02/25/09   Equity Stress Test

Editor’s Corner

Equity Stress Test

Ron Rowland

For years, financial advisors have pressed clients to invest in equities because stocks always go up in the long run.  Just buy and hold for, say, twelve years or so and you’ll be fine.  Dollar-cost averaging?  Real men fully invest their lump sum 401k distributions immediately.  Oops.  With the Dow and S&P 500 now back where they were in 1997, people are learning that the long-term can be a lot longer than they thought.  On the other hand, if you failed to save and invest “properly” you now have a second chance to get started.
The global economy is in free-fall.  This week’s trade news from Asia revealed that Japanese exports plunged 46% in January from a year ago.  Car shipments to the U.S. were down 81%.  Japan, the Mother of All Exporters, ran a $9.9 billion trade deficit, importing more goods and services than it exported.  Germany posted slightly less dreadful numbers, but the trend is not favorable.  This is not a minor concern to the U.S., since our trade deficit with such countries is what allows them to buy U.S. Treasury securities.  Not coincidentally, perhaps, Secretary of State Hillary Clinton apparently devoted a good part of her recent Asian tour to making sure the Chinese will continue financing our debt.  Unfortunately, they will not be able to do so indefinitely.
Banks in the U.S. will begin enduring new “stress tests” this week.  We find the entire concept of these tests to be ludicrous.  We had a real-world stress test back in September, and all the major banks failed.  They continue to exist only due to the generosity of the Fed and the taxpayers.  All the fears about bank nationalization are misplaced: for all practical purposes, the banks have already been nationalized.  Predictably, the government’s management is proving to be just as inept as that of the people who created the present crisis.
Meanwhile, the stock market is also having a stress test.  The aforementioned decline to 1997 levels coincided with a breakdown of the November 2008 lows, leading many to suspect more downside ahead.  We love technical analysis, but we also have to admit it is not always an exact science.  The truth is that we are in the middle of a process that could resolve itself either way.  A rally from here will look, in hindsight, like a successful retest of the lows.  Just as the years 2000 and 2007 now look like a giant double top for the S&P 500, the years 2002 and 2009 could be a giant double bottom.  Another way to look at it: the S&P is now at the bottom end of a 114%, twelve-year trading range between 730 and 1560.  Time will tell.
Treasury bonds are now roughly back where they were at the end of November, about midway through the major rally that topped out around year-end.  As noted above, there are many question marks about the rapidly growing budget deficit and who will lend the U.S. government unprecedented amounts of cash.  The good news is that the rest of the world is in even worse shape, so the U.S. dollar is still relatively strong.  At the same time, all the money that has fled equities has to go somewhere, and t-bills are the obvious choice for many investors.  The bad news is that the liquidity now being created will come back to haunt us at some point.  Ben Bernanke appears to have decided to cross that bridge when he gets there.

All sectors lost momentum in the last week.  Health Care is still on top of the pile, though Telecom posted a positive return and jumped into the # 2 spot.  Consumer Staples eased into third place while Financials, Industrials, and Materials still own the bottom.

Only a few weeks ago all the Style categories were in a very narrow range, but now we have large dispersion.  There is a difference of 49 points between the top category, Large Growth, and the bottom category of Small Value.  All three Growth styles are on top while the three Value groups are on the bottom.  All the readings are extremely bearish, though Value has reached unsustainable downside momentum levels.

China is again on top of the Global rankings, but its absolute momentum score barely budged.  Other regions such as Latin America lost relative strength.  The EU nations are still on the bottom.  This week several news stories reported on the huge exposure of banks in Western Europe to the quickly disintegrating economies of Eastern Europe.  iShares MSCI EMU (EZU) is down approximately -24% year to date; only about a third of this loss can be attributed to a decline in the Euro vs. the U.S. dollar.  Europe’s worst problems may still be ahead.


The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

“That day of reckoning has arrived, and the time to take charge of our future is here.”

Barrack Obama


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