Weekday Commentary
from Jim Puplava
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Source: Wall Street Journal
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Thursday, October 24, 2002
Fundamentals and Perception
Fundamentals are the drivers of financial markets longer-term. In the short run perceptions, human emotions, myths, hype and a lot of hyperbole can drive markets. Other times it is pure complacency. The buy and hold mantra has been in force with most investors as evidenced by the money still sitting in stock equity funds. Since this summer money has begun to slowly exit the markets, but it hasn’t turned into a stampede yet. There is still hope that we have finally hit bottom. In fact, one of the constant themes over this last year is the number of Wall Streeters who are coming out daily calling for a market bottom. The market always manages to fool every one of them. Just when you think the market has hit rock bottom, it rallies and then plunges to lower lows. That is the way bear markets work. Bull markets tend to rise slowly over long periods of time. Bear markets are shorter in duration and more violent in their movements.
Bear markets like the bull markets that precede them have three phases. The first phase is the distribution phase; the pros and the insiders sell and get out of their stocks at close to the market’s peak or shortly thereafter. The second phase is the “panic phase” where buyers become scarce and sellers multiply. This is the phase where the general public realizes that the bear market is for real. Downward trends in prices accelerate in sharp downward movements that scare the living daylights out of John Q. This is when you are most likely to see a series of 90% down days. They represent investor capitulation and are usually a sign that the market has hit an intermediate term bottom. After the panic selling second phase of a bear market, a time of recovery follows. This secondary recovery is then followed by the third phase of the bear market where the last of the discouraged sellers bail out of their stocks. This is when the popular sentiment is against ever owning stocks again. This is when you hear stories from your neighbor on how much money they lost as they vow never ever to own another stock or mutual fund again in their lifetime.
Panic Phase Ahead
This has been the sequence of most bull and bear markets. My reason for mentioning this is that I believe the second panic phase lies directly ahead. We have not seen a panic phase in this market as evidenced by the vast majority of stock holders having held on to their fund holdings. The only market that has eliminated a lot of its froth has been the Nasdaq where the final mania in the bull market occurred. The Dow and the S&P 500 have yet to be hit by a full-scale selloff. In fact, the blue chips have held up rather well, especially the Dow. Foreign money and institutional money has merely been reallocated into the safer blue chips. As money migrated out of the Nasdaq it found a home in the big blue chip stocks of the Dow. While the Nasdaq has lost over 70% of its value, the Dow is down only 29% from its peak, and the S&P 500 is down only 42% compared to a plunge of 74% for the Nasdaq. The second phase, when it comes, will hit the blue chips even harder because that is where a lot of froth still remains.
The notion that stocks are cheap can quickly be dispensed with while PE multiples on the Dow and the S&P 500 remain at 22 and 28 respectively. Dividend yields look even worse although they have improved. The dividend yield for the S&P 500 is only 1.78%. For the Dow it is 2.28%. Dividend yields are important when considering long-term returns for the markets. Historically the majority of the return in stocks came from dividends. At one point in time before the 1950-60’s bull market, stocks paid more in dividends than the interest earned on bonds. This was because stocks were considered to be riskier investments so investors required a higher return as compensation. Before this bear market is over I believe stocks once again will be offering investors a higher dividend yield than what they can receive on a bond. That is the way it should be because contrary to popular fiction, stocks are riskier than bonds.
Now in terms of the argument that stocks are cheap, this morning’s article in the Wall Street Journal on S&P reevaluating earnings based on pension costs and the cost of stock options should dispel that notion. Earnings for S&P companies for the 12 months ending on June 30th were $26.74. After adjusting these earnings for actual returns on pensions and stock option expense, those earnings fell to $18.48. Using the latest S&P adjustments to earnings, the S&P 500 is trading at 24 times earnings on a pro forma basis and 37 times earnings on a net income basis.
As to my belief that the second phase of the bear market lies directly ahead of us it is based on investors’ attitude in the markets. Investors are ignoring almost all bad news these days. Wall Street believes this is an encouraging sign that a new bull market has begun and a bottom has been put in place for stocks. It doesn’t matter what the news is, declining or worsening profits, underfunded pension plans, terrorist attacks, an upcoming war, conflicts of interest by the CEO of a major bank, credit downgrades, widening credit spreads and a possible loan default by Brazil; it has all failed to deter fund managers and investors. In the words of one manager, “Investors want to be in stocks so we will oblige them.” Another manager went on to say, “We [the financial industry] need to get something going in the markets. Stocks have been down far too long.”
A Common Story
A client of mine is concerned about his golf partner. He tried to get him out of stocks. Last December I saw that individual and told him to liquidate most of his positions since I felt his portfolio was vulnerable. He owned a lot of telecomms, techs, and financial stocks, the kind of stocks that had done well in the later stages of the bull market. When I saw this individual his portfolio was well into seven figures. His friend recently referred him back to me. My message this time was the same. His portfolio hadn’t changed and had fallen another 30%. He appeared distressed. This was his retirement portfolio and it was what he lived on after his social security. This time he was more willing because he had brought his son along, the heir to the fortune who was even more distressed. Plans were made to liquidate. Unfortunately a rally began recently in the stock market and my client’s friend was of the opinion that the market had bottomed. He was back to his bull market beliefs because that is what had made him a fortune. I truly believe I will see him again under more unfortunate circumstances.
This story is one I see repeated in conversations with friends and acquaintances who still believe that the bull market never ended. I believe this divergence is what explains the vast majority of investors still holding on to their fund holdings throughout the entire first phase of this bear market. The pros and the insiders are out or short, or are in alternative asset classes. What will initiate the second phase, or ‘panic selling’ phase of the market will be a ten-sigma event, the topic of an upcoming Storm Update. One only needs to pick up a copy of a domestic or foreign newspaper to find a long list of likely candidates. As far as investors ignoring the bad news and believing in a new bull market, I believe it is just the opposite. It is a sign of complacency where new bear markets spring forth.
Today’s Markets
Looking at today, stocks fell on concerns the recent gains have gotten ahead of any fundamentals in earnings. A number of companies gave poor third quarter reports and warned of further deterioration in profits. Most companies that have reported good earnings have made those earnings from cost cutting and not sales increases. Cost cutting can only take you so far. In order to grow earnings you have to grow sales and that is not happening.
Market internals continue to weaken with advancing volume dropping off and hitting lower highs. Advancing volume has been weaker than the summer rally. Breadth has also been hitting lower highs showing that momentum is stalling. Volume rose on the downside selling today to 1.68 billion shares on the NYSE and 1.94 billion on the Nasdaq. Market breadth was negative by 18 to 14 on the big board and by 18 to 15 on the Nasdaq. The VIX rose .52 to 39.9 and the VXN advanced 2.21 points to close at 54.58.
Overseas Markets
European stocks rose as KLM Royal Dutch Airlines NV followed companies such as Royal Philips Electronics NV, SAP AG and Nokia Oyj in saying cost cuts are helping lift profit. The Dow Jones Stoxx 50 Index climbed for the first day in five, rising 2.9% to 2558.81. The index fell 3.4% yesterday, the biggest decline this month. All eight major European markets were up during today’s trading.
Japanese stocks fell, paced by retailers such as Ito-Yokado Co., on concern the economy may return to recession because of a government plan to clear bad loans and a slump in exports. Fitch Ratings said it may cut Japan's credit rating next month, while government figures showed that exports fell for a fourth month as U.S. growth slowed. The Nikkei 225 Stock Average shed 1.2% to 8614.30.
Bond Markets
Treasuries witnessed plenty of back-and-forth action throughout the session before rallying in late afternoon action as stocks sold off. The 10-year Treasury note was up 25/32 to yield 4.13% while the 30-year government bond rose 1 1/8 to yield 5.09%.
Copyright © James J. Puplava
October 24, 2002