By Starry
Administrator
Sgfunds.com
Over the last 2 months or so, we received many emails asking for market direction, opinions on conflicting analyst reports and more recently, what should they do seeing the market rebounded strongly. Understandably, this must be a very confusing time for most investors out there. Just when the credit crunch and sub-prime issues were hogging headlines, FED suddenly pull a trick out of their bag with a cut of 50 basis points. What now? Is this good or bad? There were so many conflicting reports (I received quite a few everyday), with expert economist or analyst conflicting each other with their views and opinions.
So why another article from us on this issue? Because we feel that addressing the current market situation from both fundamental and technical point of view would give a clearer perspective. We have not seen many reports attempted that. Also, having given some earlier comments in the forum about our thoughts on this correction (and invited a lot of emails), we feel obligated to do a follow up on our earlier comments.
Before we end this report, we also decided to show why the Oct 87 collapse is unlikely in the current market environment. This is to address one of the reports from a "famous bank" where they claimed that there is a high chance for that event to happen again. We will show you why that collapse is unlikely.
One of most popular question I received is what make me think that the recent "correction" is a correction and not the begining of a bear market (due to the sub-prime and credit crunch issue). Many seems to had sold off their shares due to all the fears lingering around the correction period. To understand this, let's take a look at the current technical picture below
TECHNICALS
There is a lot of information in the Dow Jones daily chart above. I try to use similar colours to address similar technical issues. In short, if you look at the chart above, the technicals will tell you that the market was preparing for this correction since late May, 2 months before the correction itself! The MACD was losing momentum since late May and we got into a triple resistance situation. The clear divergence in the MACD tells you that a correction could be coming. But the biggest hint of all is in mid July whereby the breach of the triple resistance yields only some pathetic volume. If you put all these together (from MACD, formation of triple resistance, poor volume when resistance breach), it is very likely the market is going to correct.
If you see a correction coming 2 months before the event itself on the chart, it is not likely it is going to turn into a bear market. Bear market usually happen in a less obvious manner in the charts. Of course, you also need to combine with some fundamental data and current investor sentiment to decide if that's a correction or the start of a bear market.
However, what is more interesting is where the market is going to go from here. For this, notice that the volume (words in green) is flying off its averages somewhere around Sept 10. This should lift the market above the reverse head and shoulders formation. Clearing this formation is a very strong hint that the market will rally from there on. However, the MACD gap is a bit too wide, so this week we might see a little consolidation before DJI goes higher.
While the daily chart is useful, the real "meat" lies in the weekly chart. I cannot emphasise enough how important it is to look at the weekly. Let's take a look at that now.
Now if daily chart gives you an headache, the weekly chart will give you a clearer picture. Even if you cannot sense the correction might be coming since late May, the most obvious signal is in the weekly chart somewhere around late June. If you combine the MACD signal from the weekly chart and the one from the daily chart, you will have a very strong case of a correction coming. The media says sub-prime issue dragging down the market. We say the market was ripe for a correction anyway seeing these signals, whether sub-prime or not.
What is more important in the weekly chart is the crossover of the weekly volume against the last 10-week averages (highlighted in green). You add that to the turning upwards of the MACD and that tells you that the volume and momentum is building yet again. Another important point to note : The double long white candle formed during the last two weeks tell you straight that the market psychology has changed. From bearish last month, the mood has completely changed. You add all these together, you are likely to get a setup of a strong rally to come.
However, I believe the conviction that a strong rally is ahead lies not just on the technicals but more importantly on the fundamentals. Let's go through that one now.
FUNDAMENTALS
Valuations
Currently the US market is trading at a PE of around 15-16 and that's almost at its historical average. Because it is almost at its historical level and with all the sub-prime issues coming in, the bears screamed that the market is ripe for declining. In our opinion, that's far from the truth.
Looking at just the PE level may not give the correct interpretation of the current market situation. In the world of investment where bonds and stocks are chasing for the same investors' money, perhaps it is better to look at the earning yield of the current stock market and compare that with the long term bond yield. If you invert the PE of 15, you get about 6.6% of earning yield against a 4.6% of a 10-year US bonds yield. In other words, stocks are relatively cheap compared to bond now. If FED continues to lower the interest rate (which is expected to do so), stocks will continue to look attractive even if its PE continues to go a tad higher. Because of this, we are very much convince that the stock market still has much legs to run.
FED decision
One of the main reason we strongly believe that this market will continue to rally (even up to crazy levels) is because of FED recent decision of cutting 50 basis points. That decision is a big indication of their current motive. FED's main duty is not to bail out hedge funds or mortgage lenders or helping Wall Street. Their main duty and the reason why they were formed is to fight inflation. Curently with the extra liquidity pumped into the banking system and with oil price at sub $80 level, they should be more concern about controlling inflation by tightening rates. Why is it then that they choose to take a risk in that and went bailing out Wall Street with a drastic cut of 50 basis points? It's like telling the world "forget about inflation..controlling recession is more important now". But controlling recession is never their job and recession is not a always a bad thing.
In any case, their motive is clear. With the cut of 50 basis points, they are trying to get as much liquidity into the system so that the banking system does not collapse. In short, they are just putting a handiplast to the wound and hope the bleed would stop for awhile. But this action is going to create an even bigger problem. With liquidity flowing into the system, this liquidity will find its way into the stock market pushing up stocks prices to dizzying levels. Look at it this way. If you are holding US dollar now...there is only a few things you can invest into. Either stocks, bonds, gold, properties or just hold onto that US dollar. Bonds yield and US dollar is declining, so forget about that. Properties look very vulnerable now with all the housing issues. Gold would be a good alternative, but it will get more expensive when the USD slides further. Only stocks look really good now and with interest rates dropping, stocks look like a great alternative for investment returns.
The main concern is not so much within US itself, but with China and Japan holding loads of USD surplus, where will they invest into? Their long time favourite, US debts are now dropping in yield. So probably it will start flowing back into the stock market as well as some to gold. The Tech bubble was created partially also due to this reason. And we have no doubt that such scenario is going to repeat itself again because FED seems resolve in bailing out Wall Street as much as they can.
Historical facts
Probably some would think it is a myth that we even mention this, but we do believe there is some basis to the US Presidential cycle. Since 1925, there were only three negative years when the President is in his third year. Amazing to some, even 1987 (with a deep market crash) ended up +5.9% for the year. That was when Reagan was in his third year. With only three negative years since 1925, we really wouldn't want to bet against that!
However, if we look into the current US politics now, it may be clear that probably FED cut of 50 basis points has something to do with next year Presidential election. With more democrats in the senate now, our sole Republican President better be sure that the mood is right going into the next election. Wall street and the US economy better be secure and well. This is of course speculative, but with historical data backing up, this could be a possibility.
CONCLUSION
Adding the technical, fundamental and historical data together, we are convince that we are likely to see the stock market rally from the current levels. We might even face a bubble going into 2008 and 2009. Dow may touch 15,000 or more by end of 2008. We would be very cautious from mid 2009 onwards. There is a real problem behind the US economy and it may lead to a very severe recession once this bubble collapse.
However, even if the market is to rally, it never goes up in a straight line. There will be correction from time to time. This will be an opportunity to load up. Also some gold in your portfolio would be good. I have advocated gold since the start of this forum when gold prices was at USD$400++. Even now at USD$700++ , gold is still very cheap compared to historical inflation-adjusted previous high (around USD$2230). Gold will not give u dizzying returns, but with bond yield dropping and USD declining, gold will be a great stabiliser to your portfolio.
Also another point to note. Do not just focus on small/mid caps growth stocks. I know some people love to do that. But with interest rate dropping, big cap value stocks will get their chance. You may also want to cut down your US equities since the decline of USD will erode your returns. Asia is still relatively attractive and this is where you should focus in the next couple of years or so.
ANOTHER OCT 87 CRASH?
Recently, there was an article from a "famous bank" quoting the similarity between the current price patterns in the DJI with the one in 1987. They use the peak in August 87 and compared against the peak in July 07. Hence they conclude that we might be facing the same thing in October this year.
In our opinion, there are two things we need to consider. Looking at price patterns may not be enough. One is that the fear for Oct 07 has been old news. We have seen people talking about this since the beginning of the year. Some even since last year. In most cases, when there is great fear of certain stories/news surrounding investors, that story would have already been priced into the market. I am pretty sure there is no sense of mania in the markets now and infact, probably a lot of investors are at the sidelines waiting for October to pass. I can't say however, that the same happened in 1987. Which brings me to the second point : the current market psychology is very different compared to Oct 87. And as we all know, market is driven by human psychology, definitely not by price patterns alone.
To validate my point, below are the charts of Oct 87 and now :
Oct 87
Current 2007
One way to "measure" the market psychology then and now is to look at the returns since the begining of that year. In 1987, the gains in the Aug 87 peak was a whopping 42% since Jan 87. If you are an investor then, obviously your psychology build-up towards the market is going to be very different compared to now where there is only about 11% gain since Jan 07 (from the last peak in July 07)
Market psychology aside, even the valuations are different. One quick and fast (may not be very accurate though) way to see if the market is "expensive" then is to compare with its 200-Days moving average. In Aug 87, DJI was 22% higher than its 200-DMA. For 07, the peak in July was just 10% above the 200-DMA. High, but nothing to be concern about. If I use technical indicators, I could have shown much more differences in the market psychology now and then but by looking at the gains itself, I am sure most readers would sense that the market psychology itself is already different.
Ok..let's go a bit more. Forget about market psychology now and 87. Let's look at earning yields and Bond yields then. We talk about fundamentals now. Before the crash, the US market was at PE 19, which gives an earning yield of 5.2%. Guess what was the 10-year bond yield then? It was a whopping 10%! When you have a market that has gain 42% since the beginning of the year where the bond yield is almost twice the earning yield of the market, that's almost a recipe for a collapse. Are they the same now? Obviously not.
Well, Oct is not here yet and who knows? It might still crash and burn. But we have just showed that there is a fair number of differences between now and then, and hence, very unlikely that crash is going to happen this year. No one knows Mr.Market for sure, and we could only invest based on probabilities. In this case here, the probability for an Oct collapse looks low.
That's the end to this article. I hope you guys enjoyed reading it!
Disclaimer : As of all investment articles, what was said in this article can go wrong as no one can tell exactly where the market is heading. Please do due diligence in your own financial and portfolio matters or get a financial advisor to advise you on that. Sgfunds.com nor the writer is liable to any of your investment loss due to the contents of this article.
