Christmas Rally? Maybe, But a Cold Winter Ahead

Bull or bear this year, it has been all about timing. Recently, the timing has been astonishingly off the norms, as the typical sell-off in September/October never came (did it arrive early in August or late in November???). Of course, we are down significantly in the normally favorable November/December period and are even down so far this month. With so many leading stocks rolling over and others making new 52-week lows, it is starting to look more like Halloween. Where is Santa Claus when you need him?

I learned at a young age not to publicly suggest that Santa Claus may not really exist, so I won’t go there, but I will say this: Santa may show his face briefly, but all you have to do is look at the retailer stocks to know that he won’t be delivering big packages. I am not ready to suspend my immense negativity on the market just yet, but I will concede that it is really tough to call a two-week period, which is all that’s left of this year of the great bifurcation. As Dickens said, “It was the best of times; it was the worst of times”. As you can see below, there are certain sectors that killed investors this year, and others that rewarded them handsomely. Below, I will share my views on some technical and fundamental issues facing 9 of the 10 economic sectors for which there are SPDRs. The one I omit is the Telecommunications Services, which represents just 9 names (and about 3.6% of the market cap). First, though, here is the performance across market capitalizations by economic sector, data courtesy of Standard & Poors (click all charts to enlarge):

Clearly, there were the places to be and to not be. Across all market capitalizations, Energy, Materials and Industrials have exceeded index returns YTD in excess of 5%. Consumer Discretionary and Financials, on the other hand, have lagged the overall returns of the indices in excess of 5%. Ironically, those have been the only weak areas at all except for the Small-Cap Telecommunication Services, which is a miniscule 0.1% of the S&P 600. Additional strong sectors for the S&P 500, again defined as at least 5% outperformance, included every other sector except Health Care (which is modestly positive). Staples are strong across capitalizations, while Health Care is stronger in the smaller capitalizations relative to in Large-Cap. IT has been strong, while Large-Cap Utilities have been as well.

For those trying to figure out why Small-Cap has done worse than Large-Cap and Mid-Cap has done the best, the answers are rather obvious. Looking at Mid-Cap, notice that the returns for the S&P 400 are higher than the S&P 500 in every sector except Utilities and Technology. Earlier in the year, the strong performance was attributed to the M&A bid, which has certainly been lacking in Utilities. In Technology, the sector has been boosted by the very strong performance of a select group of Large-Cap names like AAPL and GOOG. Now, comparing Small-Cap to Large-Cap, the returns have been lower in every sector except for Health Care. It doesn’t hurt that the S&P 500 also has a significantly larger weighting in the big winner, Energy or a much smaller weighting in #2 loser Consumer Discretionary. I believe that there may be some other considerations regarding relative performance. Small-Cap has less exposure to international business than Mid-Cap or Large-Cap. Additionally, lower interest rates have perhaps attracted some attention to the higher dividends that larger companies generally pay. Finally, Small-Cap valuations were relatively high to Large-Cap valuations. For those who are curious, the current 2008 PE ratios are 14.1 for the S&P 500, 15.4 for the S&P 400 and 14.9 for the S&P 600 on a cap-weighted basis. Below are a few broad charts, each of which looks to be topping to me. I would like to highlight that they look to be making “head and shoulders” types of formations that suggest significant downside should we move slightly lower.

All of the rest of the charts will have a comparison in the bottom panel to SPY, the SPDR for the S&P 500. In this case, I have included Core CPI. Like all things in life, everything in moderation. Back in 2003, when core inflation was weakening, there was great concern regarding the potential for deflation. In the last few years, core inflation has progressed to the point where any acceleration is likely to be viewed negatively. I would argue that the recent environment of a modest reinflation over the past few years created the best of all worlds: Sales (and earnings) growth and a reasonably low level of interest rates. Were it not for the credit crisis, one has to wonder what rates would be doing now (instead of sitting at multiyear lows). The chart above shows a typical bull market that lasted 5 years after severely oversold conditions following the bear market of 2001 and 2002. Note that the recent high in October marginally eclipsed the July high and that the market pulled back to about 1420 both times. While the potential right shoulder didn’t make it quite to the July high (yet?), notice that the 50dma is rolling over and is close to slicing through the flattening 200dma. Pay attention to this one!

The Russell 2000 ETF failed to confirm the high made by the S&P 500 in October. It too has pulled back twice to about 74 and is perilously close to breaking through that level. Note that the Small-Caps peaked in early 2006 relative to the S&P 500 but have been in a pretty tight range since the end of 2003.

The QQQQs made the most extreme new high and have had terrific relative strength since the market’s first top in July. With that said, the chart is looking somewhat toppy at this point, with some underpeformance over the past 45 days relative to the market as well.

Sector Reviews

Energy is the strongest of all sectors though not particularly extended. It is hard to deny that this one has portended the pick up in core inflation over the past few years. Valuation isn’t particularly high for the group as the market seems to believe that the current pricing structure is unsustainably high. I am not sure that this bull market doesn’t have more legs despite having beaten the market by 100% since late 2003. Anyone remember how big the sector got back in the 80s?

Another beneficiary of inflation apparently, this bull market looks potentially to be early. Similar to energy, it appears to have legs.

While industrials have been slightly better than the market over the past 5 years, they show a similar pattern to the overall S&P 500 in terms of testing critical support.

After trading in a very tight range relative to the market in the 4 prior years, this sector has been going straight and steadily down. While it is oversold and could bounce, especially on a relative basis, I would be shocked if it didn’t test 31 shortly and 29 in early 2008. We have a lot of payback for years of easy credit and a spend-now mentality that has permeated our society.

Not surprisingly during the economic expansion, Staples have lagged the market. Notice, though, how it really changed as the market began to top mid-year. While it appears to be slightly ahead of itself in absolute terms, I would expect this sector to outperform the market in the first part of 2008.

While prices have increased for the past 5 years, the sector has underperformed the market too, perhaps for similar reasons as the Staples and perhaps because of the problems for Big Pharma. The chart looks better than for most sectors and the valuation is certainly low compared to Staples. Everyone is afraid of the presidential election, but I think that those fears are mostly already reflected in the prices. Count me in on this sector!

28 is key, key support, but I expect that it will break. Like Consumer Discretionary, this sector muddled along with the market until just this summer. Unlike Consumer Discretionary, the pain actually just started! It hasn’t even been that great yet – it has caught up to Health Care only. As I wrote in early August and then in late August, STAY AWAY FROM FINANCIALS! We could drop a great deal. P/B levels are still too high, especially in light of the questionable book values. I would be surprised if we didn’t test 21 before this is over, implying that we are just halfway there. There have been just too many doubters. Yes, the sector is very oversold and overshorted, but there is more to go in my opinion.

Large-Cap Technology has been remarkably market-like during this bull market. The move over the past year and a half has moved the performance back to its late 2003 peak. I personally find the sector to be so much less compelling than prior to the bubble. The barriers to entry are too low and the competition too great in so many of the industries that comprise the sector. I think that they call it “profitless prosperity”. Like Industrials, this one looks likely to roll over, but I am not expecting much relative to the market.

This is just sad! How can it be that this sector has been the second best of all the sectors during the bull market? It helps that investors have reached for yield. In fact, this ETF has seen its dividend yield decline from 5.60% in 2003 to 2.58% today. As other high-yield equities have had large capital losses lately (REITs in particular), the group has benefited from a flight to safety. The unrest in the muni markets and other fixed-income markets has contributed as well. CAUTION: If you agree with me that the current plunge in long-bond yields is a head-fake, this sector could get hammered. Technically, it is somewhat extended. I expect it to pull back 10% in the coming weeks. With that said, though, it is hard to imagine that Utilities won’t outperform the market if we are in a bear market.

In conclusion, as I have been discussing since late June, I remain quite bearish. I expect some of the leading stocks to get pounded beginning January 2^nd due to deferred tax selling, similar to what happened in early 2005. Recall that 2004 had very narrow leadership as well – check out the price action on SBUX or ADSK early the next year. 2008 will be a year of declining profit margins and potentially higher interest rates (unless we have the great depression!), both of which are big negatives for stocks. Remember, no matter what the Fed does or says, bull markets don’t last forever. We are about 9-10 months away from what will probably prove to be a low for the market in front of the elections. Be careful out there!

Disclosure: I am short through a derivative of the QQQQs

Comments

[NutritionFacts:]

I think your position of "immense negativity on the market" is unwarranted. But, that's what makes a market, and I am comfortable (indeed perchance comforted?) that yours is the majority view right now.

2007 Dec 16 11:50 AM