The Dow Jones Industrial Average recently closed below the 11,000 level for the first time since February of 2006. Much of this selling pressure can be attributed to the usual suspects, such as the ongoing weakness in the housing market, along with the weakening economic outlook. More recently, a few more concerns have popped up, such as the IndyMac Bank collapse and renewed pressures on Fannie Mae and Freddie Mac. In addition, it is not only U.S. equity markets that are under pressure. Within the MSCI World Index, which includes equity prices from 23 industrialized nations, only Canada was able to avert the bear market decline of 20%.
At the beginning of this year there was a general feeling that bull market forces would reassert themselves in 2008. Never mind that last year a major bullish seasonal indicator failed to live up to its reputation. History has shown that the third year of a presidential term is usually the best year for stock index futures gains. The question that must be asked is; what happened that caused this usually reliable indicator to fail? In fact, the S&P 500 was down on a year to year basis last year and is well on its way to put in a repeat performance this year. History has also shown that the second best performing year for stock index futures is the fourth year of a presidential term. The same question must be asked again now. What is happening this year, in spite of the bullish fourth year of a presidential term indicator? At least for now, stock index futures are giving an even less impressive performance compared to last year. However, not all of the historical relationships that have been observed over the years are failing now. It appears as though only the bearish seasonal indicators are working this year. There is one historical indicator that is conforming to expectations. It is called the January indicator and it states that the price direction in January for stock index futures can predict the direction of the market for the balance of the year. Higher prices for the indexes in the month of January imply further gains for the rest of the year, while just the opposite is likely when January is a down month. January was a down month and the rest of this year, so far, has not been too good either. Currently, there is little to suggest that this rule of thumb will not work in 2008. Where did all the optimism go?
Only short covering rallies?
There has been substantial help form the Federal Reserve and from the Treasury, which at least temporarily, has helped stock index futures to stabilize. But is it enough? The Federal Reserve said they will lend Treasury securities to troubled banks in exchange for mortgage backed securities that have lost much of their value. A good portion of this distressed paper is directly due to homeowner mortgage payment defaults. By lending Treasuries in exchange for mortgage backed securities, the Federal Reserve will let banks exchange debt that is less liquid and less desirable for Treasury paper. Within the plan, the Federal Reserve will lend Treasury securities for 28 day periods to at least 20 institutions. On the condition of anonymity, a Fed official said the program could be expanded as needed. This plan was announced after it had become more obvious that other measures they had taken to limit the impact of the credit crisis had failed to have the intended result. Losses at financial firms have been substantial and there is probably much more to be revealed in the months ahead. Currently, there are rumors that one or more major commercial banks are having severe liquidity problems. Some traders are saying the Fed’s rescue plan may have been a pre-emptive strike to alleviate a variety of possible credit market problems. Based on what has happened recently, these fears have proven to be warranted.
In spite of this, there have been some rays of hope this year, but not many. One example of this took place on Wednesday, July 16th, when the financial sector had its best single day advance in 16 years. What inspired this rally was news that Wells Fargo, which is the largest bank on the West Coast, reported better than expected earnings along with a 10% increase in their dividend. The initial bullish response to this news was impressive, but it remains to be seen if the gains can be held.
Technical and fundamental indicators
There appears to be no good reason to think that these bearish signals are likely to change anytime soon. Current technical and fundamental analysis suggests, in the weeks ahead, stock index futures prices will continue to work lower. My technical analysis places a lot of weight on how stock index futures respond to various types of news. This brings us to one indicator that I have found to be very accurate for all markets and especially for stock index futures. This is the “opposite reaction to news” indicator. This signal may be a bit more subjective and less scientific than some indicators, but it works very well for short-term analysis and often when markets are making major highs or lows. The best example of this signal is when the news is all bearish, or bearish on balance, and futures are able to trade higher. This is a sign that some bullish factors are present, but not yet apparent. For example, the fundamentals: 1) may be changing for the better or; 2) possibly one or more large traders may be overextended on the wrong side or; 3) possibly there is little for sale above the market. Either way, it is a bullish indicator when futures perform better than the news would suggest. The bearish application of this indicator was evident during much of the recent decline in stock index futures, as price trends showed a tendency to ignore bullish news of any kind, whether it was in the form of lower interest rates, bullish economic reports or an improved international situation. So far this year, as was the case late last year, bullish news has not been able to support stock index futures for very long, if at all. In addition, bearish news tended to produce an overreaction on the downside.
Another technical indicator of great importance is how well futures follow through when chart buy or sell signals are generated. When chart buy signals do not produce results and sell signals tend to work well, we can conclude further price weakness may be in store for any given market. This is the situation that we are seeing now. One often over looked short term leading indicator of the likely direction of stock index futures is the level of the U.S. dollar, especially against the Japanese yen and the Eurocurrency. History has shown that the U.S. dollar has a tendency to be a leading indicator of a change in direction of other financial markets, including stock index futures. As long as these major currencies remain firm against the U.S. dollar, we can expect further selling pressure to come into stock index futures.
One of the best of the longer term indicators remains bearish as well, and that is the yield curve indicator. Although the yield curve is now normal in the U.S., after being inverted earlier this year, yield curves in other parts of the world have recently become inverted. The current yield curve inversion is an extremely reliable signal that an economic recovery may be a long way off. If the world economy is slowing, it will be difficult for the U.S. economy to do much better.
Where are futures headed from here?
Weekly S&P 500 Futures
Weekly Dow Jones Futures
It appears as though the bullish impact of the Federal Reserve’s rescue plan has run its course, as traders took a second look at its ramifications and placed more emphasis on the inflationary aspects of more money injected into the banking system. Most likely, the plan will only have a temporary bullish impact on stock index futures.
Futures prices are likely to come under selling pressure this month as second quarter corporate earnings reports are likely to be weaker than analysts’ estimates. Currently, it is expected that S&P 500 companies will report a drop in quarterly earnings by as much as 11% from the year earlier period. However, our own analysis suggests corporate earnings will be weaker than the Wall Street estimates. Profits at financial firms are expected to be down 60%.
I have received many questions lately pertaining to downside price objectives. While a major market move is taking place, my analysis tends to focus on timing objectives rather than on price objectives. However, once our timing objective has been met, whatever the level of stock index futures is at that time will be the price objective. For now, expect lower futures prices at least through the first quarter of 2009.
There is a bright spot in our analysis, however. Some of the bearish signals that we have outlined are likely to reverse later next year, leading to a new bull market for stock index futures in the second half of 2009.
For more information about this article, please contact Alan Bush 1.800.243.2649 or email at alan.bush@archerfinancials.com .
Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. The views and opinions expressed in this letter are those of the author and do not reflect the views of ADM Investor Services, Inc. or its staff. The information provided is designed to assist in your analysis and evaluation of the futures and options markets. However, any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to ADMIS. Copyright © ADM Investor Services, Inc.
