Hope you enjoy exploring the earlier market forecast and continue to have fun in part2 of the Market Forecast 2008 by Bernie Schaeffer
Technicals
Key Levels and Trendlines
In the first half of 2007, technical analysts concerned themselves with historical levels. Former all-time highs and significant round-number zones challenged the major market indices, but by the waning weeks of summer, these areas of looming resistance had been overtaken. The Dow toppled 14,000, the S&P 500 Index broke 1,500 and then exceeded its March 2000 closing and intraday highs of 1,527.36 and 1,553.11, respectively. The Russell 2000 Index (RUT) muscled through the 800 mark to hit a new all-time high. And the Nasdaq Composite (COMP) hurdled the 2,500 level to reach its highest point in six years. Additionally, the tech-rich index moved above the 2,566 mark, which represents half of its March 2000 high of 5,132.
The final quarter of the year was defined by a successful test of long-term trendlines of support, which refused to yield even when selling pressure mounted. Most notable is the 80-week moving average on the S&P 500 Index, which contained pullbacks in mid-August and late November. Barring a colossal mistake from the Fed in terms of monetary policy, we have confidence in these levels being supportive heading into 2008.
Where We Could Be Headed
The S&P previously rallied off its 80-week moving average in August 2004, October 2005, and June 2006. The average rally following these pullbacks was 18.6%, and the average duration was eight months.
For the S&P in 2008, I'm looking to a mid-year S&P mark of 1,625, with a move to 1,700 by year-end. So I'm essentially projecting a bigger pop higher sooner rather than later.
For the Dow, I believe we could add about 15% in 2008. By mid-year, I think we could see the average hit 14,600, taking out the 15,000 mark sometime thereafter to close the year around 15,300.
I'd expect the Nasdaq to rise to 2,900 by mid-year and reach 3,100 by the year's close. If the index behaves better than I anticipate, the 3,120 mark could come into focus. This is the 50% retracement point between the index's March 2000 peak and its October 2002 nadir. As for the Russell 2000 Index, I still have faith that some of the best bullish opportunities are in the small- and mid-cap growth area. Retailing growth names, biotechnology issues, and alternative-energy stocks are some particular pockets of strength among the smaller-cap sect. But in recent months, the RUT itself has been weighed down by its components in the beleaguered housing and finance sectors. That said, despite this struggle, I expect to see the RUT retake the 800 level early next year and move to 850 by the middle of the year. By the end of 2008, I'd like to see the RUT hit the 900 mark.
Sentiment
Then and Now
While 2007 faced comparisons to 2000, with the tech bubble of then compared to the housing bubble of now, the reality is that it was a different market environment entirely.
First, stocks are much more fairly priced from a valuation standpoint. As of mid-December, the price-to-earnings ratio on the S&P 500 Index overall stood around 20.50, down from the 37-38 area in late 2000.
Most importantly, the overwhelming sentiment that ruled the market in 2007 was one defined by hesitation and caution. The issues plaguing the 2007 market overshadowed any good news, investors were bailing out of domestic equity funds at record levels in favor of foreign alternatives, and the news stands regularly featured doom-and-gloom predictions.
In 1999 and 2000, greed played a part in every financial decision. The sky was the limit, and losing wasn't on anyone's radar. Euphoria was palpable … and it was dangerous. While I wouldn't say the current market was quite one defined by "despair," it's certainly arguable that we're in the "disbelief" stage.
The Short Story
The short-selling contingent remains a force to be reckoned with as 2007 draws to a close. By the end of November, the total number of Big Board shares sold short rose 3.1% to 12.77 million, up 3% from mid-November, when 12.39 million shares were sold short.
The short-interest ratio reached 8.2 in late November. In other words, total short interest across the New York Stock Exchange (NYSE) is more than eight times greater than the average daily volume on the exchange. This short-interest ratio on the NYSE is on par with the 1997 level, when we were in the middle of a raging bull market.
In addition, put open interest in the options market is at record levels, perhaps a reflection of the huge growth in the dollars managed by hedge funds in recent years. This contingent by definition "has derivatives exposure and knows how to use it".
The bottom line is that the large and ever growing short trade keeps a lid on market rallies (thus reining in any "irrational exuberance") and provides support on market pullbacks (as shorts take profits on declines and as portfolios with put protection in place become exempt from panic liquidation). Market crashes are very unlikely to occur when major money is already positioned for them.
Analysts' Apprehension
The "Big Money Poll," conducted by Barron's every six months, poses a variety of market-related questions to more than 100 investment professionals and money managers.
The latest installment revealed that just 47% of those polled have a "bullish" or "very bullish" outlook for equities through the middle of next year. This is quite a drop from the 64% of managers self-described as "bullish" in late 2005. Profit growth on the S&P 500 Index is expected to be a modest 4.6% for next year.
Meanwhile, 20%, or a fifth of the Big Money Poll respondents, say they are "bearish" or "very bearish" about the market's prospects, up from 17% in the last Poll, conducted in the spring of 2007. Those describing themselves as "neutral" account for 33%, down from 37% seven months ago. This caution among money managers is healthy as markets tend to climb a "wall of worry."
Using Zacks.com data to check in on the overall tone on Wall Street, the percentage of "buy" ratings is underwhelming. Of all analysts' ratings on S&P 500 stocks, just 47.7% are "buys," leaving 46.8% in "hold" territory and 5.5% as "sells."
Meanwhile, in June 2000, when the market's peak had long come and gone, the percentage of "buy" rankings stood at a whopping 72.0%. What's more, 50.3% of analysts' ratings were "buys" even when the market was at its 2002 low!
In other words, the Wall-Street collective is positioned more bearishly right now than they were during the bear market of roughly 5 years ago.
The outlook on mid-cap and small-caps stocks is equally skeptical. Specifically, 42.9% of the ratings on mid-cap stocks are "buys"; 43.89% of small-cap stocks have earned "buy" ratings. This is reflective of a "lowered expectation bar" that is very conducive to analyst upgrades should the 2008 environment prove less gloomy than the consensus believes.
Negativity on the Newsstand
One of my favorite and time-honored measures of anecdotal contrarian analysis has always been the cover story. When a trend in the market (or on an individual stock or sector) has gained such attention that it is appearing on the covers of many widely read publications, it could be about time for that trend to turn. This is based on the theory that once a trend hits the covers it is so widely known and universally accepted that it is set to turn not long after the unsophisticated public jumps aboard based on the "big news" in the cover stories.
A recent commentary from Paul Montgomery, whose work I greatly admire, pointed out the slew of doom-and-gloom headlines we've seen in the financial press related to the housing crisis and the dollar. Granted, as Montgomery also points out, financially-focused magazines don't carry quite the contrarian punch as a more general periodical such as Time, but the contrarian cover-story indicator is still undeniable. Here's a mere sampling of some cover-story headlines we've seen in the past three months:
- BusinessWeek, "The Consumer Crunch," (November 26, 2007)
- The Economist, "America's Vulnerable Economy," (November 15, 2007)
- The Economist, "Lessons from the Credit Crunch," (October 18, 2007)
- BusinessWeek, "That Sinking Feeling," (October 15, 2007)
This is, of course, not to mention the myriad of non-cover articles with bearish themes in the daily, weekly, and monthly press (a recession in 2008 is considered to be a slam dunk). When negativity turns so prevalent that warnings scream to us from the newsstands, pessimism could be nearing a peak. Given the broad market's decent price action amid so many fundamental challenges as highlighted by the headlines we see on a daily basis, this should be good intermediate-term news for the bulls.
Fund Flows
As I alluded to above, one element that makes today's market backdrop dissimilar to the wild ride of 1999-2000 that ended so badly is the fact that investors are bailing out of domestic equity funds. (Around the turn of the millennium, annual fund inflows into domestic funds were setting records in the $200 billion neighborhood).
According to TrimTabs, U.S. equity funds lost roughly $8.3 billion in November alone, marking the seventh consecutive monthly outflow. In May through November, $50.3 billion was pulled out of U.S. funds; this is equal to 56% of the record-setting seven-month outflow of $90 billion seen as the bear-market era was carving out a bottom in June 2002 through December 2002.
But fund players aren't just taking their money to the craps tables or tucking it under their mattresses. Global funds have reaped the benefit of rejected domestic opportunities. In November, $7.9 billion in assets was funneled into global equity funds. What's more, while that $50.3 billion was being erased from locally-based funds, international equity funds have seen $70.9 billion in inflows, huge with respect to the outflows from domestic funds, but small in comparison to the $200 billion in domestic inflows in 2000.
The advent of hedge funds is another major change to the world of investing in the past seven years. And in October, hedge funds posted an inflow of roughly $16 billion (according to TrimTabs data). During the first 10 months of 2007, nearly $280 billion in assets were funneled into hedge funds. In other words, there is a definite preference for funds in which hedging is an instrumental part of the strategy, such as shorting stocks.
So the market in 2007 held together despite headwinds on the economic front and despite headwinds from big money flows into short selling strategies and despite outflows from domestic mutual funds. As fear subsides and the risk/reward profile shifts in 2008, outflows from domestic funds could lessen and possibly even shift back to inflows as pessimism collectively unwinds. A reversal in the fund-flows environment would be very supportive for the U.S. stock market.
Margin Madness
Just a few of weeks ago, I came across the news that the level of margin debt recently exceeded that posted in the 1999-2000 market. This fact seemed diametrically opposed to the sentiment underlying the massive outflows we've seen in the mutual-fund arena, and I hardly believe it's the product of small investors borrowing above their means to buy U.S. stocks (the traditional view when margin debt ramps up).
My sense is that these ramped-up margin-debt figures are tremendously skewed (and rendered practically meaningless) by current present-day factors as hedge-fund activities and exchange-traded funds. (Hedge funds are also largely responsible for the increased demand for short positions referenced above).
Exchange-traded funds (ETF) were practically non-existent during the 1999/2000 bubble, and they are a hugely popular investment vehicle now. There is far less risk in buying an ETF on margin than in buying individual equities.
The risk of buying, say, the Select Sector SPDR Financial Fund (XLF) on margin in no way compares to buying a risky dot-com venture on margin eight years ago. And back to the hedge funds, I'd imagine it would be common practice for them to hedge stocks on margin against short positions in ETFs on margin for a net trade that is actually lower risk than buying stocks with cash.
Stay tune for the summary and net-net bottom line that is going to be revealed in part 3...
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