Weekday Commentary from Jim Puplava
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Dow 30's Wild Ride
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Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Tuesday's Stock Market WrapUp
Spin Cycle
They are all turning out to be one-day wonders. The markets explode on the upside with no follow through. One day up and the next day down. The financial markets have recovered from one of the worst months for the stock market in decades. However, the recovery has been in one-day explosive spurts rather than an orderly advance. They are becoming known on the Street as intervention rallies. They are sparked by big movements in the futures markets followed by heavy buying in key selective stocks that drive up the indexes. Yesterday it was the financials and the semis that rose explosively to the upside. The move in semiconductor stocks was prompted by an upgrade of the sector by Goldman Sachs following the firm’s purchase of 10,000 calls on the SOX the night before the upgrade.
As the graph above shows, the recovery hasn’t been orderly, but in large explosive spurts that seem to have no staying power. As stocks rise, investors seem to be viewing the rise as an opportunity to sell rather than buy. The momentum players are trading the market, but very few believe this is the bottom, or in fact, that the stock market is now cheap. The problem as discussed in previous WrapUps is valuation. Despite the media and Wall Street spin, stocks are still extremely expensive if you look at the broader indexes, such as the Dow or the S&P 500. There are two ways stocks can become cheaper: earnings or price adjustments. In order for the S&P 500 to become a bargain, earnings would have to double each year for the next two years -- something I don’t expect to happen given the pressure for companies to come clean on their books. You also have to remember when we talk about earnings for the S&P 500, we are talking about pro forma earnings and not the real bottom line. Even here, Bloomberg lists trailing earnings for the S&P 500 at $28.23. This places the pro forma P/E on the S&P 500 at 32. That equates to an earnings yield of 3.13%, hardly a bargain.
The Dow is much cheaper, selling at 24 times earnings or an equivalent earnings yield of 4.16%. This is better than the S&P 500, but once again, hardly a bargain by historical standards. The historical average for the markets has been between 12-14. We haven’t even come close to historical averages much less bargain levels. Forget the Nasdaq as it has no earnings.
Wall Street is hoping that the public stays in the market and comes off the sidelines with their cash. The big boys are trading or shorting this market; while the small investor is just hanging on.
The Ostrich Effect
Following last Friday’s story in the Wall Street Journal on investors not panicking by not opening up their monthly account statements, a similar story appeared on CNNfn last night. The vignette featured an street interview of Manhattan investors who refuse to look at their monthly statements. One woman said her husband got mad if she opened their monthly investment statements. Instead, the statements got thrown in a desk drawer where they have been piling up since the beginning of the year. Another husband leaves the room if his wife puts on the financial channel. I call this the ostrich effect. After seeing markets go down 2 1/2 years, investors put away their statements rather than face the grim reality of 50-60% losses in their portfolios. The financial industry has done their job well. The new trend in investing is to put your head in the sand. One of the street pedestrians interviewed last night in the CNNfn piece said he was too busy working and making money to watch the markets. He then said, "I go to work to make money, then I invest it and lose money." We had the new paradigm economy and bull markets in the 90’s. This kind of thinking must be part of the new paradigm recession.
In the same piece last night, the well-respected anchor, Lou Dobbs, said it amazed him that gold had been going up in this kind of low inflationary environment. He was flabbergasted by the fact that investors were buying gold. Dobbs doesn’t understand that gold does well in either an inflationary or deflationary environment. The financial community has failed to take into recognition that gold is rising in all markets across the globe. Gold is rising against the yen, the euro, the Swiss frank and the dollar. For the first time since the 70’s, investors are fleeing paper assets and heading into things, especially gold and silver. There has been a synchronized rise in gold prices against major currencies around the globe. This movement reflects an inflection point in the markets that runs counter to prevailing investment attitudes towards the markets. The rise in gold is signaling that major trouble lies ahead for the financial markets and the banking system.
Since this bear market began, fund managers have been fleeing the markets and going into bonds. This has helped the Treasury market rally. It has also replaced the drop in foreign investor demand for Treasuries. The next shock to the financial markets is going to come from the bond market. When investors wake up to the fact that treasuries are offering very little in return, especially against dollar depreciation, the final prop in the financial markets will have fallen.
Talk about the bull market in gold being over will be proven just as shallow as the repeated calls for a second half recovery over the last few years. Anyone with a bit of knowledge in reading charts can see this reflected in the price of bullion and the price of gold and silver equities. The summer rally will be with us only for a short period of time and then the primary trend in this bull market will continue -- this time in full force. As mentioned so many times, not until the excesses of the 90’s credit boom have been cleansed from the financial system and values are restored to the markets will we begin a new bull market in stocks. When you see your neighbor forswearing to ever invest in the markets again, we will be close to reaching a bottom.
Bank Balance Sheets Troubling
There are too many problems at the moment to be reconciled that pose even larger threats to the financial system. Like a brushfire, they keep popping up all around the globe simultaneously. Bank balance sheets are full of non-performing assets. For the fourth quarter of 2001, the top three banks, Citigroup, J.P. Morgan Chase, and Bank of America, had non-performing assets respectively of 12.33%, 9.54%, and 10.12% of equity. According to the latest FDIC report for 2002 Q1, non-performing assets continue their long-term rise, but at a decreasing rate. Non-performing loan growth has slowed down to 5% from 9% during the fourth quarter. However, the second quarter this year has been another bad quarter, so non-performing assets could be in an uptrend. The FDIC report shows that loan growth remains stagnant. See 4Q 2001 and 1Q 2002. We still don’t have a clue on what is happening to the derivative book of the big three banks listed above. We won’t know that until the fourth quarter when the OCC reports the derivative position of the big banks as of the third quarter of this year. At the moment all we hear are the rumors circulating around that the big three are in trouble. The Financial Times recently did a story on the banking system entitled, "Where’s the risk?" The editorial states that there is growing concern in the derivative markets of another LTCM-like crash in the banking system.
Most banks derivative books are made up of OTC-type derivatives that are high risk and illiquid. According to the FT, "… there are dangers that institutions take bets on particular risk models that turn out to be wrong." It could be that a few of these trades lie at the tail end of the curve. They are the ten-sigma events that regulators can’t foresee, but their probability of becoming a reality are becoming even greater because of the degree of leverage now in the financial system. Everyone from banks and insurance companies to hedge funds have had to use leverage to increase their returns in what has become one of the lowest interest rate environments in half a century.
The Financial Times goes on to point out that with corporate default rates up at record levels, the chances for coping with mounting losses may be too much of a strain for the financial system. At the moment, financial institutions have been spreading the risk by transferring it to other players. This is lot like a hot potato that may be tossed back to banks if the other counter-party to the derivative contract goes under. The rise in gold is now reflecting the risks in the financial system, such as derivatives, and the chances for a systemic breakdown that is ignored by the financial markets. It is like a sailor heading out to sea and ignoring what the barometer is saying. It is these kinds of risks that have become so pervasive in the financial system that are now being ignored by investors.
The Dominoes Are Falling
Today Providian Financial reported its profits fell 34% on loan defaults. Vanguard Airlines filed for bankruptcy. Brazil’s currency fell to a new record low, and the nation’s bonds slipped to lower levels as concern mounts that the IMF loan package won’t keep the country from defaulting on its sovereign debt. Meanwhile, Uruguay closed all of its banks today as the country faces the worst economic crisis in decades. Uruguay’s central bank announced it has suspended all banking operations in the country. Experts say there is an eerie similarity to what happened in Argentina. Money has been fleeing the banking system, the currency has gone into a nosedive, and the financial markets are plunging in the country. Now the question is which banks are on the hook for the country’s external debt? Latin America is going down in domino fashion as one country after another follows each other into a financial crisis. Analysts fear that the domino effect may be heading north to Mexico and then the US. This is just one more example of the kinds of systemic risks that lie at the tail end of the curve, which is not factored in most models. So far there have been six-sigma events. The question is where will the ten-sigma event come from?
Today's Market
It was another mixed day in the markets today following yesterday’s one-day wonder. That has been the pattern for month of July. The markets finished mixed after spending most of the day in negative territory. The tech sector was riddled with losses that miraculously transformed into gains by today’s close. Investors were in no mood to take risks. They were buying defensively. Today’s winners were concentrated mainly in the utility, gold, and the natural gas sector. Volume came in at 1.81 billion shares on the NYSE and 1.73 on the Nasdaq. Market breadth closed on a narrow positive by 17 to 15 on the NYSE and 18 to 16 on the Nasdaq.
Overseas Market
European stocks fell as lower confidence among manufacturers and consumers sparked concern about economic growth. The Dow Jones Stoxx 50 Index fell 1.0% to close at 2720.82. Three of the eight major European markets were up during today’s trading.
Asian stocks rallied on optimism a surge in U.S. equities will lift consumer confidence and spending in the biggest overseas market for exporters such as Sony Corp. and Samsung Electronics Co. Japan's Nikkei 225 stock average had its biggest one-day gain in a month, while South Korea's Kospi index advanced 3.4%.
Treasury Market
Treasuries closed mixed, forfeiting most of their earlier upside following a recovery in the equity market late in the day. The 10-year Treasury note shed 6/32 to yield 4.59% while the 30-year government bond gained 9/32 to yield 5.405%.
© Copyright Jim Puplava, July 30, 2002
