We flirted with it several times but on Thursday and again on Friday, the Dow Jones Industrial Average actually closed above the 12000 mark. But how secure is this lofty perch we sit atop?
A casual observer of the chart above might say that the last year has been hectic. The sudden turn downwards in May depicts the old adage, "Sell in May and go away." In fact, after flirting with the 10700 level in June and July, the three month acceleration to Dow 12000 is a testament to market bullishness. But pulling back the curtain a bit reveals upcoming headwinds.
At 23.27 the current Price-to-Earnings (P/E) ratio is near historic highs. Think about it, that means we're paying $23.27 for every dollar of earnings. These 30 companies are priced for optimal performance. Yet, cracks are starting to appear. One component - Caterpillar reported lower then expected earnings and has issued lower earnings guidance for the year.
Let's take a look at the five year chart...
Now the puzzle takes on an added dimension. To some degree the Dow has retreated every October. Some retreats - '01 & '02 - have been more dramatic then others. 2003 & 2005 were mild but '04 was noteworthy and '06 may prove to be as well.
In his book, "The Vital Few vs. The Trivial Many: Invest with the Insiders, Not the Masses", George Muzea explains that institutional investors (approximately 70% of the market) sell their losing stocks in September and October to offset their capital gains. We've certainly seen some serious capital gain recently, haven't we?
Friday, the NYSE reported declining issues of 1755 versus advancing issues of 1460. Volume for declining issues was more then 880 million while advancing volume was 707,352,000. Are the scales poised to take on a downward bias?
Frankly, I suspect that we are hitting a plateau and a pullback is in order. I believe you can expect a low between 11435 and 11000. The question in my mind: does the slide start before or after the mid-term elections?
What I'm Watching
If you follow financial news, you've probably heard of the Yield Curve. In June of 1996, economists Arturo Estrella and Frederic Mishkin wrote an article for "Current Issues in Economics and Finance" which is published by the Federal Reserve Bank of NY. In it they discuss the relationship between the yield curve and economic recessions.
Their study focused on the relationship between the 90 day T-Bill and the 10 year bond. Their study provided a guide using the 90 day average of the spread between the two yields and the probability of recession in the next four to six quarters ahead.
I've run the data for the past nine months and the results are sobering. Each quarter has indicated a 30-35% chance of recession starting as early as the first or second quarter of 2007. When nine months of data is telling the same story, I think it's safe to say that if we skirt a recession, there's a 65-70% chance of economic slowdown ahead. Stay tuned.
In The News
It's possible that we've witnessed the first step in Social Security Reform. In August, President Bush signed H.R. 4, the Pension Protection Act of 2006.
Aimed at reforming pension laws and strengthening the Federal Pension Insurance System, the law also includes provisions covering defined contribution plans - i.e. IRAs and 401(k)s. Specifically, it makes permanent the higher contribution limits initially passed in 2001.
According to the November issue of "Entrepreneur" magazine, "...the new law encourages employers to automatically enroll workers in a 401(k) plan unless an employee specifically opts out." The bill outlines certain provisions to begin enrollment at 3% in year one and increase contributions to 6% in year four. Plus, the plan encourages company matching funds. "None of the changes are imposed on businesses, but they offer opportunities for entrepreneurs to take new tax breaks and redefine their retirement plans." You can bet that those "opportunities" will translate to changes in many existing 401(k) plans.
Who knows? In twenty years you might be means tested to determine if your 401(k) nest egg is sufficient to lower or eliminate your potential social security paycheck. I would have liked to have seen an in kind percentage reduction such that the employees 3-6% contribution was offset by a reduced FICA tax obligation of the same percentage. That would go a long way to offset financial burdens on the middle class and increase savings while, at the same time, defusing the potential Social Security time bomb.
Next Week In the Fund Informer...
I'm going to take a look at the Russell 1000 Index. I'll begin to explain the value of the Price-to-Earnings ratio and take a look at oil (will the current lows continue?).
Is there something you'd like to see more - or less - of? Click here and let us know.
Till next week...
Posts
