(originally published on January 19, 2008)
Stocks had another awful week, dropping between 4-5% for the week. The broad-based S&P 500 slumped 5.4% this week, its biggest weekly decline in five years. Last week, we had compared the stock markets to a chronic alcoholic who has had frequent unsuccessful visits to Alcoholic Anonymous; as time goes by, his addiction gets stronger and it becomes increasingly difficult to wean him away. Even the announcement of a major fiscal stimulus package this week failed to evoke any significant response from the bulls.
S&P 500 - Daily Chart
The front-line indexes are now trading well below their summer lows and are a long way off their recent highs. The S&P 500 is down 15.9% from its October highs; the Nasdaq Composite on the other hand is on the verge of entering a full-blown bear market, having declined over 18% from recent highs. As shown in the table below, a decline of this magnitude has heralded greater downside in previous bear markets.
Only 11% of the S&P 500 stocks are now above their 50 day moving averages. In hindsight, the rally off the summer lows was rather feeble and lacked the conviction typical of a bull market. To further prove our point, take a look at the chart below from Bespoke Investment Group that compares the daily breadth in the S&P 500 stocks with its daily % change. Since 2003, there have been only six days where the S&P 500 advanced more than 1% with a breadth of under 250, i.e. only half of the 500 stocks rose on these days. Four of these six days have come since August 2007.
Scatter plot of daily breadth of the S&P 500 versus daily percentage change (2003-2008)
In the face of a relentless decline since the beginning of the year, volatility is now beginning to pick up. Nine out of the 13 trading days this year have seen a daily closing change in S&P 500 in excess of 1%. The 50-day average trading range for the S&P 500 is at 1.68% - its highest since early 2003. The VIX, a measure of expected 30-day volatility, shot up this week after a prolonged lull, suggesting that fear is setting in the minds of market participants, albeit much later than the 2007 summer panic meltdown. Bear markets are typified by slow grinding downtrends, as traders get accustomed to the idea of daily declines.
Comparison of S&P 500 and VIX : Volatility gradually creeping up
On the other hand, the unrelenting market-wide selling pressure is now pushing stocks into oversold territory. Out of 71 technology stocks in the S&P 500, all but two have seen YTD declines. Only four of these stocks are above their 50 day moving averages. The Put-Call ratio, one of our favorite contrarian indicators, spiked up this week, surpassing its 3-sigma 99.73% confidence level for the first time since August of last year. With several stocks now deeply oversold, we would advocate booking some profits at these levels. A pullback to possibly 1360-1370 levels on the S&P 500 would provide an attractive entry point for fresh short positions.
Comparison of S&P 500 and Put Call Ratio: PCR crossed its 3-sigma level this week
The last two weeks have been anything but dry. But the Baltic Dry Freight index ended down almost 25% in just a week. The index, a widely recognized leading indicator of global economic activity, is now down 37% from its mid-November peak. This is a significant development that could possibly rebuff the entire global decoupling hypothesis. The economic releases this week were mostly negative. The Conference Board's index of leading economic indicators dropped 0.2% in December, its third consecutive drop. Consumer prices rose 0.3% in December, receding from the scorching 0.8% gain in November. For whole of 2007, headline inflation has risen 4.1%, the most since 1990. Housing starts declined 14% in December to an annual rate of 1.006 million, the lowest since 1991. Starts registered a 25% decline in 2007, the biggest since 1980.
The market continues to reel under the weight of massive write-downs. Merrill announced a $16.7 billion write-down in its 4Q results, while Citigroup did even better with a $18.1 billion write-down along with a cut in its dividend. This is most certainly the worst quarter ever for investment banks.
Tally of write-downs by investment banks (as of January 19, 2008)
While the economy continues to spiral towards a recession, the concerted central bank efforts to thaw the credit market freeze seem to have worked. The TED spread - the spread between three-month LIBOR and Treasuries of the same duration - is at its lowest since August 13. The 3-month LIBOR rate is now below the Fed funds rate for the first time since June 2003.
Spread between three-month treasuries and three-month LIBOR
The sixth century Chinese poet Lao Tzu penned that those who have knowledge do not predict, while those who predict do not have knowledge. After a vicious decline, a near-term oversold rally looks on the cards. But we have to side with Lao here; in view of significant bearish headwinds mentioned above, we would defer a bullish prediction for now.
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