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Grudge Match: Fed Model versus the Historical Mean

Thursday, May 29, 2003 | 11:19 AM

Today, we dissect the battle between the believers and the infidels (better known as Bulls vs Bears), and the schools of thoughts underlying each side's perspectives.

The Bulls point to the so-called Fed model; It compares the earnings yield of the S&P500 with that of 10-year Treasuries. There should be a rough parity between the two, goes the theory; When the earnings yield is appreciably lower on the 10 year than the S&P500, it reflects an undervalued stock market – prompting comparison shoppers to choose between stocks and bonds. Based upon this model, the S&P500 is ~30% undervalued. That suggests a move to SPX 1500, and Nasdaq 2000.

Several researchers have found flaws in the Model. Ned Davis Research observed that the Model worked well from 1980 to 2000, but was not reliable before 1980. Others note the model fails to incorporate risk (Treasuries being guaranteed by the USA) and does not account for inflation.

On the flip side are historical measures, which suggest the Markets remain pricey. Long term measures of P/E, Price to Book, and Dividend Yield disagree with the Fed Model’s conclusions. The markets have always "returned to trend" near a P/E of 14; Assets well above trend do not reward investors over the long haul, whereas those below do, reversion to the mean (RTM) advocates argue.

RTM is why all hitting streaks end, why the hot hand grows cold, why the house eventually wins. The mathematical issues of RTM can be resolved in one of 3 ways: 1) If it “really is different” this time; 2) If earnings increase dramatically (raising the “E” lowers P/E); or 3) Stock Prices come down a lot (a lower “P” also lowers P/E).

This battle between the Fed model advocates and the Reversion to Mean theorists will determine where the market goes. Fed model folks are in ascension; The reversion to the mean crowd will eventually assert themselves. Meanwhile, Sentiment governs the day to day.

One final thought: Interest rate increases not only make companies less profitable – its more expensive to borrow money – it also makes stocks appear less of a bargain as vis-a-vis the 10 year as yield rises. It’s a double whammy for stocks if the Fed raises rates –lowering profits and hurting valuations. If the economy manages to improve only modestly, the Fed might still be loathe to raise rates a year from now . . . Its quite possible that we may not see rate increases until after the 2004 Presidential elections.

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Quote: "Any intelligent fool can make things bigger, more complex and more violent. It takes a touch of genius-and a lot of courage-to move in the opposite direction."
-Ernst Schumacher

Thursday, May 29, 2003 | 11:19 AM | Permalink | Comments (0) | TrackBack (0)
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Bah, Humbug Tax Cuts?

Tuesday, May 27, 2003 | 11:25 AM

Bah, Humbug? The Market typically greets all tax cuts with unfettered joy; Even more so for Wall Street targeted cuts such as capital gains or dividends. Tax rate reductions simply provide that much more manna to feed the beast. “Hey, let the Bond Ghouls worry about deficits” is the typical attitude from equities.

That makes Mr. Market’s muted reaction last week to the $800 Billion plus set of cuts (true cost) enacted last week rather intriguing. One expected a sharp move up off of that news, as the size and scope of the cuts was not baked into the market yet; Perhaps a few issues are worth looking out to figure out why this hasn’t happened – yet:

· Weakening Dollar: As the chart (at right) makes clear, Trade Imbalances lead to a falling dollar. The gentle slide we’ve enjoyed becomes a much greater concern when the dollar starts to get jerked lower in a more violent fashion;
· Burgeoning Deficits: As the WSJ noted last week, the actual cost of the recent tax cut is $810 Billion, not the $350B advertised. The lower number assumes sunset provisions will allow the tax cuts to lapse – something most political observers put as rather unlikely.
· Anemic Economy: Signs of recovery are still AWOL; This week has a lot more data points to look at, as opposed to last weeks quiet economic news.

Perhaps it’s a matter of timing – the cuts came as the market was pausing after a healthy run up. Regardless, the lack of response to giant tax cuts is surprising.

Contrary Indicators, part II ?
Bob Pisani (CNBC) had a fascinating report Friday: Several pension funds are conducting studies regarding lowering their equity exposure as part of a broader asset allocation review. Holding over 21% of all U.S. equities, a pension fund shift in allocation could have broad repercussions for the markets. The $24B Colorado PERA has recently lowered its equity exposure to 45% from 55%; Currently reviewing their asset allocations are the Pennsylvania SERS ($20B), Arizona’s SRP ($17B), and Ohio’s SERS ($6.5).

With Bonds yields at a 45 yr lows, and equities down 50 - 75% after a 3 year Bear Market, perhaps this discussion might have been more timely several years ago. Do the Investment Committees who manage these funds reflect the general population broadly enough to make this a reliable contrary indicator? . . . Its unknown at this time, but its certainly worth watching.

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Quote: “"Man is not the creature of circumstances. Circumstances are the creatures of men." - Benjamin Disraeli (1804-81)

Tuesday, May 27, 2003 | 11:25 AM | Permalink | Comments (0) | TrackBack (0)
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Analyze This: Technicals versus Fundamentals

Thursday, May 22, 2003 | 10:42 AM

Analyze This: The markets continue to show impressive resilience, despite ongoing mediocre economic reports. As mentioned last week, the market was overbought and due for a digestive pullback. Even Monday’s hefty pullback was on light volume.

The internals of this last rally have been better than any of the previous bear market bounces, and that factor is one of the more Bullish issues facing investors. Based upon a variety of indicators – A/D line, up/down volume, new highs/lows – the internals look solid. Pullbacks remain shallow and on light volume, with an apparent ready supply of buyers below.

Asides from the Technicals, the market has a variety of things going for it, at least over the intermediate term: An accommodative Fed (Interest rates and Money Supply), Congress (tax cuts) Treasury Secretary (Currency) and White House (Dividend/Capital Gains Tax cuts) are pulling out all the stops to get the market and the economy moving. This should have positive effects going forward.

There still remains areas of concern: Some savvy economic observers expect to see little in the way of growth or inflation, most notably, Bill Gross. Agree with him or not, Gross is a guy who cannot be merely ignored. For better or worse, he controls ~$400BB – he makes the market, he does not follow them. If you think that is trivial, consider that his net assets are 10x that of Buffet’s book value.

Sentiment is also a bit befuddled: IIAA sentiment survey shows that bulls now number 56%, while the bears are down to a surprising 20.9%. That’s the lowest level since the 19% reading, circa 1987. That excessive sentiment is troubling from a contrarian perspective; Bull markets do not typically begin with only 19% Bears. With self-admitted Bears so few, surprisingly, the put call ratio has moved up to higher levels. This suggests the “wall of worry” is being rebuilt. That’s a necessary component of a sustained advance. Contradictory and worth watching.

The last technical concern is a lack of confirmation by the Dow. It hasn’t kept up with the other indices. That doesn't mean the market cannot reverse itself here; However, patient investors might scaling in between here and a better entry point – more towards the 8200 level. That ensures that if this pullback is indeed shallow, traders will have long positions to take advantage of the move.

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Quote: “"Power is not revealed by striking hard or often, but by striking true. -Honoré de Balzac, 1799 - 1850.

Thursday, May 22, 2003 | 10:42 AM | Permalink | Comments (0) | TrackBack (0)
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It’s all about the Benjamins

Monday, May 19, 2003 | 11:36 AM

The Benjamins: Equities react to Money Supply, Currencies and Interest Rates. More than anytime in recent memory, these monetary factors are having a very significant impact on the markets. On top of these broad monetary adjustments, significant fiscal changes are about to be enacted (again) through wide changes in the tax code. This is the second major tax cut in as many years.

As we noted back in November, intervention in the marketplace creates crosscurrents: Ultra low interest rates (now at 45 year lows), deflating U.S. Dollars (also at a multi-year low), and on top of it all, the biggest weekly gain in M2 in 15 years. In fact, since 1999, MZM – the supply of all Money and equivalents (Money with Zero Maturity)– has increased by 50%, from $4 trillion to over $6 trillion. It has doubled in only 7 years, since 1996. The previous doubling (from $2T to $4T) took 11 years from 1987 to 1998.

Some commentators have suggested that this increase in M2 is reflecting an increasing demand for money, possibly pointing to a rebound in the economy. That’s a chicken and egg argument, however, as the economy’s statistics have yet to show any meaningful increase in demand. Perhaps this is more accurately reflects the wishful thinking of optimistic practitioners of the dismal science.

More alarmingly, money growth may actually be reflecting how anemic the underlying economy is. More than responding to demand, it may be force-feeding fuel to a market with little horsepower of its own. There’s a problem with turbochargers: in trying to wring maximum performance from an engine, they tend to, on occasion, blow them up.

That’s a danger: The Fed is trying every trick in the book to get this Economy moving; They’ve cut interest rates to half century lows, cranked up Money Supply dramatically, while the White House has encouraged the U.S. Dollar to drop precipitously while cutting taxes (soon to be twice).

The cure for a deep bubble is time. The danger of all this broad intervention is that if it fails, it will make the recession worse, and only take that much longer to heal.

While we are still constructive on this rally – the internals are better than all the previous bear market bounces, and we would use the imminent 50% retracement to buy stocks – the Macro picture continues to give us pause. As said previously, Mr. Market will give the economy two quarters to show signs of a recovery. Without signs of a recovery by Fall, we would expect to revisit Bear market lows.

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Quote: “"Wisdom is the power to put our time and our knowledge to proper use." -Tom Watson, IBM Founder.

Monday, May 19, 2003 | 11:36 AM | Permalink | Comments (0) | TrackBack (0)
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Small Caps and Contrary Indicators?

Thursday, May 15, 2003 | 10:41 AM

The market continues to show impressive resilience, despite rather overbought conditions, and significant overhead resistance. It is apparent that buyers are below – pullbacks have been shallow, the market’s internals remain firm, and the general tenor of the action is healthy. That said, we continue our practice of bringing to your attention issues that bear watching going forward:

SMALL CAP RALLY The only Green yesterday (see above) was the Russell 2000. Small caps have been hot Hot HOT!, with many hitting new 52 week highs. This suggests that a speculative fervor has returned in force, with “panic buying” occurring in many of the above names. This can at times be a warning sign of an impending short-term blow off top.

BOND RALLY With interest rates at 45 year lows – that’s 1958 for the math impaired – there is an audible clamor of investors piling into Treasuries; Our Bond desk believes the fixed income market is a screaming sell right here; Bond funds continue to suck up loose cash, while the equity markets are enjoying only modest inflows. According to AMG Data, for the week ending May 7, equity fund inflows were $1.1Bil, while bond fund inflows were more than 3 times that amount – $3.4B. This is definitely a continued concern for the equity market, and yet another thing to keep an eye on going forward.

Contrary Indicators abound; Several broad factors which often coincide with Market bottoms are present:

As mentioned previously, the financial press has been in a severe retrenchment. Beyond the gutting of CNNfn and the ratings drop off in CNBC, a trio of high profile financial magazines have closed recently; This is noteworthy, if for no other reason than as potential contrary indicators. Mutual Funds Magazine, Bloomberg Personal Finance, and now Worth reflect Main Street’s newfound lack of interest in Wall Street – a necessary component of a bottom.

Also on the Contrary Indicator list is the recent Morningstar new fund category classifications; Noteworthy is the new category for “Bear Funds.” It strikes us as rather late to the party after a 75% drop in the Nasdaq, to just now be opening Bear Funds, or establishing a category for this group. Just as the scramble to roll out new Internet funds in 1999 and 2000 was topping sign in that sector, the belated rush to Bear Funds could very well be a positive, long-term signal that the bottoming process is further along than many realize.

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Quote: “As long as the reason of man continues fallible, and he is at liberty to exercise it, different opinions will be formed.” -James Madison, The Federalist, No. 10

Thursday, May 15, 2003 | 10:41 AM | Permalink | Comments (0) | TrackBack (0)
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Monday, May 12, 2003 | 11:38 AM

As this leg of the rally starts to run away, concerns are popping up. None of these issues changes our underlying perspective–the market is in a cyclical bull mode and may end up 15–20% higher before significantly reversing. Regardless, signs of a near term pullback are appearing, and they are worth reviewing:

Too Many Bulls: The nearly 56% Bulls (24.4% Bears) in the most recent sentiment survey by Individual Investor is an initial cause for concern. People get Bullish after they buy stocks, not before (that’s just Human Nature).

Overbought: By most measures, the markets are have come pretty far pretty fast. The measure of OB/OS is strictly a function of price and time; An overbought condition can be alleviated by either a pullback (price), or by treading water for a while (time). If the market marks time (instead of pulling back), its somewhat bullish.

Speculation remains a concern as many third tier issues and high priced dotcoms maintain their aggressive chart patterns. Hints at days of old, and that’s bearish. Even DELL is up nearly 50% since February 2002 (3 months ago).

European Bourses look anemic and on the verge of rolling over. The German Dax was down nearly 3%, while the (non-Euro denominated) FTSE turned positive. The weak dollar/strong Euro makes goods from Europe more expensive here; Europe is already in a near recession, and without US consumers, the situation there could worsen.

Equity Put Call Ratio has moved up smartly, without a commensurate move in the VIX. This suggests that portfolio managers are buying cheap insurance on their long positions. If the VIX had moved up sharply along with the Put/Call ratio, that would indicate a “Wall of Worry” is forming; Without that concern, the P/C ratio remains Bearish.

We expect a shallow, buyable pullback over the next week.

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-Rod Serling , 1924 - 1975

Monday, May 12, 2003 | 11:38 AM | Permalink | Comments (0) | TrackBack (0)
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Dollar Disconnect ?

Thursday, May 08, 2003 | 10:58 AM

I know you were planning to disconnect me, and I'm afraid that's something I cannot allow...

How is it that the dollar is in freefall, Bonds are steady, and equities are up? Why the disconnect? The inter-market relationships between these asset classes seem to have (temporarily, at least) vanished; Bonds and equities tend to move in opposite directions at the same time. Equities and the US dollar – at least in the ‘90s – had a high degree of correlation. Lately, these assets have gone off on their own ways. Here are a few thoughts as to why:

Bonds: Steady bonds may be reflecting a fear of deflation; Perhaps the fixed income market is pricing in yet another rate cut; Add some ill-timed chasing by retail (with yields at 40 year lows), and that may explain some of the recent action. I wonder how many individuals switched to Bond funds in their IRA/401(k), making monthly contributions; Could this be sufficient to offset the asset allocations of Funds away from fixed income and into equities? Perhaps. Regardless, expect this to end badly.

Market Technicals: The internals of the markets haven’t looked this good in quite a long while: Maybe it’s a case of “been down so long it looks like up to me.” The number of stocks near 52 week highs are up, and trending higher; A/D line is near its year high; Major indexes are above their 50 and 200 day moving averages.

By most technical measures, the equity markets are healthier than we have seen in a long while. That doesn’t mean we aren’t overbought, or susceptible to a pullback (we are); Indeed, with bulls now up to 55.8%, and bears down to 24.4%, sentiment is reflecting that the market has gotten ahead of itself. But the technical picture hasn't been this nice in quite a long while.

Earnings: have been coming in much better than expected, and this is somewhat misleading as to the overall health of the market. You may be startled to learn how much Energy companies have impacted earnings gains (See: First Call) of the S&P500: With 21 of 23 energy firms reporting, estimated earnings growth for Q1 2003 is up an astounding 180% - that increase is making S&P500 earnings look much better as a whole than individual sectors actually reflect. At least as far as other sectors are concerned, this has not been as terrific an earnings season as the total number suggests.

Back out energy, and this would have been a disappointing reporting season. The spike in Oil during the War may have led to a one time, windfall profit growth. This is worth watching, as it’s a potential danger sign going forward.

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Quote: "Always do right. This will gratify some people, and astonish the rest." -Mark Twain

Thursday, May 08, 2003 | 10:58 AM | Permalink | Comments (0) | TrackBack (0)
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Cinco de Mayo!

Monday, May 05, 2003 | 10:50 AM

The 5th day of the 5th month gives us an excuse to look at 5 key issues confronting the market over the next 5 months:

1) Earnings are much better than expected; Although its widely acknowledged that the bar has been dramatically lowered, the psychological impact of beating instead of missing. It produces a very positive impact on sentiment, and that cannot be underestimated. Still, the key will be how company’s report in the October Q – after the war has become ancient history, and far enough forward to see of a 2nd half recovery is the real deal or not.

2) The Economy continues to be sluggish, with occasional signs of not getting worse. The War seems to have givewn the Economy a pass, at least for now, and at least as reflected in the Market. It’s worth noting that economy often looks the worse at the bottom, and things are looking, well, less bad than a few months ago. The key question remains whether the economy is expanding, contracting, or merely marking time.

3) Speculation has returned to the market; If not quite with a vengeance, well, at least as quite a force. Last week, e.g., Priceline.com (PCLN) was up 30% in a day as the result of a reverse stock split. While many of the beaten down telecom and tech stocks are still decent value plays, we must respect what excess speculation potentially means to the longer term health of the market. Do not confuse aspects of speculation with NASDAQ’s leadership; No rally is sustainable without some Generals leading the charge, and for now, its tech and financials.

4) Resistance (as shown on the Nasdaq chart at right) is a short distance away near ~1600. The Comp has had a huge run off of the recent March 12 reversal, rallying 20% from 1253 to over 1500 in 6 weeks. That fast move suggests a somewhat overbought condition, which may take some backing and filling to alleviate.

5) Valuation is still a big issue going forward. The S&P500 P/E is 32.4, which is unusually pricey. Perhaps it can be justified if there is a very hefty spike in earnings – a distinct possibility given the lean, mean condition companies find themselves in during this earnings trough. Any revenue increase would in fact have meaningful impacts on earnings; That could make high P/E stocks look very cheap very quickly.

These 5 issues are worth watching as we move into the usually quiet Summer period.

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Quote: “To fail is a natural consequence of trying, To succeed takes time and prolonged effort in the face of unfriendly odds. To think it will be any other way, no matter what you do, is to invite yourself to be hurt and to limit your enthusiasm for trying again.” - David Viscott

Monday, May 05, 2003 | 10:50 AM | Permalink | Comments (0) | TrackBack (0)
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