We will shown below that the current fundamental state of the S&P 500 is not particularly attractive. Unfortunately, technical state of the S&P 500 is also presently negative.

Fundamentals:

• Valuations are not attractive (trailing PEs are around 20)
  
• Earnings are weakening
  
• Credit is contracting
  
• Economy is weakening

Housing Remains a Key Driver

• In the last credit crisis, bank stocks hit bottom in November of 1990.
  
• Losses in housing and non-performing assets at banks did not peak until well into 1991.
  
• According to the National Association of Home Builders (NAHB), the average number of months of supply of unsold new homes in 1990 was 8.5 months. In 1991, it was 6.2 months. The average of 1990 and 1991 was 7.35 months.
  
• The NAHB’s latest published figures based on data through June 2008, show a 10 month supply of new unsold homes, which is 36% percent higher than the 1990/1991 average.
  
• Inventory levels of unsold homes appear to be too high for a lasting bottom in financial stocks.

The law of supply and demand says housing prices have not bottomed, which means the problems at banks and with contracting credit are not likely over either. While ,at the moment, lower oil prices are driving stocks higher, it is difficult to envision a lasting bottom in stocks until we at least see some meaningful stabilization in home prices.

This article ("The Stars Have Yet to Align for Stocks," 08/03/08) by Mark Hulbert points out some additional fundamental and technical reasons to remain skeptical of the recent rally in stocks. Another article ("Markets were up, but not 9-to-1 up," 08/05/08) by Hulbert outlines more technical evidence which implies the current move in stocks is not likely the start of a new sustainable bull market.

Homebuilder Lennar (LEN) bottomed in late October 1990 several months before losses in housing and write offs for banks peaked. Therefore, if we see meaningful evidence of a bottom/trend change in housing stocks, it would increase our confidence that housing prices may be nearing a lasting bottom. Similar to the financial stocks, the homebuilders stocks have not moved far enough to put the primary downtrend in jeopardy. A more convincing bottoming process in these stocks will be a good sign for all asset markets.

From a BusinessWeek article dated July 29, 2008:

Patrick Newport, a housing economist for Global Insight in Waltham, Mass., said he's more concerned about the inventory of unsold homes continuing to rise as more and more foreclosed homes come onto the market. Newport plans to extend by three months his earlier forecast that existing home prices would hit bottom in the middle of next year. He stated if you combine today's release with the other housing releases, it just tells you that the outlook over the next year is not good.

• The main argument against buying a home now is that values are still spiraling downward. Stay on the sidelines and you'll be able to buy that dream home for a much lower price than now -- about 25% less in Los Angeles County, predicts Celia Chen, director of housing economics for Moody's Economy.com. Chen bases that guess on several factors, including the high inventory of unsold homes and the gap between current prices and income. Fewer than 11% of adults in the L.A. area earn enough to buy a median-priced home of $412,000, according to a National Assn. of Home Builders index. As recently as 2001, when the median was lower, that figure was about 38%.
  
• Los Angeles economist Christopher Thornberg believes that home prices will stabilize when homes are affordable to about 25% of the adult population. For that to happen in Southern California, home prices would have to come down 20% to 35% from their current levels, Thornberg said. ‘There's no way in hell the house you buy now will be more expensive next year,’ he said.
  
• Home prices are also relatively high compared with rents. The ratio of home prices to annual rents in the Los Angeles area was 20 as of March 31, meaning the median home sale price was 20 times a year's rent for a comparable property, according to Moody's Economy.com. The 15-year average ratio in Los Angeles is 16.4.

Financials, Foreign Stocks, and Commodities

Foreign stocks also have negative alignment of the fundamentals and technicals.

We Make Decisions Based on Evidence Not Opinions, Fear, or Unreliable Forecasts

In today’s markets, it is critical for us to stay focused on the big picture rather than get caught up in the day-to-day swings. From a technical perspective (looking at charts), you need to have a good feel for what a trending market looks like. If a market is currently trending in your favor, there is no need to overreact when the inevitable countertrend rally goes against you. Using long-term charts helps keep your emotions in check when things get uncomfortable (a common occurrence for both bulls and bears in the current environment).

200-day moving averages (MA) are used to smooth out shorter-term volatility within the context of the longer-term or primary trend. Markets which trade consistently above their 200-day MA tend to be good buy candidates. Markets which trade consistently below their 200-day MA tend to be good sell candidates. The chart below illustrates the concept using the NASDAQ from 1992-2002.

From a technical perspective the facts concerning U.S. stocks are still negative. There is nothing on the chart below that yet indicates any change in trend for the S&P 500. The trend remains down. The 200-day moving average is shown in blue below - note the S&P 500's current value remains below the blue line. If you compare the chart above of the NASDAQ 1992-2002 to the chart below of the present day S&P 500, it is clear stocks remain in a downtrend. This is obviously subject to change if the market continues to move higher.

No Real Evidence to Support Current Rally in Stocks

Some comments from an August 11, 2008 update from respected money manager John Hussman:

• With bonds and utilities deteriorating, stock market internals are becoming unusually hostile. This sort of joint deterioration in interest sensitive securities has often provided important warning of steep subsequent losses, as we observed for example in 1966, 1987, and 1990. While the market is still sustaining something of a relief rally from the lows of a few weeks ago, I've noted that hostile yield trends have a tendency to cut such advances short, even when bearish sentiment and oversold conditions would otherwise invite more sustained bear market rallies.

• As of last week, the Market Climate in stocks was characterized by unfavorable valuations and unfavorable market action. In addition, stocks are again overbought in an unfavorable Market Climate, which tends to produce unusually poor subsequent returns, on average. Combined with hostile yield trends in interest-sensitive securities, current market conditions warrant unusually strong concern. Though I have a longstanding aversion to forecasts, the outcomes from prevailing conditions have historically been so negatively skewed that the distinction between "average outcomes" and "forecasts" is not meaningful.

The Dollar & Commodities: Historical & Present

As stated above, the dollar crossed its 200-day moving average on Friday, August 8, 2008. The chart below shows the movements of commodities after the dollar crossed its 200-day MA in 2005. There are numerous economic differences between 2005 and 2008. The intent of the chart is not to paint a bullish picture for commodities, but to highlight the need to keep on open mind about relative movements between the dollar and commodities.

The chart below shows some technical evidence of an intermediate trend change which occurred in 2005. If we are presented with similar evidence today, it may warrant some additional defensive action with investments related to a weak dollar.

We Will Become Bullish on Stocks When We Have Evidence to Do So

Chris Ciovacco
Ciovacco Capital Management