FYI | Nov 30 2007
(We are currently experiencing some problems with uploading the charts – the ones displayed in this story will be replaced by improved ones on Monday)
By Greg Peel
“Handicapping US economic prospects, or what the Fed may do is, at this stage, a daunting challenge,” suggests GaveKal analyst Steven Vannelli. In response to queries from concerned clients, the respected consultancy and research house has had a look into its own indicators of market sentiment.
One question is, why is the situation now any different to what is was in August (when the Dow was last at current levels)? After the August low, the US stock market rallied back to its previous highs. GaveKal was never convinced over that interim rally, believing a “growth scare” was still in the offing. The market, however, just didn’t believe it.
In August, notes GaveKal, there were still not enough people calling a recession. One indicator of such (apart from stocks) was the US bond market. While yields fell to August, they didn’t fall as far as the previous lows that began the inflation scare in July 2005 (six months after the Fed started ratcheting up rates). To take out those lows would have required a good deal of belief a recession was around the corner.
That happened this week. GaveKal, however, does not see a recession coming, agreeing with the pervading argument that economic activity is moving away from fixed domestic investment and into exports.
GaveKal believes a “good low” is only made not only from a low in stock prices but from a low in the risk-reward ratio. The last major low in the US stock market was in 2002 – the last recessionary period which followed the tech-wreck and 9/11. Looking at a risk-reward chart of 2002 provides some spooky similarities.
Note that the risk-reward low occurred in July, but stock prices did not reach their ultimate low until October. A graph that includes 2007 then shows a very similar pattern – risk-reward low in August, stock market low in November.
Another indicator of risk sentiment is the put/call option ratio on the S&P 500. Calls are highly sought after in the good times, while puts are sought for protection when things turn black. As soon as the rush to buy puts fizzles out (and in times of panic puts can become so expensive as to be uneconomic) the market tends to rally. The graph below shows the ratio has pushed up over one standard deviation once more.
Yet another indicator is the ratio of advancing stocks to declining stocks in a day’s trade on the New York stock Exchange. The graph below shows just how rarely the cumulative measure has been as low as it is now.
A similar picture is created when assessing the number of new highs made by individual stocks.
Put all of this together, and GaveKal concludes the US stock market is simply oversold. It is the perfect opportunity for the contrarian (who disagrees with recession fears) to get on board for a Christmas rally.
