Saturday, January 05, 2008

Stock Market Update 05 January 2008

Greetings and welcome to the first ECAM stockmarket update for 2008.

Firstly, be forewarned this update is somewhat more lengthy than usual. The reason for this is because I want to first review 2007 before going onto the current conditions. Afterwards I will give my "crystal ball" outlook for 2008.

First the year 2007. For the year the Emirates Provident Fund A & B equity funds returned the following:

-Blackrock/MLIM Equity fund: +5.9%

-Fidelity International Equity fund: +13.2%

-Russell 90 fund: +10.4%

By comparison, the Dow Jones World Index (that I use in this blog as my proxy fund) returned 8.1% over the year. If you had invested 1/3 of your equities in each of the 3 funds, you would have returned an average of 9.8%; not bad considering the volatility that occurred in the second half of the year.

This highlights the importance of not picking any one equity fund within the provident fund as year to year their results will sometimes vary considerably. I feel it is much better to divide your equity position equally amongst the 3 offered.

The first chart is the DJW year to date chart ending 31 Dec 2007 (click on all charts to enlarge):

The key thing to note is, of the 4 currencies I monitor regularly, a positive DJW rate of return was only achieved in the USD and the British pound. Due to the relative strength of both the Euro and the Aussie dollar over the year, the end result was a loss on the DJW when priced in those currencies.

Throughout the year it can be seen the market experienced 2 significant corrections (one in March which is unusual, and one in August). This could be described as somewhat of a "typical" year given the continued strength from the beginning of the year into the summer, followed by a mid-summer correction, followed by a strengthening period into the year end.

See the next chart which is a 25 year averaged chart of the MSCI index which shows the tendency for strength into the summer followed by a correction followed by a further rise. Also if you take the average rise over the past 25 years (100 to 109) you'll see that on average over the past 25 years the index has returned 9%. As such, our year this year was very much an "average" year; not great but also not bad.

Along with the historical seasonality, I also find it useful to monitor the 4 year presidential cycle. For those who have never heard of it, the theory is that the year before an election the political machinery begins to inflate the economy in the hope that by the time the actual election occurs in November of the following year the economy is doing great, unemployment is low, and the stock market is booming. The hope is that in doing so the incumbent party (currently the Republicans) would be re-elected.

Here is the long term historical chart of the Dow Jones average going back over 100 years:

Once again it can be seen the markets generally do well in the early part of the year, swoon in the summer period, but then move higher into year end. Also note in a pre-election year the Dow Jones Industrial Average has returned an average of approx 9% over the past 100 years(this year it returned 6.4% so was somewhat below average).

In summary, the markets in 2007 did pretty much what they should do on a historical basis. The big question is where are we currently at and where might we be going in 2008.

First chart is the DJW as of yesterday's close:

It has been a tough opening week for the markets in 2008:

Nasdaq Composite Index: -6.35%
S&P 500 Index: -4.52%
Dow Jones Industrial Average Index: -4.23%
New York Composite Index: -3.79%
Dow Jones World Index: -3.19%

Note that the DJW index, while down significantly on the week, did better than the rest of the U.S. indexes. This indicates that, while things might be rapidly falling off the rails in the U.S., the rest of the world seems to be holding up slightly better (for now?). Also note it is still well above it's August/2007 swing low whereas the U.S. indexes are close to violating (or already have violated) their August swing lows. This is another reasonably bullish sign things might be ok in the DJW index.

Next chart is the DJW daily line chart:

On a short term basis the market is still in a corrective declining channel. The ADX (14) sell signal issued in early Nov continues. Price remains below the 50 day moving average. Price closed .04cents above the last swing low that occurred in mid-November (but as of today still has not violated it). This is not encouraging short term.

Next chart is the DJW PNF 1-box:

This chart confirms the bearish price action in the short term. A double bottom breakdown occurred on Friday and this chart now indicates a bearish projection to a 283 price objective. Another short term negative indicator.

The only positive to take from this chart is it still held above 292 (it's closing price of 292.21 just avoided printing a new "O" at "line in the sand" I spoke about in my previous post.

Next chart is the DJW PNF traditional:

This chart remains bullish as of today and still projects a target of 430. HOWEVER it is also within .21 cents of printing another "O" at 292 and doing so would change the chart to bearish. It is virtually poised on the edge of a cliff and could either way from here.

Next chart is the 6 year DJW line chart:

Once again, from a medium-long term point of it is bullish as of today. Note that while the 13 ma has not yet crossed the 34 ma, it is awful close to getting there (13 ma @ 301.70, 34 ma @ 299.23). A cross would be the first time this would have happened since the bull market began in 2003.........should this occur it will be very bad news. However, one again to stress the positive as of today it has not happened. It has been close before, maybe this time is the same? Only the next couple of weeks will tell for sure.

Last current chart is the DJW monthly chart:

Once again, the key here is ON A MONTHLY CLOSING BASIS this chart has not violated the 12 month moving average since the bull market began in 2003. It has tried 6 times inter-month since 2003 (as seen by the "pins" that poke below the 12 ma) but has yet to close there. It is currently sitting below but until January ends to confirm it could just as easily move back above by the end of the month. I continue to monitor this one closely.

Bottom Line:

As of the close of trading on 04 January, within the Emirates Provident fund A and B accounts I still remained positioned 50% equities, 25% Euro cash, 25% USD cash. Nothing that occurred this week in the markets has changed my positioning.

HOWEVER, as I mentioned above, the charts are literally sitting on the edge of a cliff. Any significant down day next week (DJW close below 292) and I will be forced to lighten up my positions into a 25% equity/75% cash posture. Should a 13/34 cross occur by the end of next week I'll be 100% cash.

Alternately, should the markets turn around in the next week or two (which is very possible given their extreme oversold condition), I would look to go into a 75% equities/25% cash position on:

-price climbing above the 50 ma on the daily line chart (currently at 303.75 as of today) combined with a green buy signal on the ADX (14) (green line crossing above 60), and

-a new buy signal on the 1-box PNF chart (currently it would take a closing price of 303 or greater).

It is that simple.

2008 Forecast

Now comes the fun stuff.

Firstly, I must stress all of this is strictly conjecture/thoughtful analysis/common sense/etc and as such nothing said here should be used to make investment decisions in any way.

Having said that, here are my predictions:

1) the stock markets will go through a very turbulent 1st half of the year. The current bearish malaise overhanging the U.S. will continue (4th quarter earnings for many firms will be downgraded, housing foreclosures will increase, a least 1 major financial institution may face bankruptcy, individual and class action lawsuits will be filed as a result of poor business practises associated with the mortgage industry, government investigations into various firms who provided these toxic mortgages will occur, etc). In short, for the first half of the year "everything will be bad" from a sentiment point of view.

From an economic point of view, I expect the U.S. is already in recession but the "official" numbers won't confirm it until the summer. Note that during a "typical" recession the S&P 500 index loses 26-30% of it's value from peak to trough. Taking the peak of 1576.09 achieved in early-mid Oct 2007 as the benchmark, should a recession actually occur I see the S&P 500 index finding a bottom in the first half of 2008 in the region of 1166-1103.

2) I expect U.S. house prices to decline at least another 10% nationwide next year (and bottom in 2009). This combined with a further deterioration in the Asset Backed Commercial Paper market (ie. the credit markets) will result in significant unemployment in the U.S. This will spike the unemployment rate to 6%.

3) All this will be highly deflationary for the U.S economy initially (at least the first quarter of 2008) but then will lead to "stagflation" later on (stagnant growth with increasing inflation). I expect the Fed and the U.S. government to become very aggressive in trying to reflate the economy to avoid a significant recession or depression. The Fed will lower rates dramatically and the government will offer numerous "plums" to get the economy moving in what appears to be the "right direction" (probably tax cuts, tax incentives, debt forgiveness for many sub-prime real estate loan defaults, etc). It would not surprise me to see the government introduce some sort of "price controls" to attempt to control inflation in commodity(food) prices. All this liquidity injection will lead in time to inflation with weak to stagnant growth (stagflation)

4) The combination above will lead to a market bottom in the May-June period. From there I expect a significantly more bullish market into year-end as per the traditional election year performance over the past 100 years:

By the summer all the "bad stuff" will be out. From that point the media will shift their focus from the economy to the Olympics and in the fall to the Presidential elections. This distraction will take our minds off how bad the markets are (people will be so disillusioned by the markets at that point that they will have no interest in them). It is then the markets will begin a dramatic rebound into year end.

5) All this re-flation of the economy will become highly inflationary. I expect the USD to set new record lows (but not as bad as many believe as I think the Euro, Pound, Aussie and Canadian dollars will do worse so on a "relative" basis the USD will not be the worst performing currency next year). I expect gold to go above $1000/oz.


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