Trading and Investing » 2007» April

April 30, 2007

Sell in May and go away?

Filed under: Trading — reblace @ 2:28 pm

When you’re trading (not investing) the market, it is critical to realize that short term (hours/days/weeks) stock performance is largely based on factors other than the financial profile of the companies in question. Some of the less obvious factors often include:

Time of day/week/month/year
Holidays, elections, other events of global importance
The weather

While some of these might seem silly, consider the following:

Historically, the biggest market gains take place during the fall months. Historically, the worst performing months are those of the Summer. This actually makes a lot of sense when you consider that the summer is the biggest vacation period of the year. Lots of vacations means less productivity, less people trading, more people taking money out of the market so they can afford the nice beach condo, etc. All of these things equal low volume, which means a flat or down stock market. The fall is when people are done with summer and get back to work with a fresh sense of purpose. They put their money in and start trading aggressively again. Just how much of an effect can this have?

“Money invested in the Dow stocks in the “best six months” and then switched to fixed income in the “worst six months” over 56 years grew to $544,323. But money invested in the Dow in the “worst six” and then switched to fixed income in the “best six” compounded to a loss of $272.“
CNN Money

The important idea to grasp here is that there are many non-obvious factors affecting market performance in very consistent ways. Being cognizant of these factors is critical to understanding the market and trading effectively.

Comments (0)

April 25, 2007

CME Housing Futures

Filed under: General — defo @ 2:54 pm

Last summer, the Chicago Mercantile Exchange began trading housing futures contracts on the Case-Shiller Home Price Indexes for 10 major US cities. The Case-Shiller Home Price Indexes are the gold standard in the academic community (and now the financial community) for measuring home price appreciation over time. Robert Shiller, of course, is the author of the popular book, Irrational Exuberance, which called for the implosion of the tech bubble in the 1999 edition and is calling for the implosion of the housing bubble in the 2005 edition.

The futures markets are currently predicting home price declines in all 10 cities from February 2007 to February 2008:

data from www.cme.com

The futures markets are predicting an average decline in these cities of 5.2% in the next year. And I’m not sure things will look any better one year from now.

Take a look at the graphs below of the last 20 years of home prices, and you can draw your own conclusions.

The web site Paper Dinero has produced graphs for all 20 cities currently tracked by the Case-Shiller Home Price Indexes (note: only 10 of these cities have futures markets). Note that all values to the right of the first quarter 2007 represent futures contracts and have not actually occurred yet (they are projections). Click on the pictures to see the full versions.

Graph 1: US Composite Index
(looking peaky?)

Graph 2: Boston
(always one of the housing market front-runners)

Graph 3: Washington DC
(does this city look in trouble or what?)

Graph 4: Las Vegas
(forget about it…)

From 1996 to 2003, the US housing market was experiencing a normal housing boom cycle, which last maybe 10-15 years from peak to peak. During this time, year over year gains were strong but not unusual. But then from 2003-2005, 50-year-long lows in the Fed funds rate (and thus mortgage rates) combined with new liquidity from mortgage-backed-securities opened the flood gates for money into real estate. Easy money and a housing surge soon turned into speculation. The result: just look at Las Vegas prices in 2003-2005.

There is a reasonable argument, maybe, that prices are just rising to a new plateau - that this price appreciation was long overdue. Or maybe we’re just in a new housing paradigm (where prices grow at over 5% per year indefinitely??). The problem is that rents have not been keeping up (see my December 2006 post on Price to Rent Ratios). If housing really has become scarce relative to the population, then shouldn’t we see rents increasing as well? Rents are rising for sure, but nowhere *near* the speed of home prices in the last 5 years.

My view is that most of the price appreciation from 2003-2005 was bogus and that these real estate indexes will decline by at least 15% in the next few years. That may not sound like a lot, but if you only put a 20% downpayment on your house, you’ve lost almost your entire investment. Certainly the degree of speculation and higher-than-sustainable prices vary substantially by location, and so will the price declines.

Of course, all of this depends on whether the decline happens quickly or slowly. A faster decline means nominal prices will actually fall. A slower decline means that prices may only fall in real terms (after adjusting for inflation). Either way, we’re probably looking at negative inflation-adjusted price appreciation for years to come.

– defo

Comments (0)

April 20, 2007

The Dow Jones is on a tear, but in which direction?

Filed under: General — defo @ 5:25 pm

The US stock market has certainly been on a tear lately. The Dow Jones closed the day at a new record of $12,961. Yes, that’s higher than its pre-”Internet Bubble” peak in Jan. 2000 of $11,719.

Many US stock market bulls point out that if you had invested at the Dow low in Oct. 2002, you would have earned a 70% return on your money in the last four and half years. That’s an annual return of 12.5%. Pretty good, eh?
Here is the chart of the Dow Jones Industrial Average from 1999-2007:

But the 70% return is only a nominal return, priced in US Dollars. It doesn’t count the fact that the US Dollar is getting weaker relative to other currencies and commodities. For example, the same 70% return priced in Euros would only be 23% (4.7% per year) with the Dow priced in Euros:

The outlook is worse still when you price the Dow in gold, an alternative form of money. Priced in gold, the Dow has dropped 21% (5.26% per year) since its 2003 low and has lost a whopping 53% (10.0% per year) of its value relative to gold since its 1999 peak. Is this really the recovering US stock market that people are talking about?

The fact of the matter is that the US stock market is losing value relative to gold, oil, real estate - just about any hard asset. The Dow, which is made up of productive companies, is supposed to outperform a barrel of oil, right? But in fact I would have more purchasing power right now if I’d bought a barrel of oil in 2003 and stored it in my basement than if I bought into the US stock market.

The nominal gains in the US stock market do not represent real increases, but instead reflect the weakening of the US dollar, which is approaching record lows against almost all of the major world currencies. The name of the game in investing is increasing the purchasing power of your investments over time. And the US stock market won’t win this game for many years to come.

– defo

Comments (0)

April 5, 2007

A testable prediction

Filed under: General — defo @ 12:09 pm

It’s about time to declare a testable, timely prediction for how I see the market unfolding. Here it is:

Before the year 2008 ends, we will see at least one of the following:

[1] Gold above $900 an ounce (that’s 35% higher than it’s current level).
[2] The Dow below 10,000 (that’s a 20% decrease from it’s current level).

I think either scenario is about equally likely, but probably both will not happen together (though I wouldn’t rule it out). These two movements represent two scenarios playing out in the economy:

Scenario 1. Housing and corporate earnings slow down and the Fed cuts rates to “save” the economy –> the value of the dollar plummets –> the stock market stays high nominally but inflation and gold are even higher.

Scenario 2. Housing and corporate earnings slow down and the Fed holds –> real estate prices decline substantially along with corporate earnings –> the stock market tanks and gold either rises or holds.

The probability of each Scenario depends on how severe the housing recession is and to what extent corporate profits are affected. The more severe the correction, the more likely I’d say we are to go for Scenario 1 (where the Fed is forced to lower rates despite the inflationary consequences).

The alternative scenario that could unfold that would make me change my prediction is if corporate earnings increase by 10% per year or greater in 2007 and 2008 while inflation stays below 3%. If this were to occur, I would retract my prediction above (but I think this is a low probability event).

Well, that’s about it. Calling it for the end of 2008 might be a bit aggressive, but that’s what blogs are for, right? Besides, it’s only a matter of time before the market realizes how weak housing really is.

– defo

Comments (0)