Friday, October 11, 2002 (Puplava Friday market wrap)
Bottoms UP!
Was it earnings? No. Was it economic news? No. Was it political news? No. The market rallied because it was technically oversold. By Wednesday of this week they (Wall Street) needed to get something going. The economic news wasn't getting any better, corporate earnings were coming in way below expectations and troubles were brewing in the financial sector. J.P. Morgan got hit with another credit downgrade as the bank's profitability continues to decline. On the Street everyone knew that the economic numbers this week weren't going to look good. They didn't. Bad loans are growing in the banking sector and talk was everywhere about systemic risks in the financial system. The major averages were hovering at key support levels. If those levels were breached, then it was, "Katie, bar the doors" to lower levels. How low? Possible lows for the major indexes would be in the 6,000 range for the Dow, somewhere in the 600's for the S&P, and 900+ for the NASDAQ. Something needed to be done to keep the market from crashing to new lows. What Wall Street didn't want to see is investor capitulation. There is still a lot of money sitting in mutual funds, which are hemorrhaging. If major averages headed lower, the market could experience a series of 90% downside days or a washout for the markets. A 90% downside day is an event where downside volume equals 90% or more of the downside and the upside volume and when points lost in the market equal 90% of points lost and points gained. Historically a bottom is reached after 3 to 4 90% down days that are followed by several 90% upside days.
We haven't experienced a series of 90% down days typical of bear market bottoms. There has been no clear evidence that a major market bottom has been put in place. What happened is that the markets responded to oversold technical indicators. After hitting a peak of 962.7 on August 22nd we have experienced six weeks of declines in all major indexes. The rally in late July and August was feeble at best with no accompanying volume. The rally in July came quickly in a series of big point gains and then quickly fizzled. The rapid point gains were attributed to short covering. Afterwards there wasn't anything to write home about as hopes were dashed as the rally ended in late August. The public was absent from most of the August rally with money flowing out of mutual funds until the very end of the rally.
The Four-Step Rally
The new sequence of engineering a rally seems to be following a four-step process:
Phase 1 One-two-day wonder rally, with intervention.
Phase 2 Short covering drives violent upside surge in indexes.
Phase 3 Day traders and technical traders come in a play rally bounce.
Phase 4 John Q comes in at end of rally after uptrend has run out.
After the rally plays out as nothing more than a technical bounce, the bad news sets in as expectations are readjusted and the markets head lower. Notice that you no longer hear about the second half recovery in earnings or the economy. Third quarter pro forma profits have gone from 30% to 5%. The fourth quarter has gone from 40% to below 20% and is still headed lower. Wall Street has plenty of history to fall back on to justify and spin a new rally with talk such as "this market has bottomed," "stocks do well in an election year," "this market has already lost close to 50%, therefore we've hit bottom," "the Fed will lower interest rates," etc. There is no end to the spin, but the spin can't hide the fact that this is the longest running bear market since the Great Depression. Stocks aren't cheap. They have gone from mania like valuations to becoming simply expensive. That's all. There is nothing compelling to entice investors to want to own stocks other than to trade this market technically.
Reading Between The Lines
Now let's look at some of the news. Retail sales fell in September by 1.2% along with consumer sentiment. Consumer confidence hit a 9-year low. The University of Michigan's Consumer Sentiment Index fell to levels not seen since September of 1993. Sales are coming in weaker than forecasts as debt burdened consumers begin to retrench. Lower retail sales at Wal-Mart and J.C. Penney indicate the consumer, who accounts for two-thirds of the US economy, is slowing down on spending plans. Auto sales declined in September despite zero percent loans and now zero down payments. GM, which had pulled back on zero percent loans, has had to revive them adding to it, zero down payment and zero percent interest to get buyers into showrooms. Most retailers, from discounters to general department stores, are seeing sales volume drop. More is expected in the months ahead, especially during the key fourth quarter Christmas season. Retailers will also have to deal with the possibility of war next month and the effects of a West Coast port shutdown. Many retailers are reporting late receipt of holiday goods and higher freight costs.
In other news on the corporate side, companies are still announcing massive layoffs. Lucent today announced that it would lay off another 10,000 workers to reduce costs and help stave off bankruptcy. The company had 123,000 employees two years ago. Plans are to reduce employment to 35,000 by the end of 2003 -- a reduction of over 71% of its workforce. The biggest maker of telephone equipment will also take another $3 billion restructuring charge. Lucent looks like it will not make it and could be closing its doors soon if it isn't taken over. The company cancelled $1.5 billion in a line of credit and another $500 million facility to head off an anticipated default by violating its debt covenants. The company may seek a reverse stock split to boost its share price and avoid being delisted.
The key to the tech outlook next year is what companies will be saying about employment as they release third quarter results. If they plan on letting go of more workers, then it will tell you that capital spending plans are still weak. If that is the case and we have a retrenching consumer, then what is going to give us the 3-4% economic growth that forecasters are calling for in the fourth quarter and for next year? To avoid looking stupid, major investment strategists on Wall Street have not only been trimming earnings forecasts, but also trimming back their ridiculous forecasts for the major indexes by the end of the year. Many strategists now refuse to go on the air. There are many fallen gurus and divas of the investment world that prefer not to be seen or questioned. Their calls have been an embarrassment over the last three years. In 2000 they told us it was merely a correction and in 2001 it was the terrorist attacks on the Trade Center and Pentagon. Maybe this year they will get lucky and blame it on the war if it starts, as I believe, next month.
Then there are earnings. GE helped to ignite today's rally by reporting earnings that grew by 25% during the third quarter. GE has been both a catalyst for a rally and for a decline. They helped to spark a short-term rally several weeks ago by announcing they would meet third quarter estimates. They then helped to trigger a major selloff by warning they would have difficulty achieving double-digit gains next year. The 25% third quarter gain [for GE] was helped by the sale of its electronic-commerce unit as reinsurance and private investment businesses experienced their second straight quarter of losses. The weakening economy has slowed down revenues and profits at the company's two large industrial divisions. The company is running out of rabbits to meet demanding expectations on Wall Street. At the moment, the company is meeting earnings estimates through acquisitions and cost cutting.
Yahoo! beat the Street with revenues and earnings that rose from very depressed levels from last year. Comparisons to last year should be easy this quarter because of the huge writedowns companies took last year at this time. We don't count huge losses and writedowns when they occur, but include them when we want to make earnings comparisons. That is how the earnings game is played. Analysts lower earnings estimates and exclude large writeoffs, and companies pretend things are going well by playing along with beating lower estimates. Shares of Yahoo! are up over 30% this week with a current PE multiple of 103. I think we can dispense with the notion that this is a 30-50% earnings-generating growth company. Yahoo! has become nothing more than a tradable tech stock. It is doubtful it will ever become a great profit generator.
The best thing that can be said about this market is that the little guy hasn't jumped ship. John Q is still holding on in the hopes that he will break even. As the graph of mutual fund inflows show, the vast majority of investors came into this market in its final third phase, which began in 1995 when the Clinton-Greenspan bubble began. That is when the Clinton Administration greased the wheels of the economy with easy money creating the bubble economy. Now we have multiple bubbles as a result of the continuation of easy money and ample credit. I've already covered the various bubbles in "Bubble Troubles."
What's Ahead of Us?
So where do we go from here? It is my guess that this rally may follow a similar path as the late July early August rally. We could get several days of strong point surges that are then followed by a weakening rally as the shorts cover their gains. A rise in stock prices will be capped off by a declining economy, worsening earnings, and emerging market debt defaults. Watch Brazil, and the prospects for war. In the end this will be nothing more than a tradable rally. For tech traders it will be a few more days, or maybe weeks of fun, and then it will be time to add to short positions again. There are no firm convictions in this market. Opinions change daily, weekly and monthly with the whims of the market. The amazing fact to me is that there are gullible people that still believe we are in a bull market and that stock prices are coming back. The bull market ended in the first quarter of 2000. A new bull market began in "things" such as commodities, which also includes gold and silver. Just like the bull market that began in stocks in August of 1982, very few people believed in it. It wasn't until 1995 that the vast majority of money came into this market, which was during the third and final phase of the last bull market.
Become A Believer in Things
That is where we find ourselves with gold and silver today. Very few people believe in it. There is no widespread public participation nor is there widespread institutional ownership of this new bull market in "things'. All you find is disbelief, which is how I like it. The old adage buy low and sell high has never been more appropriate. Precious metals stocks of unhedged producers have only experienced the first phase bull market run up. They have retraced a good portion of those gains, but are still up significantly. It looks very similar to what happened in 1982-83 followed by the selloff in 1984. I don't intend to elaborate on the bull market fundamentals that are now in place. I've already written about them and more recently James Sinclair has waxed eloquently about gold's fundamentals. The financial world is still in denial, while the public is playing ostrich. That is where how bear markets end and bull markets begin. I would suggest that the intelligent investor consider and read more on these topics as elaborated in my Storm, Storm Updates, and PowerShift series and draw your own conclusions.
I will end this part of my weekend WrapUp with a chart of the market and financial cycles from my Storm series. The reader will notice that there are long periods of rising stock prices that are followed by periods of long declines. During these periods of decline, the commodity markets are experiencing periods of rising prices. These cycles seem to reappear every 20-30 years. This graph needs to be studied for it will cure the reader of the illusion that good times are permanent. One market's summer is another market's winter. I would suggest that the world of paper whether stocks, bonds, or currencies are heading from fall into winter; while commodities or "things" are coming out of winter and entering spring.
In summary a bear market in paper is entering its second phase and is far from a bottom. A new bull market in commodities from oil, grains to precious metals have just begun.
The Markets This Week
The Dow and the S&P 500 rose 4.3 percent this week while the NASDAQ advanced 6.2 percent. This leaves the losses down year-to-date for the Dow to 21.67 percent, 27.24 percent for the S&P 500, and 37.94 percent for the NASDAQ. This week looks more and more like a temporary snapback triggered by short covering. To get any more legs, this market still needs the day traders to come in and finally the investment public at the very end of the rally.
Economists are still calling for 3.6 percent economic growth this quarter and possibly 4 percent for the fourth quarter. Analysts are still bullish with CRAP or pro forma earnings estimates for the fourth quarter. They have now lowered pro forma earnings so low that any company experiencing declining profitability is now bound to look good. The GAAP PE ratio for the S&P 500 is close to 30 and the dividend yield is 1.9 percent. Wall Street and the financial media use the CRAP PE ratio, which is 17. It still doesn't make stocks cheap, but it makes them look less expensive. The Dow still trades at 22 times earnings with a dividend yield of 2.4 percent. At 3 percent the Dow will be fair valued which necessitate a drop to around 6,200, which is where I expect we will be when this next leg of the bear reasserts itself. The NASDAQ, well what can I say other than that it has no earnings. The NASDAQ 100 still sells at 37 times earnings with declining earnings and growth rates.
No, Virginia, this isn't the bottom.
This is a trading rally only with key resistance levels of 8,000 for the Dow, 850 for the S&P 500, and around 1,240 for the NASDAQ.
Money flew out of stocks this week with Trim Tabs reporting that mutual funds saw an exodus of $4.2 billion this week following last weeks $2 billion inflow. Money keeps flowing into bond funds with bond funds taking in $2.3 billion this week after taking in $1.7 billion last week. This is the next bubble to burst. Even Vanguard is warning its bond investors to diversify and not just buy bonds. The bursting of the bond market bubble will be the last leg of a five-leg fundamental set for gold's new bull market. Once the bond market bursts, then there will no longer be a safe haven left in paper.
Overseas Markets
European stocks gained as J Sainsbury Plc, Porsche AG and Deutsche Lufthansa AG indicated earnings expectations for this year might be too low. The Dow Jones Stoxx 50 Index recorded its second weekly gain in seven, climbing 5% to 2457.24. It has gained 8% since closing at a 5 1/2-year low Sept. 24. All eight major European markets were up during today's trading.
Asian stocks rose after a rally in U.S. shares and signs of a recovery in the world's largest economy boosted optimism that demand will increase for Canon Inc., Samsung Electronics Co. and other exporters. Japan's Nikkei 225 Stock Average advanced 1.6% to 8572.51. South Korea's Kospi index climbed 1.2% as the government said it will announce stock-boosting measures today.
Bond Market
Treasury issues got slammed for a second session as equities registered more heady gains. Treasuries closed at 2 p.m. ahead of the Columbus Day holiday and will be close on Monday. The 10-year Treasury note surrendered 1 7/32 to yield 3.80% while the 30-year government bond lost a whopping 1 20/32 to yield 4.815%.
© Copyright Jim Puplava, October 11, 2002
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