It is Now Late in the Cycle!
(March 31, 2005)
Dear Subscribers and Readers,
Okay, I have not chose to run this poll earlier since I didn't want our commentary to bias our readers' positions. But please vote in our latest poll (non-registered posters can now vote as well): Where do you think the long bond is heading in the next six months? i.e. If you're in the market for a house and need to get a mortgage, where do you think mortgage rates will be heading in the next six months? Please vote and let us know your thoughts. Again, registered posters are also welcomed to create their own polls on that board!
I know I have probably beaten this horse to death already but I want to emphasize my beliefs on where we currently are in terms of both the credit cycle and the profit cycle. I have discussed and emphasized this before and I will do so again: I believe we are now late in the cycle! We are also preparing to go 50% short (the maximum allowable short position) in our DJIA Timing System within the next couple of weeks.
This is the reason why I have been mostly defensive in both my commentaries and in our MarketThoughts discussion forum. A market in an oversold situation in the early part of the credit and profit cycles is different from a market that is oversold in the latter part of the credit and profit cycles. That is, in an early bull market, one can buy individual stocks in a slightly oversold situation and reasonably expect to make money in the longer-run. Conversely, this is not such a good idea in a maturing bull market - as breadth will invariably get narrower and as the number of new highs will surely shrink going forward. In the latter stages of a bull market, companies that miss earnings will decline much more significantly - along with the historical observation that more companies will miss earnings as well. Most of the easy money was made during the March 2003 to January 2004 period. Some money was also made during the August 2004 to December 2004 period. Going forward, the upswings will be getting more difficult to catch. Since we are now in the latter stages of a bull market and in both the credit and profit cycle, I do not advise my readers to initiate long positions here until we have sold off to a more "quality low" - that is, much lower prices and a more oversold condition than the early August low in the major stock market indices. Only by buying at or near that upcoming low will my readers have a decent chance of making money on the long side during 2005. We will sit out the first nine months of the action if we have to (unless one wants to go short which is most probably the best time to do now given where we are in the cycle).
Some of my readers may think I'm going nuts here, considering I have communicated in the past that I don't think this cyclical bull market is over yet. Right you are - I don't think the cyclical bull market has ended yet. But the point is: The quality of the rallies will considerably worsen as the bull market matures. The only part of the bull market worth "playing" at this late stage is the final 'blow off phase" which I will be looking for - a phase similar to the final October 1999 to March 2000 rally that I am sure will materialize at some point (although not to that great of a degree, of course). This final "blow off phase" will put an end to this cyclical bull market once and for all. I expect this "blow off phase" to materialize sometime in 2005 but again, I will not buy until the major indices have sold off to the "very oversold" situation that I am looking for.
The latest corporate profits (for the quarter ending the fourth quarter of 2004) and GDP data have just been released - this is now confirming my beliefs that this bull market is maturing and that we are in the late stages of the profit cycle that began soon after the tragic events of September 11th, 2001. Following is a quarterly chart showing the absolute levels of domestic corporate profits vs. domestic corporate profits as a percentage of GDP from the first quarter of 1980 to the fourth quarter of 2004:
As mentioned on the above chart, both the level of corporate profits and corporate profits as a percentage of GDP have risen considerably since the last profit cycle trough in the third quarter of 2001. Now, let's look at the previous profit cycle: From the profit cycle trough (when corporate profits as a percentage of GDP hit 5.6%) in the third quarter of 1992 to the profit cycle peak in the third quarter of 1997 (when corporate profits as a percentage of GDP hit 9.3%), the level of corporate profits rose 119% in a span of exactly five years. Now, the latest profit cycle: The profit cycle trough (when corporate profits as a percentage of GDP also hit 5.6%) in the third quarter of 2001 to the fourth quarter of 2004 is a little over three years. However, the level of corporate profits has also risen dramatically - rising over 90% from $567.9 billion to today's $1,080.1 billion. Probability now suggests that the profit cycle may have reached its peak, and since the stock market is a discounting machine - well, let's just that the profit cycle now suggests that we should be very careful with earnings predictions for the market and for individual stocks going forward.
This "little conjecture" of mine is further confirmed by the latest chart from www.chartoftheday.com. The following chart shows the trailing 12-month inflation-adjusted earnings of the S&P 500 along with its 50-year trend lines:
As the commentary in the chart says, earnings of the S&P 500 components are now substantially above its 50-year old trend. Probability now calls for a decline of profits or at least a decline of profit increases. The 10% profits increase that people have generally been looking for is much too high given that GDP has most recently only grown at 3.8%. In fact, since profits cannot sustainably grow at a rate above the growth rate of GDP, probability now calls for an increase in profits that are substantially below GDP growth rates in the next five to ten years.
Can profits rise significant more at this stage and can profits grow at better than the level of growth in the GDP? Sure it can - but the probability of that happening is low - especially as we are now in the late stage of the game when it comes to the credit cycle and commodities (the declining profits of companies that produce commodities will also add a strain to corporate profits). Global liquidity is now declining and has been since the beginning of this year. I have previously extensively discussed the relative strength of the Philadelphia Bank Index declining below its two-year support line - relative strength has stayed down ever since and it has continued to under perform since then (except during yesterday's bounce). This is further confirmed by the fact that the absolute level of the Bank Index is also now sending out warning signals:
As mentioned on the above weekly chart, the Bank Index, after barely just making a new 52-week high in late December, is in the process of breaking down once again. Closing below 95 would be very ominous - as it will make the first time since the cyclical bull market began that the Bank Index has made a lower low.
In previous commentaries, I have discussed a scenario that I believe will materialize sometime this year - a scenario involving the slowdown of the various emerging markets and potentially a near-collapse of a major emerging market country - a scenario which will drive down commodity prices. Mr. Carl Swenlin at Decisionpoint.com has talked about the potential for a significant top in the CRB Index right here. Dr. Edward Yardeni, in his latest commentary, noted: "One of the best leading indicators of inflation in industrial commodity prices, PPI crude goods excluding food and energy, and non-oil import prices is the yearly percent change in FRODOR (foreign official dollar reserves). It is my favorite indicator of global liquidity.4 On a year-over-year basis, it peaked at 36.2% during the week of August 18, 2004. During the week of March 23, it was down to 16.3%. It actually leads the level of the CRB raw industrials spot price index by 52 weeks and strongly suggests that industrial commodity prices are likely to peak soon (Figure 1)"
Following is the relevant Figure 1 that Dr. Yardeni was referring to, showing the total foreign official dollar reserves (pushed ahead 52 weeks) vs. the CRB Raw Industrials Spot Price Index:
As suggested by Dr. Yardeni's chart, a good time frame for a significant top in commodities is between now and the next six months - which will fit perfectly with what I have "conjectured" in my commentaries over the last several weeks.
Conclusion: I don't like to be repetitive but we are now definitely very late in the credit, profit, and commodities cycles. The easy money has already been made - the rallies will just keep on getting shorter and weaker until we have a great capitulation washout. The best candidates to go short over the next couple of weeks will be financials and other cyclical stocks such as companies that produce commodities or even the homebuilding stocks. While the bounce was pretty impressive yesterday (despite the number of lows outnumbering the number of highs on both the NYSE and the NASDAQ), I expect the downtrend to reassert itself again within the next couple of weeks. Any upcoming downtrend will be the strongest downtrend we have seen in over two years, and I will not initiate any long positions here until we have reached a more oversold situation than even what we saw during the early part of August 2004. Over the next couple of weeks, I want all my readers to exit their long positions in commodity/cyclical stocks and financial stocks. We will also be going 50% short in our DJIA Timing System within the next couple of weeks as well. More details to come!
Henry K. To, CFA