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March 18, 2004

Bears Awaken, But Still In Limbo
by Brady Willett

Richard Russell believes that the top is in, Financial Sense's Martin Goldberg says that "this is a momentum market that has lost its momentum", and the boys at Comstock recently speculated that the markets could be close to a "final panic sell-off". Yes, and in case you had not already noticed, the recent market sell off has brought many bears out of hibernation.

Notwithstanding the insights the above 'bears' have to offer, it is difficult to agree that the bear market rally that began in March 2003 has finally ended. Rather, unless events materialize to negatively impact investor psychology (i.e. unless the 90+ million mutual fund owners begin to shun stocks), the liquidity outlook for stocks remains positive. Quite frankly, the tiny sell off in the markets since February - while temporarily quickened by the Madrid attacks - may not alone be enough to mark a distinct change in investor psychology.

With this in mind, there are three interrelated points of interest that suggest that a stock market route is not imminent:

1) Thanks to the unyielding rally in 2003 brutalized short sellers will need a negative catalyst before they become as daring/numerous as they were during 2001 and 2002.
2) With US interest rates low and money market returns unable to best inflation, the average investor is bereft of investment ideas that are unrelated to equities.
3) Most fund managers will continue to chase stock prices higher so long as quarterly performance is more important than principles.

Along with these points of interest it is worth chiming the obvious bullish case for stocks: the US economy is expanding, corporate earnings are improving, and dividend declarations are up. Moreover, on almost a daily basis anecdotal information arrives to suggest that times will continue to 'good'. For example, earlier this week the Manpower Outlook survey - which, reportedly, since 1990 has predicted future employment trends 'spot on' - forecasted more hiring in the second quarter, and yesterday Moody's had this to say:

"Not one company with rated corporate debt defaulted last month, the first default-free month in more than six years." USA Today

If times are so good why not rush headlong into stocks?

The above speculations - or that the markets may not yet be ready to retrench - were not made in an attempt to suggest that stocks are an attractive investment. On the contrary, part of the reason why safety minded investors like Warren Buffett are having a difficult time putting any new money to work in the US stock market is because shares are extremely overvalued by historical standards. Lets be honest, the bullish argument ignores traditional valuation measures and relies primarily on one relatively new matrix - the Fed model - to suggest that stock prices are rationally priced. With an average dividend yield of roughly 1.6% (S&P 500), and the economy/stocks extremely sensitive to the interest rate situation, is it prudent to not blindly believe that stocks should rally without question every time interest rates move lower?

Suffice it to say, in order to plunge into stocks today the investor must bank on a sustained rebound in the US economy and corporate profits, while at the same time betting on only a small rebound in interest rates. Given that the Fed has coddled the economy with 13 rate cuts in a row and growth is now picking up, the danger here is obvious:

Any notable growth in payrolls is likely to compel the Fed to start tightening -- any tightening in monetary policy is likely to have a dramatically negative impact on economic activity - stocks do not respond well to negative economic trends.

With this in mind, what is not obvious is why stocks fail to price in an end to the so called 'reflation trade'. But alas, the story goes - or at least it can be inferred - that tax cuts and interest rate reductions will, somehow-someway, provide a permanent boost to the economy and corporate profits. This is the bedtime story bears read before they went to sleep in mid-2003...

Risks Be Damned - Bulls Ignore Indicators

Many well regarded stock market indicators - investor confidence, insider selling, and valuations to name only three - have wrongly been warning of an imminent pullback in the markets since mid-2003.  However, none of these indicators explicitly forecasted the most recent correction in the markets. In fact, probably the best indication that a correction was developing came from Marc Faber's wife in early March:

"I recently received the strongest sell signal I have ever experienced: my wife, who in the 25 years that I have known her has never shown any interest in buying stocks, wanted just recently to buy some Thai shares. Some friends had told her that you could buy in the morning and sell in the afternoon and make a profit!"

The lesson to be taken from this is that, regardless of valuation risks, investor appetite for stocks is largely unpredictable. For certain, one cannot gauge with any degree of accuracy how many Mrs. Faber's are waiting to try their luck at playing the greater fool.

Market Rotation Could Last Until...

The Dow Jones Industrial Average reached an all-time intraday high of 11,908.50 in early 2000. Less than two months later the Dow was trading lower by more than 2,000 points on an intraday basis as the great bear market began to stir.

If you are unfamiliar with history the above chart might suggest to you that the Dow entered a serious slump in March 2000. After all, the markets lost ground in 2000, 2001, and 2002 - the Dow must have performed poorly during this time frame, right? Wrong! Rather, even as the Nasdaq crashed - from 5,132 on March 10, 2000 to 1,923 on March 12, 2001 (-62.5%) - the Dow traded sideways as capital rotated out of 'new economy' and into 'old economy' stocks.

The Dow closed at 9928.82 on March 10, 2000.
The Dow closed at 10644.62 on March 9, 2001.
The Dow closed at 10611.24 on March 11, 2002.

Point being, it took two years of tech losses and failed rotation schemes before investors began giving up on all stocks. Despite a plethora of ominous considerations today - the two foremost being the potential for chaotic currency/interest rate movements - it could take a great deal of time before the 90+ million strong start giving up again.

When the Wheel Stops Spinning

Despite holding steady even as the Nasdaq crashed in 2000 and 2001, the Dow finally collapsed in 2002. Why? Because the average investor began to take money out of US equities for the first time in more than a decade, because money managers lacked the new capital to leverage their chasing fetish, and because short sellers became daring.

"Our capital is underutilised now, but that will happen periodically. It's a painful condition to be in but not as painful as doing something stupid." Warren Buffett

It is stupid to gamble your capital on an imminent US stock market collapse. However, it is equally stupid to believe that stocks have somehow broken free from herd like movements and/or that the Mrs. Faber's are making sound investment choices and not being bamboozled into believing they can make money playing the markets like a roulette wheel. Buffett is being selective about which stocks he buys because the majority of investors are gambling on a lasting recovery in the economy and profits. The majority is usually - eventually - proven in the wrong.

A small crack in the rally is heard after TrimTabs estimated that equity mutual funds had net outflows last week for the first time since the week ended July 2, 2003. However, only when 90+ million Americans stop treating stocks as savings and bruised short sellers get back their brawn will the markets bust lower. With the US economy living off of unsustainable stimuli this day could be closer than many people think. However, don't be surprised if the bearish case remains in limbo until equity rotation schemes are exhausted.

Russell, Goldberg, the Comstock boys, and many other bears are not necessarily relying on wishful thinking to concoct their bearish diatribes. On the contrary, what the methodical 2000-2002 market decline also taught investors is that bearish psychology can eventually and rapidly trigger large markets declines. The Dow was trading above 10,000 on May 28, 2002 and below 7,200 on October 10, 2002. Needless to say, this is the type of decline that awakening bears envision happening...eventually.

Brady Willett
FallStreet.com

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