Market Caught in the Crosscurrents Comstock Partners, Inc. Thursday, May 25, 2006
From both a fundamental and technical view the stock market appears to be in transition from bull to bear as it rapidly approaches a no-win situation. Fundamentally the market is being pulled by the fear of inflation on the one hand and the fear of recession on the other. We are seeing soaring prices in energy, industrial commodities and gold at a time when the dollar is weakening and the core PCE deflator is pushing against the upper limits of the Fed’s tolerance. Anecdotally, a number of companies have announced that they are passing through these price increases and many others have indicated that they are close to doing so.
At the same time some leading sectors of the economy are softening, and it may already be too late to stave off a recession. By far the most important of these sectors is housing, both because of its historical record of leading the economy and the hundreds of billions of dollars in mortgage equity withdrawals that have powered consumer spending. Existing home sales fell 2% in April and are down 5.7% from as year ago. Monthly supply of homes for sale is the highest since January 1998. Although new home sales were up in April, they are down 11% since October, and the 5.8 months of supply is near a ten-year high. The NAHB index, a measure of builder optimism, is at its lowest level since June 1995. Today Ryland said its second quarter sales were running 35% below last year and sharply cut its earnings estimate for the quarter and full year. This week Toll Bros. also slashed their sales and earnings estimates. Other leading home builders have issued similar announcements over the past two months. Housing is likely to weaken even further due to eroding affordability, rising ARM rates, the crackdown on creative financing and the increasing caution of investment buyers.
The eroding housing market is likely to have a serious impact on consumers who have been heavily dependent on soaring home prices to finance their spending. According to the University of Michigan Survey, the index of consumer real income expectations has plunged from 90 in early 2004 to 69 in the latest reading. Although the bulls would have you believe that consumers just don’t know how well the economy is doing, we note that on an annualized basis, real DPI less interest payments were up only 0.9% in the first four months of the year. Weekly new claims for unemployment insurance are rising once again while payroll employment growth is sluggish.
In response to these conflicting potential forces of inflation and recession the market appears to be in the process of shifting to a major downtrend. The narrow six-month uptrend in the S&P 500 was broken last week. The more significant mild uptrend in force since the end of 2004 is still alive with support at 1220. The number of daily new highs on the NYSE peaked in January 2004 and has been dropping ever since. The percentage of stocks above their 200-day average has dropped to 49%, indicating that half of the stocks are already in their own bear markets. In our view the risk in the market remains at high levels.
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