Trying to Act Sane When Everyone Else is Crazy
By James J Puplava CFP, May 5, 2003
This weekend I watched Michael Douglas in the movie Wall Street. There are three lines in that movie that I think are appropriate for today's markets. I disagree with Mr. Gecko's view on greed. It isn't good and it doesn't clarify as he intimates. It got him in trouble and will most certainly get today's momentum investor in trouble. I will get more into that thought later on in this missive. At the beginning of the movie when Bud Fox, his new apprentice, gets concerned about one of his bow-wow stocks, Gordon Gecko admonishes him and tells Fox, "Don't get emotional about stocks. It clouds your judgment."
The markets today are driven by emotion instead of fact. The constant mantra you hear repeated each day is that "earnings are better than expected" and "stocks are cheap." Therefore, don't get left out of the next big move in stocks in what bulls believe to be a new bull market. Buy now or regret it later. Investor sentiment has moved back over 50, indicating widespread bullishness has returned to the market. Volatility has decreased as the VIX and the VXN have fallen. In the case of the VXN, it has fallen to new bear market lows. Complacency and greed have once again taken over the markets. The big worry now for investors is being left out of the rally and recouping part of their losses over the last three years.
Don't Believe The Lie
Yet as I have to continuously point out, stocks are not cheap and earnings aren't as rosy as Wall Street would have you believe. Yes, companies are easily beating estimates. However, that has more to do with the Q1 benchmark for earnings being drastically reduced just before earnings season began. Therefore, when actual earnings started to come in, companies began to beat them easily. As analysts have correctly pointed out, pro forma earnings have actually increased. The analysts have been adjusting these earnings in real time as they come in. They have moved--as of last week--from $11.96 to $12.39. These are not real numbers, but pro forma or CRAP* numbers. In other words, they are make-believe.
The bottom line numbers according to GAAP have actually moved slightly lower from $11.43 to $11.40. According to the GAAP numbers, the P/E ratio for the S&P 500 is running at close to 31 making the earnings yield less than 3%. That, my friend, is anything but cheap. I find it necessary to keep repeating this fact because the words "cheap" and "earnings are getting better" is a relative fact.
As far as other facts are concerned, the economy--despite the improvement in today's service sector report--appears to be getting weaker. This morning's Challenger, Gray & Christmas report shows that announced layoffs surged 71% in April, increasing to 146,000. That figure included 58,000 government jobs.
Furthermore, dissecting last Friday's unemployment report showed that the devil was in the details. The Labor Department reported that the manufacturing workweek got shorter and the number of hours worked got fewer. The Conference Board's Help-Wanted Index fell in March to its lowest level since 1964. For unemployed workers, jobs are getting scarcer.
A rising unemployment rate, an increase in new unemployment claims, fewer hours worked and a shorter workweek does not speak well about where the economy is headed. If the economy is improving, there isn't any evidence yet in the job numbers. If we are to get the much-ballyhooed second-half recovery now forecasted for the fourth consecutive year, it will be a jobless recovery.
If the economy and the markets were doing all that well, the President wouldn't be calling for tax cuts nor would Wall Street be calling for more rate cuts from the Fed. The President's tax cut is key to his reelection campaign to get the economy going and looking stronger by election time. If the economy is weaker, unemployment higher and the stock market is lower, the President may be facing his own unemployment. It is one reason why the Bush Administration is pushing for tax cuts and it is another reason why the competition will do its best to deny them. A weak economy favors the opposing party. Current thinking among Democrats is that a weaker economy favors their reelection chances and hopes of capturing the White House and Congress. Expect an uphill battle over the President's plans to rescue the economy.
Besides the best intentions to rescue it, the economy is still suffering from the after-effects of the 90's stock market and credit bubble. The credit bubble has expanded even further since the stock market bubble burst. We have yet to liquidate all of the malinvestments of the 1990s, and the stock market isn't even close to ending its bear market journey.
The Danger of Deficits
The second line in the movie Wall Street that I would like to address here is the line where Gecko addresses the shareholders of Teldar paper. In his speech he refers to the US as becoming a "...second rate economic power due to its giant trade and budget deficits."
Look at the two graphs on the left of the US trade deficits and the US.
The trade and current account deficit is running $1.5 billion a day or over $500 billion a year. The government deficit is now running at over 3% of GDP and could be approaching $400 billion soon if the war continues and the economy weakens. Those two figures alone add up to close to $1 trillion a year. That is big money even by American standards. It is the reason why the US dollar is coming under pressure in the currency markets.
As the US Dollar Index chart below shows, the dollar has not benefited from the rally.
A dollar run could force interest rates higher at a time when they would pose a threat to the debt markets. If foreigners ( who have been losing big dollars as a result of the dollar's decline) continue to pull out, a gradual decline could become a route leading up to a crash as it did.
Tax Tactics Tipping The Scale
On top of deteriorating economic statistics, I also would add the reckless and recessionary tactics of state governments that seem incapable of reining in spending. Here in the People's Republic of Kalifornia, our dear governor is raising income taxes to the 11% level on top of raising other taxes on motor vehicles, gasoline and I'm sure anything else that can be taxed. Instead of cutting spending on bureaucracies, they are cutting services. The governor is also playing tax games such as cutting the rate of increased spending and calling it a spending cut. It is no surprise to me that California has one of the highest unemployment rates in the country just behind Oregon and Alaska.
At a time of economic weakness, states--along with the Federal government -- should be reducing the people's tax burden. To get budgets balanced, they should be cutting government waste and bloat. Instead, they are cutting services and preserving high-end bureaucratic jobs. Teachers are being let go; while administrators are kept.
Just today while writing this WrapUp, my wife just informed me that since my broker-dealer is registered in the fine state of Tennessee, I now have to pay an annual Professional Privilege Tax of $400 to do business in the state. Apparently if you are a professional and employed in certain occupations, you must now pay a tax for the privilege. If you are a company and have multiple employees, you must pay the tax and file separate returns. How special! This is the kind of thing that makes recessions last longer or get worse. With state deficits mounting and getting even larger, tax burdens for workers and businesses will get even worse. Governments in the 21st Century have become incapable of fiscal discipline. States can't print money, so all they can do is increase taxes. Cutting real spending and reducing waste is an anathema.
Let's Get Real And Rational
Now getting back to Gecko's admonition to never let your emotions cloud your judgment, it is necessary to look at this market from both a technical and fundamental perspective. The fundamentals aren't improving. It doesn't matter whether it is earnings or the economy. The pro forma earnings are getting better, but we are still talking about CRAP* numbers versus GAAP numbers. I pay very little attention to the pro forma numbers and would recommend you look at the firm's GAAP numbers. Check out the company's cash flow numbers with their earnings numbers to see if they line up with their pro forma numbers. Are things getting better or worse? Next look at P/E multiples and dividend yields, if they offer a dividend.
What I'm encouraging you to do is try to act rational at a time that bubblenomics has come back into the markets. The Fed is injecting an enormous amount of liquidity into the financial system as shown in my Market Observation, "The Reckoning". Some of that money is going into stocks and corporate bonds and some of it is going into the economy via housing and mortgages. The hope is if they can reliquify the markets, confidence will return and renewed spending by business and consumers will reignite the economy. The problem is that businesses aren't buying, and hence, the layoffs. It remains a question if they can get consumers to buy it. The home refi market is keeping consumer spending alive. What happens when that runs out? Hopefully another bubble in stocks can be resurrected to take its place.
The Market's Technical Countertrend
As I wrote last March regarding the bubble in stocks, it is clear that this rally is a technical countertrend. Nothing goes straight up or straight down. This rally is strictly technical and is being driven because of technical trends. The fundamentals aren't there to make this rally permanent. Regarding technical trends, I have included a graph from my friend Tim Wood's latest newsletter. Tim shows the rising wedge pattern of the last three rallies since last July. Note the first chart on the right. Each successive rally has been weaker, including this one. According to Tim's work, which combines Dow Theory and Tim's own work on stock market cycles, there are three mitigating statistics that indicate a strong possibility for the current rally to fade.
1) This rally has yet to take out the December highs of 9,043.37 for the Dow and 954.80 for the S&P 500.
2) George Schaefer's 50% retracement rule regarding market corrections. The retracement rule states that whenever a primary movement is corrected by a secondary movement in the opposite direction, which fails to retrace at least 50% of the preceding move, then the primary trend movement will resume, in this case a bear market move.
3) Seasonal rallies that fail to rally to a level of at least 50% of the previous cycle decline end up failing. Tim found 14 seasonal cycles that failed to rally of which 12 occurred within bear markets. When this happens, Tim found the subsequent decline to average 27.61% with a 73-97% probability.
Tim's second chart shows the greatest hurdle for the stock market and its primary trend, which is the head and shoulders neckline for the S&P 500. The stock market has made the attempts at taking out this neckline including the current rally and has failed. The neckline of a head and shoulders pattern is a formidable obstacle and one that is difficult to overcome.
Source: Tim W. Wood's Cycles News & Views
It remains to be seen if the Fed can inject enough liquidity in the system to overcome a bear market and create another bubble to replace what looks like a fading bubble in real estate and home refi's. This will be especially hard given the economic fundamentals, which have worsened, and the gross overvaluations in the stock market. P/E multiples of over 30 for the S&P with dividend yields of less then 2% are poor indicators of future returns.
What's An Investor To Do?
Given the current insanity and the risk of a severe market correction or an unexpected event, what should a sane investor do? I would suggest focusing on companies that pay reliable dividends and provide a product or service that people need. In a weak economy, the things that people don't need are falling in price, which means poor profit margins. This especially applies to the technology sector right now. The tech sector is still plagued with overcapacity, rising inventories, stiff competition and grossly inflated valuations. This is a sector to trade or short--not to own long-term.
In contrast to the bubble in tech, the price of things that people need like food, water, medicine, and energy are going up. Most of these commodities are produced overseas. With an ever-widening war in the Middle East and central Asia, the price of most commodities is only going to go higher. There are three trends driving commodity prices right now: one is China, the second is war, and the third is movement out of paper into hard assets. People have to have water, food and energy in order to live. The cost of medicine is also necessary if you suffer from a disease or ailment. Another sector worth looking at is defense. The world is at war and has yet to recognize this fact. Defense is the one area that is getting plenty of money from the US government. Even European defense contractors look attractive as the European Union considers rearming Europe.
By focusing on what people need and where there is still pricing power, you'll find plenty of companies selling at low P/E multiples and offering attractive dividends that are better than Treasury bonds with upside inflation potential. At least with a dividend you get paid something while you wait for the stock to appreciate. A high and strong dividend backed by real earnings may also be a safeguard in a market correction.
Outside the area of necessities, every portfolio should be hedged with silver, gold, and strong foreign currencies. The chart of the dollar above shows the danger and risk to dollar-denominated assets. The dollar looks like it is headed much, much lower, so you need to protect your purchasing power. What I recommend you do is don't get emotional with your investments right now. Ignore the hype and spin and stay focused on long-term fundamentals and not on all the bubble talk. Remember the words of Gordon Gecko at the opening of this WrapUp, "Don't get emotional about your investments. It clouds your judgment."
Right now the public and Wall Street are getting emotional about the markets, believing this is a new bull market. If it is, it will be the first time a bear market has ended with valuations this high. Conversely, it will be the first time a bull market has begun with valuations this high. When everyone is declaring it a new bull market, when public sentiment is this high and bullish, when portfolio managers say the bull is back, think otherwise. When it is common knowledge, it usually isn't so common any more. I'll end with a verse from Rudyard Kipling's "If"...
If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you
But make allowance for their doubting too,
If you can wait and not be tired by waiting,
Or being lied about, don't deal in lies,
Or being hated, don't give way to hating,
And yet don't look too good, nor talk too wise:
Back at the ranch, blue chips headed south; while the NASDAQ squeaked by with a narrow gain. The blue chips took a hit after Verizon announced that it was cutting prices for high-speed Internet services. Telephone and cable stocks slid in response. Analysts are worried by Verizon's news, which may indicate lack of pricing power and signal that companies may not be able to sustain pro forma profits. The one encouraging piece of news today was that the ISM Service Index rose above 50 from 47.9 in March. The Fed meets tomorrow in Washington, but very few economists and analysts expect the Fed to cut rates. If they cut rates, they could endanger the money markets where a lot of money is parked on the sidelines. Lower rates would endanger the returns from money markets by making them negative. The yield offered by funds would no longer cover expense charges.
So far the biggest winner in this recent rally has been tech and especially computer-related stocks. Analysts expect tech earnings to rise 35% this year. It goes without saying those are CRAP* earnings. If things are going so well inside the tech sector, then why are insiders like Bill Gates and Ted Turner selling off shares? It was announced after the market closed that Ted Turner sold off 60 million shares of AOL. Turner is AOL's largest shareholder. Ted said he still had full confidence in management, which I'm sure is why he sold off 60 million shares.
The real earnings this quarter have come out of the financial and technology and energy sector. Energy earnings have been explosive yet ignored by investors. Exxon's earnings tripled, yet the stock continues to languish. The energy sector earnings like the fall of the dollar with a rising stock market is another anomaly that currently exists.
The day's biggest winners were in brokerage, gold, and airline stocks. Market strategists from one Wall Street firm to the next have all turned bullish. Many feel this is the beginning of a new bull market. Many firms have recently raised their year-end targets for the major averages. Those same firms now expect gains of 10% or more this year. In fact, they are now projecting 8-10% gains for the remainder of the decade. Today Richard McCabe said that stocks have bottomed and are now moving into "a major recovery and cyclical bull market for 2003."
Most firms that have become bullish cite investor sentiment and the increase in the advance/decline line as well as increasing volume over the last few weeks. NASDAQ volume last Friday was the highest it has been in more than a month. John Q. is coming back into the market.
Volume fell to 1.4 billion shares on the NYSE and 1.9 billion on the NASDAQ. Four stocks rose for every three that fell on the Big Board. The VIX fell .37 to 23.24 and the VXN continues to slide to new bear market lows by falling .67 to 31.69.
Charts courtesy of AGaryShilling.com, stockcharts.com, Tim W. Wood, CPA
* CRAP Cloudy Reporting Accounting Principles
© 2003 James Puplava