Holding the Line

By James J Puplava CFP, April 2, 2003

Holding the Line You can throw rational thinking out the door. If you tried to explain the market's machinations since the summer of last year, you would need the services of a psychiatrist more than you would the services of an analyst. Investor horizons don't extend far beyond the latest news updates on the war.

One-day markets rise because of postponement of war; the next day they explode on the upside because of the outbreak of war. Markets then fall because the war is taking too long; the next week they rise because the war is going well. Economic news, earnings warnings, bankruptcies and accounting scandals have taken a back seat to the coverage of the war. In military terms, records are being set in terms of the U.S. ability to advance so far so quickly. The problem is that with 24-hour news coverage, most of it is news filler. There are too many analysts and pundits making comments on every single fire fight, every little skirmish, each fatality, as well as forecasting the military's next move.

Markets respond to each news event emotionally, moving up on so-called good news and falling hard on bad news. Since last summer with the failure of monetary policy to stem a market decline, active intervention has become part of government policy. There is now an active effort to reflate the financial markets.

What Washington and Wall Street don't want to see is a stock market crash. A stock market crash would be the final blow to the economy. Since last summer at every sign of a severe drawdown in the financial market, direct intervention is brought to bear on the markets. You can see this from the charts on the right, which show the markets downward trend and then the consolidation channel since last summer. The markets have been confined to a narrow trading channel as seen in the yellow boxes at the far right of the graph. All three major markets have been contained within this narrow trading range.

The reader will also observe that both the S&P 500 and the NASDAQ have fallen below their neckline, which has served as resistance to any upside break-out in prices. Each time market averages rise and challenge neckline resistance, they are quickly repelled. Of all the major averages, only the Dow Industrials remains above its neckline support. The Dow has been the least affected by the bursting of the bubble. Some of this reflects institutional preference. As the NASDAQ and many of the S&P companies have broken down, money shifted into blue chips in a flight to safety. Therefore, the Dow has lost the least amount of money.

Hanging by a Hinge

Going forward there is a lot of money relying on the successful outcome of this war. The economic and earnings news has been terrible, but it has been dismissed and explained as collateral damage of war. Once the war ends, all of this will improve. The hopes are that by now the stock market policy makers can resurrect a recovery. If prices rise on equities, companies can use rising equity valuations as currency to buy and merge with other companies. Rising stock prices might also generate a wealth effect and stimulate spending just as rising housing prices did in the real estate sector. Maybe instead of home equity loans we'll see margin loans as another means of stimulating consumption.

What is clear at this point is that every effort is being made to reflate the markets. Interest rate cuts have run their course, although many expect more rate cuts to come here in the U.S. and in Europe. Europe's economy-- along with the U.S. economy-- now look like they are both headed back into recession. By summer there is a growing expectation that both rates in Europe and in the U.S. will be cut even further. All stops will be pulled out to make every effort to avoid a severe economic downturn and more importantly a stock market crash.

It's Not Investment ... It's Speculation

However, in its effort to intervene in the financial markets, the Fed has encouraged widespread speculation in the financial markets. This can be seen by the amount of "hot" money moving in and out of the markets. Institutions and hedge funds aren't buying stocks and investing anymore; it has become a speculators game. This next set of charts shows the rise in volume in the exchange traded funds that are used to mirror the major indexes such as SPDR's (Spiders = S&P 500), DIA's (Diamonds = Dow Industrials), and the QQQ's (Q's = Nasdaq 100). Exchange traded funds have become the preferred vehicle of choice for speculators. There is plenty of liquidity and they are easily traded as money is moved in and out of these funds quickly. You can buy at the opening bell and sell by lunchtime.

The pattern for intervention is becoming clearer and more obvious in each surprise rally. I have commented before in previous WrapUps on how these rallies are engineered. It may help the reader to repeat the process once again. The process is described below.

The Four-Step Rally Process

This pattern has been repeated consistently since last summer's July rally. The four-step process is as follows:

1) Intervene in the market (done by buying futures).
2) Higher stock prices through intervention forces short covering.
3) Stock prices that lurch higher brings in momentum players.
4) If the rally lasts long enough, John Q may move money into mutual funds. This happens just about the time the rally fades.

The rallies usually begin with intervention that comes in to support and prop up the market at key technical support areas. The danger technically is that with so many eyeballs and computer screens watching, the same technical charts breaching key support areas would generate further selling pressure. Falling through key support areas generates more selling that takes indexes down to even lower levels until the next area of support is found on a chart. Therefore, intervention seems to come any time key support levels are in danger of being violated.

You can see this pattern repeated consistently since last summer's nadir in the markets. The markets are driven up violently in sudden surges that take place on a few major days of trading. They then seem to consolidate until additional intervention is brought to bear on the markets. However, beyond the few days of intervention that generate the four-step rally process, you can see momentum indicators begin to decline. What is clearly transparent is that there are no follow-through rallies that come from widespread public participation. John Q is slowly exiting the market. The exit traffic is small and building momentum. This is one reason you can see a clear trend in the major averages of declining volume that has been evident since last summer and continues to this day.

Recognizing the Pattern

In light of the theory of avoiding drawdowns, it is important to recognize how the pattern plays out. After several days (sometimes weeks of falling prices) as major averages drop to key support levels, a rally occurs. They usually take place in an explosive fashion. Markets can go from negative to positive and end up the day by 3 to 5%. Some inane explanation is usually given as a reason for the market's sudden turn. If stock averages have fallen far enough, it usually takes about 3-4 four days to kick the rally into gear. This is because of widespread skepticism behind the rally. Two or three days of powerful intervention is usually enough to force widespread short covering, which triggers further gains in the market. Then the momentum crowd comes in, giving the markets an additional boost. At the end of the rally you may see small money flows come into the market by small investors. However, there is a growing tendency by small investors to forgo participating in these rallies because they are so volatile and unpredictable. In most cases the small investor is using these rallies as exit points to withdraw from the market. The little guy may still be holding on, but he certainly isn't buying the miracle stories anymore. If anything, most individual investors are moving their money into bonds, which I believe is one of the next bubbles to burst.

What we now have is a giant speculators' game taking place in the financial markets among institutions and hedge funds and professionals. It is becoming a game of musical chairs with very few chairs in which to land. The"hot" money simply moves in and out of the exchange traded funds because there are very few compelling investment themes other than speculation. Long-term investing is certainly not a theme of today's investment markets. What the Fed has created here is a magnification of the "moral hazard." Speculators are encouraged to gamble in the markets in an effort to keep them afloat with the idea that the Fed, ESF, the PPT, or whoever is doing the intervening, will put a floor underneath the markets.

Technically what traders are doing is trading a sideways or directionless market contained and confined within a narrow band or trading channel seen on the far right corner of the major average charts shown above in my opening. A dangerous speculators' game will end when the unexpected occurs. In many ways it resembles the late 60's and early 70's markets that were confined in a narrow channel until the political events in 1973-74 with the Yom Kippur War, Oil Embargo and the resignation of President Nixon pushing the markets over the edge.

Back to the Future in '73?

Markets traded within this range until political events overwhelmed the markets. By 1974, the stock market had finally bottomed and a new bull market would begin. However, by then most investors had lost so much money they no longer cared. Instead, money was shifting into hard assets because the monetary policies of the Fed had created a distrust in paper. Investors no longer wanted to own paper. The investments of choice were now commodities or things as the price of most things was going up. The economic climate was described by a new economic term referred often to as "Stagflation."

This seems to be where we are headed today. Like then, the dollar was under pressure because of expanding monetary aggregates and Fed polices of inflation. Price controls were put into effect and failed miserably. Oil prices skyrocketed because OPEC no longer wanted inflated paper dollars. Authorities still tried fiscal and monetary measures to inflate the economy and the markets. They eventually ended in failure and the dollar was in danger of losing its status as the world's reserve currency. This could indeed be where we are today with the rise of the Euro and talk of gold backed currencies in Asia and in the Middle East.

Today's Market

So here we are today with another miraculous rally in the markets after a week of drawdowns in rapid succession in the stock averages. The reason given for today's miracle in the markets was the market was discounting the future conclusion to the war. It is widely expected that the U.S. will emerge victoriously from this war, so the market is simply telegraphing in advance the war's successful conclusion. Wall Street is now expecting the stock market to rally as much as 25-30% after the war is concluded. Yesterday's rally was attributed to the possible appearance of Saddam Hussein on Iraqi TV. He never showed up. Today's rally was associated with the coalition force's rapid advance toward Baghdad. In other words, the faster the war is prosecuted, the sooner the good times can begin. Investment strategists are pointing to the markets' ability to ignore a lot of bad economic and earnings news as a stellar sign that a new bull market in equities has begun. The stock market is considered to be a forward economic gauge and right now analysts believe the markets are forecasting good times ahead.

Flagpole Rallies in all three Major Indexes April 2, 2003

Open 8070.98 Close 8285.06	Open 858.48 Close 880.90	Open 1374.71 Close 1396.72

The rally, which emerged out of the futures pits this morning, ended up pushing stocks up across most sectors. Advancing issues beat out declining issues by a 23:1 margin on the NYSE and by a 22:1 margin on the NASDAQ. Volume picked up to 1.57 billion on the Big Board and 1.62 billion on the NASDAQ. Technology stocks, which are widely expected to report the worst earnings in Q1, led the rally. As speculators jumped on board stocks, they sold defensive issues such as gold. Treasury bonds were also dumped in favor of speculative plays in technology. As a sign of the times Internet stocks such as Amazon, Yahoo, and eBay have more then doubled over the last 12 months. Amazon.com is up 85% over the last 12 months and trades at a P/E multiple of 85. Yahoo is up 31% and sells at 132 times earnings, while eBay is up 62% and sports a P/E multiple of 102. Perhaps Mr. Greenspan's monetary alchemy has produced another round of irrational exuberance?

Overseas Markets

European stocks rose, sending the Dow Jones Stoxx 50 and Stoxx 600 indexes to their first two-day advance since the war in Iraq began, as a push by allied forces renewed optimism that the conflict will be resolved soon. Insurance companies including Munich Re, Axa SA and Allianz AG paced gains as investors bought shares that may be most likely to benefit from a rally in stocks. The Stoxx 50 rose 3.2% to 2207.10 and the Stoxx 600 climbed 3.1% to 184.46.

Japanese stocks rose 1.5% in U.S. trading, as measured by Bank of New York Co.'s Japan ADR index. Nikkei 225 Stock Average futures for June delivery rose 125, or 1.6%, to 8155 on the Chicago Mercantile Exchange, as 1,094 contracts traded.

Charts courtesy of StockCharts.com & Bloomberg

James Puplava

Contact Information

James J. Puplava CFP
PFS Group
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San Diego, CA 92150-3147
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