Weekday Commentary
from Jim Puplava
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Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Week in Graphs 
Storm Watch 
Geopolitical News 
Energy 
Precious Metals 
Raw Materials
Monday, October 28, 2002
Making The Adjustment
Beating earnings is no big deal. In the words of the Director of Research at First Call, “The actual earnings always beat the final estimates.” First Call analyst Thomas O’Keefe said, “Just beating the estimates does not mean the earnings picture is improving.” Most of the companies within the S&P 500 have reported Q3 results. Year-over-year it looks like pro forma earnings will be up about 7% over the same time period last year. This was an easy quarter for comparisons since last year at this time things were so bad after the terrorist attacks on 9-11. The improvement has been at the pace of a snail, with nothing big or spectacular. Of even greater importance has been the fact that companies once again don’t see any major improvements ahead. That is why they are still laying off workers. However, that hasn’t been the message of the markets. The markets are basically saying that better times lie ahead. The fact that the markets have rallied this reporting season seems to be taken as a new sign of bullishness for the markets.
There is nothing new this last quarter that has altered the perception that Q4 is going to be a barnburner when it comes to earnings. In addition to earnings estimates being too high, economic reports indicate the economy is slowing down again. Unless a company is going through aggressive cost cutting, it is unlikely revenue growth is going to accelerate enough to cause earnings to improve significantly. At this point earnings estimates are still too high. Just because this is the time of year markets do well doesn’t mean that markets will. There are always anomalies, and this bear market isn’t your ordinary bear market. So despite the fact that Wall Street is bullish doesn’t mean that they are right. They have been wrong for three years running, and I believe they will be wrong once again.
Perceptions right now are for higher earnings going forward, but there is nothing right now that would justify that view. Even many of the companies that actually experienced real earnings growth this quarter said that they don’t expect to see these improvements going forward. Microsoft had a good quarter, but it was an anomaly that had more to do with the way they do business and an accounting change than a marked improvement in the PC business. Before any sustainable rally can take place, you are going to need consumer spending to stay at high levels and for capital spending by business to turn around. There are no visible signs at this time that this is happening. What we are likely to get is tradable rallies which is what I believe this current rally.
What is of concern is the fact that the latest Barron’s poll finds most money managers are remarkably bullish and remain so even after three years of consecutive losses. The consensus seems to be that stocks have gone down for so long they have no where else to go but up. There is now talk of the Fed cutting interest rates again as another bullish factor for the financial markets. If the Fed cuts interest rates, it will be because of a crisis and that things are getting worse instead of better. If 11 interest rate cuts failed to stop stocks from falling or prevent a recession, what makes people believe another interest rate cut will do the trick? What will one or two more rate cuts do that 11 have failed to do so far?
The simple fact is the stock market is grossly overvalued. It may not be the message most investors want to hear, but it is an irrefutable fact. Last week S&P published a better picture of real earnings to establish a reliable and accurate benchmark for investors to value equities. By adding back writedowns from ordinary business, adding pension losses and accounting for stock options reduced S&P 500 earnings by more than a third. Stocks are still selling at 37 times earnings and 54 times net income or real earnings. This is why the markets have trouble staying afloat after short-term rallies because stocks remain overvalued. As plain and simple as this is, it is still misunderstood by most investors and analysts on the Street. Contrary to popular opinion, bear markets can last for very, very long periods of time. Just because stocks have fallen for three years, doesn’t mean they don’t have much further to fall. Bear markets end when most people have sold their stocks, foreswear ever owning them again, and valuations are extremely low. That is not the case today. Does that mean that stocks can’t rally? No. Stocks can still rally, but those rallies will be short-term and will be tradable rallies only.
So what comes next?
I suspect the next downward leg will be triggered by some unseen event of the ten-sigma variety that gives most day traders, speculators and complacent investors a wake up call. This could trigger a capitulation liquidation phase in the market that gets most investors’ attention. It should take stock prices down to fair value and initiate a series of monetary and fiscal developments out of Washington to help turn things around. That could give us a rally that may last 3-6 months as markets rally based on assumptions that governments can help resurrect markets. It could be similar to what happened to the markets after the “New Deal” in the 1930s. When it is realized these numerous fiscal and monetary policies don’t work, like they didn’t work in the 30’s, the final leg of the bear market should fall into place. The final leg or third phase of this bear market will take stock prices down to bargain levels. It is when stocks are selling at give-away prices that the pros will come in and start buying and holding longer-term. We are a long way off from that time. My advice is this: unless you are adept at trading and have thorough knowledge of technical analysis, or have a very clear understanding of fundamentals, you should stay out of this storm and head for a safe harbor. Even if you have a good understanding of technical analysis, it won’t save you from a ten-sigma event. Ten-sigma events don’t show up on the charts until they occur. There is no software program, charting package or mathematical formula that can tell you when they will occur. All you will ever know is their probability of occurrence. If there were a program that could tell you when and where they would come from, LTCM would still be in business.
I spend some time each week visiting chat rooms and various gathering sites on the web. I use these visits as a gauge of investor sentiment to back up other technical indicators we follow. What I find is widespread complacency almost everywhere. I also see a lot of bravado that seems ill-placed. That bravado speaks of lack of confidence. When you’re not confident, you don’t brag or boast. Just when you think you’re on top, the markets have a way of teaching you humility. This is a major bear market and you need to think in those terms. In bull markets everyone can become an investment genius. Real genius comes from having the ability to survive and then prosper from a bear market all the way through completion. What I’m about to say can’t be repeated too often.
This is the time to be thinking of return of your capital rather than return on capital. There are too many external factors outside your control that aren’t readable on a chart, which could very quickly devastate your investment plans. I don’t need to belabor the point. Just remember that the “era of peace and stability” is over. The world is heading towards war -- not peace. During war, people die, things get blown up or destroyed, and this time it includes the US. That is the message of 9-11. The United States is no longer immune from events that initiate elsewhere.
Today's Market
Markets fell across the board today as the realization set in that earnings estimates remain too high. Earnings projections are going to start coming down, and as they do, so will stock prices. With most of the S&P 500 companies having already reported earnings, the markets are going to start focusing on the economy again. This week we will get the first pass on Q3 GDP, consumer confidence, The Supply Management report, the unemployment report for October, and auto sales for last month. These collective reports should show that the economy is once again slowing down. The big stories going forward for the markets will be the economy, the coming war, and what pension plan contributions are going to do to earnings next year. This year it was accounting scandals and stock options. Next year it will be pension plan contributions.
Based on the latest Q3 earnings reports, analysts are now busy chopping Q4 estimates. They have already dropped close to 30% in July, 22.9% in September, and 19.9% in October, to the latest estimate of 16.9% as of today. In addition to revising estimates for the major indexes, analysts are cutting estimates for companies as well. Morgan Stanley downgraded their rating of Cisco. Wal-Mart fell after the world’s largest merchant reported sales at its Sam’s Club warehouse chain fell for the second week. After the markets closed, Qwest announced that it would take a $10.8 billion charge to record asset writedowns. The government also reported it would need to borrow $76 billion this quarter due to rapidly falling tax revenues.
This is the kind of news that awaits tomorrow’s open for the markets. Upgrades by analysts of three drug stocks weren’t able to resuscitate the major indexes which all sustained losses for the day. Over the past few weeks the financial markets have shrugged off a series of bad news to go on a rally. This was one of those days it didn’t as market momentum begins to deteriorate. Most sectors fell with utility, energy, and gold stocks drawing in buyers as investors go defensive again. Volume came in at 1.37 billion on the NYSE, and 1.64 billion on the Nasdaq. Breadth was negative by 18 to 14 on the NYSE and by 18 to 15 on the Nasdaq. The VIX continues to fall ending the session down 0.60 at 35.67 while the VXN rose 1.13 to 51.52.
Overseas Markets
European stocks rose on expectations increasing demand for electronics and computers will lift earnings at companies such as Royal Philips Electronics NV and Infineon Technologies AG. The Dow Jones Stoxx 50 Index added 1.1% to 2574.72 after earlier rising as much as 2.9%. Seven of the eight major European markets were up during today’s trading.
Japanese stocks fell after U.S. reports showed that consumer confidence dropped to a nine-year low in October and durable goods orders slumped. Companies that rely on U.S. sales, such as Honda Motor Co., declined. The Nikkei 225 Stock Average fell 0.5% to 8687.46, paring Friday's 1.3% gain. The Topix index dropped 0.8% to 864.72, with Honda accounting for 7% of the decline.
Treasury Markets
Short and intermediate Treasuries trekked higher while the 30-year bond languished. Growing expectations that the Fed may cut rates when it meets next week provided the front end with a solid bid. The 10-year Treasury note climbed 3/32 to yield 4.085% while the 30-year government bond was off 10/32 to yield 5.11%. October consumer confidence is due out on Tuesday.
Copyright © Jim Puplava
October 28, 2002