The War, the Markets & Dis-Equilibrium

By James J Puplava CFP, March 21, 2003

The war rally is proceeding just as expected. From the charts on the right you can see that the stock market has rallied, the dollar has gone up and oil and bond prices have fallen. These changes in the markets are being driven by perceptions. These perceptions are important to note since they will be reversed once real data comes in that challenges these perceptions. The assumptions are as follows:

Businesses aren't spending because of war. Once war is over, businesses will open up the purse strings.
Profits are falling because of war. Once war is over, the profit picture will improve.
Consumer retrenchment is due to the war. After the war consumers will go on another borrowing and spending spree.
Once the war is over, oil prices will plunge to new low levels and supplies will become plentiful.
Once war is over, the economy will start growing again and the current soft patch will end. In other words, expect another second-half recovery.

These are the key assumptions making up perceptions that are driving the markets. These perceptions are also driving investment behavior on Wall Street and in the investment business. Fund managers, hedge funds, and large institutional investors have taken large positions in the usual suspects. Tech stocks have performed the best in this war rally because that is where the money is. Fund managers have taken large positions in this sector as well as other growth sector favorites. Everyone expects that once the war is concluded, the economy will be spurred on by a leap in business and consumer spending will take off and surge.

Another favorable factor is market intervention by the Fed. It was revealed this week that the Fed and Japanese officials have made an informal agreement to intervene in the financial markets, currency markets and in the commodity markets. (Please see BBC report) Wall Street and institutions know that the Fed, through intervention, has put a floor under the markets. In addition to a floor, they have intervened in an effort to drive prices higher. Therefore, the green light has been given by the Fed to institutions that it is okay to go ahead and speculate in the markets for the Fed stands willing and able to step in and support the markets whenever necessary. The moral hazard is now at work in the markets with the Fed acting as a willing accomplice in speculation, so that is exactly what you are seeing now. All three major indexes are in the rally mode, the dollar has risen in the currency markets, and the price of oil has come down into the mid-20's. In contrast, commodity prices have fallen, especially gold, and the price of bonds has plunged with 10-year notes now yielding close to 4.1% and the 30-year bond is back over 5%.

Speculative Investment into Troubled Sectors

Meanwhile, speculation in all sectors of the market are running rampant with the airline sector jumping almost 9% in the last week, even as more companies are curtailing travel as a result of the war. The airline industry stands on the verge of bankruptcy. This week has been full of weak economic reports and plenty of earnings warnings. In addition to weaker economic and financial numbers, another round of layoffs and cost cutting has begun at major companies. This week Gateway Computer, Applied Materials, Solectron, and many others announced double-digit layoffs of their work force. You don't lay off 17% of your employment base if business is improving. I expect as we head into the second quarter the US economy will be back in recession led by a severe retrenchment in spending by the consumer.

The terrible news coming in on the economy and the corporate earnings front, especially in the tech sector, hasn't stopped wide scale speculation from occurring. It seems the worse the news gets, the greater the institutional buying. Large institutions and fund managers are still caught up in the bull market of the last century that ended over three years ago. It isn't coming back. Fund managers and institutions keep looking through the rear view mirror instead of what is in front of them. It has been this way for the last three years. In contrast to a bull market where investors climb a wall of worry, institutions keep sliding down the slope of hope. This regrettably may be looked back upon as the last chance or opportunity to salvage whatever assets or profits remain from the twin decade bull market of the last century. Last year I mentioned that the 10,000 level in the Dow would not be seen for a very long time. I believe we will also look at the 8,000-9,000 level in the same way. What I feel is ahead of us is the terrible three�s: 3,000 for the Dow, upper 300�s for the S&P 500, and lower 300�s for the NASDAQ. These are minimum targets that may go much lower once the depression and widespread fear sets in that the bull market isn't coming back for a very long time, perhaps the rest of the decade.

The institutions and the big fund managers still don't seem to get it. I recently met with a wealthy family whose father had left a substantial inheritance, which is managed by a major bank trust department. Over the last three years, even with 40% of the portfolio in bonds, the trust company has lost over 35% of the trust assets. The investment policy of the trust limits the trust company to only about 600-700 stocks, mainly companies in the S&P 500. Outside of municipal, treasury and investment-grade corporate bonds, they have no alternatives. My potential client suggested that the trust department consider investments in natural resources along with investments in gold. The head trust officer looked at him as if he was suffering from a bad case of flatulence. The message was �no way.� The trust department intended on holding their equity position since they were long-term investors. In essence my potential client was told to relax since the bank expected the economy to recover in the second-half of the year along with the stock market. In the minds of the trust department, war fears were keeping the economy and the markets back.

It is absolutely amazing how many institutions and professionals haven't gotten over the fact that the bull market is over, or the fact that we are now heading towards a depression. Apparently the lessons of the 30's and the late 60�s have long been forgotten. During the late 60�s and early 70's banks were big investors in the �nifty fifty� stocks. These stocks were considered to be a sure thing no matter what price was paid for them.

It hasn't quite dawned on anyone that attempts to stimulate the economy like the mid-90's that led to the late 90's boom has now created conditions for the bust. The economy was artificially stimulated by large doses of credit that led to over consumption and excessive stock prices. The bust arrived in 2000. However, by trying to fight the natural tendency of the markets to cleanse themselves of all the excesses of the previous boom, the Fed has stepped in to artificially stimulate the markets. Instead of resurrecting the markets all they were able to achieve is create additional bubbles in mortgages, housing, and consumption. The result is that the markets are now in dis-equilibrium. Intermarket relationships have been distorted, especially between commodities and bonds. In effect we may also add the bond market bubble to the list of other bubbles that have been created since the stock market bubble burst and stage one of the depression began.

Massaging the Message Labels

In our present age where euphemisms and politically correct thinking have become commonplace, we have invented pleasant metaphors to take the place of words that more accurately describe financial events. "Recession" replaced the word "depression." Then recession was replaced by "downturn." After that, downturns have been renamed "soft patches." Although the word bear market is still in widespread use, it has been replaced by words such as second-half recovery, market bottom, and every temporary rally has been labeled a new bull market. As we have climbed down the stairs of this new major bear market, at every step down we are calling it a bottom and every temporary rally a new bull market.

In order to perpetuate this fallacy we have even invented new metrics of making stocks look cheap. We now have pro forma earnings, a pro forma economy, and we may even get a pro forma war. It is all part of the macabre world of politicized markets that no longer trade freely. We have political intervention in all aspects of our economy and now our financial markets. The huge malinvestments and distortions that they have created now make my ten-sigma event almost an assured possibility. There is too much speculation, fueled by credit that is distorting the economy and our financial markets. This has created not only malinvestments in telecomm and technology, but also malinvestments in consumer goods, mortgage markets, the bond market and real estate.

In the end the markets are going to have their way. Companies that are over leveraged will go under. Bad investments will be liquidated; excess capacity will be sold, abandoned, or liquidated in bankruptcy. Stock prices will experience their eventual waterfall decline. In the end as throughout all of history the markets will have their way with governments, for in the end markets are much bigger than governments. Politicians, analysts, and economists have not defeated the forces of the market in the same way that man has not learned to control nature. If a hurricane force like storm is building there is nothing the government will be able to do to prevent it other than to not stand it its way. In the end the markets will crush the forces railed against it just has a hurricane destroys anything in front of its path.

With this in mind, it is getting close to the time to be putting new short positions, add to gold and silver positions, and move out of the dollar. Despite money and cordite coming out of the woodworks, and the strongest intervention in the markets seen since the 1987 crash and 1994 peso crisis, technical aspects of the markets look dismal. Put/call ratios have fallen rapidly, the TRIN is low, the advance/decline line has been barely able to rise and volume keeps receding. Daily buying surges and short-covering rallies have barely been able to generate a respectable A/D line, which tells me the markets will soon be heading for trouble. The required 10-k reports for 2002 will be due at the end of this month. The ones I've seen so far speak volumes of future profit problems. This year's profit killer is going to be pension plan contributions. Pension funds are hemorrhaging at the government, state and federal level. They are equally bad at the corporate level. Many pension plans are now so grossly underfunded that it is going to take massive pension contributions to get them even close to covering future pension liabilities. We should soon see all storm fronts start to unite this year as troubles in the financial markets merge with troubles in the economy and the financial markets to form the Perfect Storm. I believe it will be some sort of ten-sigma event coming from either the geopolitical side or from the derivative sector that sets the different storm fronts on a course toward collision.

Meanwhile, despite deteriorating economic and earnings news the Dow had its biggest weekly rally in 20 years as US and UK warplanes bombed Baghdad. The Dow rose 2.8 percent and is up 8.4 percent for the week. The S&P 500 rose 2.3 percent today and is up 7.5 percent. The NASDAQ rose 1.3 percent on Friday and is up close to 6 percent for the week. The Dow and the S&P 500 are now up close to 2 percent or more for the year.

Stocks got a big boost as B-52�s bombed Iraq and a BBC report that circulated today that Saddam Hussein might have been killed in the opening attack of the war. The hope now is that Iraqi troops surrender and that coalition forces will be in Baghdad in three-four days. Oil fields in southern Basra are now under allied command so the risk of further oilfield fires has been arrested. The relief so far is nothing unexpected has happened. The war has been going according to plan. However, despite the enormous push up in stocks, market breadth was weak again with only 2 stocks up for every stock that fell. Volume hit 1.8 billion on the Big Board. So far the war rally has added $1 trillion in market value as the Dow has surged 13.3 percent, the S&P 500 11.9 percent. For the Dow it has been the biggest rally for the blue chip index since December of 1998. For the S&P 500 it was the best showing since June of 1997. The bombs have been wonderful for stocks. Thank goodness the war has gone well because it has distracted investor attention from how bad the economic and earnings numbers have been. Today's big push in stocks began in the futures pit where S&P 500 futures rose 20 points. The NASDAQ Q's rose more than 13 points. This rally is close to ending with the possibility of another one-day surge that accompanies good news on the capture or surrender of Baghdad. After that, unless the "shock and awe" can be kept going daily, the news over earnings and the economy should come back to the front pages if an unforeseen event doesn't occur first.

Overseas Markets

European stocks surged, sending the Dow Jones Stoxx 50 and Stoxx 600 indexes to their biggest weekly gains in 18 months, as U.S. and U.K. troops moved into southern Iraq, securing the country's two largest oil fields. Companies that stand to benefit from a drop in oil prices, including chemical makers such as BASF AG and airlines such as Deutsche Lufthansa AG, led the week's advance. The Stoxx 50 climbed 3.7 percent to 2308.29, extending its gain this week to 8.5 percent. The Stoxx 600 added 3.3 percent and is up 7.7 percent since last Friday's close.

Asian stocks advanced after U.S. and U.K. forces entered southern Iraq in a second wave of attacks. Hyundai Motor Co., United Overseas Bank Ltd. and other stocks that slumped before the war started, paced gains. South Korea's Kospi index climbed 1.3 percent to 575.57, surging 7.1 percent, and Singapore's Straits Times Index gained 6 percent. Japan's stock market was closed for a public holiday.

Chart courtesy of StockCharts.com

James Puplava

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James J. Puplava CFP
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