Is the Dow due for a reversal?

published 26 October 2006

The American stock market was not going to be satisfied until the blue chip Dow Jones Industrial Average had made a new all-time high above 12000. This has now happened, so now what?

That a reversal is overdue was illustrated by John Hussman in his recent letter Temporary versus Permanent Returns" which can be read in its entirety by visiting the website www.hussmanfunds.com. He makes the point that it is over 900 trading days since there has been a 10% correction in the American stock market, one of the five longest uncorrected advances on record.

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Not surprisingly, given recent stock market strength, this indicator, often called the fear index' registers an absence of fear. Investors are unfazed by the risks to the economy, choosing to believe, for the time being at least, that the US house market will enjoy a soft landing and corporate earnings (at record levels based on record margins) can continue to grow at double digit rates. Of the Four Horsemen, this is the one that can most quickly register change it would take just a couple of days' fear to frighten his horse in the most alarming way.

Since two weeks ago, the Philadelphia House Market Index shows no meaningful change. It is pretty obvious that the sharp rise in property values for the past five or six years enabled Mortgage Equity Withdrawal. Now, with the house market in serious difficulty, the willingness to treat the house like a cash card is slowing markedly; worse still, consumers may even start saving and paying down debt.

During this last two weeks, Alan Greenspan has poked his head above the parapet attempting to pour oil on troubled waters, saying "The house market appears to be emerging from its recent travails and the worst may be over I suspect that we are coming to the end of this downtrend as applications for new mortgages have flattened out." Additionally, the National Association of Home Builders Index of Home Builders' Sentiment came in for October at thirty-one, fractionally above the record low set in September of thirty. The latest figure for new home starts was better, up 5.9, on the surface a good sign, except that it was accompanied and spoilt by the other news that building permits were down 6.3%, the lowest level since 2001 permits are real; starts are volatile.

Those looking for direct evidence that historically, the health of the house market has had major consequences for the stock market, need only to look at the chart we publish showing the S&P composite lagged 12-months compared to the NAHB House Index. This chart shows an extraordinary 0.79 correlation! If that level of correlation were to continue, then there is only one way for the American stock market to go down big time! Where the American stock market goes, we would expect the majority of the world to follow.

We are now in the fifth month of Dow Theory non-confirmation. The new highs set by the Industrials have still not been confirmed by the Transports. As we said earlier, on the day when 12000 was hit by the Industrials, the Transports were as much down as the Industrials were up. This ongoing non-confirmation is an indication of potential trouble unless before too long the Transports confirm the new highs of the Industrials.

Inverted yield curves are alive and well in the US and the UK. There are those who say that this time round, for all kinds of reasons, its different and the inverted yield curve is not an indicator of economic problems ahead. Nonetheless when 50-year UK gilt yields are 3.9% and London three-month money is 5.03%, something isn't right. To that can be added the fact that in the US 30-year yield is 4.90% whilst their three-month money is 5.31%.

Every week John Mauldin at www.investorsinsight.com publishes an essay by a different third party which he calls John Mauldin's Outside-the-Box e-letter'. On 9th October the essay was by Van R Hoisington and Lacy H Hunt, PhD., of Hoisington Investment Management Company. They produced an important insight into the Conference Board Leading Index comprising ten different leading indicators. What's interesting is that only on seven occasions has the Index declined on a six-monthly basis when, at the same time, there has been an inverted yield curve. Of those seven occasions, 100% of them have been followed by recession with an average lead in time of nine months. If there is to be a recession in the US next year, and we are pretty convinced there will be, then the stock market will have declined before the recession. The stock market declining is part of what causes a recession, not the other way round.

We continue to watch certain of the Asian markets, believing them to be the long-term stock market investment opportunity. Except, of course, we fear any reversal in western markets might be contagious. Nonetheless, of particular interest over recent weeks has been the development of Smaller Cap Japanese stocks. Those are the companies who predominantly serve the Japanese economy. Japanese smaller cap stocks suffered a considerable decline of about one third since January but now look set to move ahead again. If the Dow sustains itself above 12000 and a buy signal is confirmed for the Japanese smaller companies, we may well look to take initial modest positions protected by a tight stop loss.

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