Watching the S&P 500 over the past two years has been like listening to Kellogg’s famous breakfast cereal hit a bowl of milk.
The ‘snap, crackle and pop’ you hear at breakfast is the sound Rice Krispies make when you rapidly change their temperature by pouring cold milk over them.
What’s this got to do with the stock market? Well, the markets have been changing temperature rapidly too. The ‘snap, crackle and pop’ in the most important US market, the S&P 500, has come from three important share price drivers.
Sign up for free stock market and property investment seminars
The S&P 500 is the best gauge of US stocks
The S&P 500 earnings growth rate (the snap), sentiment as reflected by the level of that index (the crackle), and the ongoing oil and commodities boom (the pop) all point to shares falling for the rest of 2008.
I monitor the S&P500 because it is the single best gauge of the US equity market, the most important stock market in the world. The S&P500 represents 75% of the US stock market and most fund managers’ performance is measured against it and it is therefore very important.
Sign up for free stock market and property investment seminars
Shares don’t rise for long while earnings fall
Snap goes the S&P 500 earnings growth rate! The bull market that started in March of 2003 is over. Why? The main reason is that earnings growth on the S&P 500 slowed sharply towards the end of 2007.
Cracks in the bull market started to show at the end of the third quarter of 2006. S&P 500 earnings in Q3 2006 were $23 per share. By Q3 of 2007 earnings had slumped to $20 per share.
Confirmation that the bull market was over came in Q4 2007 when earnings came in at $15, as compared to $21 for Q4 2006. This dramatic year on year decline in earnings clearly signalled that the US economy was in trouble.
Sign up for free stock market and property investment seminars
Sustainable rallies require rising earnings
You can see then why shares have faltered in the US. Earnings growth went from +10% for Q2 2007 year on year, to -9% Q3 2007 year on year, and then to -31% for Q4 2007 compared to the same quarter a year before. The S&P 500 sold off soon after that, and we have been in a market correction since mid-October 2007.
I expect the market to trend down until the end of October 2008, and then we might have a relief rally into the end of the year. But until there is “growth” again in the S&P500 earnings, I don’t believe we will enter a new bull phase. Any low volume rally should be seen as a short selling opportunity, as prices are likely to spike upwards and then fall back sharply.
Key resistance areas in the S&P 500 are around the 1,400 level, with key support areas at 1,325, 1,275, and 1,175 respectively. There are still significant down side risks to this market. In market corrections, investors should hold CASH, and not look to buy stocks until the market has confirmed a new bull phase.
Sign up for free stock market and property investment seminars
‘Crackle’ and the floor fell out of the market in 2007
After the snap of lower earnings growth came the crackle as the S&P500 market had one last desperate run to a climactic top at 1,576 level on the 12th of October 2007, and it has been downhill since then.
There does not seem to be any chance of further rate cuts to boost sentiment either. Recently the Federal Reserve indicated that the interest rate cut cycle is now at an end and that support for the dollar, together with fighting inflation, is now high on the agenda.
For stocks to go up, we need earnings growth, lower inflation, and a healthier overall economic environment. We do not have the first two, so what about the wider global economic environment?
Sign up for free stock market and property investment seminars
Oil and commodities will go pop!
At the moment, the global economy is surging despite the slowdown in the US. Rapid economic growth in China, India, Brazil and many other emerging economies has been sucking in unprecedented quantities of raw materials.
This extraordinary demand, plus low supply, has driven oil and commodity prices to successive all-time highs. Goldman Sachs thinks oil will be trading at $141 by the end of the year. T. Boone Pickens a very influential and successful oil investor, thinks that oil could surge to $150 a barrel.
Who ever knows where oil is going to trade at a year from now will be a very rich man. I believe that these high prices are in fact a bubble waiting to pop, though it may not happen immediately.
Sign up for free stock market and property investment seminars
Where are oil and commodities going?
So far this year oil has performed really well. The West Texas Intermediate (WTI), also known as the Texas Light Sweet Crude, which is used as a benchmark in oil pricing on the New York Mercantile Exchange for oil futures contracts, has hit record highs.
This in turn put global economies under pressure. WTI Oil should experience resistance around the $148 level, with downside price correction to $134 and $120 levels over the short term.
Further downside could be as low as $106, $92, $78, by the end of the year, beginning next year, and if all goes well with a correction in WTI Oil, a potential area of support $50 late into next year.
Sign up for free stock market and property investment seminars
What should investors do now?
We need strong earnings growth to turn this market around. A reacceleration in the S&P 500 for two consecutive quarters will be very bullish for stocks. Stock market rallies before that should be seen as short term rallies in an overall down trend.
Dust off all those old short selling strategies, for you going to need them. Investors should be in cash in time like these, and not looking to fight a down trend.
“The financial markets generally are unpredictable. So that one has to have different scenarios. The idea that you can actually predict what's going to happen contradicts my way of looking at the market.” George Soros
Beware the low volume rallies in the market, if still in doubt, go pour some milk over a bowl of Kellogg’s Rice Krispies, and listen.
Richar Muller is an independent proprietary trader, trading equities, index futures and forex, with more than 14 years professional investment management and trading experience. Mr. Muller is an investment consultant and mentor at WinInvesting LLP.
