Thursday, October 4, 2007

The Stock Market – It May Not Be the Real Deal

Once again I would like to make some comments about the stock market. Please note that I do not give out investment advice. The purpose of my comments are to stimulate conversation and contemplation.

Based on comments on a number of posts, a couple of articles in the WSJ (#1 and #2), and response to an earlier post I began to question why the market is moving up in light of the economic and market news. For a stock market to be considered a “real” rally the increasing market has to be broad based with increasing or high volumes.

First the Economic and Market News Isn’t Good:

It is now clear that the housing market is in free fall. When commentators start saying things like the market will not turn around for another 12 – 24 months or existing house owners need to drop their prices to move their houses, things are not good and are not getting better next week.

Capital markets, except for the very high grade debt, continue to struggle with liquidity and confidence issues.

Banks, both the US and overseas, and investment banks are beginning to report large losses due to the write down of mortgage debt.

Job creation is slow in the US.

The dollar is reaching all time lows against the euro. Other countries are beginning to relinquish their need to hold US Treasuries as a reserve currency.

To Test the Strength of the Market:

To address this question I once again went back to my simple minded indices that I developed to address the issue of how the retailers were doing. After all, if the stock market was up but the retail component is lagging the market clearly does not think the retail sector will do that well in the near term. If the retail sector is a surrogate for consumer spending, maybe the market is not really that confident about the strong economic growth in the near term. Just maybe all recent increases in stock prices are caused by the euphoria of a rate cut and have nothing to do underlying fundamental strength of the economy.

To test this idea I created a simple index, using June 1, 2007 as a base, so the S&P 500 index could be compared to the S&P Retail Index.

The two graphs below were first published on September 24 and not much has changed. Updates of the graphs to October 1 data does not indicate any improvement. If anything things may have deteriorated somewhat.

The first graph below clearly shows that although the S&P 500 has had its ups and downs since May, the index is only slightly off the highs sustained through May, June and July. The S&P Retail Index is, however, a different story. The Retail Index also had its ups and downs in May, June, and most of July, but beginning in late July the index began to decline from the base period. More importantly, although the index has recovered from its lows in mid-August it has not recovered as much as the S&P 500 index over the same period. As a matter of fact if the difference between the two indices is calculated it clearly indicates that the S&P 500 is recovering much more quickly than the Retail Index (graph two). (Double click on the graph for a larger image.)

Although this is not proof positive that the current market trend is not a widespread rally it certainly suggests that some sectors of the economy are lagging. By the way, if you compare the returns of the Dow Jones Industrial Average (DJIA) to the S&P 500 you will note that the DJIA has outperformed the S&P 500, indicating that what we are seeing may be a flight to safety and not a broad based rally.

The second test of market strength is to look at volume. Once again a simple index of the DJIA and its associated volume was developed using June 1, 2007 as the base. The graph below indicates that the rise in stock market prices did not have an associated increase in volumes indicating that the stock market rise lacks strength. (Double click on the graph for a larger image.)

The stock market rise since the Fed rate appears to lack a broad base and lacks volume, suggesting that this rise is anemic and may not be sustainable.

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