· Stock markets begin long-awaited correction
 

Market Synopsis

Over the past three weeks, the financial media has been rampant with discussions concerning the meltdown in share prices in China, the carry-trade based on borrowed yen, and the sudden “appearance” of a problem with sub-prime lending. North American stock markets have experienced their largest declines since mid-2006 and technically, there is little reason to believe that a bounce will bring them close to their 2007 highs. While the three situations are hardly independent, it is rather instructive to see how they might affect the markets here as we progress through 2007.

The “China Syndrome” has been a tale of two different markets with the shares listed on the Shanghai exchange rebounding firmly in the days following their 9% loss on Feb 27. On Friday, they stood 2.2% lower than their close on Feb 26 having regained much of their value lost in the ensuing three weeks. Interestingly though, were we to compare the rebound with the Powershares Golden Dragon Halter USX China ETF, we would discover a striking anomaly with the initial drop on Feb 27 of 9.6% (with an intraday low of 17.5%) approximating the current loss as of Friday. (This ETF is comprised of the US-listed stocks that derive the majority of their revenue from China.) The prevalent belief is that the Chinese stock market had become the latest and greatest asset bubble in China and, being virtually accessible to everyone from all levels of society, participation had grown immensely over the past twelve months. The mere fact that the Shanghai market has rebounded so strongly could represent a new wave of speculation by native Chinese. Thus the ETF would be far more representative of the reality in China and offers the added benefit of more rigorous accounting leading to more realistic financial statements.

The fall in stocks related to the sub-prime lending market had begun earlier in the year however the announcement in early February that New Century Financial would be restating their earnings for the previous three quarters was electro-shock therapy to a comatose financial system. It is not hard to see for anyone with a rudimentary grasp of lending practices that mortgages whereby the only monthly payment required is interest and where initial payments are not required, could only bring future trouble. And especially when these sub-prime loans comprise such a significant part of the market for borrowing. This week’s announcement that homes entering the foreclosure process increased 0.54% in the fourth quarter of 2006 and the delinquency rate of all mortgage loans reached 4.95% should not be terribly surprising but still the market registers shock.

While the combination of the Chinese stock market collapse and the decline in the sub-prime mortgage industry contributed strongly to the initial drop in stock prices across North America, the subsequent winding up of yen carry-trades added potent fuel to the fall. The yen carry-trade was characterized by borrowing yen at near zero interest rates (established by the loose monetary policy of the Bank of Japan) and using the funds to invest in other markets. No one truly knows the magnitude of this carry trade and thus nobody is able to predict when it might be completely reversed through the repurchase of yen. As stocks fell in recent weeks, the value of the yen has risen strongly, clearly indicating that the process of repurchasing yen was on going. It is certainly more than a passing coincidence that on Feb 27, the yen rose a staggering 2% while stocks were sold recklessly. As institutions and hedge funds lower their exposure to the yen carry-trade, they have been forced to liquidate investments including evidently, those of Chinese stocks and mortgage-backed securities, the latter which has prompted tightened credit pressuring other sub-prime lenders in the process.

Though this process of liquidation will continue and may apply significant pressure to the sectors most affected: Chinese stocks and those connected to the housing industry, there is a potential rebound occurring in the US economy with industrial output rising 1% in February and capacity utilization jumping back up to a strong 82%, which is the highest level since September. In two weeks, new ISM Purchasing Managers survey data should provide more clues to the probability of the rebound.

Technically Speaking

The most important element of the technicals this week was the key reversal day on Wednesday when stock indexes touched an intraday low and subsequently closed at their highs on strong volume. Friday’s action negated this performance partially as volume was much greater, however Friday marked the quadruple witching hour with expiry in options, futures etc. and as such there is a normal increase in trading volumes on these particular days.

Strong support levels also played a role in the bounce as the S&P 500 closed above both its 200-day moving average around 1350 and its support at the May 2006 highs around 1325. Similarly, Nasdaq Composite shares uncovered support at their May 2006 highs of 2350 and the Nasdaq-100 found its respective support at 1720. Both Nasdaq indexes remain well above their 200-day moving averages. Finally, the Dow Jones Industrials was supported near the 12,000 level and its own 200-day MA.

Preserving these support levels is constructive for the indexes but much will depend on price action in the coming days as further tests will most certainly be forthcoming. Failure to contain losses will mean the strong likelihood of another leg down for stock prices.



New Buy Recommendations (in order of preference):

Tsakos Energy Navigation (TNP)  This shipping firm specializing in oil tankers closed just below its all-time high on Friday on very large volume after beginning the week with another surge in price and volume. The initial jump on Monday was attributed to its extraordinary fourth quarter performance and this has set the stage for the likely start of a new leg higher. On weekly chart and monthly charts, there are Lindahl buy signals supporting the rise in price.

American Superconductor (AMSC)  The rise in price coupled with strong volumes on Tuesday and Friday of this week propelled this stock back near its highs for 2007 and it appears prepared to break through multi-year highs near $17. The new 2-year high is especially visible on the monthly chart and coincides with the Lindahl buy signal seen here as well.

New Short Sales  

None.

Stock Positions to Sell/Exit:

None.

Portfolio Comments:

New stops have been added to the list while others have been modified. Those that have blanks are being carried unstopped for now. Please see our complete list of stops in the table below.

List of Current Stock Recommendations:

Action Ratings. The following is the legend for designating immediate action
for our stock recommendations. The first is B, meaning the stock is timely
to buy but the case for doing so right here is not overwhelming. Either the
stock may have gotten ahead of itself and may be vulnerable to a retracement or
else the stock has been performing disappointingly but may simply be
regrouping. B+ and B++ indicate stocks for which there is a technical case
to buy now, with plusses adding weight according to how many there are, up
to a maximum of two. Stocks rated H are ones to hold, awaiting confirmation
to buy more or to sell. SELL, of course, means what it says. It seldom pays
to override this designation. In the case of stocks held short, the rating is S where positions should be retained. S+ and S++ indicate stocks for which there is a technical case to add to the positions with plusses adding weight similar to long positions. The maximum number of plus signs is 2.

N.B. There are no longer restrictions on foreign stocks held in Canadian retirement savings accounts.