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Deep Impact?

Monday, June 30, 2003 | 11:05 AM

Since the March 12 reversal, the markets have had a "fast and furious" ride, gaining more than 25% in 3 months. Today, we evaluate the factors influencing the markets to guesstimate their future impact on equities.

• Window Dressing: The decorating period ends today. The best quarter since the Bear Market began in March 2000, hedgies and mutual fund managers are not going to let their performance numbers and bonuses slip away. (+);
• Where the Bears? With 71.4% Bulls, and nary a Bear in sight (Only 8.6%!) this is the highest bullish percentage since the all-time peak of 75% on Jan. 6, 2000. We need not remind you how that enthusiasm ended. (-);
• Overhead resistance: Indices are at levels where a pullback/consolidation would be healthy (chart at right) (-);
• Downside leadership: Watch the upside winners to see how far we go down -- Semis, financials, housing, biotech, & internets led the move upwards; Whether they show good relative strength or lead the markets during the pullback will be telling to the next phase. (+/-);
• Lack of Credible Alternatives: Where else can investors put their money? Bonds are peaking after a 3 year bull run, and money markets pay less than 1%; Equities have become the only game in town. (+);
• Terrorism: Will the terror alert level be raised to Orange for the July 4th holiday? How investors react to the color change (Have they become inured?) is worth watching (-)

Two last issues are worth thinking about: First, predictions that tax cuts will significantly stimulate the economy, starting this Summer, are likely overestimating their net impact. 'Though the tax cut was substantial, it was mostly hi-income loaded; Actual additional dollars finding their way into the "spending classes," (i.e., the lower and middle income groups) is de minimus. While it will have an impact via increases in the saving/investing rate of high net worth individuals, it will not cause a huge spending spurt. Economists are counting on big gains of increased consumer spending; Their overestimations will likely leave the dismal scientists – and the economy – somewhat disappointed.

Second, the Fed rate cutting cycle is now over. Although nearly free money will continue to chase cash out of money market & bonds for some time, the psychological edge of having an accommodative Fed is fast fading. Greenspan’s next move will likely be to raise interest rates, lest the economy starts to overheat, near December 2004.

Impatience at the Federal Reserve

Wednesday, June 25, 2003 | 11:55 AM

in Finance

The New Productivity Paradox and Fed Monetary Activism. The full report, titled "Impatience at the Federal Reserve" can be downloaded in your favorite flavor:
Word Doc
PDF

Excerpts:

Of the past 13 eases, today’s is the most difficult to justify, at least on a purely economic basis. Since the war in Iraq ended, consumer confidence has rebounded, retailing has improved and oil prices have come down. The Wall Street Journal noted that “Corporate bond issuance is booming, and mortgage-refinancing applications exceed the capacity available to handle them. Total commercial bank assets have climbed by 11% in the past year and bank profits have soared – a clear sign that the financial system is not starved of liquidity . . . Purchasing managers' indices are rising, deal-flow is improving again on Wall Street, corporate bond spreads have narrowed sharply, and the stock market is up.”

Our curiosity has gotten the better of us: What is it that is motivating the Fed? The Fed’s impatience is an enigma. Unless the system receives another external shock (i.e., war or terrorist attack), it’s reasonable to expect a slow but continuing recovery. Indeed, the possibility of a “shock event” is itself reason to keep some powder dry, just to be able to determinedly respond if such an untoward episode were to occur. This makes today’s cut all the more intriguing.

The New Monetary Activism

Its hard to call a 13th rate cut “new;” Its only within the framework of the present environment that what was once a gradualist form of intervention has morphed into something much more radical. The Fed has subtly changed from being “social rate cutters” into “problem interventionists.” I suspect they are thinking: “We can stop anytime we want . . .”

The weak but improving economy certainly doesn’t demand further cuts. Its not as if there’s been a “ground swell of complaints about high interest rates or tight money,” observed the Wall Street Journal. The American Enterprise Institute similarly noted that “GDP growth will rise to 4 percent and probably overshoot to 5 percent for one or two quarters in 2004, in a long-awaited, normal cyclical recovery pattern, on the way to sustainable growth of 3.5 to 4 percent.” With the economy on the mend, GDP should start creating jobs over the next 24 months. Today’s 1/4 point cut reveals more about the Fed’s impatience than it does about the state of the economy.

Nor does the recent Fed jawboning about deflation ring true. Some strategists have taken to referring to the specter of falling prices as “the deflation ghost.” None other than former Federal Reserve Chairman Paul Volcker addressed the subject earlier this week. Speaking Monday at a forum on the state of the global economy at the London School of Economics, Volcker commented “If I were setting odds on deflation in the U.S., the probability wouldn't reach 0.1 percent. I see no prospect of real deflation like we had in the U.S. and other countries in the 1930s.” The widely respected Volcker’s comments effectively repudiated deflation as a factor in making further rate cuts . . .

The Fed’s role

Apparently, the Fed’s role has changed from “cushioning the pain in a downturn, towards creating a new expansion cycle.” This is a radical change.

The new objectives of monetary policy, as well as the methodologies employed, reflect a newly radicalized Fed: “This policy cycle can arguably be seen as revealing a more powerful and preemptive use of fiscal and monetary stimulus than any prior post-World War II cycle,” observed Michael Englund, chief economist for MMS International Analysts. In a recent Business Week article, Englund further added, “much of the economic stimulus in the pipeline is only now taking effect, as yields on longer-dated securities have just recently pulled back a significant degree, and a big portion of the combined tax cuts of the last three years is expected to kick in during June and July. All this is occurring while "real" interest rates (as adjusted for inflation) have fallen from cyclically firm levels to historic lows that now reflect extraordinarily depressed nominal levels overall.”

Indeed, this radically new monetary activism – and its broad intervention in the markets – is now in uncharted waters. “We have an amount of stimulus beyond anything I've heard of in history” were the not so subtle observations of former Fed Chief Paul Volcker.

Relationship between the Productivity Paradox and Monetary Activism

The economy has reached the point in the cyclical recovery where the Fed’s considerable economic stimulus is finally having an impact. All manners of economic activity have shown a modest rebound. And, much of the stimulus is still “in the pipeline.”

The biggest laggard remains employment – historically, the last data point to see a rise in any economic recovery. As the excesses of the bubble get worked off, employment should see a gradual improvement. But this development will be a function of time, not monetary policy. Indeed, some have argued that the extremely cheap cost of capital allows companies to “hang around,” instead of weakening to the point where the normal consolidation processes can occur.

The combination of this excess capacity and increased productivity suggests that employment will continue to lag the broader recovery, only gradually rising when GDP growth finally tops 3.25%. Barring unforeseen circumstances, that’s not likely to occur until later this year at the earliest, and more likely sometime in 2004. But it should happen eventually.

Hence, the Fed’s impatience and monetary activism appears to be unusually tied to the calendar. Unwilling to allow their already substantial stimulus to gradually work its way into the system, the Fed has opted to engage on a surprisingly activist agenda.

The most obvious event in 2004 possibly motivating the Fed’s latest intervention is the Presidential election.

The Dangers of Excessive Intervention

The Fed’s impatience and their surprisingly activist stance raise several danger signals: Aggressive market interventionism is invariably accompanied by unintended consequences. We suspect that – eventually – the result of the Fed’s impatience will be felt long after the present Fed Chief has retired

In the 1960s, then Federal Reserve Board Chairman William McChesney Martin made the famous quip that it was the Fed's job "to take away the punch bowl just when the party is getting going." Alan Greenspan tends the economic bar differently: He is freely offering drinks to the already inebriated; We should not be surprised by the consequences.

The Sure Thing

Monday, June 23, 2003 | 10:42 AM

in Film | Finance

Two major articles last week – both by journalists with ties to the Fed – announced that the FOMC would be cutting rates this week for the 13th time this cycle. The dueling articles each came to a different conclusion about the size of the cuts, with the Wash Post predicting a half point, while the WSJ expecting “only” a quarter point move.

The only surprise would be if the Fed did nothing, which we believe is all but impossible. The yield on the two year treasury note fell below the Fed funds rate; This invariably foretells a rate cut. The Fed fund futures are also saying a cut is a “Sure Thing,” pricing in a “100 percent probability that the FOMC will lower the target rate by at least 25 basis points from 1¼% to one percent, and a 52% chance of a ½ point cut” (percentages based on June 20th closing prices).

With all these factors suggesting an imminent rate cut, it behooves us to consider what the market’s reaction might be. Is this an insurance cut, as some Fed members have suggested? Or, is it a sign that the Fed is getting nervous? As previously mentioned, I believe this cut is part of a broader attempt to crank GDP up over 4%, in an effort to start creating jobs. Presidents do not get re-elected nor Fed Chairman reappointed when the economy continues to shed workers at the alarming rates we’ve seen the past 3 years.

There is also a danger in misinterpreting the market’s reaction to the Fed’s decision Wednesday at 2:15pm; The markets have been quite overbought for some time now, and a variety of our favorite indicators have suggested that a modest pullback is way overdue. There is a danger in misreading the meanderings of the markets as a vote of confidence (or not) in whatever the Fed does.

Greenspan has long been thought of as a gradualist; As the chart at right makes clear, he has brought rates down over the course of 2½ years. Investors may be best served by considering the Fed’s next move as the last in this very long series of interest rate adjustments, as opposed to over interpreting the significance “Lucky 13.”

The rally (which began on March 12) has gotten a bit ahead of itself; This suggests those who are already long should consider tightening up their stops; We will look at where the downside leadership may come from later this week. Those looking for an entry should consider scaling into equities as the Dow approaches support at 8,900-9000, the S&P 500 between 950-960, and for the Nasdaq from 1,550-1,565.

The New “Productivity Paradox”

Thursday, June 19, 2003 | 05:44 PM

in Finance

In 1987, Nobel laureate Robert Solow famously observed: “You can see the computer age everywhere but in the productivity statistics.” Despite massive investment in IT infrastructure, productivity growth was nonexistent. At the time, this was known as the “Productivity Paradox.”

Since the mid-‘90s, the Productivity Paradox appeared to have been solved, as U.S. productivity growth surged. Since 1995, labor force productivity has been increasing at 2.25% per year, double the annual rate of the previous two decades. This “productivity feast,” as its been called by Fed Chairman Greenspan, is the largest increase in non-farm business output per hour in 30 years.

Therein lies the new Productivity Paradox: Productivity continues to increase year after year at 2.25%; At the same time, the labor force itself is growing at ~1% per year. Thus, Real GDP has to increase at 3.25% per year just for the economy not to hemorrhage any more jobs.

During the boom year, productivity increases got the credit for a myriad of positives: increased living standards, higher corporate profitability, boosted tax revenues, better funded pension plans. Now, we are confronting the dark side of productivity: Companies need less laborers to produce more goods and services; Less workers means less consumer spending, lowered tax receipts, weaker corporate profits.

In order to stem the tide, one of two things needs to occur: Either GDP must improve dramatically, or productivity gains must tail off, if not reverse. If neither of these events occur, the U.S. could continue to lose jobs at a disturbing rate.

Unemployment seems to have stopped getting worse, but its not yet getting better. This is what the next Fed rate cut may actually be about: Getting GDP to the point where, despite the high productivity, the economy starts creating, instead of losing, jobs. That demands a GDP over 4%.

That’s the heart of the argument favoring a ½ point rate cut on June 25. The economy probably doesn’t need more than a ¼ point cut – if even that. We could muddle along for a few Qs at a 2% growth rate, with GDP rising to 2.5-3% in ’04 . . . But that’s not what’s driving this debate. What’s on the line is not merely the economy, but Sir Alan Greenspan’s legacy as well as the President' re-election.

Any rate cut will be a near-term positive for the markets, but could lead to unintended consequences. That’s the danger when politicians start mulling over about their place in history, instead of their immediate charges.

Original reports for download:
Word Doc file
PDF file

Last Man Standing

Monday, June 16, 2003 | 11:09 AM

in Film | Finance

We’ve discussed several models and the different methods they use to place a valuation on stocks. Now, we consider one last approach, which doesn’t bother with valuation at all: eliminating any and all competition to equities.

Conceivably, this is a designed strategy intended to increase the equity markets, which will in turn improve consumer confidence, which will help in jump-starting the economy, which ultimately may start creating jobs.

That concept is consistent with the jawboning heard from both President Bush and Federal Reserve Chief Greenspan (and other Fed members). From the March lows, the market has enjoyed lots of stimulants: weak dollar, increased liquidity, tax cuts and rate cuts. These have put starch back in the markets’ sails. Despite many indicators suggesting we’re overbought, with sentiments at extreme levels), the rally continues to show that it’s not quite ready to quit.

Stocks have become the “Last Man Standing;” Cash, Money Market Accounts and Bonds (including Junk) have all become increasingly unattractive places to deposit monies:

· Money Markets are now yielding 1% and falling; The widely expected Fed rate cut will take Money Market account rates to 0.5% or below; This makes these accounts unprofitable for the firms that manage them;
· Treasury Bonds are now offering yields at 45 year lows; The 10 year Note is about to penetrate below 3.1%; The 30 year is at 4.15%.
· High Yield Bonds have run up over 21% (Lehman Brothers High Yield Index), over the past 6 months; As we have seen, momentum begets additional momentum.

The Bond action suggests one of several possibilities: Investors may believe that rates are about to enter a deflationary spiral, and are buying in before the rates plummet further; Or, they are buying ever-decreasing quality in a desperate bid for Yield. Lastly, and most ominously, Bond investors may be doing the same thing their equity counterparts did at the top of the Bull market: Chasing momentum, believing they will be able to jump off before its too late; That self confidence is rarely well placed.

The risk, as any good conservative knows, is that broad government intervention in the marketplace rarely works; It’s often accompanied by many unintended consequences. Equity holders should enjoy the ride while it lasts . . .

Smart Money?

Thursday, June 12, 2003 | 11:09 AM

in Finance

Some of the contrary indicators we track are themselves giving contradictory signals. When combined with the strong internals of the market, this suggests that while there is more upside from here, the market may need to gather itself up for the next leg up.

The biggest danger is the excessively optimistic viewpoint revealed by recent sentiment surveys. The II survey now shows 58.7% bulls (vs. 56.5) and 16.3% bears (vs. 20.7), or 3.6 Bulls for every Bear. That extreme level of sentiment begs the question: “Who else is left to buy?”

Self reported sentiment indicators (such as this one) come with a caveat: They are external to the markets, rather than internal; In other words, they are not a function of price and volume over time; As such, they are once removed from actual market action. Jason Goepfert (sentimentrader.com) notes that “since 1969, each of the other times the bearish percentage dropped this low, it stayed that way for many weeks or MONTHS on end. A single such reading is not enough to sell stocks en masse, but it should at least raise a caution flag.” We agree.

On the other side of the ledger is the Smart Money Index (see chart at right). The SMI is based upon the principal that the first 30 minutes of trading is emotionally based. It’s reflective of all the "hype" which came out from between yesterday’s close up and today’s open. The early trading is considered "dumb" money; The last hour’s trading, on the other hand, is based primarily on more contemplative factors; Its considered the "smart" money.

The SMI suggests that since the 2002 Summer lows, institutional money has been quietly accumulating stocks. Although it peaked during the recent March ’03 lows, it has since maintained relatively high levels. When the SMI is upwardly sloping while the DJIA makes new highs, it confirms the Dow’s rise, suggesting more upside remains. The danger sign comes when the SMI diverges: When the Dow make makes new highs, but the SMI is dropping, that’s a signal that institutional “smart” money is quietly leaving the field.

Although the sentiment readings give us pause, we continue to be encouraged by the SMI that this rally is not yet done.

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Quote of the Day: "It is apparent that the public preference for stocks is not only as marked as ever, but also, the will to speculate is still a speculative factor not to be overlooked. The prompt return of huge speculation and the liberal manner in which current earnings are again being discounted indicates that it will be difficult to quench the fires of stock market speculation for long." -Barron's "The Trader" column, March 24, 1930

The Quick and the Dead (aka “the Short and the Dividend Paying”)

Monday, June 09, 2003 | 10:41 AM

in Finance

Friday’s opening pop and reversal suggests that the market may be finally starting to get tired. Some consolidation is likely before the next major leg up. This has been seen in the overbought condition of the market, and the excessively bullish sentiment indicators: The put/call ratio, Arms index, 52 week high/lows (see chart at right) and advance/decline line all are reading way overbought, while both the AAII survey and the II numbers reveals far too many Bulls and too few Bears for comfort.

The high volume, intraday reversal suggests profit taking by the bulls; Keep in my mind that the Quarter is ending in a few short weeks, and there is huge pressure on the under invested fund managers to keep up with the indices.

Meanwhile, on the short side, there is a lot of hoping and praying for a reversal, if only to salvage the Quarter and earn their bonuses or incentive pay.

Whether the Bulls or the Bears blink first is unknown, but it’s important to understand which sector groups have been rising, and why. It’s been the highest Beta, most heavily shorted NDX stocks have been leading the charge up. Notably, Biotechs, Internets, Telecoms, Software and Semis have been on their tear, as shorts cover and fund managers attempt to “catch up” to the indices via the highest Beta equities they can find.

On the other side of the ledger, dividend payers have been feeling the love from the fund community: Utilities, Financials, Oil Service, Retailers and Industrials have been winning new fans from various money managers. Credit the new tax laws for the newfound affection for dividend paying companies; Expect this to continue to until interests rates tick higher . . . Something we don’t expect to happen until the economy appears much healthier, or the 2004 elections happen – whichever comes first.

So the Quick(high Beta, heavily shorted issues) and the Dead (previously unloved dividend stocks) are what’s been leading the market higher; Expect this pattern to continue at least until this Quarter ends. Healthy dips are likely to be shallow and therefore buyable, but note the following caveat: Pre-announcements will add to the volatility, and should be some considered prior to making purchases.

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Another day, another 100 points

Thursday, June 05, 2003 | 10:52 AM

in Finance

The market's current momentum continues unabated. So far, Dips have not gotten very far, as buyers await any and all discounts. Internals remain very strong: 25 to 8 positive advance-declines on NYSE, 22 to 10 on Nasdaq, with strong up/down volume. Nasdaq volume neared 2.5 billion, with over 1.8 billion on the upside, a strong 3 to 1 up/down volume advantage. NYSE was even stronger at 6 to 1.

The Bears have been panicked into covering short positions, regardless of price. The Bulls are deathly afraid of being under-invested, with last week’s pullbacks described as “healthy.” Until some force intervenes to derail the momentum, the market could easily move higher. What could send the locomotive off its tracks? Here are a few issues definitely worth watching:

· Insider selling Corporate insiders have sold more than $3.1 billion worth of stock in May. The WSJ notes this is “the most such selling in 24 months.” Though far from being perfect indicators, insiders are at least implying that corporate executives have major concerns about the alleged 2nd half economic recovery.
· Too many Bulls Chartcraft.com Investor's Intelligence shows the bulls now number 56.5%, while the bears are at a low 20.7%. Unless the bulls are woefully under-invested, its hard to see how much higher the market can run without the “Wall of Worry” getting rebuilt a bit.
· Pre-Announcement Season for Q2 2003 is now underway; We’ve already seen some surprises from minor companies; The good news is year-over-year comparables are easy. Intel’s Mid-Q conference call tonight will be a major tell for the tech sector (Expect a neutral report).
· Fed Rate Cut Already Factored In The yield on the two-year Treasury note fell below the fed funds rate; This relatively rare event suggests that a Fed cut is imminent. Is this an insurance cut, as some Fed members have suggested? Or, is it a sign that the Fed is getting nervous?
· Technically Tired? Some momentum indicators are at all-time highs. The markets closed at the top of their intermediate up-channel, an area offers resistance, and reflects overbought conditions. The recent “spike-up” also implies too-far-too-fast. A digestive pause, or a “back-and-fill” may be needed before the march forward continues.

The trend is your friend, and the trend remains up. Until it reverses, scaling into pullbacks is the desired way to get long.

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Hat trick!

Monday, June 02, 2003 | 11:14 AM

in Finance

For the third consecutive month, the indices all scored major gains. The Dow rose 4.4%, the S&P500 saw a 5.1% increase, while the Nasdaq raced ahead 9.0%. This marked the 6th up week out of 7 for the SPX and the Nazz.

The Rally continues to show impressive resilience, as internals remain strong. The potential negatives are the deteriorating sentiment data, the speculation in internets and bio-techs, and the continued issue of valuation. Meantime, the trend remains your friend, and until it reverses you should assume the path of least resistance is up.

One curious element of this rally has been the lack of leadership shown by some of the “Generals,” i.e., GE, MSFT, BAC, IBM, C or PFE. Compared to the Nasdaq, the Dow Jones Industrials have been downright soporific.

The relationship between the more conservative blue chip index and the more aggressive, tech heavy Nasdaq is shown in the chart at right. Over the past 3 years, the “spread” between the Dow and the Nadaq has fluctuated widely; At times, the Dow has been 7 times the point value of the Nasdaq (at last Summer’s lows), and as low as just over 2 times Nasdaq (pre-Sept 11th).

There are several interpretations of the data: Since the bubble was primarily in tech, telecom and internets, it makes intuitive sense that immediately after the April 2000 crash, the Nasdaq would still retain a relatively large percentage of the Dow (in points).

As the sell-off accelerated over the next 3 years, that percentage fell, until last July and October, when the Nasdaq was barely over 1100. At that point, the multiple between the two indices was 7 X – it’s widest since 1990 when it was 7.4. As evidenced by the ensuing rally, investors have (obviously) found the Nasdaq attractive relative to the Dow at those levels.

Since 1981, the relationship between the two has averaged 5.03; Its currently at 5.54. Look for the Nasdaq to decelerate as it approaches the historical average of 5. While an overshoot below that level is possible, I would expect to see some Nasdaq consolidation – or Dow catch up – at price levels near that multiple. If the Dow reaches 9000, that implies a Nasdaq near 1800 . . .

Chart of the Week
Over the past 3 years, the ratio of the Big Cap Blue Chips in the Dow has traded at varying multiple to the tech-laden, more speculative issues on the Nasdaq.

Ratio of Dow Jones Industrials to Nasdaq

Chart courtesy of StockCharts.com

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