Oh, The Weather Outside is Frightful...
By James J Puplava CFP, November 27, 2002
All right, I realize that this is the beginning of the holiday season and we all are badly in need of some good news. In deference to the upcoming holidays, I will try to end this missive with some positive holiday cheer. But first, you and I must wade through the fog of balderdash, hype, hyperbole, and what is otherwise known as spin coming from Wall Street and the financial media. Suffice to say that the balderdash coming out of the financial sector is thicker that any fog I've encountered in more than 15 years of sailing. I'll begin my discourse with a review of some of today's relevant economic news.
Economic News Roundup
A key story out today is that personal spending by consumers went up in October after falling in September. Personal income rose 0.1% last month; while personal expenditures rose 0.4%. First off, personal spending in October after adjusting for inflation is less than the previous three months. In terms of income, it was the lowest increase in the last three months. What is more worrisome is the fact that the American consumer is having to go deeper in debt each month to maintain his standard of living. The difference between personal expenditures and income growth is debt. Borrowing more money each month to pay your bills is not sound financial planning, nor is it good economic policy. Wall Street and Washington hail this as a sign of our economy's resiliency. To me, it is another reminder that policymakers and consumers have taken a collective leave of their senses. To my knowledge, I know of no economy, nor have I met any individual or company, that has been able to borrow their way to prosperity.
A concomitant side effect of all this debt accumulation has been the jump in bankruptcies, delinquencies, credit downgrades, and the write off of debt. The FDIC reported that bank credit card write offs surged 35.6% during the third quarter. Commercial banks wrote off $3.9 billion in the latest quarter as credit problems accelerate. The good news is that bank profits rose 34.8% as the spread between what banks pay depositors on the money they leave with banks and what they charge customers to borrow widened. As a result of large layoffs over the last year, many Americans are falling further and further behind in paying their bills. Bankruptcies surged by 12% during the third quarter to 401,000. This is a new record. The American Bankruptcy Institute, a group made up of bankruptcy judges, lawyers and credit experts, said that filings rose 30% from Q4 of 2000.
Corporate Credit Downgrades
The picture doesn't look much better on the corporate front either. The credit rating agency, Moody's Investor Services, reported today that it downgraded the debt of 41 higher quality companies; while it upgraded only 5 companies. That's a ratio of 8.2 to 1. Last year at this time, the ratio of downgrades to upgrades was 5.2 to 1. The credit picture for corporations is deteriorating just like it is at the consumer level. Moody's said the downgrades are the result of companies taking on too much debt in the 90's. There is a definite debt overhang on the economy. This is preventing companies from spending money on new plant and equipment and hiring more workers. Plants are operating at low rates of capacity, profit margins have fallen, and sales have been lackluster. The high concentration of debt means most companies are trying to conserve cash in order to survive. To put this into perspective, Moody's said that this is the 18th consecutive quarter of downgrades exceeding upgrades, just shy of setting a new record. The credit agency expects that a new record will be set since it expects more downgrades of debt in the future. Currently Moody's has put 50 more U.S. companies on credit watch for possible downgrade. By comparison, only seven companies have been slated for upgrades. This would make the ratio for the next quarter 7.1 to 1. That should give us a tie with a previous record. The first quarter of next year will give us the 20th consecutive quarter of downgrades, which should give us another new record.
The next issue is corporate profits, which is closely associated with deteriorating credit. It is the ability of a company to earn a profit and service its debt payments that determines credit quality. In this regard the picture has improved slightly, but is still poor. Despite the hype by Wall Street of companies beating estimates, the latest revisions to GDP show that it has been a profitless recovery. As the graph-of-the-day above shows, Q3 was the third consecutive quarter of declining profits. Profits from current production were down 1.8%. Year-to-date profits have contracted 6.60%.
Since profits are dependent on an economic recovery and economic growth is expected to contract to an annual rate of 1% in Q4, it stands to reason that profits will also contract. Q4 will be the fourth consecutive contraction in profits this year, a fact that hasn't been fully discounted by the markets so far. Wall Street is still predicating pro forma (make believe) profits of 14.9%. The good news is that year-over-year profits, although down this year, are up 6% from last year. Last year's decline in profits was worse than this year. When you hear that profits are up this year, just remember that they aren't talking about real profits, but only make believe numbers. The real picture is that profits will fall for the fourth consecutive quarter in Q4. In other words, the loss in profits will be less this year than last year. That is as far as the positive news goes.
The drop in profits and the way it is reported by analysts and anchors is one reason Standard & Poor's has had to resort to defining core profits recently. The credit rating firm has added back expenses such as stock options, pension losses, and restructuring charges that most companies' analysts, and anchors exclude in their reporting of earnings each quarter. According to the rating agency, profits are much lower than reported, which is collaborated by the graph up above. Therefore the stock market is more overvalued than reported. The current market is selling at close to 50 times earnings instead of the widely reported multiple of 15-20, which is based on bogus expected profits. The fact that this market is reported as undervalued due to interest rate comparisons or expected earnings is as much fiction as the profit numbers themselves.
Our Current Bear Rally
Now as for the current bear market rally, it is important to note that it has none of the characteristics of a bull market rally, such as reasonable valuations in the form of low P/E's, dividend yields and price-to-book ratios, surging profits, negative psychology, and investor capitulation. As "The Slope of Hope" graph from our friends at Elliott Wave illustrates, every one of these bear market rallies have been accompanied by a jump in bullish sentiment and more recently by a plethora of calls of a "market bottom." Each bear market rally has been called "the real thing." After each brief respite, the market heads to newer lows with 2002 marking the third straight year of double-digit losses. This is beginning to worry Wall Street because investors may learn the truth about bear markets that follow booms. This revelation could be devastating for investors and last a very, very long time.
The current rally is being compared to the surge in stocks in 1933 after the Dow had lost 90% of its value. The comparison is made because of the four-day spikes in the run up in stocks. (More to say about that in a moment.) However, as Bob Prechter has pointed out in the recent issue of Elliott Wave Theorist, stocks were at their cheapest level in history at the time of that rally. Furthermore, the advance/decline ratio was over 9 to 1. By comparison, in this rally the ratio has been 3.5 to 1, even weaker than the rally of this summer, which was 4 to 1. The next graph shows the Dow from April of 1930 to July of 1932. During this period the Dow rallied seven times ranging from 20-40%. Each new rally was followed by an even greater plunge in the index until 1933 when stocks were priced to sell at some the greatest bargain prices in market history.
Time for a Reality Check
The current rally in the Dow (22%), the NASDAQ (33%), and the S&P 500 (21%) has lead to increasing bullishness that this is it, the long waited return of the bull market. The current rally is number five since this bear market began and you can clearly see the trend in the graph of the "collapse ahead" which is shown below. What is not emphasized is that this year, despite this recent rally, the Dow is down (11%), the S&P 500 is down (18.2%), and the NASDAQ is down (23.41%). Each new rally has brought renewed hope only to find that hope dashed with by a reality check as the news gets worse.
The only thing driving this rally is the optimistic social mood, which wavers at each new trough in the market. Just compare today's feeling to last July when I was calling for a summer rally. Just as pessimism was supreme, this gave me more confidence to forecast a rebound. The current bullish sentiment, the drop in the VIX, VXN and other sentiment indicators gives me the confidence to be bold enough to say that another drop is close by that should retest the October lows, then rally into the end of the year before the big drop of next year. The markets should head sharply down beginning sometime in January as the news of profits, a dismal Christmas retailing season, slower economic growth and war weighs in on the market. On the positive side, after a sharp drop down to the 4,000-6,000 level should then give us another intermediate rally that will be replete with bargains.
Let's Clear the Air of Half-Truths
It is absolutely ludicrous that Wall Street is telling investors that stocks are cheap or that profits are rising. These are only half-truths. It is true that profits have fallen less than last year. However, please refer to the graph above of quarterly profits. That is not the story you have been told about profits. The fact of the matter is that we have only gone through the first stage of this bear market. The next graph shows you where we are now and where we are headed.
To trade this market is one thing, but to believe in it is another. The return of the bullishness of the herd, the stocks that investors are bidding up again and the explosiveness of their rise, tells me that people have once again taken collective leave of their senses.
What makes me somewhat suspicious of this rally is the four gap days and the pattern of what I call flagpole rallies. This can be best illustrated by today's graph of the NASDAQ. Notice the sharp straight up-rise in the session, followed by a meandering waving flag pattern the rest of the day. The rallies are being jump-started in the futures and the options market.
When the futures markets rise sharply, this creates an arbitrage situation in the cash market and buyers come into the cash market. This can be viewed in the second graph below of the NASDAQ since the rally began in October.
The Triple Play
Well, enough of the reality check. Now for a bit of good news. For a market that has been yield-starved, a safer way to play this downtrend is to buy issues that are rising and in a bullish trend. Many of the defensive issues have been sold off in this more recent collective-leave-of-the-senses rally. You can find many dividend-paying stocks that are yielding between 4-6%. In addition to the yield, you can write covered call options on these stocks that can produce anywhere from up to 3-6 percent option premiums per quarter. These calls can be written at prices that are 15-20 percent above the current spot price of the stock.
On a worse case basis, the stock till may decline or it could rise above the call price. However, if investors are looking for income, especially pension plans or IRA's, or investors looking for income, this strategy can produce income returns of 8-12 percent with the possibility for some potential appreciation. At a time when interest rates are at 1 percent, and the major indexes are down double-digits for the third consecutive year, this strategy can help you survive the volatility of the markets and reward you for your patience.
Areas that you can find these gems I'll give you a hint: look at things. Look at companies who provide a product or service that people need regardless of where the economy is going. Look at the geopolitical situation and that will lead you to another promising area. Look at what people need as compared to the idiocy that is going on in techs, telecomms and financials. Income returns of 8-12% may not sound like much at a time when the SOX goes up 8% in a single day. However, which return do you think is more dependable -- a dividend paid in cash or a rise in the value of the stock based on the idiot theory of higher prices?
Let it Snow, Let it Snow, Let it Snow.
Finally, as we head into this holiday season, all of us at Financial Sense wish you safe passage to wherever you are traveling. The very best to you, your family, and loved ones, and that special person in your life this holiday season. Remember, always look at the positive -- one man's winter is another man's summer. We may be in a continuing bear market in paper, but a new bull market in "things" has just begun. God bless and have a happy Thanksgiving.
Charts courtesy of Elliott Wave International
© 2002 James Puplava