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TheGarcipian (42.84)

Medusa, You Look Awful! Can't We Do Something With Your Hair?

Recs

12

August 05, 2008 – Comments (7) | RELATED TICKERS: SPX

Lo, this market is a horrible sight, isn't she?

If you’ve not read my first installment regarding the S&P500 Corrections and the Coppock Curve, I suggest you backtrack and start there. Then come back to this article so you can better understand what I’m about to lay out. Of course, if you are the type of person who only reads the instructions after you’ve discovered you can’t put the new toy together, then go for it and plunder ahead!

As promised, I have some updates to the Coppock Curve and the S&P500 Corrections graphs that I’d posted a month ago. (Sorry it took awhile but since the lottery hasn’t paid me yet, I’ve gotta keep the day job, which took me to Detroit for awhile, which leaves things at home queuing up until I got back, yada yada yada).

In the comments (#10) of the first “Sweet Medusa” post, I mentioned there is a correlation present between the Housing Market Index (HMI) and the S&P500 Index. The former is produced by the quintessentially optimistic NAHB (National Association of Home Builders). One of the reasons that MauiPeter and I wanted to wait until the 15th of July is because that’s when the Barney-imbued NAHB updates their HMI figures and charts. “I love you, you love me, please don’t bad mouth NAHB…”

In this blog, I’d like to add a little more fuel to the fire to explain why I think we’re in for more bad news to come. In particular, I want to talk about the work of David Rosenberg, the Merrill Lynch economist who discovered an interesting relationship between the HMI and the S&P500 in 2002(?). After some back-testing, Rosenberg found that the S&P500 followed the HMI fairly closely with a one-year lag. That is, the HMI could be used as a leading indicator for how the S&P500 would do 12 months into the future within some close correlation. How closely, you ask? How’s an 80% correlation factor grab you? Yep, a pretty fair following, I’d say. But, as with most back-testing techniques, there are limitations to clairvoyant applications of said data projections. Like unicorns, those crystal balls are exceedingly rare and can completely disappear if you bet the house on them. Let’s examine it more closely to see what we can learn…

The NAHB began distributing their HMI in 1985, and until 1996, the correlation between it and the S&P500 held about as much real value as the recent African rumor of penis theft via black magic. (Notice I didn’t say ‘penis snatching’ as some reports have, because that might imply a completely different sort of transformation…;-). However, since then, things have changed. As reported in this 2007 article:
“Between 1996 and 2000, the HMI increased 90 percent while the S&P 500 more than doubled in value. Between 2000 and 2002 the HMI dropped 40 percent while the S&P 500 lost 46 percent from peak to trough.”

Chartmaster MauiPeter has provided me with his own graph of this trend, as shown below. Click on the picture to get a larger view, if so desired. He’s taken the HMI graph and scaled it by 20X so that it can be plotted on the same Y-coordinate axis as the S&P500.

HMI vs. SPX Curve
Click here for the full image.

Other variations of this chart have been shown on the Web with one of the two curves shifted forward (or backward) by 12 months, in order to demonstrate that the two curves line up fairly well for the period of interest. For comparison, here’s one example from late 2006 (source: TradingEducation.com):

Coincident HMI vs. SPX

Humans are such visually-based animals; trusting that someone really computed an 80% correlation factor pales in comparison to actually showing you the overlain graph lines. However, the data in our chart has not been shifted by any number of months so that you can see for yourself what the HMI and SPX values were for any specified date (something which you can’t do with other versions of this data on the Web, which don’t have this recent data logged either). But trust me: the correlations were computed in an Excel spreadsheet using the “CORREL” function.

The correlation held tight until the summer of ’05. Then, in early July 2005, the HMI topped out at 71.6 and has nose-dived to about 18 today. For the correlation to have held, the S&P500 should have started moving down around July 2006, but it kept right on rising (then around 1270) until October 9th, 2007 (at 1565). So, the correlation was broken then, right?  I don’t think so. Not yet, and not completely.

Rosenberg found the 80% correlation to exist in data taken between 1996 and 2002 (approximately). Hard as it may be to believe, the correlation has actually grown a bit tighter recently. My friend MauiPeter fiddled with his spreadsheet and found that by shifting the SPX curve backwards by 15 months (instead of 12), the correlation improved to 85%. Those additional 3 months might explain some of the delay, but it doesn’t explain all of it.

Also, if you look closely, you’ll see that the S&P500 is back exactly where it was two years ago on July 10th 2006 at 1236.20. All that SPX value over the past 2 years has evaporated; as of August 2nd, 2008, the SPX is at 1249.01. So perhaps we’ve caught up (caught down?) with the HMI’s precipitous fall. Contributing factors for the SPX’s delayed decline have been suggested to be as varied as:

&nbsp&nbsp&nbsp the Fed’s continued insistence of devaluing the American dollar (something by which I think everyone is quite confounded);

&nbsp&nbsp&nbsp  the extraordinary bubble into which housing was led by cheap money and avarice lending & investment house practices (which didn’t really get started until 2002), a bubble which many people think has passed by us, but it hasn't;

&nbsp&nbsp&nbsp the rise in oil & commodity prices;

&nbsp&nbsp&nbsp  the war in Iraq and it associated governmental largesse (“War is Peace; Freedom is Slavery; Ignorance is Strength,” anyone?)

Each of these, I believe, has pushed the S&P500 curve out to the right in the chart above.

Rosenberg's work is not without its detractions, though. Most notably, the period prior to July 1996 yielded very little correlation. Who’s to say that the period we’re entering now won’t completely unwind the Rosenberg correlation? Well, you might, but I won’t. Not yet anyway. If the correlation is breaking down, it won’t do so overnight or even in 6 months. For all of these reasons, I think we’re still in for a lot of pain to come, at least as far as the stock market indices go.

Here are the updated S&P 500 Corrections (normalized to Oct. 1st, 2007) and the matching Coppock Curve through July 27th, 2008.

SPX Curve -- Corrections
Click here for the full image.

Coppock Curve
Click here for the full image.

Looking at the S&P 500 Corrections curve, the black line represents our current debacle (fitting color, isn’t it?), placing the index at around 1260 now. That black line seems to be following the leads of the 1973-1974 and 2001-2003 slides, tracking one for a couple dozen weeks, then switching to track the other. If this market decline is going to be as worse as either of those two slides, we could see the S&P 500 index cut to 810, a 48% chop from the high of 1558. A shockingly low number indeed! It’s hard to believe it will fall that low. However, I do think it will fall to 1000, plus/minus 50 points, by December 2009. That’s a 21% drop from today’s value.

As you can tell from the updated Coppock Curve, we still have a ways to fall to reach the 2001-2003 low. Personally, I think this recession will be worse than that 6-7 years ago (though it’s still hard to get my head around an S&P500 value of 800!). If it’s only as bad as the 2001-2003 slide, we should count ourselves extremely lucky. The Coppock Curve, perhaps, is showing us some good news in that if (and I must bold-face & italicize this), if our current slide will be only as bad as the last one, then maybe we’re more than halfway there, and the downward slide won’t hit the “810” mark.

Ok, what have I been smoking?!  Time to take off the Pollyanna hat!

I think we’re going to have a Coppock Curve like that for the 1973-1974 recession, dropping to the -30 value, meaning we have much further to go. This is why I’m pretty sure we’ll see the S&P500 index fall to at least 1000, and possibly lower. The one variable I don’t have a good grip on (amongst many, I’m sure) is inflation. An open question: How does the rapidly ramping up inflation (now estimated at 5.02% for July, based on government figures though, which we now are purposefully low-balled) affect this predicted number of mine? Note: the S&P numbers in the graph above has not been corrected for inflation either. These are straight out of Yahoo! Finance historical data.

As previous bubbles have deflated, there always seemed to be a new area into which money could/would flow, thus begetting a new bubble (in time). I don’t see many places like that right now, except perhaps energy & maybe some commodities, though commodity price increases are being driven partially by interest rate cuts and its darker side, inflation.

So here’s my second group of questions: What are you doing to protect yourself, and where do you see value in this crazy market, if anywhere? Do you think commodities stand a chance at keeping to their elevated prices, in particular copper? Also your thoughts on the above graphs would be appreciated too.

And finally: Has anyone seen Perseus? Where is he when you really need him?!

7 Comments – Post Your Own

#1) On August 05, 2008 at 2:22 AM, AnomaLee (28.64) wrote:

Insightful update,

Shorting has been my easiest conclusion. If you think/worry everything is going down why not buy an inverse ETF?

I suppose commodities could correct further, but after six weeks of decline(like equities - especially financials) I'm expecting to see a support base and/or a short-term bounce. Supposing a 'worst-case scenario' oil could possibly correct 40% towards $90 and copper could fall towards $290 but that would be a hand-out because it will only spur future demand.

We are discussing valuations in volatile/nominal U.S. dollars.

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#2) On August 06, 2008 at 1:32 AM, Tastylunch (29.29) wrote:

How on earth did this only get three recs? I'm trying to take a week off from CAPS but injustices like this keep dragging me back.

Re: the first two graphs .Hmm I dunno Gar. I think it's telling that the major point of divergence previousy was 1991-1992, which  to my recollection was  the most recent major real estate correction we experienced (my old man loaded up on properties during that time if I recall). I think that actually disputes your point somewhat re the HMI's predictability of the S&P. Perhaps in major hosuing corrections the correlation doesn't hold.

In regards to Coppock Curve and inflation. Truth be told I really don't know, I do know inflation compresses P/Es of stocks and the market typically so I suppose it could be that inflation may be a central cause of why 73-4 and 2007-?exhibits the sameish pattern on the Coppock Curve.That's really neat stuff

What am  I doing to protect myself? Well I've changed my spending habits (tradedown on retail/restaurant purchases, cut back on entertainment and I've grown a garden this summer) .I've been cashing in frequent flier miles when I have to travel (my guess is the airlines will probably raise redempton requirements soon).I'm lucky enough that I dont have any debt so I'm working on controlling expenses.

My money is mostly in cash, I've been largely out of stocks since last year except for some small positions and a few ultra longs. I do short stocks ocassionally. I probably ought to buy some foreign currency but that's not really my core competency.

At work we are phasing in price increases and sacrificing margin to try to not alienate customers (already two competitors of mine have gone under in the last three months). I've cut my own salary some to help make up the difference (and so I don't have to fire anybody).I think it's helping us gain market share. Our july sales were up 25% yoy. And for August we're already on pace for a 40% jump if we can hold it.   I also installed CFLs and LEDs last year to cut down on energy costs. I'm now starting to get stuff ready to winterize the building. Heating costs are going to really sting this year I think. The main issue we've had is shrinkage is up this year (that's not unusal in economies like this)

as for commodities, I wish I knew. Since about March I thought a correction in commodties might be coming due to a global slowdown in demand from recession. Looks like it's finally kicking in. I do think in the long run they are going back up as the traditional killer of commodity rallies doesn't seem present yet (namely that the oversupply issue that happens when companies overbuild during a boom), can't tell you when. I'm sure you know better than I. 

as far as Perseus goes , I think ole homeboy likes to be called Percy in the new world. :-) Haven't seen him in a while. These days Heroes are in short supply in the financial world...

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#3) On August 06, 2008 at 4:45 AM, TheGarcipian (42.84) wrote:

Tasty,
You're early -- only 3 Recs so far... :-)
I think having my status fall so far in such a relatively short time has dropped me off some people's radars (just a month ago, I was at #150, and now I'm at #524). I hope the work above does get noticed, because I think it will help people prepare for the worst, which we've not seen yet. But boy, you've got that last thing right: heroes are in incredibly short supply, especially in the financial world. I am shocked, dismayed and bewildered that people are as callous, indifferent, lying, selfish or just plain greedy as has been epitomized by this Administration and its flagrant ties/handouts to Big Business.

Interestingly enough, I saw a Charlie Rose interview tonight with Clare Lockhart, the co-author of "Fixing Failed States", a study of what makes states fail and what makes them succeed. A "failed (or failing) state" is a government that is unable to provide for its people in one of 10 critical areas, including an agricultural basis or food supply, a healthy financial system, shelter & security. She and co-author Ashraf Ghani point out that among these 10 characteristics of failed or failing states, one of the most important is an open view into the government's finances, a public accountability for the system which doles out money. When the trust evaporates from that accountability, it is a very difficult thing to ever regain and provides much instability to the state or nation for decades. It disheartens me much that we Americans continually experience this with endless and untold monies flowing into Iraq to covert companies like Blackwater and overt ones like Halliburton and its no-bid contracts, neither of which will admit to how much money they've simply squandered or swallowed whole.

On the bright side, I'm glad your business is doing better than last year. Hopefully, you & your family can ride out the tide over the next 12-18 months. Also, I'm happy for you that you are mostly in cash; that's probably the best place to be right now. I'm not there yet, but am trying to get there without losing too much money. Don't know if I'll make it, or if I should just hole-up with where I'm at now. 

You might have something about the 1991-1992 real estate bubble not being reflected in the HMI vs. SPX correlation, but then again, there was no correlation during that time, so it's an apples-to-oranges comparison. Time will tell, but I think the SPX curve will follow the HMI downwards, and soon (?in 6 months or less?).

AnomaLee,
Thanks for the ultra-short ETF idea. I'd run across DemonDoug talking about SKF in a blog, and I think that might be a way for me to hedge my losses. He was suggesting waiting for it to fall to about $100/share, then buy-in. I just might do that.

True, we are talking about commodities in volatile US dollars, but I'm glad to hear you're thinking like me, that the commodities market will have to rebound because the demand will still be there, i.e., after this short-term trouncing. Of course, the question is when will it return? 

Thanks to both of you for your time and your thoughts.

Best Wishes and Good Investing,
--Gar

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#4) On August 06, 2008 at 12:05 PM, Tastylunch (29.29) wrote:

TheGarcipian

well good! seriously though this far better than  a 4 rec post (so far ;-) ). This is easily one of the top 5 post of the last week in terms of useful information. The CAPS blogging community has gotten off track I think into politics too much lately.

re: clare Lockhart, that's just depressing. That's right up there with Habeas Corpus being suspended. :-( I wish I knew what to do about it.

Thanks, I'm sure my family will be ok. If we ever do decide to close, it will be of our own choice, which is a fantastic luxury to have. I hope your loved ones are well.

Yeah it's tough to close losing positions, I have lots of trouble with it myself. Whatever happens, I hope you make out well. In a market like this merely not losing is a big win imo :-)

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#5) On August 06, 2008 at 6:23 PM, binv271828 (< 20) wrote:

Gar,

Both this blog and the Sweet Medusa blogs are fantastic. Yes, for what its worth, I believe there is much more pain to go. The recent bear market rally and dumping of commodites have been killing my Caps score (down to about -1600, yeeoouch). But I am sitting fast, I refuse to be shaken out of my positions. That may ulitmately be to my detriment, but I like living on the edge :). Yes, there is much more pain with the S&P in general, and Housing and Financials in particular. The Fed will not do anything about inflation except create more of it.

Gold will resume its climb after the summer doldrums. It will be the first "commoditiy" to do so (I have argued that gold is more of a currency than a commodity). I think natural gas and oil have more pain near term but will eclipse their recent peaks in about a year. That is my theory at any rate. My Caps score is paying the price for bad timing, but that is how the cookie crumbles.

Great blog and thanks for all of the data and the correlation. Further evidence that all is not well and the "second half recovery" line that gets spouted by Wall Street analysts with teret's is just a bunch of garbage.

Tasty,

I just have to second everything you said :)

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#6) On August 09, 2008 at 11:48 PM, Tastylunch (29.29) wrote:

In response to your earlier query on my blog, if you ever need to email me , my email is tastylunch  at fastmail.us

the email I signed up for with CAPS is so full of spam if you email me there I may not see it.

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#7) On August 20, 2008 at 1:08 AM, JonBarleycorn (71.47) wrote:

Gar,

Great blog.

On the subject of the July '07 disconnect, I believe the term exogenous event applies. As you know, it's not fair to ask correlation calculations to handle rule changes.

IMOH market forces were moving along nicely when Uncle Ben panicked and bumped the money spigot. It took the market all of 2 - 3 months to say WTF.

JB

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