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Breakdown: What the Stock Market Is Telling Us  

March 19, 2005: Originally posted September 17, 2004, this turned out to be a very incorrect read on the market direction, as stocks promptly shot up October - December, 2004. However, it now seems that perhaps the views expressed here were simply six months before their time, as the Nasdaq has just hit a new yearly low and the broader indices are stumbling from new highs reached less than a month ago. The markets seem to be awakening to the fact that there is simply not enough oil in the world to meet demand, General Motors is heading for Chapter 11 bankruptcy, inflation is on the rise, and the enormous current account and Federal deficits may not be quite as benign as Greenspan and Company insist. With those realities about to make their presence known in the Fairyland known as Wall Street, this piece seems more relevant than ever.

In an interesting footnote, Smith Barney fired Louise Yamada and her entire technical analysis staff in early 2005, saying that the firm wanted to focus on "fundamental research." As a long-time Smith Barney client, my own view is that Yamada and Crew were fired for not being sufficiently bullish about U.S. markets. The Emperors--the dollar and the U.S. stock market--have no clothes, but woe to anyone in Fairyland who dares note their nakedness.

For rare voices of reason in the industry, I recommend reading Stephen Roach of Morgan Stanley and Richard Bernstein of Merril Lynch, both of whom have been well-informed, persuasive skeptics for many months.

May 5, 2005: As is well-known, occasional sharp rallies are a recurring feature of all bear markets. The current rally may well run for some time, and "going long" may well be the best strategy at the moment. The following essay is not investment advice, nor is it in any way suggesting the market will go down or up at any particular time. It is only looking at some fundamental economic issues which may well influence stocks, bonds and currency exchange rates at some point.


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The stock market is ill, and its recent stumble to new yearly lows could end in a very nasty fall.

Says who? After all, hasn't the market rallied handsomely from those lows? The consensus of investors and Wall Street--not to mention the Federal Reserve and the White House--is that the economy is in a temporary “soft spot” and that a return to rising profits and employment lies just beyond this pesky spike in oil prices.

This sanguine view is reflected by the Chicago Board Options Exchange volatility index, or VIX, which measures expected volatility via analysis of stock options. When the index is under 20, as it has been for virtually all of 2004, it suggests “the market” is unperturbed about the future. Indeed, the VIX just fell to a multi-year low of 13. This indicates the market is supremely confident that nothing untoward can happen to the U.S. economy, and by extension, to the U.S. stock market.

Market gurus use the VIX as a contrarian indicator; a VIX above 50 signals fear rules the day, and that typically marks a market bottom. Conversely, a low reading indicates complacency is ubiquitous, and that marks a market top. So why, as the market bounces off new lows for the year, is complacency still reigning supreme? The expected reaction would be growing fear--a rising VIX--as markets trend ever lower. The current conundrum can be stated simply: Either the market is wrong, or the consensus is wrong.

If you dig a bit, it’s hard not to conclude that the market is telling us something is very wrong with the rosy economic picture painted by the complacent consensus. How is it telling us? By breaking down to ever lower lows, and reaching ever lower highs at each attempt to regain its footing. That’s a called a “trend,” and this trend is very obviously down.

There are plenty of voices predicting the market has more to fall, maybe a long way, and they’re coming not from the rabid fringe of doomsday prophets but from respected voices in the investment community.

Richard Russell, a dean of the so-called “geezers,” those market pundits who correctly called the last great Bear market from 1974 -1982, wrote last week to clients, “My advice is to be OUT, OUT, OUT of this market and to be in cash. The way this market is going, I expect it to at least 'test' the September 2002 low of around Dow 7,500 and maybe lower.”

Too strident and apocalyptic, perhaps?

Then consider Louise Yamada, Smith Barney’s well-regarded technical analyst, who concluded in a recent research report that “the path of least resistance may now be down.” As a technical analyst, Yamada has a number of ways of assessing the market, including some esoteric tools only of interest to dedicated chartists and number crunchers-for instance, the 40 and 80-week cycles, which just happen to point to a bottom in October.

Of greater interest is Yamada’s analysis of trading volume, which according to her measure has dropped-a bad sign, she says, as “volume is the weapon of the Bull”-and her comparison of the late-90s tech bubble and the current post-bubble activity with the Dow’s eerily similar runup and collapse in 1929-32. Yamada traces out four so-called “Bear market rallies” which occurred after the initial 1929 collapse, and she concludes that we’ve just experienced the high point of the first such post-bubble rally.

“The possibility exists,” she wrote in July, “that this advance may now be complete.”

It may be easy to overlook the often-obscure work of chartists, but Smith Barney’s U.S. Equities Analyst Tobias Levkovitch is also bearish. “The temptation to put hope and desire above reason and fact stems from the overconfidence that got investors into trouble during the tech bubble,” he writes in an August 5 report.

Levkovitch bases his appraisal on several key factors: pre-tax corporate profits are at 35-year high, and are therefore unlikely to keep rising, interest rates are going up, generally a negative for stocks, and the investor complacency which marks a market top. Levkovitch charts what he calls “the other PE,” “the panic/euphoria ratio” (as opposed to the usual Price/Earnings ratio used to judge stocks’ profitability and value), and he finds the current mild euphoria alarmingly bearish. “We find the downside risk to U.S. equity markets has not yet abated, given slowing profit growth, rising interest rates and investor complacency.”

Though that may sound bland, in the carefully measured econo-speak of Wall Street analysts, it’s a shrill clarion call.

Other skeptics are calling into question the entire underlying story that the world economy- the U.S. included- is doing just fine.

Richard Bernstein, Chief U.S. Strategist with Merrill Lynch, wrote in mid-June, “It seems nearly impossible to find a growth story in the global economy which isn’t tied to a significant amount of, or the increase of, leverage.” Leverage, in this context, simply means borrowing a ton of money based on some asset.

Referring to the recent binge of refinancing which pulled hundreds of billions out of Americans’ home equity, he states acerbically, “The US consumer still does not realize that savings and consumption are mutually exclusive.” After observing that Americans’ home equity is at an all-time low, he concludes, “They continue to find new and innovative ways to destroy their balance sheet while still believing they are saving for retirement.”

Challenging the Feds’ (and the real estate industry’s) benign view of the current housing boom, he writes, “Although one could argue whether we are in the first inning or ninth inning of a housing bubble, the characteristics of a financial bubble have been, and continue to be, undeniably in the housing market.” With a decidedly somber tone, he adds, “It used to be that people built wealth through the equity in their homes. Today, people speculate on the price of their home going up.”

Many other analysts have pointed to other negative historical correlations:

1. Rising oil costs have always been accompanied by recession."Not this time!" according to the current party line; oil is a smaller percentage of GDP than it was in the 70s, and there’s at least a $10 per barrel “risk premium” which will dissipate once the uncertainties in the Mideast lessen.

But such views seem outright Pollyannish once you consider the underlying supply-demand picture. Demand for oil is rising at the highest clip in 20 years, and there is only a razor-thin surplus which can be pumped to offset shortages. The world pumps 80 million barrels a day and the surplus is at best 1 million; according to some sources, the excess is all high sulfur content “sour crude” that no refinery wants. If demand-both in the U.S. and Asia (China and India)--is growing faster than anytime in the last 20 years, and suppliers are pumping flat out, it’s difficult not to conclude that anyone expecting a drop in oil prices is in the grip of a powerful denial.

In the Smith Barney technical analysts’ view, oil is on an inexorable rise to $46, $51, and eventually, $67 a barrel. Is this something to be complacent about?

2. Inflation is on the rise, and may be poised to break out. It’s generally accepted that the Chinese and other low-cost manufacturers have been exporting deflation to the U.S. economy via lower prices for goods, and this was part of the Feds’ rationale for being worried about creeping deflation in 2002. But a funny thing happened on the way to deflation: the cost of everything other than manufactured goods has been going up.

China’s hyper-demand has pushed up the price of basic materials such as oil, coal, steel and nickel, and everything which is unaffected by low offshore costs, such as medical care and transportation, have been rising, too. Although the official inflation rate is currently around 3.3% per year, anecdotal evidence suggest the real rate is much higher but is being absorbed-at least for now--by businesses. At some point they will be forced to pass the price increases on to the consumer. If the consumer balks, then some businesses-for example, a major airline or two-may be forced to close their doors.

Rising inflation and stagnant economic growth-termed “stagflation” in the bad old 70s-is historically the worst environment for stocks. Not only are companies struggling to keep profitable, but the rising interest rates which inevitably follow on the heels of inflation make fixed-rate investments like bonds and money market funds more attractive than stocks.

This was the backdrop during 1974-1982, when the stock market traded sideways for eight long years; some analysts see that period as an analog for the rest of this decade.

3. Interest rates cannot be held below inflation much longer. Even with the Fed clicking up the Fed Funds rate a quarter point to 1.5 %, that’s still only half the inflation rate of 3%. Although there are two “official” inflation rates-the real one and the prettied-up "ex food and energy," it's an absurd parsing, as food and energy are precisely what people can't do without. Listen to the conversation in any supermarket checkout in the country and you hear people talking about their $100 or more a week gasoline bills and rising food costs, and the effect those increases are wreaking on their budgets, and then try not to chuckle too cynically when the “ex food and energy” inflation rate comes in at 2%.

Rising interest rates are bad for stocks because they raise the cost of borrowing for businesses and suppress consumer borrowing.

Historically, rates rise to an equilibrium above the underlying inflation rate. Economists generally agree that the Fed rate should be 1% or 2% above inflation; if the interest rates paid to bond holders and savings accounts is less than inflation, then that is essentially a negative “real return”-clearly an unsustainable policy in the long run. By this rule of thumb, the Fed needs to raise the basic rate to at least 4% or 5%--a long way from 1.5%. Recall that as recently as 2001, the Fed rate was 6%.

Given these three long-term historical negatives for the stock market, the current complacent buzz of the investor class in the face of almost daily declines is unsettling, to say the least. And to be fair, we should add the other negatives in the economy: a brewing bubble in housing, lousy job growth, skyhigh levels of indebtedness, rising medical costs, and low wage growth.

So are the analysts with decades of experience like Russell, Yamada and Bernstein just flat-out wrong, and the market is actually poised for another sustained runup to new heights? It’s certainly possible-maybe oil will suddenly decline by $10 a barrel, and maybe costs will magically decrease-but maybe it’s the consensus which is wrong. Maybe it’s the accepted view of benign economic growth which is about to be rudely awakened from a soporific slumber of low inflation, low interest rates and rising profitability.

One chart should give pause to anyone convinced the good times in the stock market are here to stay. It’s an overlay of all the recent bubbles in the world economy: the NASDAQ 1996-2004, the Nikkei 1986-92, gold in the early 80s, and the 1928-32 stock market bubble and crash. Not surprisingly, the NASDAQ tracks the other bubbles with an eerily disturbing accuracy: the slow buildup, the parabolic spike up, the breathtakingly sharp decline, and then the post-bubble bounce. Looking at the chart, it’s difficult not to conclude that we are now exiting the post-bubble bounce that is a key feature of all bubbles, and are now heading down for the re-test of the lows nobody believes possible.

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