By James J Puplava CFP, March 10, 2003
In the stock market, perceptions are more important than reality over the short-run. Longer-term fundamentals dominate markets and economies. Right now, the markets are moving constantly on changing perceptions and short-term news events. What happens in the morning is forgotten by the afternoon. The markets are increasingly being driven by short-term trading patterns and momentary news events. One day we are going to war; the next day war has been postponed. On Friday analysts and investors were optimistic over earnings; today they are pessimistic. There are no constants in the markets right now except change, change in market direction, change in sector leadership, and constant sector rotation. One day it’s bonds; the next day it is stocks.
This is important to understand right now because the market is being driven by false perceptions. The prevailing thought on Wall Street and in the fund industry is, "Things will get better after Iraq. Once the bombs start dropping, it will be back to good times for stock investors." The economy is slowing down, consumers are backing off from the spending, businesses are laying off workers and cutting back on spending plans. Debt levels are skyrocketing at all sectors within the economy. The trade and current account deficit are at record levels; state, municipalities are back to running deficits, and the federal deficit is ballooning out of control again. The money supply is going parabolic as the Fed floods the financial system with liquidity. The money supply is growing at double-digits; while money velocity drops. It also is monetizing debt. The fingerprints of the Exchange Stabilization Fund (ESF) and the Plunge Protection Team (PPT) can be seen in all of our financial markets. In other words, the government is monkeying around with the financial markets, trying to alter their outcome. What they are trying to prevent is a market drawdown or another stock market crash, similar to 1929 and 1987.
Meanwhile, the stock market is heading down for the fourth year in a row--something we haven't seen since the Great Depression. In the last 100 years there has only been one time that stock markets fell four consecutive years in a row and that was from 1929-1932. It is widely believed it can never happen again. I'm here to tell you that it will. Put aside the perceptions for a moment and look at reality. What will the war with Iraq do other than to worsen things over the long run? This war is unlike the previous Gulf War. The mission and objective have changed. We aren't trying to repel an invading army this time. We are trying to disarm a rogue nation--a rogue nation that has weapons of mass destruction. Iraq has used these weapons before against its neighbors and against its own people. This time the war will last much longer since a new government will have to be found, the country stabilized and its economy rebuilt. These are far broader objectives and far more difficult to achieve. There is also the risk that terrorists have plans already in place and are set to carry them out whether we go to war or not. These attacks will come against the US with or without war.
Let's Face The Facts
Back on Wall Street, it is widely believed that the only reason major averages such as the Dow, S&P 500, and the NASDAQ are down 9.3%, 8.2% and 4.3% this year is because of Iraq. The fact that P/E multiples are anywhere between 28-46 for the S&P 500 and 26 for the Dow or negative for the NASDAQ is quickly dismissed. Dividend yields of 2.7% for the Dow and 2% for the S&P 500 are also ignored. Record debt levels at the consumer level, record corporate debt, widening credit spreads and growing bankruptcies are glossed over. Today markets plunged after Fed President William Poole made comments that the nation's leading mortgage lender Fannie Mae and Freddie Mac may be inadequately capitalized and pose a threat to the nation's financial system. The fact that these two government-chartered companies may be grossly undercapitalized is starting to gain more attention. Their growing capital inadequacies have been ignored over the last few years as a result of a growing mortgage and real estate bubble. That bubble was created as a result of Fed policies to prevent a recession and stop a bear market. On both accounts, Fed policies have failed miserably. The eleven rate cuts didn't stop a recession from occurring. Twelve rate cuts failed to arrest a bear market in equities. In place of a stock market bubble we now have multiple bubbles in the stock market that have partially deflated, and bubbles in mortgages, consumption and real estate. We now have four bubbles instead of just one.
Now let us return to this year's stock market and economic recovery scenario. Fund managers and Wall Street firms have been loading up on tech giants and other growth stocks under the assumption that once the war begins, the stock market goes ballistic. In other words, Wall Street is expecting another replay of the last Gulf War without understanding that this will be a different war. The objectives and the mission have changed. Nonetheless, once the bombs start dropping, stocks are expected to start hopping. It is very possible that the first few days and the first few weeks could go well for the US provided no weapons of mass destruction are used against Israel or the US and allied troops in the region. The problem comes afterwards in Iraq, in the US, and in allied countries. It will be a long, drawn-out occupation. You can’treplace a tyrant and dictator without creating a political vacuum that will take time to fill even under the best of circumstances. Another Marshal Plan will be needed to rebuild Iraq, but who has to money to fund it?
As far as Wall Street is concerned, everything goes well and they haven't thought this through beyond the first few days of battle. Still that is the perception held by many on the Street that once the bombs are dropped that all of the other problems such as debt, delinquencies, bankruptcies, overvaluations, lack of business spending, growing government deficits, a falling dollar and rising commodity prices all go away. The fact that one out of four factories lay idle in this country, that the book-to-bill ratio is falling and that most companies are experiencing a drop off or slowdown in sales and falling profit margins shouldn't concern you. These problems all miraculously go away when the fighting starts. It hasn't quite sunk in yet that we are now a world that is at war. It isn't a conventional war, but an asymmetric war that will be unlike anything the world has ever experienced before. It will be fought from fighters in the skies and terrorists from the skies. It will be fought in the cities, in buildings and on the streets. It will be stealth combat fought at places and times not of our own choosing. It will be fought against the US and then against others. Lives will be lost and property destroyed and markets will be disrupted. Those are the aims of the terrorists. Many battles will be fought openly; others will be waged silently. The only battles we will hear about are the ones that take lives, destroy property and create chaos in commerce and in finance.
These circumstances aren't conducive to long-term growth in the economy or stability in the financial markets. Wall Street believes that once geopolitical uncertainty is removed, then all other problems go away. It shows how myopic the thinking is on the Street. It also points to the fact that the bull market mentality in stocks hasn't disappeared despite four consecutive years of losses. Until the last bull market is finally discredited and the new bull market in "things" is acknowledged, this volatility and �wait and see� attitude by the public and fund managers will be kept alive by false hope.
Add a little help from the ESF or the PPT and it isn't hard to see a sharp and quick rally begin if the initial stages of the war go well. You could see explosive 500-600 point moves in the Dow, and 75-100 point moves in the S&P 500 and the NASDAQ. The first days or weeks of the rally could produce gains of 15-20% before problems start to set in. A pattern similar to what we saw occur in late July when I was calling for a summer rally may unfold once again but in a quicker and in a more violent fashion. This quick rally could see stocks rise, bonds fall, and the dollar rally. Likewise, it could see gold, commodity prices, and strong foreign currencies such as the Euro and the Swiss Franc decline. Then the problems will start to set in with debt, delinquencies, retrenchment by consumers, a capital spending slowdown accelerates. Finally, there are the aspects for terrorist attacks to follow. The latest capture of the al-Qaeda commander who planned the World Trade Center attacks revealed that he was working on other plans to destroy this nation's energy complex, bridges, and other elements of our economic infrastructure. It would be hard not to assume that other terrorist commanders and cell group leaders are now plotting similar acts of terror. We would indeed be a fortunate nation if no other attacks were to follow the attacks of 9-11.
In summary, expect a fast and furious rally to follow if all goes well in the early days of fighting. While financial assets rally, hard assets will fall. You have already seen this happen especially with the gold shares. I suspect the recent selloff in gold and silver mining shares has a lot to do with increasing short positions. New short positions for precious metals stocks should be available this week. I also suspect, given the action in the metals shares versus the price of bullion, that short positions have increased again. Many of the unhedged gold and silver shares have seen short positions build every month. The short position in silver stocks has increased as much as 92.71%. In one silver stock, it grew 35,097% since Q1 -2002. The silver equities short position is far larger than the short position in the actual bullion. The same situation holds true for gold mining shares where short positions have increased from 84.42% to 4,146.92% in one mining stock. [See Short Positions]
This has occurred against a background of rising bullion prices. There are four major anomalies in the financial markets right now. The first is the rise in gold bullion versus the fall in gold shares. The second is the rise in oil and natural gas prices and the drop in energy shares, and the third is a falling dollar and rising commodity prices and falling bond yields. The final anomaly is between falling interest rates and falling stock prices. Inter-market relationships are out of kilter right now. This topic will be discussed with this week's Financial Sense Newshour guest, famed market technician John Murphy. Suffice to say it appears that the alchemists are at work not knowing what monsters or demons they are creating in the financial markets with all of their tinkering and intervening. We will report the changes in the short positions later this week as they are made available. If you are thinking of panicking right now, you play into their plans. I would suggest you read Five Smooth Stones. Remember, short-sellers have to buy back. They can only buy back if there are shares that are freely available. They hope to buy back at lower prices. They can only do so if you sell them your shares at lower prices. Please review the charts of the S&P 500 and gold in Five Smooth Stones before you do and then think hard about it. I would also like to suggest reading " The Next Big Thing."
Back at the casino, today's gambling results produced big losses for investors with the major averages suffering their largest dip since early January. All three major indexes lost over 2% with many of the major indexes such as the Dow and S&P 500 and the Dow Utilities Index down close to 10% for the year. The stock markets fell sharply after a Federal Bank President said mortgage financiers Fannie Mae and Freddie Mack lack sufficient capital to weather a financial storm. On top of financial worries there were worries over Iraq. France is leading a political coalition against the US war effort with Iraq. France abstained from voting on the resolution for disarming Iraq and putting in place weapons inspections after the Gulf War. France is supplying Saddam with weapons grade plutonium; it is also building Iraq's nuclear reactors and training Iraqi personnel. So it should come as no surprise that those countries with large commercial interests with Iraq would be opposed to US actions to disarm Iraq. The discord that is created between the coalition led by Iraq-friendly France and the one led by the US is also translating into discord for the financial markets.
However, concerns that Fannie and Freddie may be undercapitalized and that AMR may be the next airline to go bankrupt is creating a new worry for investors. There is then the ultimate worry which is systemic risk in the financial system. The financial system is a leveraged house of cards that stands on the edge of a precipice. It won't take much to topple it and bring the whole financial system down. That is what worries policymakers. This hasn't stopped fund managers and Wall Street betting the ranch on a stock market rally once the bombs start dropping. Wall Street remains leveraged and clueless as to risk in the financial markets. Traders sit comfortably behind their computer models that only look at volatility as a means of risk. War is looked upon as favorable for the financial markets. Leverage and unexpected events are nowhere to be seen on any one's radar screen. In the minds of traders, war, leverage or any unexpected event has been completely hedged against. In one sense there are no risks and those that do exist are considered to be small and remote. For these reasons Wall Street firms, hedge funds, mutual fund managers, financial intermediaries, and mortgage lenders such as Fannie and Freddie have no lifeboats. The financial system, like the Titanic, is considered unsinkable. No lifeboats are at hand. That is what should be a bigger worry for investors. It keeps Fed officials and Warren Buffett up at night. It is why Buffett wrote in his letter to shareholders of Berkshire Hathaway he is worried about derivatives and the impact their implosion would have on the financial system. [See Buffett Resource]
Volume hit 1.2 billion on the NYSE and 1.11 billion on the NASDAQ. Market breath was negative by 3-1 on the NYSE and the Nasdaq. The volume of declining issues was 14 times advancing volume. This is not a good sign. The VIX jumped 2.20 to 37.85 and the VXN edged up by .64 to 47.03.
European stocks fell after U.S. Secretary of State Colin Powell said the possibility of war with Iraq is rising, sending the dollar lower. Royal Philips Electronics NV paced losses by exporters. The Dow Jones Stoxx 50 Index slid 2.7 percent to 1981.83, dropping for a fifth day. Insurers and banks with insurance businesses including Aegon NV and Credit Suisse Group posted seven of its 10 biggest losses. The Stoxx 600 Index shed 2.3 percent to 167.86. Both indexes are around six-year lows.
Japanese stocks fell, with the Nikkei 225 Stock Average dipping below 8000 for the first time in two decades. Sumitomo Mitsui Financial Group Inc. and other banks slumped on concern stock losses will erode their capital. The Nikkei sank 1.3 percent to 8042.26. The Topix index lost 1.5 percent to 784.52 as all but two of the 33 industry groups fell.
Charts courtesy of www.stockcharts.com
© 2003 James Puplava