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Our 3Q 2009 Stock Market Outlook

(July 2, 2009)

Dear Subscribers and Readers,

I want to start off by saying Happy Canada Day (July 1st) and Happy Independence Day (July 4th) to our North American subscribers.  In these tumultuous times, it is difficult to lose sight of the tougher times before us – especially times of war and the uncertain times during our nation's founding.  Even the double-digit inflation and unemployment of the early 1980s were tougher in comparison to our current experience.  While the aftermath of a housing and credit bubble is definitely no cakewalk, subscribers should understand that we will come through this, and will emerge from it stronger than ever.

In this commentary, I will focus on our outlook for the broad market – i.e. the Dow Industrials and the S&P 500.  For those who purchase individual stocks or industry ETFs, I highly recommend reading Morningstar's 3Q 2009 outlook for both the US stock market and the various sectors and industries (along with our previous commentaries on the retail, restaurant, credit card, casino operator, etc, industries).  While I don't necessarily agree with Morningstar's various industry outlooks (e.g. in general, I do not believe credit card companies offer any good value, including American Express), their analyses are generally well-researched and thus provide valuable, objective data points.

In our commentaries over the last two weeks, we asserted that the stock market was due for a pause – especially after the 29% and 52% rallies since March 8th in the Dow Industrials and Dow Transports, respectively.  Specifically, we believe in the short-run, the market is due for a correction.  From a fundamental standpoint, there is no doubt that the broader market is now hugely overbought – especially given the lack of visibility in both earnings and the global economy over the next few years.  This is reflected in Morningstar's “Market Valuation Graph” of their full coverage universe, as shown in the following chart (courtesy of Morningstar.com):

Market Valuation Graph

The above chart shows the current valuation of Morningstar's full coverage universe as a ratio of its “fair value” (weighted by market cap).  That is, the current ratio of 0.92 means that in general, the Morningstar coverage universe (which consists of over 2,000 stocks on the NYSE and the NASDAQ Composite) is trading at an 8% discount to its fair value.  At the bottom in late November 2008 and early March 2009, this ratio traded in a range of 0.55 to 0.60 – suggesting that Morningstar's full coverage universe was trading at a 40% to 45% discount to “fair value.”  With the rally since early March and various earnings revisions (combined with the lack of visibility), valuations are now nowhere near as compelling as where they were a mere four months ago – suggesting that the market is now highly vulnerable to a significant correction as 2nd quarter earnings are released sometime in the next few weeks.

In addition, cash levels as a percentage of total assets at equity mutual funds have sunk (as of the end of May) to its lowest level since the end of September of last year, as shown in the following monthly chart:

Monthly Equity Mutual Fund Cash Levels (January 1996 to May 2009) - Aftering spiking to an 8-year high of 5.9% at the end of February, cash levels as a percentage of total assets at equity mutual funds has declined back to 4.8% - its lowest level since the end of September of last year.

That is, while there are still tons of cash sitting in money market and savings accounts, both retail and institutional investors have chosen not deploy their cash just yet (the investing discipline has totally broken down).  More ominously, this suggests that many mutual fund managers no longer have spare cash to deploy in a declining market – which further increases the vulnerability to a market correction as 2nd quarter earnings reports are released.

From a technical standpoint, the US stock market has been gradually losing momentum and “buying power” since early May.  Not only is this evident in the declining breadth and upside volume on both the NYSE and NASDAQ Composite (not shown, but which we have discussed over the last four weeks), this is also evident in the declining strength of the NYSE Common Stocks Only McClellan Oscillator and Summation Index, (as shown in the following chart courtesy of Decisionpoint.com):

NYSE Common Stocks Only McClellan Oscillator

Specifically, the lower highs in the NYSE CSO McClellan Oscillator and the declining NYSE CSO Summation Index suggest that the current rally is losing strength.  Until we get some kind of spike down in the NYSE CSO McClellan Oscillator (which would signal an oversold situation), subscribers should hold off on purchasing new positions in their portfolios.

Staying on our theme of the general lack of central bank liquidity creation (a topic which we've discussed over the last couple of weeks), the latest (June 2009) Japanese monetary base data has been released.  The following monthly chart shows the year-over-year growth and the rate of change in the year-over-year growth (second derivative) in the Japanese monetary base vs. the year-over-year change in the Nikkei from January 1991 to June 2009:

Year-Over-Year Growth In Japan Monetary Base vs. Nikkei (Monthly) (January 1991 to June 2009) - The y-o-y growth in the monetary base declined from 8.2% at the end of April to just 6.4% by the end of June. On an absolute basis, the Japanese monetary base has now declined two months in a row - suggesting that liquidity conditions in Japan are no longer elevated, and confirming that the world's central banks are no longer being as accommodative as they have been over the last few months.

As mentioned in the above chart – after making a short-term peak of 8.2% at the end of April, the year-over-year growth in the Japanese monetary base has since declined to 6.4%.  More ominously, the absolute value of the Japanese monetary base has declined two months in a row – signaling that the Bank of Japan is no longer adding liquidity to the financial markets.  Combined with a slowdown in the Federal Reserve's asset purchases and the fact that the Bank of England is now bumping up against its 125 billion pound purchase limit (the size of its debt monetization should be above 100 billion pounds by the end of this week), there is no doubt that the actions of global central banks now represent a headwind to equity prices.  I continue to expect a stock market correction over the next few weeks as 2nd quarter earnings reports are released.

Signing off,

Henry To, CFA

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