Sample Content : Weekly & Biweekly Research Reports

BEARS TAKE CHARGE  

History shows that increased optimism in the face of a declining market is often an indication of further selling pressure ahead.  This rise in optimism is seen in the latest American Association of Individual Investors sentiment survey that shows the percent of bullish traders at 44.2%, its highest levels in more than 4 months.  In addition, capital inflows in the Rydex OTC and S&P 500 bull and bear funds show that many investors are in no hurry to sell assets in the bull funds or at least to hedge the decline in stock prices (See Charts #1 and #2).

Our measures of supply and demand also paint a negative picture in the near term.  For instance:

• The S&P 500 posted 93.4% and 92.0% points lost as of total points on July 20^th and 24^th, respectively.  This negative reading was then followed by a 90% downside day on July 26^th.  A 90% downside day occurs when points lost and down volume reach 90%+ of total points and total volume.  (See Chart #3)

• Our short and long term sell pressure indicators made a decisive move above buy pressure.  Past historical readings often suggest an increase in the pace of profit taking.

• Our breadth readings in the S&P 500 such as cumulative points, advance/decline issues and up/down volume reached new-multi month lows in the recent bout of selling.

While the short term outlook for stocks does not provide an encouraging picture there are important trends emerging in the broad market.  The recent surge in speculative credit spreads was accompanied by a similar surge in the relative strength ratio of large-cap growth stocks to the overall market (See Chart of the Week).  This emerging trend is of particular importance to money managers and to those investors with a long-tem investing horizon.  We would advise investors to underweight small-capitalization stocks and to use the next oversold market juncture as an opportunity to deploy funds to the large-capitalization growth segment.

MARKET INTERNALS & TRADER SENTIMENT

Chart #1: The chart above plots the percentage of assets in the Rydex OTC fund (bull fund) as a percentage of the total assets in the Rydex OTC and the Rydex Inverse OTC (bear fund) funds as shown by the red line.  The black line plots the daily price structure of the Nasdaq 100 index.  A rising red line indicates that investors are optimistic about the Nasdaq 100 and vice-versa for a declining line.  In our last report we alerted investors that the quiet increase in optimism could trigger a wave of selling in the near term.  Instead of turning negative on the market investors actually became more bullish.  Thus, the recent bout of weakness in stocks is likely to persist in the near term.

• The Dow Jones Equity REIT index closed at its worst levels in more than 1-year.  REITs continue to paint a gloomy picture in our overall rankings.  Investors and money managers should remain underweight in this market group.

• Utility stocks declined on a renewed wave of profit taking as the Dow Jones Utilities index closed at its lowest levels since February.  The water utilities group is the only exception in this market sector as it rose in our rankings in the past few weeks. 

• Water utility stocks remain resilient in the face of a declining market.  Issues displaying relative technical strength are MSEX, AWR and CTWS.

• The basic materials sector displayed the highest selling pressure reading in our performance rankings.  Industry groups under strong profit taking are industrial metals, integrated oil & refiners and specialty chemicals.  The odds continue to favor further downside pressure in these groups in the near term.

• The plunge in the crack spread (margin or spread that refiners can earn by turning a barrel of crude oil into derivative products) continues to affect refinery stocks.  Thus, the odds continue to favor further selling pressure in refiners such as VLO, TSO and RDS.B

• Liquidation in insurance stocks continues to accelerate as the Dow Jones US Insurance index closed at its lowest levels in more than 9 months.  Stocks under strong liquidation are MMC, AIZ, UNM, FPIC, and AIG.

• The trucking group registered a strong selling pressure reading in our rankings.  Investors and money managers should remain underweight in this group.  Stocks under strong liquidation are CNW, YRCW, HTLD and KNX.

Chart #6: The chart above plots the relative strength ratio between the consumer staples and the consumer discretionary sectors.  A rising line indicates that the consumer staples sector is outperforming the discretionary sector and vice-versa for a declining line.  Periods of outperformance by consumer staples over discretionary often indicate a defensive market which is characterized by limited price gains in the broad indices and a strong rise in market selectivity.  Note that the relative strength line broke above a 9-month consolidation base as shown by the green horizontal line and yellow circle.  The weight of the evidence suggests a difficult investing environment in the weeks ahead.

WORLD MARKET RECAP

Equity markets across the globe experienced a strong wave of selling.  Latin American bourses suffered the sharpest declines as the Brazilian Bovespa finished the week lower by 7.87% and followed by the Argentinean Merval down 5.6%.  European bourses also suffered sharp declines as the London Financial Times index declined 5.62% for the week, and followed by the German DAX Composite down 5.44%, and the French CAC 40 index down 5.05%.  One should note that equity averages such as the London FTSE, the German DAX and the French CAC 40 broke to the downside from low price volatility conditions.  The initial leg of selling pressure generated new price momentum lows which increases the odds of further selling pressure ahead. 

Losses in the Asia/Pacific Rim were also widespread.  The South Korean Kospi index led the decline in the region by finishing the week lower 4.79%, and followed by the Taiwanese Weighted index down 4.42%.  The long-term technical structure in most foreign bourses remains bullish, but the recent downside pressure is emerging from deep overbought conditions.  Thus, the potential for further profit taking in the weeks ahead remains high.

FIXED INCOME RECAP

The widening spreads between speculative bonds and Treasuries combined with a sell off in stocks led investors to seek the safety of government bonds.  The flight for safety, however, was not only confined to the US market.  European bonds gained for a third straight week as the yield on the German 10-yr. bund reached its lowest levels since May.  The Japanese 10-yr. bond also rallied to reach its highest levels in more than 8 weeks.

The readjustment in the cost of capital is not only confined to US markets.  The iTraxx Europe Series 7 index which tracks the prices of credit default swaps in European corporate bonds closed at its highest levels in more than 2 years.  The iTraxx Japan Series 7 which tracks the prices of credit default swaps in Japanese corporate bonds also posted strong gains for the week. 

It is also interesting to note the sharp readjustment in the implied probabilities regarding a Federal Reserve rate cut as measured by options on federal funds futures.  Traders reacted strongly to the latest existing home sales and Beige Book data.  The implied probability of an unchanged stance in rates for the October Fed meeting tumbled from an 85% chance to 65%.  On the other hand, the implied probability for a rate cut of as much as 0.5% (from the prevailing 5.25% to 4.75%) rose from the low teens to as high as 20% for the October meeting.  This is the sharpest readjustment in implied probabilities in the past 13 months.  In summary, investors are beginning to discount an increased possibility of slowing economic growth later in the year or in the earlier part of 2008.   

CURRENCIES

The carry trade currencies such as the Canadian Dollar, the New Zealand Dollar, and the Australian Dollar suffered sharp losses for the week.  These currencies have become popular targets of carry traders because of their high interest rate differential when played in conjunction with the Japanese Yen.  In simple words, traders are selling the Japanese Yen and are buying the Canadian, New Zealand and Australian Dollar.

In the past 5 trading sessions the Japanese Yen advanced 6.5% against the New Zealand Dollar, 5.64% against the Australian Dollar and 3.92% against the Canadian Dollar.  The sharp decline of these currencies against the Yen is short-term oversold which increases the odds of a short term bounce.  On an intermediate term basis (several weeks to a few months), however, the technical structure is negative and the likelihood of further unloading of the carry-trade is high.  In summary, the risk appetite of investors decreased sharply in the past several sessions.  For now, we would advise investors and money managers to stay away from the highly speculative areas of financial markets and to wait for positive signs of technical stabilization.

COMMODITIES

In the commodity market industrial metals suffered a wave of profit taking as the Goldman Sachs Industrial Metals index declined 6.15% for the week.  Copper finished the week lower by 4.24% and followed by aluminum down 2.84%.  Palladium, platinum and silver also suffered losses for the week.  Despite the recent setback in industrial metals commodities the Goldman Sachs Industrial Metal index remains above a major level of price support defined by its late June low.  A violation of this support level is likely to trigger further profit taking in stocks of mining companies such as BHP, RIO and RTP.  

Crude oil continues to be the focus of attention in the commodity market.  The price of a barrel rose 1.76% for the week to close at $77.02.  Crude prices are now less than 2% away from the high established in July 2006 of $78.40 per barrel.  While the short term technical structure is overbought and vulnerable to a bout of correction the long term price structure is still in bullish territory.

Chart #7: The chart above plots the daily price structure of the Natural Gas continuous contract.  Natural gas is the biggest lagger in the commodity energy complex.  Prices are currently testing a key level of support as shown by the horizontal green line and yellow circle.  It is worth noting that weather projections for the 2007 Atlantic hurricane season, which officially began June 1^st and ends November 30^th, forecasts a 75% chance of being above normal in activity.  Historically, the Atlantic basin displays strong activity from August to November with maximum activity in early to mid September.  Investors and money managers should keep a close eye on natural gas prices as price volatility is poised to expand in the months ahead.

One of the main consequences of widening credit spreads is the rise in the cost of capital and a drain in liquidity.  As a result, lenders will tend to favor companies with stronger balance sheets and superior earnings growth rates.  It is in this environment that large capitalization growth stocks tend to outperform their small capitalization counterparts.

The chart above plots the spread between speculative graded credit and the US Treasury yield curve as shown by the blue line.  The red line represents the relative strength between the Dow Jones US Large-Cap Growth index and the Dow Jones Wilshire 5000 Composite index.  A rising red line indicates that the Large-Cap Growth segment is outperforming the broad market, and vice versa for a declining line.

The results indicate a statistically significant correlation of returns between the variables with the odds of such relationship occurring by random chance alone in a 1 to 38 shot.  In simple words, a rise in credit spreads is compelling evidence that the large-cap growth segment is likely to outperform the broad market on a relative or absolute basis.

We also analyzed the effects of credit spreads by ranking the entire S&P 500 universe of stocks based on the debt to equity ratio.  This ratio is calculated by dividing the long-term debt by common equity.  Companies with a high debt to equity ratio are more leveraged and as a result tend to suffer in an environment of rising capital costs.

We divided the entire S&P 500 universe by quartiles based on the debt to equity ratio.  The top quartile represents the companies with the smallest debt to equity ratio, while the bottom quartile the companies with the largest debt to equity ratio.  In summary, the bottom quartile companies finance their growth with larger amounts of debt than the  top quartile ones. 

Next, we obtained the average year-to-date return for both top and bottom quartile groups as shown on the table below:

Note that the companies financing their growth with smaller amounts of debt show much superior returns on an average basis.  The yellow cells above highlight the statistical results that test for the difference in the means.  The results show that the difference in average returns between both control groups is statistically significant with a chance of occurring by random chance alone of 1 in a 345 shot. 

In summary, the tide is slowly changing in favor of large-capitalization growth stocks.  This market segment has underperformed the broad market for the past 7 years as measured by the Russell Index historical database.  Investors and money managers would benefit by slowly changing the portfolio structure towards this market segment in the months ahead.  

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