By James J Puplava CFP, June 4, 2003
Bernard Baruch attributed his timely withdrawal from the stock market prior to the market crash in 1929 to his reading of Charles MacKay's Extraordinary Popular Delusions & the Madness of Crowds. Baruch went on to say, "I have always thought that if in 1929 we had all continuously repeated ‘two and two still make four,’ much of the evil might have been averted." What Baruch wrote then should be a warning to investors participating in today's speculative frenzy in the financial markets. On Wall Street two plus two no longer makes four. In the minds of most analysts today two plus two can equal or mean anything. Most of the time it means what the analysts want it to mean. They have product to sell so there is always a positive spin to everything both good and bad.
That we have now approached a level of insanity in the markets again is no more evident then to look at what passes as understanding of the markets today. Unlike the beginning of the last bull market, which began in 1982 where P/E ratios had fallen to 7 with the dividend yield equally as high, today's market offers no such values. In fact, despite three years of falling markets, stock prices have taken on a greater bubble-like quality. Valuations are higher today than before the market crashes of 1929 and 1987. They only look cheap when you look at comparisons to the bubble valuations of the tech mania at its peak in the spring of 2000. The fact that Cisco no longer has a market cap of $600 billion and instead is now $119 billion does not mean it is cheap. Cisco's growth rate is much lower today than it was in the 90's, its return on equity has fallen dramatically, and its earnings are overstated through the use of generous stock option grants.
~ The Madness of Crowds ~
Intel is another example of how market values are still at extremes--more so today than where they were in 2000. Intel, like Cisco, doesn't treat stock options as an expense, overstating its earnings by a third. If the company accounted for stock options, its estimated P/E ratio would be 47 and not 30. Its trailing P/E ratio is over 41 and the company trades at 4.5 times sales. Back in the 90's when sales and earnings were accelerating, Intel sold at only two times sales. Furthermore, Intel's prime markets in PCs and laptops have also matured. Markets for motherboards have fallen off a cliff and domestic demand is down 30 percent year-over-year. What demand remains is coming overseas, which is also experiencing a slowdown. As a recent Barron's article stated, the gap between Intel's expectations and those of motherboard manufacturers and distributors is wide enough to drive a truck through.
It's A Matter of Meat Over Milk
Part of the problem today is that a generation of investors has grown up with no concept of linking value or any other fundamental metric to the underlying economics of a business. Ask an investor today about a stock and chances are they can fire off the price, the volume, or where the stock traded yesterday, last week or last year. Ask that same investor about what is going on in the industry or the company's latest financials and you will probably draw a blank. It reminds me of a story I read in The Wall Street Journal in 1999 about two day traders in CMGI and Yahoo! stocks. Both individuals knew very little about the company, didn't even know the name of the company president, or the economics of what drove their sales or earnings. All they knew was where the price of the stock was at any five-minute interval and what market makers were holding in inventory.
Don't get me wrong.
Speculators help to add liquidity to a market. They are a welcome addition to markets and help to keep them liquid. What I believe is harmful, however, is when the vast majority of participants think they are investing, when in fact they are speculating. Where a stock is at one particular moment in time tells you nothing. The conceit of Wall Street in believing that today's closing print is reliable and predictive of the future as some mathematical model would suggest is pure hubris. Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk reminds us that no rules can be extracted from the past and applied with certainty toward the future. Market history is punctuated with those rare events that seem more common these days that periodically surface and throw all risk calculations out the door. The greatest mistake is to assume probabilities equate to certainties. No such margins are allowed for unpredictable events. Statisticians call then "outliers." I refer to them as rogue waves. They tend to surface when you least expect them and when the experts have marginalized them. They also occur more frequently in the midst of storms.
My Laundry List of Economic Worries
The fact that we are in the midst of a storm is more apparent with each passing day. The Fed will meet this month to consider the use of "unconventional means" should the markets and economy fail to recover in response to monetary or fiscal stimulus. The idiotic assumption that the biggest worry is deflation at a time the government is already running massive budget deficits is ludicrous. The Fed is pumping vast amounts of liquidity into the system. Interest rates are at half-century lows. The housing and bond market are in bubble territory. Consumers are borrowing and spending feverishly. The trade deficit is perpetually setting records. Equity valuations border on absurdity. Energy prices are rising. And the dollar looks like it is about to fall off a cliff.
All this tells me deflation is the least of our worries.
And Yet, We Keep On Chugging
What it does indicate is that the Fed has succeeded in reinflating the equity bubble again through its attempts to bring down interest rates and reliquify the markets. Despite anemic economic growth and sub-par earnings growth, money is pouring back in the markets again as fund managers and investors get on board the momentum train. The most disturbing aspect of all is the current sentiment indicators. According to Peter Eliades, there has never been more than a three-week period throughout this bear market where bearish sentiment has exceeded bullish sentiment. The current investor sentiment is running almost 3-1, the lowest ratio of bears since February of 1992. According to Tim Wood, the greatest market advance in history between 1992 and 2000 did not produce this degree of bullishness. Both the VIX and the VXN tell a similar story which no fear amongst investors and extreme complacency. With fundamentals this bad, earnings this low, valuations this high, this market is running on pure adrenalin. It is strictly hot air or money chasing money. All rationality has been completely abandoned with market participants thinking that all of the damage of the bear market is over with and behind us. If stocks are cheap as most Wall Street believes they are only cheap by comparing the prices of one bubble to another. I would stick my neck out here by saying that they are even worse if I look at sentiment and fundamentals. At least in 1999 investors were under the illusion that profits were growing and improving. We now know that those profits were fictitious as we are reminded each day by each new SEC probe into accounting malpractices.
|S & P 500 Earnings||EPS*||P/E**|
|As Reported (GAAP)||$30.42||31.79|
|Pro Forma (CRAP)||$47.47||20.37|
|Source: Standard & Poors
* 12-month trailing earnings as of 1st Qtr 2003
** S & P Closing prices June 2, 2003
I'm amazed by what is reported each day. Every economic report is spun to look better. Every earnings report is always "better then expected." Each daily scandal or fraud revelation becomes only a sideshow and is ignored by the market. Fictional numbers are still carried and reported and bandied about without any due diligence or investigation on what is behind them. This market is not cheap by any means. It is historically one of the most overvalued markets in history. Experts now believe anything is cheap by virtue of the fact that the price has fallen. If a stock used to sell at 200-300 times earnings and now sells at 105 times earnings, it must be cheap. In this market there are no reference points. Everything is evaluated in real time without any reference to the past. Heck, in this market even the term "long-term" investor has changed. Today "long-term" may mean one week, maybe one month, but certainly not years.
The Bear Trap Has Sprung
Suffice to say the current action in the market is technical. It is pure momentum with everyone wanting to get on board and chase the price of paper in fear of being left out. Investors are more determined than ever to speculate their way back to prosperity. If they lost big in the bear market, they are even more determined to make that money back. They assume that they will not get caught in another bear market trap and in fact what they see happening is real. Everyone desperately wants the good times or the bubble to return. No one wants to suffer through a prolonged hangover. So they have become susceptible to the "contagion" of another second-half recovery promise. Washington and Wall Street are only too happy to oblige by giving people what they want and promising them that there will be no more pain. Any elected official that would tell them the truth is quickly scorned or would be voted out of office and beaten by politicians that kiss babies and promise voters more lollipops. This is a market ripe for a ten-sigma event -- an outlier that lies at the tail end of the curve that nobody is expecting. I hope to return to part 2 of Ten Sigma shortly after the second part of The Catalyst in the next week.
What to Do?
The best advice I could give now is caveat emptor. If you're an agile trader, then trade. However, you better have a hedge. Without one, you are exposed to any unexpected event. On the other hand, if you are truly are a long-term investor, then invest in what the fundamentals are pointing to--a falling dollar and a price rise in the "things" that you need. The rise in natural gas at this stage of the weather cycle is indicating that supplies are tight and that suppliers will have difficulty getting winter storage levels back to capacity. Heaven help us if we experience even a normal winter much less a harsh one or a warmer then normal summer. Oil prices are expected to peak within this decade or the middle of the next decade depending on which forecast you view. The geologists say 2003-2006. The optimists say 2016. Regardless of who is right, supplies and the price are likely to climb throughout this decade as demand continues to grow; while production decline curves accelerate.
With the dollar expected to decline further, if a crisis doesn't erupt first sending it into a freefall, you should be diversified into hard currencies and at least own some silver and gold. With central banks and especially the Fed putting the metal to the monetary pedal, the price of the paper you hold is depreciating rapidly to the tune of 30% over the last year against the euro--about half that against other major currencies. Other basic items that I believe will do well this decade, besides precious metals, are food and water. With water, there are few options to choose from, but they are there if you look hard enough. Finally, if you have enough confidence in your convictions and are not startled by short-term moves or manias, I would also be short. The degree to which you go short depends on your risk tolerance, ability to absorb short-term pain and understanding of the fundamentals.
I would like to end on something that I always remind myself when I see manias develop, if only to keep myself from speculating in them and becoming one of the crowd.
"In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first".
Some delusions, though notorious to all the world, have subsisted for ages for instance the belief in omens and divination of the future, which seem to defy the progress of knowledge to eradicate them entirely from the popular mind. Money , again, has often been a cause of the delusion of multitudes...
"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
Charles Mackay, Extraordinary Popular Delusions & the Madness of Crowds.
Now to return to the madness of the markets. "Dow bulls hurdle 9,000" was today's headlines. The Dow is the last index to surpass its high of December 2nd of 9,043.37. It ran just shy of that today to close at 9,038.98. Triggering today's flagpole rally and urge to buy was a ISM report on the service sector and a revised productivity report that came in better then originally reported, but less then expected. Wall Street economists have become convinced that with this much monetary and fiscal stimulus the economy has nowhere else to go but up. The day's economic news provided the fuel for the advance, because everyone has become convinced that the economy is now on the mend. And if that assumption is held to be true, ergo profits will also improve. The concept of excess capacity and debt is oblivious to most oracles, seers and others who hold mystical financial insights. In expressing the mood of the day, one analyst said that the rally will continue and that investors are now going to be buying the dips.
All three major Dow indexes are rising, which is making some Dow theorists bullish again. However, this is no ordinary market and there are now so many anomalies that exist, that you would have to go back to the history books to find clues as to their import. Bonds and stocks are both rising together again with the 10-year note, yielding less then 3.3%. We also have rising commodity prices, a falling dollar, and rising bond prices. Then there are near-record levels of bullishness. Everyone is convinced that this is a new bull market and that the economy will recover despite excess levels of debt and spare capacity in almost every sector except energy.
It is when I ask what is right about this trend, that I grow more suspicious of it. Can it be that debt and more credit can lead us into a new prosperity? And do valuations matter anymore in this new digital age? Is today's closing price all that matters anymore? Can the production of credit replace the production of goods in creating economic wealth? These are only questions, but they are questions that few people are asking. At the moment, the only thing that matters is that prices are moving and those prices have once again attracted the hive.
Volume came in at 1.59 billion shares on the NYSE and 2.47 billion on the NASDAQ. Market breath was positive by 25-8 on the Big Board and by 22-10 on the NASDAQ. The VIX closed at 22.50 and the VXN closed at 33.0.
Charts courtesy of www.stockcharts.com
© 2003 James Puplava