Market At a Crossroads

 |  Includes: AGG, DIA, IEF, SPY
by: Alan Brochstein, CFA

What an amazing week. To those who might have been hiking in Nepal on their summer vacation and returned to see how the markets performed over the week, they might have concluded that it was a positive week. After all, the S&P 500 and the NASDAQ both rose about 1.4%, with the Russell 2000 surging over 4%.

Unfortunately, the major indices made new post-peak lows and did nasty technical things like bouncing off of overhead declining moving averages or other resistance levels. It was clearly a week of a failed rally attempt. According to data in Barron’s, the underlying market’s move bears scrutiny. On the NYSE, declining issues clearly beat winners, while on the NASDAQ, winners narrowly beat losers.

On a combined basis, more stocks fell than rose last week (bad breadth, which stinks). Additionally, the number of new lows dwarfed the number of new highs. The number of stocks making 52-week lows (almost 2000) was alarming, especially considering that the major indices are all up year-to-date.

For those who were here, though, and not off on a distant mountain, what was most disturbing about the market during the week was the extreme volatility at the security level. The Wall Street Journal nicely attributed some of what I observed to position closing by quantitative funds. My unscientific research (looking at a few stocks I know that have huge short-interest) indicated that there indeed was a lot of unwinding going on. It is hard to draw a lot of conclusions from this activity. On the one hand, it could be a sign of capitulation that bottom-fishers like to see. I look at it differently, though, as I believe that the reining in of investment capital by liquidity providers is part of a bigger trend of risk reduction.

In my comparison of the current market conditions to what I believe was a period with many similarities (1987) last week, I pointed out that despite high consumer confidence and low unemployment presently, I am concerned about the high level of debt at the household level. For those on “contagion watch”, the number one factor to watch, in my opinion, is the availability (and price) of consumer credit. For now, we have heard only rosy perspectives, such as how well credit card delinquencies have held up relative to mortgage-related delinquencies. I find it odd that people are paying credit cards but not mortgages.

Perhaps the big jump in the last two months in revolving credit amidst weakening retail sales indicates that a last-gasp effort to cover household expenses (like increasing mortgage interest) is taking place. Interestingly, ever since the housing market peaked last year (i.e. year-over-year negative growth in new and existing home sales), revolving credit growth has accelerated rather sharply. You can see the acceleration in the top panel below. Retail sales, though, have decelerated from 6-8% to just 4%. It looks to me like credit cards are being used to buy things besides $200 blue jeans or iPods. In the bottom panel, it is clear that consumer credit is a frightening percentage of personal income. If the U.S. banks start to reign in the availability of credit to consumer borrowers, we will indeed be pushed into a recession.

click to enlarge
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So, I am watching most closely for signs of a retrenchment in consumer credit. Other things that investors should monitor are the value of the dollar. A weakening dollar isn’t in and of itself bad, but we are at an inflection point. My expectation is that a 1.40 print on the Euro could have the same impact that the 5.00 print had on the 10-year Treasury in June.

If the rest of the investing world comes to the same conclusion that I have (the Fed is not in a position to lower rates without risking a major flight out of the dollar and, hence, inflation), the potential for the credit crunch to have significant consequences for our economy increases.

Finally, for those who don’t think that the housing woes can lead to a recession, take a look at the next chart. Every instance of -20% new home sales on an annual comparison has led to a recession, though we did have a recession without that occurring. Yes, the sample size is low. Yes, spiking interest rates may be the underlying culprit in those other cases. Still, though, empty houses don’t inspire consumer confidence. Stay tuned!

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