The stock market has started 2005 off with a whimper. Like I had mentioned in my 2005 Stock Market Forecast I get real leery when the Wall Street crowd begins to tout the same mantra. In late 2004, you heard about the infamous January Effect. Shortly after that, you began to hear that the years ending in 5 in a decade have historically been exceptional years for the stock market. So far, the January Effect has been a bust, and the start of the 2005 stock market has been a huge disappointment.
Soon, you will begin to hear another mantra from the experts. This mantra will be As January Goes, So Goes the Year. If the previous prognostications are any indicator, the stock market will bottom out in February, consolidate, and begin to rally in the second quarter. My best guess is the market will peak in the 3rd quarter, and the upcoming rally will be led by the defensive stocks as portfolio managers prepare for a slowdown in the economic and business cycles.
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Our Big Picture Market Gauge indicators are signaling that the economy and the stock market have some serious headwinds to overcome in order to be able to sustain an advance, and become a new bull market. Here are some of those headwinds.
Big Picture Market Gauge
1) Short Term Sentiment Indicators- NEGATIVE:
Our short term market indicators measure the bullish or bearish mood of investors. These are contrary indicators that guage the bullish/bearish expectations of investors. For example, when investors are bullish, the reading on the VIX index is abnormally low which is a warning that the market is poised for a selloff. A VIX reading of around 35 usually signals a bottom in the stock market, while a number below 20 signals a top. The current reading of the VIX index is 12.57. We may not have a deep enough correction to drive the VIX index to 35, but the current numbers are registering extreme optimism in the market place.
I also follow insider buying and selling very closely, and the picture there is not rosy either.
a) VXO- S&P 100 Volatility Index- NEGATIVE
b) VIX- S&P 500 Volatility Index- NEGATIVE
c) VXN- NASDAQ Volatility Index- NEGATIVE
d) Insider Buying/Selling- NEGATIVE
2) Corporate Earnings- DECLINING but not Negative.
The consensus earnings estimates for the S&P 500 have been revised downward for 2005. This is not a major issue right now because corporate earnings coming out of a recession are usually robust. What we have to be on the alert for is the trend going beyond 2005, and what impact oil prices, interest rates, and a potential slowdown in China will have in late 2005 and 2006.
a) Bellweather Earnings:
1) GM- NEGATIVE
2) GE- POSITIVE
3) HD- NEUTRAL
4) INTC- NEUTRAL
3) Market Cycles- NEUTRAL but declining
a) Interest Rates- NEUTRAL but rising
b) Stock Market- NEUTRAL
c) Business Cycle- POSITIVE
The key here is the trend in interest rates. Once the Fed begins raising interest rates they often over tighten and trigger a recession or bear market. The stock market knows this, and this is one reason the market has had a rough start in 2005. The major unknown is when, and at what point will the Fed stop raising rates. Once the Fed begins raising rates, it will do so 3, 6, or even 12 times. Since the Fed has adopted the mysterious gradual approach the uncertainty of when they will stop often adds to agony in the market.
As you can see, the trend in the stock market follows interest rates, which eventually filters down to the business cycle.
4) Fiscal/ Monetary Policy
a) Fiscal Policy- POSITIVE
Tax rates are low, but lower taxes are being offset by higher oil prices and higher commodity prices.
b) Monetary Policy- NEGATIVE
Interest rates are still low, but are approaching the target rate of 3% which we predicted a year ago. Based on the history of the Fed, my prediction is a Fed Funds Rate of 4-4.5% over the next 18 months.
5) Other Influences on the Economy
a) Oil Prices- NEGATIVE, but could drop sharply.
If the Chinese economy begins to soften, or comes in for a hard landing, oil prices will decline to around $35 a barrel, and commodity prices will decline. This would be great for our economy, but US companies doing business in China will temporarily see their business soften.
A steep decline in oil prices and oil stocks will present us with a major buying opportunity.
b) GDP (Gross Domestic Product)
1) Consumption- POSITIVE but declining
The consumption makes up 70% of GDP. Higher oil prices and interest rates will eventually have an impact.
2) Business Investment- POSITIVE/ but UNKNOWN going forward.
Higher interest rates impact corporate spending as does the stock market. 10% of GDP
3) Government Spending- POSITIVE but looking to cut.
15-20% of GDP is government spending.
4) Net Exports & the Dollar- NEGATIVE
The trade deficit is a major reason for the decline in the dollar. The Fed is raising interest rates to support the dollar.
c) Inflation- NEGATIVE
The government likes to use terms like excluding food and energy. I guess they are assuming we dont eat or drive a vehicle. How you can exclude the most important components in a consumers budget is mind boggling.
The bottom line here is that commodity prices, raw materials, and oil prices have gone through the roof.
1) Supply-Demand Inflation- NEGATIVE
All you have to do here is look at the skyrocketing prices of real estate and the demand that China has for just about every raw material on earth. Housing prices have increased in some areas of the county by 50% in 5 years. Beach front condos in Florida have risen 100% or more in just over 3 years. The Fed can control this type of inflation. A good dose of higher interest rates will make buyers in this NASDAQ II look a like very unhappy in the next few years.
2) Cost-Push Inflation- NEGATIVE
Higher oil and commodity prices are not something the Fed can control. These problems are difficult to cure, and potentially painful.
What to do Now:
We are going to reiterate our strategy of underweighting positions that may be severely impacted by a downturn in the economy. Specifically, I will be underweighting Consumer Discretionary (Retail, Homebuilding, Home Improvement, Leisure, Appliances, Hotels & Restaurants, and Auto manufacturers), Financials (Banks, Brokers), Technology (with the exception of select software companies), Utilities, and Industrials (except for Aerospace & Defense, and Railroads).
We will overweight the Telecommunications Sector (Integrated Telecom Services), Healthcare (Pharmaceuticals, Managed Health Care, Health Care Facilities, Equipment, and Biotech), Consumer Staples (Soft Drinks, Food Chains, Packaged Food).
Lastly, I want you to accumulate the integrated oil companies on weakness. We will also want to increase weighting on the Materials Sector if Chinas economic correction is more severe than many anticipate. I believe China is approaching an industrial boom similar to what we saw in the United States around the early 1900s. Chinas appetite for raw materials is going to be enormous, and supply and demand in raw materials remains way out of balance.
