paper versus 'things'

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    Time to Launch the War Rally

    Stock prices took a hit throughout most of the week and this morning the Dow Industrials dropped over 100 points at the open on the news that the U.S. economy lost 308,000 jobs in February. This was the largest monthly employment decline since November 2001, when companies began slashing payrolls after the 9-11 attacks. Manufacturing and service sector growth slowed last month and consumer confidence has fallen to a nine-year low. The Dow Industrials finished the week at 7740, a loss of 151 points or 1.9%. The NASDAQ closed at 1305, a drop of 2.4%, and the S&P 500 fell 1.4% for the week to close at 829. It appears that stocks are almost to the oversold levels that will be needed to launch the “War Rally.”

    There are many analysts that are looking at the war with Iraq in 1991 as an indicator of what might happen this time around. It is important to remember some of the differences in stock market sentiment and fundamental valuations from then and now. Back in ’91 more than 50% of newsletter writers were bearish on the overall market, today roughly 25% of the writers are bearish. In 1991, the “shocker” of the war was enough to turn the markets around and turn investors into buyers. Sentiment tends to work as a contrarian indicator. In 1991, the cash position of mutual funds was approximately 12%, today around 5%. Today, the dividend yield for the S&P 500 is 1.8%, the P/E ratio is 29 and stocks are selling for roughly four times book value. In 1991, the dividend yield was 3.9%, the P/E was 15, and stocks were selling for about two times book value. By these measures, stocks are twice as expensive as they were back in ’91. Debt levels are also much higher now than they were back then. The conclusion is simply that we should get some sort of relief rally, but this is NOT the beginning of a new bull market in equities.

    The headlines for today read much the same as they have for most of this New Year. Intel cut their sales forecast and 3Com said that third-quarter sales fell more than they had estimated. It seems that more and more companies are withholding guidance for the balance of this year since they can’t see clearly to a recovery. The dollar has fallen to a four-year low versus the euro and its lowest level versus the yen since August of last year. If we are unable to get Americans back to work, a second-half “double-dip” hard down recession is almost guaranteed. With this latest report it sure looks as though unemployment will be accelerating.

    Time to be Aggressive or Time to Chill?

    As investors, our primary goal is to make money! Two things are necessary for that to happen. First we need movement in prices, either up or down, and then we need predictability. Right now we have lots of price movement or volatility, but a big mess when it comes to predictability. Do we really get a war rally or are stocks ready to fall off a cliff? When predictability is lacking, not a bad idea to get some money off the table and wait until it is easier to estimate the probability of downside risk versus upside reward.

    I have taken my portfolio to almost 40% cash (trading positions), while holding my core positions that are consistent with the primary trends. I have a high confidence level that we will know much more in another week or two. In the meantime, if I miss out on some violent moves it’s okay. I just reduced the probability that I will be on the wrong side of a coin toss. For those that are planning on a sustained rally, just remember what happened to the markets after 9-11. You couldn’t sell at any price when the markets were closed. I just pray that we don’t have a similar type of event. Capital preservation is critical right now; the buying opportunities will come with patience.

    Time for a Sanity Check

    Rather than try to speculate as to what will happen over the very near term, I believe it is more constructive to check in on the primary trends to see if anything has changed in the big picture. I go through this exercise regularly to see if various asset groups are moving in harmony and if there is a predictable flow of funds in or out of specific sectors. I am mainly looking for breaks in trendlines, and a general snapshot of the overall relationships. When the markets seem crazy, this is my way of “checking-in” to see what is going on. Most often, I refer to this exercise as my “sanity check.”

    Paper Versus Things - Three-Year Charts














    The top three graphs are “paper” items that we monitor regularly. By now we all know the dollar is in trouble and the chart confirms it. Using the S&P 500 as a proxy for the overall stock market, you can see that the downtrend channel has broadened over time and has been pretty much sideways since July of last year. The upcoming relief rally could push the trend channel wider again, but doubtful it go up enough to push through the neckline at 955. The thirty-year Treasury Bond was in a much tighter channel prior to the sudden drop in November of 2001 and March of 2002. This chart is losing momentum. All of the uncertainty has pushed Treasuries to what I consider a blow-off top.

    The second three charts are tangible items, or “things.” Crude Oil is beginning to look a bit toppy. It looks like it will easily stay above $35/barrel until we know more about the Middle East developments. With oil fields on fire, the price could blow right through the top of the trend channel or head back to $30/barrel if things go well. Gold had a very nice run after breaking through the $330 barrier, it’s now in consolidation, expect an attack from short-sellers (like the $9 take-down today) and a rally in the dollar (not over 102) if it looks like we are headed to an easy victory. The CRB Index is consolidating and could test support at 240. In my mind all is status quo. No big deals right now. Stocks can rally while gold and oil regroup for the next run. Let’s get through the war noise, intermediate counter-trend corrections, and to a point where we can have a higher confidence level in terms of probabilities of potential outcomes. Investing is not the same as shooting craps. Rather than hoping for a seven to come up, I would rather wait until I can play the game where the dice each have three-3’s and three-4’s. My probability of rolling a seven will be much greater.

    The one major disconnect that I would like to point out is the fact that bond prices keep going up which pushes interest rates lower. Notice that two of the paper items are headed downhill, stocks and the dollar. Treasuries have been moving higher in the flight to safety, but I can’t believe for much longer. Interest rates normally move in the same direction as commodity prices. As it stands, rates have been falling while tangible items keep going up in price. I believe interest rates will continue to stay down as long as our policy makers have the agenda to devalue the dollar.

    We will just have to watch and see what the Federal Reserve does in their open market operations with repo agreements, short-term interest rates, and if they have to monetize the long bond to keep rates down for longer maturities. It’s beginning to get a bit “dicy” in Financial Land. If you’re trying to roll a “seven” I hope your dice are loaded with threes and fours!! Have a Great weekend!!

    Copyright © 2003 Mike Hartman
    March 7, 2003

 
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