A Tenuous Bullish Sentiment
The bullish sentiment seems to have emerged in the past 2-3 weeks. Many analysts and newsletter writers have been turning bullish and urging investors to buy stocks now. Ed Keon of Prudential Equity Group, for example, sees the market rocketed higher by 25% in 2006, according to Barron's cover story this week. But it wasn't like this when the market barely began to rise out of the bottom on Friday, October 28, 2005 (blue arrow on Chart 1).
Wall Street Journal's Market Alert issued on Thursday, 10/27/2005 titled "Dow Industrials, Nasdaq in Tailspin. The Dow Jones Industrial Average lost 115.03 points..." And, here's the economy calendar from briefing.com for that week.
|Oct 25||Consumer Confidence||Oct||85.0||85.5||88.0||87.5|
|Oct 25||Existing Home Sales||Sep||7.28M||7.20M||7.20M||7.28M|
|Oct 26||Crude Inventories||10/21||4414K||-||-||5555K|
|Oct 27||Durable Orders||Sep||-2.1%||-1.5%||-1.2%||3.8%|
|Oct 27||Initial Claims||10/22||328K||335K||340K||356K|
|Oct 27||Help-Wanted Index||Sep||38||36||36||38|
|Oct 27||New Home Sales||Sep||1222K||1240K||1250K||1197K|
|Oct 28||Chain Deflator-Adv.||Q3||3.1%||3.3%||2.8%||2.6%|
|Oct 28||Employment Cost Index||Q3||0.8%||0.8%||0.8%||0.7%|
|Oct 28||Mich Sentiment-Rev.||Oct||74.2||75.4||76.0||75.4|
These economy reports for the final week of October were either below the expectations or roughly at the expectation level except for the Conference Board's Help-Wanted Index and the advance GDP estimate. The Help-Wanted Index has been staying at 38 for 3 months since its decline from 40 in July. However, the GDP has since been upwardly revised to 4.2%.
Many of the analysts based their optimistic forecasts on the potential strong growth of the investment component of the GDP. They believe the growth in business investment would make up for the loss in the PCE (Personal Consumption Expenditure), another component of the GDP. The first problem with this "belief" is that the private investment hasn't shown a track record of steady growth for 2 years (Chart 2). It's actually been in a declining trend.
The largest component of the Private Investment, the Equipment & Software, also shows little sign of growth for 2 years (Chart 3). For quite a while, we've been hearing that businesses are going to pour more of its profits into equipment and software, but it's not happening. In fact, for the past 2 years, the 15.5% growth appears to be quite a strong resistance.
In order for investment to grow big enough to make up for the slacking consumption, it really has a lot of catching up to do in both absolute term (as discussed above) and in relative term. Investment is only 16.65% of the GDP while the PCE is 70.20% of the GDP. The government spending (18.98%) is larger than the business investment by about $300 billion. In any case, for every 1% decrease in the PCE, the Investment would have to increase 6% just to pick up the void. This means the Investment would have to grow 16.8% just to make up for that 1% loss in the consumption. And that has not happened since 2003. The only hope then would rest upon American consumers to keep on keeping on. But that's not going to happen.
We all know that American consumers have been able to keep the consumption going by extracting their home equities through cash-out refinancing. But the refinancing loan application volume has been in serious decline in the second half of 2005, and the housing market has indicated signs of fatigue. Chart 4 shows the percentage change of the number of units sold in the U.S. from the preceding month. Fewer units were sold in October than in September by 2.7%. Overall, it's not a bullish looking chart.
Incidentally, the impact of the real estate and mortgage sectors slowdown on the overall employment picture has not been addressed or studied by many. I'm not sure whether there are available statistics on the total number of employees in the housing market related businesses such as escrow services, mortgage, real estate brokerages, pest controls, credit report services, and marketing services, etc., but I know that there are currently over 2 million NAR (National Association of Realtors) members. Since not everyone working in the housing market related businesses is a member of the NAR, the actual number of employees may be many times over. And, in California alone there are almost half a million real estate licensees, according to California Department of Real Estate. With this large number of people in the housing related industries, a deteriorating housing market's impact on our overall economy can't and shouldn't be ignored.
Unfortunately, the housing market slowdown may not be the only thing on consumers' minds nowadays. The energy cost is yet another concern. Not enough data available thus far to support this thesis, but I believe the havoc caused by Hurricane Katrina might've served as a wakeup call that reminded American consumers to start paying attention to their balance sheets. Even if they don't talk about it as often anymore, it's in the back of their minds. And, by all means, they'll have higher utility bills this winter to keep them reminded. This year's average heating oil price in the U.S., at $2.41 per gallon, is 22.34% higher than the same time last year (Chart 5) despite the fact that it has declined by $0.28 since the beginning of October 2005.
By the way, we don't have to get into the grand debate about peak oil. All I know is that I'm paying 22.34% more on heating oil and 12.35% more on gasoline this year than last year.
One of the reasons commonly cited for the recent buildup of the bullish sentiment is the possibility of the Fed's rate cut at an unknown time in 2006. First of all, that's speculating. The Fed may just continue raising rates all throughout the year 2006 and beyond. And this guess is just as good as anyone else's. According to David Ranson, H. C. Wainwright and Company, Economics and former assistant to the secretary of the Treasury:
"Those who think the Fed will quit soon are assuming that inflationary symptoms will ease up in the coming months and years. As we've already said, that is not a safe assumption. Just as the prices of gold and similar commodities are leading indicators of consumer price inflation, they are also reliable leading indicators of Fed policy. Based on the historical record, we calculate that the Fed is very likely to keep hiking rates (still at a "measured" pace) until they are back to the 2000 levels of 6% or higher, from 4% for the key overnight federal-funds rate currently, and 4¼% after Tuesday's meeting of the policy-setting Open Market Committee."
Secondly, even if the Fed were to start cutting the Fed fund's rates in 2006, it appears that no one remembers (or wants to remind investors) that the Fed's rate cuts have no instant impact on the economy or the market. We're not talking about studying 100 years of the financial history here. The Fed's most recent rate reduction cycle took place only 5 years ago. From May 2000 through June 2003, the Fed cut rates 13 consecutive times, which lowered the rate from 6.5% to just 1%. The market nonetheless didn't stop sliding till the second quarter of 2003 (Chart 6). That's about 3 years after the initial rate cut.
Finally, on the longer term basis, the most recent 2005 survey by SIA (Security Industry Association) shows a declining number of Americans under age 35 owning equities since 1999. This number has declined from 41% of the U.S. households in 1999 to 36% in 2005. And, it's no accident that the last great secular bull market that started in 1982-1983 and ended in 1999-2000 coincides with the rapid increase of this age group's equity ownership (Chart 7). I'll leave the importance of this age group's participation to your own imagination and perhaps to our future discussions.
For now, relevant data discussed herein lend no support to this newfound bullish sentiment. And an unfounded bullish sentiment is, at best, a tenuous sentiment.