Weekday Commentary
from Michael Hartman
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Resistance Points for the S&P 500 Bear Market Rally
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Friday, October 25, 2002
Flight to Safety 2002
If you are still holding financial, manufacturing and technology stocks or mutual funds, I would like to direct your attention to the floor where white lights lead to red lights and red lights mark the location of the emergency exit doors. In the flight to safety during this bear market we have seen a couple of different phases.
First we saw mass exodus from the high-flying technology stocks in the Nasdaq to the Blue Chips in the Dow. In the last six months we have seen more money come out of the stock market and race to the security of U.S. Treasury debt paper of all maturities. Now is still a good time to get out of the stock market, especially if you can catch a trading high in your stocks. When we take a hard look at the upside potential versus the downside risk over the next few quarters, there is clearly more in favor of the downside risk. On the chart above, I combined the two S&P 500 charts from last week and included the neckline of the five-year head and shoulders chart formation. Even if the market can regroup to push through the 900 barrier, I don’t see it breaking through the neckline or the long-term bear market channel.
From a fundamental perspective, the price to earnings ratio is the most basic of measures. A look at history shows the average P/E to be 14. It is simply the market capitalization divided by earnings, or the price per share divided by earnings per share. The reciprocal of 14 (1/14) is roughly 7%, which is also the rule of thumb for the historical yield on the 30-year Treasury Bond. If you use rough numbers and say the Treasury yield is 5%, then the compliment in terms of P/E would be 20. Just yesterday, Standard & Poors released “core earnings” for the S&P 500 Index.
For the second quarter the “reported” earnings were $26.74 while the “core earnings” just released was $18.48 after adjustments from pension and stock option accounting. To use today’s closing price of 898 with the core earnings of $18.48, the true P/E is 48.6. If you use the optimistic P/E of 20 based on a 5% yield and 18.48 for earnings, the market value of the S&P 500 would be 370. That’s a whopping decline of 59% from what we see today! Unless there is a dramatic rebound in earnings, we have a long way to go in this bear market. If you have family and friends that are still invested for the long term in equity mutual funds you should strongly urge them to get out!
In Tuesday’s Market WrapUp this week, Jim Puplava wrote a nice piece on primary and secondary market trends. To sum it up, the trend is your friend. It’s not a good idea to invest against the primary market trend unless you really like to trade and you’re good at market timing.
For most of this week the stock market has pretty much gone sideways. The Dow rose 121.59 points to 8443.99 for a gain of 1.5%. The Nasdaq added 43.26 to close at 1331.12 for a 3.4% increase and the S&P 500 tacked on 13.27 for a close of 897.65, a gain of 1.5%. The bear market rally is still intact, but appears to be losing its momentum.
Market internals are looking poor even though stock prices have risen. Unlike the late July rally this past summer NYSE volume was much lower in this turn around. Market breadth has also been weak. The best advancing day only produced a 3.5:1 margin. Money flow has also been poor. As to the assumption that the individual investor is back, that may only apply to day traders. According to Trim Tabs all equity funds had outflows this week of $1.8 billion. This follows outflows of $9.8 billion the previous week. Money still continues to flow into bond funds with $1.8 billion going into bond funds, matching the outflows out of stocks. Day traders may be playing this market but from the looks of things, private investors continue to exit the markets. In the last two weeks alone almost $12 billion has flown out of equity funds. Mutual fund cash positions have fallen to a record low of 4.2%. Unless Wall Street can sucker individual investors, it is unlikely this rally will have any legs. Like the previous rally in July-August the bulk of the rally occurred in just a few days. The markets did very little outside those one-day wonders.
The only compelling reason to buy stocks is to trade them at the risk of being caught long when the markets take their next big tumble. At the risk of sounding repetitious, there is nothing on the economic front, the earnings side, or from a valuation viewpoint that would make the case for owning stocks. The only reason now being given to win stocks is because they have fallen 40%. What is forgotten here is that when bull market manias correct themselves stock prices can fall much further. During the Great Depression stocks lost 90% of their value. Looking at earnings prospects, stocks are still more overvalued than they were in 1929 and in 1973-74 during the last bear markets. If Wall Street wants investors to go back into stocks they are going to have to do a much better job than this.
As a side note, it is interesting to see financial and news magazines do stories on the stock market urging investors to jump in and buy. The latest BusinessWeek featured a story by author of “Stocks for the Long Run” Jeremy Segal urging investors to jump back in. The reason? Stock prices have fallen 40%. Magazines and news sources doing stories saying it is now safe to buy stocks should be taken as a contrary indicator, meaning investors should do just the opposite.
I use the S&P 500 Index as a proxy for the stock market for a few reasons. I don’t use the Dow because it is only 30 stocks and with a large movement in a few of the higher priced issues, the index can have distortions that tend to be misleading. I also don’t use the Nasdaq because it is driven by press releases, lacks fundamental logic and seems to be the arena for speculators. To make investment decisions we need to filter out the noise and heighten the degree of predictability in order to increase our probability of success.
I expect the bear market forces to reassert themselves soon because the economic news is still lousy. I am will increase my short exposure to the market as soon as I have confirmation that the bear market rally has ended.
One of the technical indicators that I use is known as the Stochastic Oscillator. It is one of many momentum indicators that use statistical price ratios to determine when a stock or index is overbought or oversold. On the charts above, the monthly stochastic indicates an oversold condition, the weekly stochastic is neutral but heading up, and the daily stochastic is indicating a short-term, overbought condition. I expect the weekly to turn down, and when the daily and weekly are both pointed south, I will pound my short position to profit from the market decline. Also note that the monthly stochastic can stay down for a long period of time just as it remained high for a great portion of the bull market.
Some of the other technical indicators that are very useful include straight moving averages, MACD (moving average convergence/divergence) and up/down volume trends. If you would like more detail on the Stochastic Oscillator, or wish to learn more about technical analysis, go to Stockcharts.com and click on the tab “chart school,” then “indicator analysis.” They have a wealth of information.
Earlier this week we saw a continuation of last week’s decline in U.S. Treasuries. As the week progressed and equities began to sell off, some of the money came back to the bond market. One very important thing to note is that the bonds with longer maturities sold off more than the shorter maturities, causing the yield spread to widen (difference between short-term and long-term interest rates). A widening of the yield spread is usually interpreted as a warning against future inflation and indicates a loose monetary policy by the Fed. For the gold bugs out there, a widening spread can be construed as “gold-friendly.”
If you go back to the second half of 2000 you will find exactly the opposite situation. The yield curve wasn’t just flat, but was actually inverted. The Fed was raising rates at the time and short-term interest rates were higher than long-term rates. That’s when the door was slammed shut on the bull market in stocks. Since then, the Fed has been backpedaling with unprecedented rate cuts. Earlier this year the yield spread topped out just over 4%, and now stands at 3.5% and is heading up again.
In light of the widening yield spread, I thought it was interesting to see the market’s reaction when the Federal Reserve released its “Beige Book” on Wednesday. The Fed basically said that manufacturing has slowed, retail sales were weak across the country, labor markets are still soft and commercial loans are weak with rising delinquencies. Today durable goods orders were released for September and showed a decline of 5.9%. That was the largest decline in ten months. The bright spot still remains in the housing sector. Sales were higher for both new and resale homes. Thirty-year fixed mortgage rates have risen from 5.7% to 6.3%, but still remain at 30-year lows.
It’s fascinating that people continue to borrow more money as personal bankruptcies continue at record levels. Back in the early nineties, bankruptcies in the U.S. were below 400,000 annually, while today they are roughly 1.5 million per year.
On the weak economic news from the Fed on Wednesday, the stock markets rallied. The speculation on the trading floor was that because of the weak economic data, the Fed might cut interest rates. I don’t believe they will. Lowering the Fed Funds Rate would further expand the yield spread and could pose a threat to the strength of the dollar. With the rate at 1.75% there isn’t much room to go lower before we hit zero like Japan. The Fed would be pushing on the proverbial string. I expect that they will save the last cut or two in the event of a financial emergency.
Next week the Treasury is going to auction a hefty $44 billion in five and ten-year notes. That should help to put a lid on bond prices by adding supply which will keep us leaning in the direction of higher long-term interest rates. It will be interesting to see when the Treasury will reinstate the issuance of new 30-year T-bonds. According to Treasury Secretary O’Neill, the issue of 30-year bonds was stopped because of budget surpluses. I have a hunch they were eliminated to decrease the supply relative to demand, which would force prices higher and ultimately reduce long-term interest rates. What a great way to re-liquefy the system and increase borrowing. Our monetary system needs inflation to stay alive. A debt based monetary system gets really ugly when confronted with deflation. They have to create new money as fast as it’s being destroyed in the markets.
Going back to my original thought of “Flight to Safety 2002”, we have gone from dot-coms to blue chips to treasuries—so where do we go from here? We’ve already seen the corporate bond bubble pop and now we are seeing signs of strain in the treasury debt bubble. As people continue to lose confidence in paper assets, they will move to tangible assets. People will want to own “things” of intrinsic value, and not just paper that represents someone else’s obligation to pay. We are moving toward stagflation where we will see continued deflation (call that destruction) of paper assets along with increasing prices on real goods and commodities. Another way to look at it would be, things that involve debt will come down (home prices, care sales, capital expenditures by business, credit card spending, etc.) and things that we pay for with cash (food, gasoline, tuition, electricity, insurance, taxes, etc.) will go up in price.
I believe that in the final phase of the Flight to Safety we will see a great portion of liquid assets fighting for capital preservation. They will start moving into tangible assets such as gold, silver, collectibles, commodities, and the like. Next week, we will take a closer look at precious metals and mining companies as a potential safe haven to preserve and increase our assets.
Overseas Markets
European stocks fell for the first week in three, as concerns about bad loans, slowing profit growth and lawsuits pushed companies such as HVB Group, ABB Ltd. and Bayer AG lower. The Dow Jones Stoxx 50 Index has dropped 2.3% this week, led by Bayer's 15% slump. The index lost 0.5 to 2547.01, after earlier dropping as much as 1.7%. Five of the eight major European markets were down during today's trading.
Japanese stocks rose on optimism the government will water down a bank bailout plan that some investors said may trigger a financial crisis. Lenders such as Mizuho Holdings Inc. led the advance. The Nikkei 225 Stock Average rose 1.3% to 8726.29. Elsewhere in the region, Hong Kong's Hang Seng Index had its biggest slide in two weeks. China Mobile (H.K.) Ltd. and China Unicom Ltd. fell after Goldman, Sachs Group Inc. advised investors to sell China's top two mobile-phone companies.
Copyright © Michael Hartman
mhartman@puplava.com
October 25, 2002
