Three signs that stocks are heading for a fall
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Dominic Frisby Sep 02, 2009
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September wil be nasty - particularly in the US
After a big down day on Monday, stock markets took an even bigger hit yesterday. The Dow was down some 185 points, while the S&P 500 fell below 1,000. It was some of the nastiest action we've seen since early July, which is odd as only last week we were being told that the economic crisis has 'ended'.
But is this the 'real deal' or just a 'healthy correction'?
(My thanks to Dimitri Speck of Seasonal Charts).
We can expect a nasty September - for US stocks in particular. September is historically the worst month in the year for US stocks, with the benchmark index losing 1.3% on average since 1928, according to Bloomberg. But it's particularly bad month during post-election years, as the chart above shows.
We have had the rally from March to August. According to the seasonal pattern we can now expect to give much of that back, as we decline into November. But three leading indicators suggest to me that this is more than just a normal seasonal correction.
Three signs that stocks are heading for a fall
The first is the Baltic Dry Index (BDI), a measure of shipping costs for commodities. It has been in decline since June, amid slowing Chinese demand for coal and iron ore, and is now down some 40%. That drop reflects a wider slide in demand for raw materials which is likely to push prices for metals, commodities and energy lower (we have seen this already, with most mining and energy stocks peaking in June). If raw material demand is down, that suggests global trade is slowing.
It's also worth noting that the direction of the BDI has in recent years correctly anticipated the direction of the stock market, usually by a month or three.
If the BDI is right, then a significant correction in the markets is imminent.
Another leading indicator has me concerned – the Shanghai Composite Index. It was the world's worst performer in August, down some 22%, and it fell another 6.7% yesterday. Banks have been tightening lending to avert asset bubbles and policy makers have been advising steel and cement industries to curb overcapacity (hence the declines in the BDI). But not so long ago it was the world's star performer, up over 100% from its November 2008 lows (for more on this, see yesterday's Money Morning: Why investors are right to be spooked by China).
Like gold, the Shanghai Index previously bottomed in autumn 2008 and began to rise, while the US indices continued their declines into March. That the Shanghai Index is in freefall yet again suggests a similar sorry story is coming to the West sometime soon.
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Our third indicator is corporate bonds, which also look like they have made a top. They too lead the stock market by a few weeks. The stock market, after its early August correction, was able to get up and retest its old highs. Corporate bonds could not. This first chart shows high yielding bonds (the Blackrock High Yielding Fund):
This next chart shows the junk bonds exchange-traded fund (ETF):
They both appear to have rolled over.
In addition, as I noted last week, various sentiment indicators have been at extreme levels, which suggests an imminent turn. There is too much negativity on the dollar (effectively, the inverse of the stock market – only 3% bulls, according to one July reading) and too much positivity on the stock market, with the Daily Sentiment Index reaching 89% last week, matching the 2007 peak.
Where can you hide from the falling stock markets?
If three leading indicators, sentiment readings and a seasonal pattern which has so far played out are all suggesting that declines are just around the corner, where's the best place to hide? At the moment I like cash and gold.
Which cash? Longer-term I like the Canadian dollar, the Norwegian krona and the Chilean peso, but these currencies rise and fall with commodities and, for now, I am not bullish about commodities. If we get a correction in stock markets, then the US dollar will benefit, just as it did in 2008, in a flight to safety.
It is a seriously flawed currency, underpinned by too much debt and a flawed economic model, but as the global senior currency, it is the first place people run to. Owning the dollar is almost like shorting stocks, so if the bear market in stocks resumes, we could get a nice rally to at least the mid-80 area (see chart below). For now, the lows around 78 on the US dollar index (the measure of the dollar against a basket of currencies) seem to be holding.
As you know, I also like gold. But in the near term, I confess to being in two minds. Despite gold's reputation as a safe-haven asset that rises when everything else falls, in recent years it has actually tended to rise and fall with the stock market. If we get some kind of liquidity event (where everyone sells out of liquid assets to get into cash), as we did last year, gold tends to sell off.
But perhaps now gold is decoupling – interestingly, it held up very well yesterday and actually rose a few dollars. In any case, gold has been stuck in a tight trading range all year. That range is getting tighter all the time and it is going to have to break one way or the other pretty soon. I suspect it will be to the upside, with a possible 'fake' to the downside first.
In any case, despite my caution over the short term (which may be a positive contrarian indicator in itself), August has usually proved a good time of year to buy gold and I remain very bullish over the long term. I own a lot of gold stocks and am not selling. Find out more about my favourite gold stocks in my extensive new report on gold and gold miners.
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