Market Notes: Q3 2005
Stock Market Overview
After all the bouncing around over the past year and a half the S&P 500 is currently trading around 1200, not far from where is was three years ago in the spring of 2002, and also not far from where it was seven years ago in the summer of 1998. In 1998 I doubt many would have thought the average large-cap stock could be bought for the same price seven years later - and given all the volatility over that time, it seems to add insult to injury. Valuations have certainly come down in the last seven years, but before anyone starts thinking we're out of the woods and in the clear there are some historical examples of post-bubble markets that we should study carefully. In many significant ways, this has not been the typical post-WWII bear market. Let's look at how the market looks in the short-term over the next quarter, and then put that in the context of another post-bubble bear market.
Staying with the S&P 500, the recent rally from the low in April has retraced most of the decline from the March high at 1229, reaching up to 1219 before last week's breakdown. The Dow and NDX have not been as strong over the past two months, with the weaker NDX actually made a lower high in late June as the Dow and S&P rallied to a new rally high; a classic end-of-rally signal that has been given time and time again since 2000. Without new highs on any major index, and with the below average volume throughout its entirety, it is highly likely this two-month rally has been a correction: a short-covering-fueled move up that will eventually give way to a decline below the April low.
The chart below shows the S&P 500 from the start of this year. From the high in March at 1229, the S&P declined in a corrective A-B-C pattern the the April low at 1136. From that low, the S&P has rallied in an over-lapping and corrective fashion up to the recent 1219 high. One of the most basic and enduring concepts in technical analysis is to follow "price and volume," and when price moves with low volume it pays to remain skeptical and cautious until given a stronger signal. In this case, from the 1229 high in early March, volume was above average on the declines down to the April low, and volume was below average the entire rally up to 1219 - clear evidence that the larger trend remains down.
To many, charts and technical analysis seem like a coded language that is impossible to crack. Although there is a large library of terms, indicators and theories, there is a simple concept to keep in mind that may help keep it all in perspective: all technical analysis aims to look at past market action to find clues about the market direction in the future, and charts are a way to visualize past market action. When we see certain signs coming out of the market, we can find similar patterns in past markets to give us clues about what is likely to happen next. Volume is a simple indicator, and in the recent past when a rally has been accompanied by lower than average volume the market has usually failed to make a new high and instead eventually gives way to a renewed decline to a new low.
Another simple technical indicator is to track the number of stocks closing up for the day versus the number of stocks closing down for the day: this is known as the Advance-Decline ratio. When a rally is strong, the number of advancing stocks far out number the number of declining stocks as most sector of the market participate in the rally, and the moving averages on the chart below will rise. When a rally is losing its strength and nears an end, fewer and fewer stocks continue to move up and the moving averages in the A/D chart below will start to decline. On the chart below you can see the blue moving average below peaked in mid-June and started declining even as the S&P 500 continued to rally higher: this was a warning sign that fewer and fewer stocks were advancing and that the rally was likely near an end.
Volume and the A/D moving average suggest a high for this recent two month rally is in, and this assessment is supported by a number of other technical indicators on the S&P 500 and other indexes. This makes it highly likely that the market is heading into the summer on its way to a new low for the year (keeping in mind nothing is ever certain in market predictions).
There are two levels on the S&P 500 that are likely targets for a 3rd Quarter decline: 1140 and 1050. The chart below shows the S&P from it's low in 2002 through July 1,2005. The 1140 area provided strong resistance in 2004 over 4 repeated attempts to break through before finally succeeding in November. The decline from the March high at 1229 found support from this broken level of resistance, and a decline from current levels is expected to test it again.
How the market reacts to another test of 1140 will likely determine the next move. A bullish possibility has the S&P finding support at 1140 and then starting a rally that would ultimately take the index beyond 1229. A bearish possibility has the S&P breaking through support at 1140 and continuing down to 1050, or below - a possibility also suggested by the current P&F chart target. Keeping these bullish and bearish scenarios in mind will help us make strategic decisions on a few minor speculative positions in the coming quarter. However, since our long-short portfolios are uncorrelated to the market, we look forward to whatever the market gives us.
US Parallels to Post-Bubble Japan
Since the stock market topped in 2000 here in the US, there have been several major themes in place. First, the stock market declined from it's speculative peak in a steep 2½ year bear market that was followed by a significant rebound that has failed to reach its previous high. Second, the central bank (our Federal Reserve) lowered interest rates just about as far as it could to support the economy and asset prices. And third, real estate prices increased significantly as record low interest rates fostered increased ownership and speculation. Most people are at least vaguely away of these themes, but what most people may not be aware of is that it has all happened this way before, in Japan.
History may not repeat, but it rhymes. The three themes mentioned above are exactly what happened in Japan 10 years before our stock market peaked in 2000. The two charts below compare Japan's Nikkei index to our S&P 500 index, offset by 10 years.
There has been much discussion over the past 4 years about how Japan's post-bubble experience can be compared with our post-bubble experience here in the US, and whether the deflationary path Japan has staggered down will be repeated in some form here. Regardless of that debate, it is clear that from 2000 to 2005 we have followed a similar path to Japan's markets and economy between 1990 and 1993. The charts above show the similarity between our stock markets, which have followed almost the exact same path on the way up to their peaks and in the bear markets that followed.
There is no question that the Federal Reserve has studied Japan's predicament closely, so it is no surprise that our rebound has been more successful than Japan's was at this point: the stock market has continued higher, as have real estate and commodities. However, the fact that the Fed has better managed US markets through the bursting of the stock market bubble thus far does not negate the long-term risks going forward - and some would argue its actions have only heightened those risks. In Japan, the price of real estate has declined from its 1993 peak in each of the last 12 years, despite optimistic arguments prior to the peak to the effect of "land is so scarce in Japan, it will never decline." And despite the initial rebound from its low in 1992, the Nikkei has never recovered and remains far below its 1990 peak. The chart below shows the Nikkei from 1980 through July 1, 2005.
There are many circumstances in Japan that are unquestionably unique to their situation and make an exact repeat of their market paths here in the US unlikely - an extreme shift in demographics in Japan is one example. However, in the US we have our own set of problematic circumstances that have the potential to keep our markets on a less-than-ideal path.
If you are planning for retirement or saving for your child's education, and our own stock market went sideways through 2010 before declining to a new post-2000 low like the Nikkei chart above, would you meet those goals? How can you adjust your strategy to meet those goals regardless of how the market performs over the next 5, 10 or 20 years? These are the questions most Americans should be asking themselves, but aren't.
Fortunately for those asking those questions and seeking solutions now, Sitka Pacific Capital Management has some answers. Our Hedged Growth portfolio is structured to be uncorrelated to the market so that the growth of your account is independent of the path of the S&P 500, and our High-Yield Growth portfolio takes advantage of high dividends and risk-reducing options strategies to safely grow your account over time. With both approaches, we give our clients a way to invest and grow independent of the market. Visit the Account Management and Getting Started pages for more information.
US Treasury Bonds
With the exception of a brief excursion below in 2003 and a brief excursion above in 2004, the yield on the 10-Year Bond has traded between 3.5% and 4.6% since mid-2002. The swings in sentiment throughout this trading range have gone from one extreme to the other and back again: from the fear of deflation in 2002, to inevitable inflation and Greenspan's "conundrum" in 2004, to the recent capitulation of bond bears like Bill Gross and the expectation of a return to 3%. For those trying to decide whether or not to invest in bonds, these opinions that tend to lag market action are of little help.
A chart of the 10-Year Bond yield, on the other hand, gives us information about the market before it shows up in the sentiment of the crowd. Let's take a look below:
The above chart objectively gives the following information. There is very strong support around 3.9%, which has been tested 4 times over the since Q3 2003 (having broke once in March 2004) - the 10Y is currently testing this level again. In addition, the downtrend from the high in 2000 (blue line) was broken in April 2004, and has undergone two tests since then: in Q3 2004 and the recent decline down to 3.8%. The MACD is also low, and ready to turn up.
This information suggests the following: if yields are above 3.9% as they currently are, the path of least resistance is up; if yields were to drop below 3.7% (below support at 3.9% and the Blue trend line at 3.7%), the path of least resistance would be down.
The current yield presents an ideal long exit or short entry as long as the TNX remains above 3.7 on a weekly basis, especially given the potential upside from here. The balance of systematic risks in the US bond market certainly favors higher yields, which is all the more reason to be cautious with bonds until some of the support and trend lines between 3.9% and 3.7% are broken.
The Dollar and Gold
As can be seen on the Dollar's Weekly Chart that can be viewed any time in Currency Notes, the Dollar has broken out of its downtrend channel and is on a new uptrend. The previous downtrend in the dollar lasted 3½ years and bottomed at strong support at 80, shown on the Monthly Chart. The sentiment at the Dollar's low was indicative of a major low, with numerous press articles on the weakness of the dollar and well known personalities like Warren Buffett and Bill Gates shorting the Dollar (George Soros announced his short dollar position in 2003, but he was probably closer to closing his position at that time and using the press to his advantage). If they hold their positions for the long-term, as Buffett says is his intention, they may be proven right. But in the short-term over the next year or so, those short positions will probably cause some discomfort.
You can keep track of short-term moves in the Dollar in Currency Notes, but today the current overbought condition of the Dollar deserves attention. The Weekly chart below highlights occasions when the Dollar reached over-bought (green lines) or over-sold (red lines) levels on the 14 week Relative Strength Index. In every case, even if the Dollar continued it's trend for a while longer, it was lower when over-bought and higher when over-sold at some point in the following Quarter. The Dollar is now in a similar condition, with it's RSI(14) reaching 70. If this is a particularly strong rally the Dollar could continue higher from here and become even more over-bought, as happened in Q1 1997. But it remains likely that the Dollar will be lower than today's level at some point before October.
Despite the rally in the dollar over the past 6 months, Gold has remained in its uptrend on its Weekly Chart. This has been coupled with the relative strength of the HUI stock index over the past month and a half. Viewed separately from the Dollar charts, Gold and Gold stocks appear to be in the early stages of another significant move higher. However Gold has yet to break out of its short-term consolidation and we will see how the HUI reacts to its recent rally before drawing any long term conclusions.
It is notable that Gold has begun to break out in other currencies besides the Dollar. Below is a chart of Gold priced in Euros. During Gold's rally in Dollars over the past 4 years, it has remained range-bound in Euros until last Quarter. If we see Gold breaking down out of its uptrend in Dollars relatively soon, then Gold's breakout in Euros will seem to be more of a currency move. However, if we see Gold start to rally in other currencies along with the Dollar, it would suggest Gold has until now been in the early stages of a much deeper bull market that is shifting gears. Given that Gold is barely in the public's consciousness, those who recognize these potential signs early will be in a good position.
In the next decade, investors who have adjusted their thinking from the bull market mindset of the 80's and 90's to the take advantage of the new investment landscape will continue to gain over those who haven't. Sitka Pacific Capital Management offers portfolio management strategies for this new investment landscape by being independent of the market and taking advantage of the emerging themes, a few of which we discuss here. For more information, visit our Getting Started page and we will contact you for a consultation.
Market Notes is a Quarterly look at various markets and trends. If you would like to receive an email when next Quarter's letter is published, or have any other questions or comments, visit our Contact page.