest rates down to support the economy and prop up housing prices, and those low rates have inflicted collateral damage on savers’ incomes. ‘It’s a direct wealth transfer from savers and retirees to overly indebted borrowers,’ says Greg McBride, senior financial analyst at Bankrate.com.”

Other news is that the struggle to establish a government-backed healthcare plan in the US received new impetus on Thursday when the Democrats in the House of Representatives tabled an $894 billion bill that included a “consumer option”. Separately, the Federal Deposit Insurance Corporation (FDIC) closed nine more banks on Friday, bringing the tally of US bank failures in 2009 to 115 - the first year since 1992 that more than 100 banks have gone under.

Next, a quick textual analysis of my week’s reading. Although “bank” still features prominently, the key words have started taking on a more normal pattern compared with the crisis-related words that have dominated the tag cloud for many months.

The major moving-average levels for the benchmark US indices, the BRIC countries and South Africa (from where I am writing this report) are given in the table below. Most of the indices, including all the US indices, have fallen below their 50-day moving averages over the past few days, but all the indices are still holding above their respective 200-day moving averages. The 50-day lines are also above the 200-day lines in all instances.

The October lows are also given in the table. A break below these levels would indicate a reversal of the uptrend since March, i.e. reversing the progression of higher reaction lows. In fact, last week’s declines resulted in some indices - including the Dow Jones Transportation Index, the Russell 2000 Index and the Nasdaq Composite Index - already having fallen below these levels.

Not shown below, the Australian All Ordinaries Index has already broken through its 200-day moving average, albeit only marginally, with the 50-day average at the same level as the 200-day level.

Below is a chart not many analysts follow, namely the Dow Jones Composite Average, made up of the 30 industrial stocks, the 20 transportation stocks and the 15 utility stocks. According to Richard Russell (Dow Theory Letters), the Composite tends to lead the market on many occasions. “Note that the Composite is trading completely below its 50-day moving average. The divergence with MACD at the bottom of the chart is spectacular. Volume is expanding as the Composite declines. In all, a nasty picture, and one that I take seriously,” said the old-timer.

According to Casey’s Daily Dispatch, State Street Global Markets has just released its Investor Confidence Index for October 2009, measuring investor confidence on a quantitative basis by analyzing the actual buying and selling patterns of institutional investors. The results indicate that the big money is starting to turn bearish. “Global investor confidence fell by 10.0 points to 108.4 from a revised September level of 118.4. The most pronounced decline was evident among North American investors, where confidence fell by 12.8 points from 113.9 to 101.1,” said the report.

Breadth indicators are useful tools to assess the inner workings of the market’s rallies or corrections, and these indicators are used to identify strength or weakness behind market moves, i.e. to assess how the bulls and the bears are exerting themselves. Three of these measures are discussed below.

The advance/decline spread tracks the difference between advancing and declining issues and is widely used to measure the breadth of a stock market advance or decline. The chart below shows that the cumulative spread between declining and advancing issues on the Nasdaq turned down a few days prior to the October 19 peak and is leading the market lower.

Net new highs are calculated by subtracting the number of new 52-week lows from the number of new 52-week highs. March 6 marked an “internal bottom” when a large number of the stocks on the NYSE recorded new lows (whereas a “price bottom” was recorded on March 9). Net new highs have since improved markedly, but it would seem that the ratio is close to falling below the zero line (i.e. when new lows will again exceed new highs).

The number of NYSE stocks trading above their respective 50-day moving averages has dropped to 34.7% from 91.6% in September. In order to be bullish about the secondary trend, one would expect the majority of stocks to be above the 50-day line. For a primary uptrend to be intact, the bulk of the index constituents also need to trade above their 200-day averages. This is a slow indicator, with the number still at a lofty 85.9% but down from its recent peak of 93.4%.

Stock market breadth has been moving in the wrong direction over the past few days and the “internals” seem to indicate further downside.

A number of commentators have been making pronouncements about the extent of a possible decline. For example, Jeremy Grantham (GMO) expects the S&P 500 to drop by 15-25%, David Rosenberg (Gluskin Sheff & Associates) sees markets falling by 20%, Doug Kass is looking at -5% to -12%, David Fuller at 10-15% and Barry Ritholtz at 5-15% (The Big Picture), with Andrew Smithers (Smithers & Co) the most bearish, viewing the S&P 500 to be 40% overvalued.

Turning to fundamentals: as discussed in a post a few days ago, a good way of looking at valuation levels, and cutting through the uncertainty of having to forecast earnings, is by means of Robert Shiller’s cyclically adjusted price-earnings ratio (CAPE), effectively muting the impact of the business cycle by averaging ten years of earnings. Using rolling ten-year reported earnings, my research (based on Shiller’s methodology, but including some refinements) shows that the “normalized” price-earnings ratio of the S&P 500 Index is currently 18.8. This compares with a long-term average of just more than 16.3 and implies an overvaluation of 13%. The graphs below show data since 1950, but the actual calculations date back to 1871.

From across the pond in London, David Fuller (Fullermoney) said: “In the short term, technical evidence suggests that we are now in a reaction and consolidation phase for most stock markets. Some of this is likely to be confined to primarily ranging patterns as we have already seen. For others, the mean reversion process towards rising 200-day moving averages is likely to include larger corrections than we have seen to date. At this stage of the stock market cycle, I regard mean reversion as a buying opportunity.”

I will bide my time while the fundamentals play catch-up. Meanwhile, caution remains the operative word.

For short comments - maximum 140 characters - on topical economic and market issues, web links and graphs, you can also follow me on Twitter by clicking here.

Economy
The Recession Status Map below, courtesy of Dismal Scientist Economy.com, aggregates growth statistics from around the world and allows one to see at a glance which economies are in recession, at risk or beginning to recover. Click on the map to link to the interactive version.

“There has been no meaningful change in global business confidence in almost three months. Sentiment improved sharply this summer and is now consistent with a global economic recovery, but a very tentative and fragile one,” according to the results of the latest Survey of Business Confidence of the World by Moody’s Economy.com. “Businesses are most upbeat about equipment and software investment and the broader outlook into early next year, and most negative about the strength of their current sales and hiring. South Americans are the most positive, and North Americans generally the most negative.”

According to Li & Fung Research Centre, the Purchasing Managers Index (PMI) in China rose to 55.2% in October, up by 1.3 percentage points from the previous month. The Index has stayed in the expansionary zone of higher than 50% for eight consecutive months, indicating that the manufacturing sector in China has continued to improve steadily.

“Several countries, such as India, Australia, Norway, and Japan, have already begun exit strategies to drain excess liquidity used to stimulate their economies to counter the global recession. India’s lenders are keeping more cash in bonds and raising statutory liquidity ratios, Australia and Norway have already hiked interest rates, and Japan has said it will stop buying corporate debt by year-end,” reported US Global Funds in its latest Weekly Investor Alert.

A snapshot of the week’s US economic reports is provided below. (Click on the dates to see Northern Trust’s assessment of the various data releases.)

Thursday, October 29
Recession is history, economy back in business
Total continuing claims are stabilizing

Wednesday, October 28
Sales of new homes decline, but inventories and prices remain favorable
Durable goods orders - mixed performance in third quarter

Tuesday, October 27
Case-Shiller Home Price Index - further improvement in home prices

Monday, October 26
Chicago National Activity Index - more validation about economic recovery

Commenting on the US GDP annual growth rate of 3.5%, John Williams (Shadow Government Statistics, courtesy of The King Report) warned that one-time stimulus or inventory items represented 92% of the reported growth.

Many people who planned to buy a car in Q4 probably took advantage of “cash for clunkers” and bought in Q3. “To put this into GDP terms, according to the Bureau of Economic Analysis (BEA) the spike you see in the chart below added 1.66% to the US GDP growth figure. Thus without it, GDP growth would have been only 1.89% (3.5-1.66%) in Q3,” reported Clusterstock.

Commenting on the US growth outlook, Asha Bangalore (Northern Trust) said: “Going forward, the lift to the headline GDP number in the third quarter is partly from future auto sales, which implies that consumer spending and GDP growth are most likely to show more muted growth in the fourth quarter of 2009 and first quarter of 2010. The Fed is on hold for several months until it is confirmed the unemployment rate has peaked.”

According to MoneyNews, bond guru Bill Gross of Pimco said the Federal Reserve would not “risk raising rates” until the US has had a year-and-a-half of sustained economic growth, at a solid 4% rate.

Meanwhile, Richard Koo, chief economist at the Nomura Research Institute, warned (via MoneyNews) that the United States may go through a “lost decade” of stagnant economic growth similar to Japan’s experience in the 1990s if Washington yanks stimulus money out of the economy too soon. “We still need more government spending,” he said, adding that it could take “three to five years to get out of this mess, even under the best of circumstances.”

Week’s economic reports
Click here for the week’s economy in pictures, courtesy of Jake of EconomPic Data.

Date	Time (ET)	Statistic	For	Actual	Briefing Forecast	Market Expects	Prior
Oct 27	09:00 AM	Case-Shiller Home Price Index	Aug	-11.32%	-13.0%	-11.90%	-13.26%
Oct 27	10:00 AM	Consumer Confidence	Oct	47.7	52.6	53.5	53.4
Oct 28	08:30 AM	Durable Orders	Sep	1.0%	0.5%	1.0%	-2.6%
Oct 28	08:30 AM	Durable Orders ex Transportation	Sep	0.9%	0.1%	0.7%	-0.4%
Oct 28	10:00 AM	New Home Sales	Sep	402K	450K	440K	417K
Oct 28	10:30 AM	Crude Inventories	10/23	0.78M	NA	NA	1.31M
Oct 29	08:30 AM	Chain Deflator - Advance	Q3	0.8%	1.3%	1.4%	0.0%
Oct 29	08:30 AM	GDP - Advance	Q3	3.5%	2.5%	3.2%	-0.7%
Oct 29	08:30 AM	Initial Claims	10/24	530K	520K	525K	531K
Oct 29	08:30 AM	Continuing Claims	10/17	5797K	5890K	5905K	5945K
Oct 30	08:30 AM	Personal Income	Sep	0.0%	-0.2%	0.0%	0.1%
Oct 30	08:30 AM	Personal Spending	Sep	-0.5%	-0.7%	-0.5%	1.4%
Oct 30	08:30 AM	PCE Prices	Sep	-0.5%	-0.5%	-0.5%	-0.5%
Oct 30	08:30 AM	Core PCE Prices	Sep	0.1%	0.1%	0.2%	0.1%
Oct 30	08:30 AM	Employment Cost Index	Q3	0.4%	0.2%	0.4%	0.4%
Oct 30	09:45 AM	Chicago PMI	Oct	54.2	51.0	49.0	46.1
Oct 30	09:55 AM	Michigan Sentiment	Oct	70.6	70.3	70.0	69.4

Click here for a summary of Wells Fargo Securities’ weekly economic and financial commentary.

Next week sees interest rate announcements by the Federal Open Market Committee (FOMC) (Wednesday, November 4), the European Central Bank (ECB) (Thursday, November 5) and the Bank of England (BoE) (Thursday, November 5). In addition, US economic data reports for the week include the following:

Friday, November 6
• Wholesale inventories
• Consumer credit
• Payrolls, etc.

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global financial markets performed during the past week.

“Mistakes are a fact of life. It is the response to the error that counts,” said Nikki Giovanni, American poet, author and activist. Let’s hope the news items and quotes from market commentators included in the “Words from the Wise” review will assist readers of Investment Postcards to formulate appropriate strategies to recover from mishaps that are bound to happen from time to time.

That’s the way it looks from Cape Town (where the early-summer weather is unbeatable).

* Dr Prieur du Plessis is chairman of Plexus Asset Management and writes the Investment Postcards from Cape Town blog (www.investmentpostcards.com)