Weekday Commentary from Jim Puplava
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Market WrapUp for the Week
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Friday, September 20, 2002 Market WrapUp
Rough Road of Recession Relapse
The slow painful process of adjustment has just begun. For so much of this year, many investors have held on to their stocks in the hopes that Wall Street predictions for a second-half recovery would come true. Instead of recovery, it now looks like we will see a relapse into recession. In the stock market, investors have had to suffer through a third year of losses. Instead of a bull market correction, they have had to endure the full force of a bear market that is about to enter its second deadliest phase. Since the bear market’s inception, the Dow has lost 32%. The Dow finished this week with a loss of 3.9%, bringing its year-to-date losses to over 20%. The S&P 500, down 45% from its peak, lost 5% this week. The index is down over 26% this year. The NASDAQ, which has now lost 76% from its March 2000 peak, gave back 5.5% this week. Its losses for the year are now over 37%.
3 Year Charts for Dow, S&P 500 and Nasdaq Composite
Sometimes we have to look back (3 years) to look forward.
The markets have been pricing in a second half recovery that now looks like an illusion. For three years now, individual investors have held on while insiders and professionals have bailed out of stocks or have gone short. Wall Street has predicted a second half recovery for three consecutive years. These forecasts have all fallen short of their targets with the economy and the stock market traveling in opposite directions. This makes the current stock market extremely vulnerable due to present valuations. Current P/E multiples are 2-3 times historical averages. And you can forget all of the balderdash of a new era; there never was one, nor is there one on the immediate horizon. Dividend yields of less than 2% on the S&P 500 and a P/E multiple of around 30 indicate that this bear market has a long way to go on the downside before any meaningful rally can occur. The situation is not quite as bad for the Dow, which is double historical norms, and only offers a dividend yield of 2.34%. Companies are still sitting on hundreds of billions of impaired assets as a result of the merger and acquisition binge of the 90’s. There will be more writedowns coming over the next few quarters. In fact, it may take another few years before companies clean up their balance sheets. The highly-leveraged companies won’t survive and those that do will need years to repair all the damages of the 90’s excesses.
Granddaddy of Derivatives in Trouble
In the foreseeable future, the markets will be dealing with the unwinding of the credit bubble. The downgrade of JP Morgan Chase raises the issue of systemic risk in the financial system. Even more important for the financial system is that this giant hedge fund, which poses as a bank, is the Granddaddy of the derivatives market. JPM’s credit downgrade raises the issue of counterparty risk. Morgan plays a sizable role as a counterparty in the swaps market. In addition to its enormous derivative book of $25.9 trillion, JP Morgan now holds 52% of all derivative contracts within the banking industry and about 25% of all derivative contracts worldwide. Current estimates are that derivatives held by all financial institutions are in the $100-$110 trillion range.
This is one risky hedge fund that could implode and bring down the financial system. Another credit downgrade, or an explosion in the price of gold, could make Morgan a relic of the past. Morgan’s gold derivative book could be the Achilles heel of this blue shoe bank. JPM is a major bullion bank with a gold derivative book of $45.12 billion. Morgan holds over 60% of all gold derivatives within the banking system. It is believed that most of this gold derivative position is short gold. It may be one reason why authorities have become anxiety-prone each time the price of gold rises. Unlike paper contracts, gold can’t be printed. Morgan would be in big trouble if they had to deliver into those shorts. Gold deficits are running at an annual rate of 1,500 tonnes or more. Without gold leasing, and sales and suppression through paper gold derivative contracts, the price of bullion would be much higher.
Insurance Premiums on The Rise
An ominous sign now emerging within the financial sector is the rise in the price of insurance in the derivatives market. This week premiums rose to $30,000 from $20,000 to cover $10 million of Fannie Mae loans. That is up from $25,000 last week. For the troubled JP Morgan, premiums rose to $95,000 this week, up from $80,000 last week and $50,000 only three months ago. Both entities disavowed any problems despite the bleeding in most segments of its business. For Fannie, delinquencies are on the rise along with defaults. In the case of JPM, it is losing money on foreign loans, corporate loans, and its trading departments profits have plummeted. In the case of the GSEs, such as Fannie and Freddie, and in the case of JP Morgan Chase, these are big entities that are too big to fail. Taking a chapter out of the book from failed policies of Japan, maybe the Fed will start monetizing their assets and in the process become their largest shareholder.
Earnings Warnings Troublesome
Other stories surfacing this week were the spate of earnings warnings coming from the likes of McDonald’s, Oracle and EDS. Analysts keep lowering estimates for pro forma earnings each quarter and companies are still managing to miss their new, lower targets. These lower expectations for lower profits have yet to be fully priced into the stock market, which tells me that this bear market has more painful adjustments ahead of it. Nobody is buying the second-half recovery, nor are they falling for the “there will be growth in the winter” fourth quarter recovery story. Pro forma profits of 22% or more for the fourth quarter may take an act of God to deliver, and God seems to be pretty occupied these days with events around the world -- a coming war being one of them.
Energy Supplies Shrinking
Other issues on the radar screen this week were the tightening supply of oil and natural gas. Natural gas prices are up 70% from this same time last year. Industry analysts expect that even with a normal winter, prices will be heading higher. Any disruption of supply or increased demand as a result of a harsh winter could send the price of natural gas soaring and present the U.S. with its second energy crisis of the new century. California’s economy would be hit hard having skated through the last crisis by experiencing warmer weather. California’s Governor Grey Davis was clueless and paralyzed as to what to do in the last energy crisis, and got lucky with a cool summer weather and a warm winter. Davis now faces a reelection bid and won't have an Enron to shift the blame. He is probably saying Hail Marys, singing Ave Marias, and making acts of contrition in hopes that God will give California a winter reprieve before the elections.
In the natural gas markets on the supply-side, production is falling. Inventories are adequate to get the US through a normal winter, but not much more. Production of natural gas is expected to be down 6-10 percent in the second half of the year. Oil inventories were down again this week by 6.4 million barrels to 292 million barrels. Oil prices are still hovering at close to $30 a barrel. It now appears that war with Iraq is inevitable. The uncertainty of war and possible supply disruptions keep oil prices high. The rush to war is based on information that Saddam may be only months away from developing nuclear weapons. Once that happens, he graduates into the big leagues. Neither the US or any other major power have ever taken action against a nuclear power. This is one of the reasons why so many states are acquiring nuclear weapons. They are less costlier to build than conventional weapons and are much more effective in their ability to kill and destroy. The nuclear club keeps growing and Saddam wants to be included. The rush to war is to prevent the dictator from acquiring these weapons, which will give him the ability, in his mind, to do great things.
Not Too Promising Next Week
Next week, outside the issue of war, we should be in full swing into the Q3 earnings pre-announcement season. The news should be bad along with slowing reports on the economy. Until the economic news gets better and markets have adjusted to the new reality (meaning lower prices), it will be difficult to get a counter-trend rally going. The technical picture looks weak. The VIX and the VIN are rising which spells more volatility ahead, but not enough to start a rally. The VIX rose to above 50 on July 23rd, which gave a strong signal that fear levels were at an extreme. The VIX and the VIN closed Friday at 44.51 and 59.01 respectively. When these two measures rise above 40 and 60, they suggest a trading bottom is near or that volatility is about to rise sharply.
This market still has a long way to go despite the losses from the beginning of this bear market. Chart formations, when viewed on a longer-term chart for most stocks, still look like their top formations are still in the process of breaking down. So what we continue to have is a weak technical picture followed by worsening fundamentals and pricey valuations. The worst of all of these is the widespread complacency by investors both amateur and professional. Mutual fund cash balances are in the low 4 percent range and John Q is still holding on preferring to play the part of an ostrich. I’m watching mutual fund outflows. This week $4.6 billion flew out the doors of mutual funds compared to inflows of $1.8 billion the previous week. It is amazing to think of all of the portfolios that have been cut in half in this unwinding bear market and John Q is still hanging in there. The worst is yet to come.
The next phase of the downturn is the white-knuckle phase that should shake the remaining apples off the trees. It will take some kind of event, of which there are numerous candidates to choose from, that may provide the final impetus. A war, a financial collapse, a derivative implosion of a hedge fund or major money center bank such as JP Morgan, or a terrorist attack, should do the job. Of course we still have Saddam who is capable of surprising us all. Add up all of the evidence and it isn’t hard to reach some very definite conclusions. At the risk of sounding repetitive, this bear market has a long ways to go. A long ways before the next countertrend rally, and a long, long way before the bear market exhausts itself and a new bull market emerges.
Overseas Markets
European stocks had their biggest weekly loss in nine weeks as economic reports showed a recovery is faltering. Insurers plunged as Swiss Life followed rivals and said it will raise money by selling shares. Today the Stoxx 50 rose 0.2% to 2387.82, although they dropped 6.5% this week and on Thursday closed at its lowest level since October 1997. Four out of the eight major European markets were up during today’s trading.
Asian stocks fell after U.S. home and job reports suggested that growth in the region's largest export market may be slowing. Kyocera Corp. and Taiwan Semiconductor Manufacturing Co. led the decline. Japan's Nikkei 225 Stock Average lost 2% to 9481.08.
Treasury Markets
Long government bonds traded lower, with fixed-income securities again taking their cues from the stock market. The 10-year Treasury note slipped 1/32 to yield 3.78% while the 30-year government bond slid 21/32 to yield 4.745%.
Next week's calendar heats up, with leading indicators, consumer confidence, new and existing home sales, durable goods orders and the University of Michigan consumer sentiment index due out. Additionally, the Fed will meet to decide on interest rates Tuesday.
© Copyright Jim Puplava, September 20, 2002