The Maginot Line
By James J Puplava CFP, February 25, 2003
The actions have mystified investors and confused most advisors for the last year. The stock market, the currency markets, bond and precious equities markets aren't acting normal. The major averages plunge on bad news only to rally into positive territory by the end of the day on no news at all. Usually the media spins the turn around with some lame story as to why stocks rebounded. Today, depending on where you got your information, the bounce back was due to any one of three reasons. One, it was bargain; shoppers who couldn't resist the urge to buy at lower prices. Two, it was relief that oil prices came down $0.42 offsetting worries that consumer confidence is at a decade low leading to a pullback in consumer spending. Retailers are constantly reporting lower sales, lower profits, and higher inventories. The stuff isn't moving out the door. If it does it has to be marked down to clearance levels, which reduce profit margins. That is why you see all the new layoffs. Last month job layoffs surged 42 percent to 132,222. Today was no different. Home Depot reported lower sales, lower profits and will not provide guidance for at least a year. The media spin is that they beat estimates. The third reason for the rally is investors jumped out of Treasuries because stocks have now become a bargain again. So take your pick from today's balderdash spun to cover intervention in the financial markets.
But the real story took place, not on Main Street or Wall Street, but in the futures pit where stock futures rose sharply and triggered rallies in the major averages. Specific buying took place at three different periods of time: at 10:30, 1:30, and the final hour of trading. There is another story that is written or talked about on the Street, which is the stock market's Maginot Line. A review of two graphs will be helpful in understanding this concept. The first graph is a weekly chart of the S&P 500 over the last three years. This chart clearly shows the primary trend of the bear market. We are still in a bear market despite all of the spin to the contrary, a point I will cover in just a moment. The next chart is a daily graph of the S&P 500 over the last year. Two points need to be focused on, which is the July and the October bottoms. What is now clearly evident when you see these miracle flagpole rallies occur is that all stops are being taken out to prop up these support levels to prevent them from being breached. If breached, they will lead to a stock market crash or capitulation by investors taking the market down to levels not seen in decades.
What we do know from the study of stock market crashes is that they are cumulative. They are based on successive down days that gather momentum as each new day's losses lead to the next day's losses as losses beget more selling and even further losses in the market as a result of a selling deluge. What intervention is designed to do is to try and keep these losses from spiraling out of control. These drawdowns, as they are referred to, are key components that make up the conditions leading up to large stock market crashes--a topic I will cover in greater detail in this week's interview with Didier Sornette, author of Why Stock Markets Crash.
Now back to why miracle rallies occur. I only need to refresh your memory from last July when it looked like we were heading into the abyss and a sudden buyer appeared in the futures pit turning things around and a summer rally was born. The same action was taken on October 10th when the night before, IBM beat estimates after reporting earnings fell 18 percent and noting in their footnotes that they would have to make a major contribution to their pension plan in Q4. IBM�s tale was no different than the story given by Intel the day before which reported similar dismal results. The difference was that a decision was made to cap the markets in an effort to prevent losses from spiraling out of control and broaching the Maginot Line. The line, once broached, could lead to complete capitulation and a point of no return.
All stops are being taken to prevent this from happening. The background noise is that the markets are trapped in a narrow trading channel until such time as the new bull market will begin. This is evident in the horizontal or consolidation channel shown in the second daily graph of the S&P 500. That is why whenever we experience a barrage of bad news and stock prices plunge for the day, the next day or week is followed by miracle rallies. These miracle rallies usually occur after morning headlines send stock prices plunging. Today is a good example of this pattern. A list of today's headlines follows:
1) 1) Consumer Confidence plunges to a new 9 year low.
2) 2) Qwest former Executive charged with fraud in inflating company sales.
3) 3) Home Depot Earnings fall on lower sales, first profit decline in two years.
4) 4) Fleming to cut 1,800 jobs says SEC probe upgraded to formal investigation.
5) 5) Kmart says Ex-Chief Conaway misled the Board as company ran out of money.
6) 6) Moody's reports corporate debt defaults soared in 2002.
7) 7) U.S deficit hits $97 billion in first four months
8) 8) Pension debt rattles bond markets.
9) 9) Fidelity looking at plans to improve performance after profits fall 39 percent.
10) Japan, its finances in disarray, picks old-school central bankers.
The geopolitical news was even worse. But lets skip that until tomorrow. The point, as these headlines illustrate, is that this morning�s headlines were bad. The stock markets headed south very quickly and were in danger of spiraling downward. The S&P 500 was down 1.7 percent after yesterday's big loss. The Dow was down close to 2 percent and the Nasdaq had fallen 2.1 percent. Gold and commodity prices were soaring again. Something had to be done. Gold was slammed, commodity prices were driven down, and miracles took place in the futures pit that led to similar miracles in the major indexes. Another day of big losses turned into gains with the Dow gaining 0.7 percent, the S&P 500 closed up 0.7 percent and the Nasdaq gained 0.5 percent. The turn around appeared out of nowhere, actually from the futures pit, which is usually the origination for most of these stock market miracles. A big unnamed buyer comes in and buys stock index futures at any price in an effort to drive the markets up. After the markets turn around it then becomes the job of giggly reporters and anchors to come up with a credible reason why the markets quickly turned around from a position of a major loss to a positive gain. The reporters feed stories to an investor audience whose incredulity gets larger by the day as the financial media feeds its audience a steady diet of constant bull stories. Every economic and earnings report is always better-than-expected. The fact that the economic numbers don't jibe with reality, that companies continue to see declining sales and profits and lay off more workers is often ignored or goes unreported. Instead, wildly bullish predictions are made or guests appear who reinforce the bullish side arguments. Meanwhile, the average investor has been numbed by losses and stories of redemption if he only holds on a little while longer. This has been the pattern that is becoming ever more obvious for the trained eye. The bottom line is that intervention is being used, in my opinion, as a means of preventing a crash. History teaches us that these efforts are useless. In the end the law of gravity will prevail. Let us hope you aren't fully invested in overvalued stocks when that day arrives, which I believe is coming soon. A ten-sigma event, an outlier on the tail end of the curve lies lurking out there, ready to strike and wreck havoc on the unsuspected, complacent, and the self delusional, fed by a steady stream of hubris.
Speaking of hubris and the delusional, one only needs to look at what fund managers are doing to be frightened out of one's wits. The fund industry and most of Wall Street thinks that we are in a new bull market that began last October. Fund managers are sitting on the lowest cash reserves in decades. Many funds have procured lines of credit in an effort to keep up their buying power. They are loading up on the usual suspects, the tech leaders of the last bull market such as Cisco, Intel, Juniper Networks, Microsoft, and the Dell Computers. They are buying tech and other Nasdaq stocks at 50 times earnings in the belief that that there are greater fools out there than themselves who are willing to pay even higher prices. In other words, they believe there is a chance that the little guy is coming back into the market in a big way and will be a big enough fool to pay even higher prices for these very same overvalued stocks. In short, they think the good old days are coming back.
Meanwhile on Main Street, consumer retrenching has caused distribution channels to back up with unsold inventories. Just about every kind of item from PC�s to video games are stacking up in warehouses. This means more discounting, lower margins, lower profits to move unsold goods. That is why companies are still laying off workers, cutting back on capex spending and are no longer giving earnings guidance on the future. Things aren't improving and they have no idea when they will. The world is plagued with a glut of capacity that has yet to work itself off. The system hasn't cleansed itself from the mania like excesses of the 90's. The delusion on part of Wall Street is that the only thing holding back investors and the new bull market is Iraq. Once we drop a few bombs its back to party time again on Wall Street and the financial markets. P/E ratios of 50, price-to-book ratios of 4-8, price-to-sales ratios of 8 or more are ignored. In summary, Wall Street is living in a world of delusion and self-denial, wishing for days long past.
A painful lesson is about to be relearned that should devastate most funds if they are long when a ten-sigma event occurs. It will also be a painful lesson for the funds shareholders who are complacent and clueless as to the real dangers that now hover over the world financial markets. I may be wrong, but I have never heard of a new bull market emerging and a bear market ending with P/E ratios at 50, dividend yields at less then 2 percent, mutual fund cash positions at record lows, and the majority of fund managers and their investors fully invested. Bear markets don't end that way, nor do bull markets begin under such circumstances. We are about to head back into recession. This time the consumer will lead us into the recession with business falling closely behind. There is nothing that all the kings� horses or all the kings� men can do to put Humpty Dumpty back together again.
Share volume picked up today with 1.48 million shares trading on the Big Board. About the same amount of shares exchanged hands on the Nasdaq. Breadth was positive by 18-13 on the NYSE and by 17-15 on the Nasdaq.
European stocks fell, sending benchmark indexes to the lowest levels in about six years. Insurance companies led the slide as Britain's Prudential Plc signaled a possible dividend cut and two Scandinavian rivals lowered or omitted payouts. The Dow Jones Stoxx 50 Index shed 2.8 percent to 2136.24. The Stoxx 600 Index lost 2.8 percent to 178.96, with insurers and banks making up more than a quarter of the loss. This is the lowest close since April 1997 for the Stoxx 50 and January 1997 for the Stoxx 600.
Asian stocks fell, led by Toyota Motor Corp., Samsung Electronics Co. and other exporters, after North Korea test-fired a missile and Iraq rejected a United Nations request to destroy banned weapons. Japan's Nikkei 225 Stock Average slid 2.4 percent to 8360.49, the biggest drop in 3 1/2 months. South Korea's Kospi index shed 3.9 percent. Tensions on the Korean Peninsula and the increasing likelihood of a war in Iraq are stifling global economic growth and curbing consumer spending, some investors said.
Chart courtesy of www.stockcharts.com
© 2003 James Puplava