Tuesday, May 13, 2014 - Record Highs and Dow Theory

Record Highs and Dow Theory

by Sinclair Noe

DOW + 19 = 16,715
SPX + 0.8 = 1897
NAS – 13 = 4130
10 YR YLD - .03 = 2.62%
OIL + 1.38 = 101.97
GOLD – 1.00 = 1295.70
SILV + .03 = 19.63

Record highs are seldom pretty; they tend to be sloppy affairs, much like our celebrations. You would like a nice neat procession, but people are marching in different directions, candles blow out, hot wax is spilled.

It doesn’t seem like we should be having record highs in the first place, but there it is:  the S&P 500 hits 1900 for the first time ever; the Dow Industrials at record highs; the Dow Transportation Average confirms with record highs. This is important because it goes back to one of the more important technical indicators in the US stock market, the Dow Theory.

The Dow Theory is based on the writings of Charles Dow, the founder and editor of the Wall Street Journal, and dates back more than 100 years. There are actually several tenets of the theory that examine the major trends in the market and posit that the market is efficient, that it incorporates and discounts all news with greater accuracy than any individual. Once a trend is in place it is likely to continue until there is definitive evidence of a reversal; in this light, the slog through the first quarter might be considered as nothing more than market noise. Dow Theory also holds that volume confirms price trends.

And the theory also holds that the Dow Transports should confirm the Dow Industrials. The idea was that the Industrial average reflected the factories scattered around the country and the transportation average consisted of the companies that hauled the goods from the manufacturer to the market. If manufacturers are producing more, they have to ship goods to consumers, so if you want to know about the health of manufacturers, look to the performance of the companies that ship the goods. The two averages should be moving in the same direction; that is, they should confirm. So, if the Transportation average hits record highs, which it did, the Industrials should also hit new highs, which happened yesterday.

In mid-March, the transports broke above prior 2014 highs while the Industrials still lagged below their corresponding 2014 high. This could have been interpreted as a divergence, and even a signal to sell the industrials. However, Dow Theory tells us that industrials lag transports. It makes sense, because goods need to be transported before they can be sold.

Now, if you want to try and front-run Dow Theory, you want to pay attention to sales. Today, the Commerce Department released April sales figures, and they were flat, up just 0.1%, but this follows a revised 1.5% increase in March; that was the largest increase since March 2010 and reflected pent-up demand after a brutally cold winter. So, March sales were spectacular, and that was reflected in the Dow Transportation Average, and eventually the Dow Industrial Average confirmed the Transports. And now, the April numbers look weak despite data like employment, as well as manufacturing and services industries surveys, suggesting the economy regained strength early in the second quarter.

A second report from the Commerce Department showed that retail inventories excluding automobile stocks barely rose in March. The government had assumed a big increase in these stocks when it made its advance growth estimates last month for gross domestic product at 0.1% growth. March trade, construction spending and factory inventory data, which the government did not have in hand for the GDP estimate, suggest downward revisions to output; likely showing the economy contracting slightly. Core sales were down 0.1% in April; core sales strip out automobiles, gasoline, building materials and food services, and correspond most closely with the consumer spending component of the GDP.

Meanwhile, the Fed reported today that Americans racked up more debt in the first quarter, the third straight quarterly increase, thanks in large part to heftier mortgages. The report on household debt and credit showed however that mortgage originations dropped to their lowest level since the third quarter of last year. Outstanding household debt rose by $129 billion from the previous quarter, boosted by a $116 billion jump in mortgage debt and smaller rises in student and auto loans.

And in the sometimes twisted logic of Wall Street, this might be considered good news, the economy isn’t collapsing but it certainly isn’t growing enough to warrant a change in interest rate policy from the Fed. Any increase in interest rates could hobble consumers, businesses, and even the government.

Prices and wages been have sluggish since the 2007-2009 recession, and especially so in the past couple of years. Inflation remains low, and it undershot the Fed’s 2% target for the 23^rd consecutive month in March, based upon the personal consumption expenditures price index. Stubbornly elevated unemployment puts downward pressure on inflation. We still have slack in the labor market, so we’ll likely have very low interest rate targets for quite some time.

Meanwhile, we’re wrapping up earnings reporting season and according to Bloomberg research, almost 76% of the 453 companies in the S&P 500 that have reported earnings had results that were higher than analysts' estimates and approximately 53% of them exceeded revenue estimates. I know this is a rigged game between corporations and analysts, but companies are making money and sitting on piles of cash.

The corporate cash pile reached $2.02 trillion in the latest quarterly filings of 2,300 non-financial companies in the Russell 3000 Index. According to Bloomberg, the total rose about 13% from a year earlier in each of the two latest quarters, the fastest six-month gain since mid-2011.  If investors aren't applying some sort of haircut to the valuations of companies with hefty amounts of cash overseas, perhaps they should be; that is the mantra of activist shareholders. And so companies are beginning to pick up M&A activity as well as share buybacks and dividend increases. Capital spending on structures, equipment and intellectual property by all US companies in 2013 increased 3.9%, the slowest pace in three years. Eventually there will be value in reinvesting in the company to grow revenue; we’re not there yet, but we’re getting closer.

Again, one of the tenets of Dow Theory is that a trend in place is likely to continue until there is definitive evidence of a reversal; we’re not there yet. The trend is bullish; the supporting data is only mildly positive. In this instance, you stay in the market and remain alert to possible reversals. The level of support for the Dow, now moves up to the 16,550 range. On the upper end, there really is no level of resistance when you hit new highs, with the possible exception of Fibonacci expansion levels, which could put a ceiling around 16,800.

Meanwhile, if you’re looking for a negative divergence, you need look no further than the Russell 2000 Index of small and mid-cap stocks. The Russell has been persistently below its 50 day moving average since early April, and last week it dipped below the 200 day moving average; yesterday it bounced up above the 200 day and remained above the average today, despite losing 12 points. So, if you are looking for an early warning, this is a good place to look. If the Russell can move above the 200 day average here, it would have to be considered positive and also confirmation of the blue chips. If there is a breakdown from here, it might drag the blue chips lower.

Now, even if the market moves lower from here, it doesn’t mean we’re crashing back down to the 2009 levels; there is no definitive evidence for that kind of a move; there is plenty of fear mongering; there are plenty of perma-bears and they are about as accurate as a broken clock. The world is not coming to an end, at least not today; the market is not crashing, at least not today. In fact, we’ve been going through one of the best five year bull runs in market history. The VIX, the volatility index is at its lowest levels in more than a year. The major trend is bullish but this is no time for complacency. One of the tricks to profitable trading is knowing when to let winners run, and when to lock in profits.

These are the days of milk and cookies. Enjoy it while you can.

Earnings, Kitchen Sinks, Whining

By Sinclair Noe

DOW + 84 = 13,596
SPX + 8 = 1480
NAS + 18 = 3136
10 YR YLD +.05 = 1.88%
OIL + .94 = 95.18
GOLD + 7.10 = 1688.10
SILV +.24 = 31.83

The Dow Jones Transportation Average logged a record high today, ending the day up 37.44, or 0.66%, at 5,681.28. The transports average logged its best opening 15 days in January in more than a quarter century. The Dow Jones Industrial Average is still well off its October, 2007 all-time high of 14,164.53. So Dow Theory purists will have to be patient for a while yet. The Nasdaq still has a way to go. But Silicon Valley is back on top. Is it 2000 all over again?

The Best Performing Cities Index from the Milken Institute may have a familiar ring to it. The country's top metro area in 2012, based on jobs, pay and technology—is San Jose, Calif. It has been over a decade since the region ranked first on the index. Coming in second place on the index is Austin, Texas, another hub for tech innovation. The Milken Institute reported that for every job added to the tech sector, five outside jobs were created.

The number of Americans filing new claims for unemployment aid hit a five-year low last week and residential construction increased in December. Initial claims for state unemployment benefits fell 37,000 to a seasonally adjusted 335,000, the lowest level since January 2008. It was the largest weekly drop since February 2010 and ended four straight weeks of increases. The jobless-claims report suggests that we’re likely to see nonfarm payrolls expand at perhaps a better rate than we’ve seen in recent months.

A separate report from the Commerce Department showed housing starts jumped 12.1 percent last month to their highest level since June 2008. Permits for future home construction were also the highest in about 4-1/2 years. Digging into the housing report, 30 percent of all housing starts in 2012 were of multi-family apartments. That is the highest share in over 20 years. In December alone, multi-family starts jumped 23 percent month to month, seasonally adjusted, and are up nearly 166 percent from December of 2011. Compare that to single family gains of 8 percent month-to-month and 18.5 percent from a year ago. The housing starts number would indicate a shift in strategy. Developers are rushing to increase supply of multi-family apartments; this even as single-family rentals continue to gain market share. Continued uncertainty in the housing market, tighter mortgage underwriting and weaker consumer wealth has pushed ever more Americans to rent; the foreclosure crisis forced others. Still, the report indicates improving health in the housing sector. The labor and housing figures were really quite compelling and exceeded expectations rather handily in both cases.

Today, the American Bankers Association's held a economic conference to complain about tax increases and continued uncertainly among government policy makers; they say it will slow economic growth and job creation significantly early this year and threaten to tip the economy back into a recession. The tax hikes already put into place following this month's fiscal cliff deal in Congress will subtract 1.25 percentage points from gross domestic product growth this year, and additional government spending cuts--or continued uncertainty--would cause the economy to grow even slower than the tepid 2.0% pace. Those lackluster projections assume a relatively orderly resolution to the debt-ceiling debate in Congress.

It's earnings reporting season; still too early to declare the fourth quarter a success or a failure. And we've been sifting through some numbers. Extending the climb in corporate profits this year is expected to grow more challenging as labor costs rise with increased hiring. CEOs say they also face uncertainty over new health-care rules and taxes. Washington’s repetitive political confrontations threaten to further lengthen their odds. The debt-limit fight comes as the economy likely is growing at an annual rate of just 1.5 percent in the first quarter, although it will probably expand 2 percent during the year.

Despite the whining from the bankers, corporate profits are outstanding. Bloomberg reports US corporations’ after-tax profits have grown by 171 percent under Obama, more than under any president since World War II, and are now at their highest level relative to the size of the economy since the government began keeping records in 1947. Profits are more than twice as high as their peak during President Ronald Reagan’s administration and more than 50 percent greater than during the late-1990s Internet boom, measured by the size of the economy. The S&P 500 index is up 80% over the past 4 years and is now at a 5 year high.

Corporations are holding more than $1.7 trillion in liquid assets; essentially, they are parked in cash reflecting uncertainty over future policies. They’re investing in capital projects only 80 percent of their available internal funds. Though that figure is up about one-third from late-2009, that ratio has been below 80 percent only once since the end of 1958. Companies have squeezed profits out of this horrible economy by making it even more horrible, laying off workers and slashing costs. 

No sector has complained more than the banks, which have been reporting profits this week, and no sector has been making more money than the biggest, most oppressed banksters. JPMorgan Chase made $21 billion last year; it would have been more except for the $6 billion in losses by the London Whale. Today, Citigroup reported it was hit by charges for layoffs and fines to the tune of $2.3 billion in the last quarter; they still managed to posted net income of $1.2 billion. More alarming, Michael Corbat, Citi’s new CEO, had the audacity to blame regulatory costs for the bank’s performance — as if it were operating under some especially onerous rules that others weren’t.

Even with these “special” and “one-time” circumstances stripped out, these banks continue to be black boxes. Investors’ only choice is whether to trust the junk they spew forth.

Bank of America really has something to whine about; the bank reported a widely expected 63 percent drop in fourth-quarter profit after making huge payments to settle legal claims over its mortgage business. The bank’s earnings, a slim $732 million, amounted to 3 cents a share. For the entire year, profit jumped to $4.2 billion. The bank’s recent legal settlements also weighed on its results. Bank of America had warned investors that it deducted $2.5 billion to settle with regulators over claims of foreclosure abuses. The bank last week also struck an $11 billion agreement to resolve claims that it sold troubled mortgages to the government-controlled housing finance giant, Fannie, which experienced deep losses from the loans. The bottom line is that, quarter after quarter, these banks turn in financial reports that are impenetrable and full of what analysts politely call “moving parts.” It’s nearly five years since the dark days of the financial crisis, yet it’s still not clear if these banks are digging out or deeper. Methinks they doth protest too much. Why, it's almost as if the banks are trying to hide something.

Consumer advocates have complained that mortgage lenders are getting off easy in a deal to settle charges that they wrongfully foreclosed on many homeowners. Now it turns out the deal is even sweeter for the banks than it appears: Taxpayers will subsidize them for the money they're ponying up. The Internal Revenue Service regards the lenders' compensation to homeowners as a cost incurred in the course of doing business. Result: It's fully tax-deductible.

Regulators reached agreement this week with Goldman Sachs and Morgan Stanley. Last week, the regulators settled with 10 other lenders: Bank of America, JPMorgan Chase, Wells Fargo, Citigroup, MetLife Bank, PNC Financial Services, Sovereign, SunTrust, U.S. Bank and Aurora. The settlements will help eliminate huge potential liabilities for the banks. Under the deal, 12 mortgage lenders will pay more than $9 billion to compensate hundreds of thousands of people whose homes were seized improperly, a result of abuses such as "robo-signing." Companies can deduct those costs against federal taxes as long as they are compensating private individuals to remedy a wrong. By contrast, a fine or other financial penalty is not tax-deductible.

Elsewhere in the world;  International Monetary Fund chief Christine Lagarde says the threat of financial collapse in the global economy appears to have eased, but she warned that developed economies still need to follow through on financial reforms and debt reduction. LaGarde said:

"We stopped the collapse. We should avoid the relapse. And it's not time to relax." Lagarde said that big economic powers, including the United States and European countries, had taken important steps to shore up their financial systems but have a lot of work left to do. She warned that there are signs of a waning commitment to regulate the financial sector. She said that reforms have been delayed and diluted, and she worries that banks are pushing back against necessary reforms. Wonder where she got that idea?

On the United States, Lagarde said any cuts should be aimed at allowing time for an economic recovery to play out. In Europe, Lagarde said she sees a lot of progress on reform. She said the European Union has a lot of new tools to deal with financial crisis. "And yet, firewalls have not yet proven operational," she said. She added that the EU still has work to do on its banking union in order to prevent future problems. On Greece, which has seen the most acute collapse of all the EU countries and which many believed would have to leave the currency union, Lagarde said recent reforms appeared to have restored confidence.

"This time it's different," she said. I think I've heard that line before.