Tuesday, July 03, 2007

One more quarter?

Last week was bracketed on both ends by nasty intraday reversals to the downside. It was quite contrary to the usual quarter end action to be expected from mutual fund “window-dressing”. To be fair, major indexes didn’t move much last week despite those reversals. On the other hand, this week, with the 4th of July falling on a Wednesday, has gotten to a good start.

Although this bull market is long in tooth, I believe it would take real weakness in earnings to knock the bulls off their pedestal. Signs are that things will still look rosy (read: S&P earnings growth just north of 10%) for the June quarter. [Very good read: Real Earnings Yield model from CXOAG, check out the Excel file of S&P earnings estimates]

One very important piece of economic news that came out last week was the Personal Consumption Expenditure report. Following the method explained in Joseph Ellis’ book, Ahead of the Curve, I have been following the YoY change in the three month average of real PCE. This measure has been trending down since last December, but still came in at 3.28% last week. More importantly, the durable goods component increased to 5.13% after spending that last two months below 5%. All in all, the results from the June quarter are unlikely to give the market a reason to decline.

Recall that in 2000, the Nasdaq peaked in March but the S&P didn’t go into a steep downtrend until September as the free-spending dot com’s went belly up. This time around the giant sucking sound is coming from reduced mortgage equity withdrawal (MEW) in a declining housing market. CalculatedRisk has again put together a nice chart that shows the precipitous decline of MEW into Q1’07 (but still well above the long term average). Note that it usually takes consumers two quarters to actually spend the money from MEW. Since a bottom in housing is nowhere in sight, not to mention higher rates and energy prices, Q3 may again bring some nasty surprises.

Practically, it probably means the market will continue grinding higher till the middle of August. I don't expect companies to lower their expectations anytime soon. Most likely, they'll be surprised by the "rapid deterioration of economic conditions". Despite this big picture view, I'm staying long as I have learned that my own opinion is a luxury that I can seldom afford. At the same time, technical breakdowns will be far more alarming in my eyes.