Sell Stocks Also

If the bond market is “right,” the stock market probably isn’t. In which case, share prices might be a shade too high.

Please allow us to explore the possibility that bonds might be more right than stocks about the likely course of prevailing economic trends. Stocks and bonds have been rallying together for several weeks. But we suspect that this intimate tango will end very soon. The most important question, however, is which party will end the dance.

Last week, as faithful Rude Awakening readers may recall, your New York editor twice scorned 10-year government bonds yielding 3.84%. He has not changed his mind; he still prefers skimpy bikinis to skimpy bond yields. But he is prepared to consider the possibility that bonds are a buy, at least relative to stocks. Or to put it a little differently, the Nasdaq Composite Index at 2,060 might be an even better sale than 10-year bonds at 3.84%.

To begin our analysis, we will recall the latest installment of Alan Greenspan’s wisdom. Last Tuesday, the Fed chairman confessed that had no idea why interest rates are so low, but that he felt sure that they would stay low for a while longer. (Really! He said that!)

“The economic and financial world is changing in ways that we still do not fully comprehend,” the chairman admitted. “The pronounced decline in U.S. Treasury long-term interest rates over the past year despite a 200-basis-point increase in our federal funds rate is clearly without recent precedent.”

Nevertheless, Greenspan expressed confidence that America’s inexplicably low rates would remain inexplicably low for some time to come. Bonds rallied immediately on word of the Chairman’s incisive analysis…and so did stocks. Therein lies the conundrum. If these two markets are both looking at the same economic data, one of them must be kidding themselves.

Either the U.S. economy is slowing, as the falling bonds yields seem to imply, or the economy is growing nicely, as the rallying stock market seems to imply. Let’s consider the former possibility.

Despite Greenspan’s professed bewilderment over the decline of bond yields, he does allow that they might be so low because the global economy is slowing, including the U.S. portion of it. “A number of hypotheses have been offered as explanations of this remarkable worldwide environment of low long-term interest rates,” Greenspan explains. “One prominent hypothesis is that the markets are signaling economic weakness. This is certainly a credible notion.”

Falling bond yields, therefore, represent argument #1 in favor of an economic slowdown, and therefore, against a continuing stock market rally. The yield on 10-year Treasurys has dropped almost one full percentage point over the last 12 months. Meanwhile, European interest rates have been declining even faster than morals at a bachelor party. German 10-year “bund” yields – currently – 3.12% have fallen to an all-time low.

Corroborating these signals from the bond market, the U.S. Institute for Supply Management’s (ISM) Index of manufacturing activity has been dropping since early last year. The ISM’s index of “New Orders” has also been falling sharply. Not surprisingly, therefore, the Conference Board’s Index of Leading Economic Indicators has been slumping for months.

Moving from the ivory tower of economic theory to the pot-holed macadam of real world trends, we find that the earnings growth of the S&P 500 is slowing markedly. As the chart below illustrates, stock prices tend to track – approximately – the S&P 500’s earnings growth trend. At minimum, slowing earnings growth is not a good thing.

Over the last few weeks, US stocks, particularly technology stocks, have been rallying from their recent lows, as if anticipating renewed economic vitality. But the evidence of vitality is sparse, particularly in the tech sector. Computer chip prices, for example, have tumbled to multi-year lows – a sign that computer demand is anything but robust.

The semiconductor book-to-bill ratio has also been slumping. In other words, new orders for computer chips have dropped well below the current sales rate. The disappointing trends in the semiconductor industry do not bode well for the tech sector in general. The Nasdaq rarely progresses very far – or for very long – while the semiconductor sector is struggling.

Hopes for a rebound in chip prices have sparked a nice rally in the shares of many DRAM manufacturers higher over the past month, leading the Nasdaq higher. The SOX Index of semiconductor stocks has jumped almost 20% during the last two months. But we fear the buyers might be disappointed.

"Supply growth from DRAM manufacturers has slowed this quarter but suppliers still hold more inventory than in the first quarter," says Nam Hyung Kim, an analyst at U.S. market research firm iSuppli Corp. "There is no evidence that demand is picking up."

These widespread signs of economic weakness may be popping up because the one-off stimuli that have been powering the economy have exhausted themselves.

“Our bearish case is relatively simple,” Comstock Partners laments. “Valuations are in the high end of the historical range. The major tax decreases that helped jump-start the economy are now in the past…Cash-outs from mortgage refinancings are about 75% below the peak. Consumers have drawn down their savings rate from the historical 7-to-9% range to a point now approaching zero. Consumer debt relative to GDP is at record levels…To top it off, the economy is already showing significant signs of deteriorating. All of these factors are symptomatic of a market that has little reason to rise and a lot of reasons to fall.”

The folks at Comstock may have a point. The evidence of slowing economic growth is persuasive, if not conclusive. And if the economy is indeed slowing, stocks prices might be a shade too high…In which case the bond market might be smarter than we think.

But since we can’t quite decide whether to sell bonds or to sell stocks, we suggest a compromise: Sell both.

Did You Notice…?
By Eric J. Fry

In addition to the budding economic weakness that threatens to undermine the rallying stock market, some of the “market internals” are also flashing warning signals.

Specifically, mutual fund cash levels have fallen close to record lows, the VIX Index of option volatility also flirts with all-time lows. Both of these phenomena indicate high levels of investor complacency, which is often the attitude that prevails before major market declines.

Recent action in the option markets tells a similar tale. The “dollar-weighted” QQQQ put/call ratio has dropped to a worrisome level. In other words, option-buyers on the Nasdaq 1000 are feeling extremely confident…and complacent.

“The latest reading for its 21-day moving average is at about 87 cents in puts traded for every $1.00 in calls,” options pro Jay Shartsis observes. “In the last year, there were levels of 81 cents in April 2004, 95 cents in July 2004 and $1.08 February 2005, each of which led to market declines. So the current level is now showing enough option trader optimism to signal a short-term top in the Nasdaq 100.”

After the close of trading yesterday, Shartsis mentioned a couple of other bearish developments. “Even with its strong earnings,” he said, “Texas Instruments (TXN) was unable to take out the trading range it’s been restricted to for several weeks. It was not even able to better yesterday’s peak of $28.25, reaching $28.20 before falling back.

“The semis have been leading the Nasdaq, which has been leading the rest of the market. So any weakness in this leading group is something to pay attention to. Just look how the Nasdaq’s been weakening over the last couple of days,” Shartsis continued. “On Monday, the Dow climbed to a new recovery intraday high of 10,481, but Nasdaq was unable to better its own prior high of 2097.80. Then on each of the next two days, the Nqasdaq has been conspicuously weak…Consider me worried.”

And the Markets…