Todays comment from Don Hays;
wheatfirst.com
August 11, 1999
The market looked to be in the "meltdown" state yesterday, mid-day,
but managed to hold on by its fingernails before plunging over the
cliff. If it had plunged, it would have been somewhat surprising to us,
since the market is extremely oversold, and typically this technical
level will at the very least support a "pause to relieve" the pressures.
But as we detailed in Monday's report, we expect the oversold
condition to only offer a couple of weeks "pause," before resuming
the really serious part of the decline.
Of course, recent memory is so much better than recalling prior
events, but as we assess today's conditions, we believe that in our
30+ year's experience, we have never been so bearish. That does not
necessarily mean that the market is about to plunge, but it does
mean that the risk in the market is very high, and unless everything
works pluperfect, the market will be impacted very negatively by any
"bump in the road."
We use that analogy, because we consider the psychology,
monetary and valuation conditions the shock absorbers of the
market. If these conditions are healthy, with a healthy wall of worry,
with good monetary liquidity, or with very attractive stock valuations,
the market can withstand assassinations, wars, and other traditional
shocks, no matter how serious. But when the opposite occurs, all
"bumps in the road" are immediately transferred to the emotions of
investors. During bull markets the most effective shock absorber
comes from monetary conditions. Bull markets will always continue
as long as monetary conditions remain healthy, with interest rates
dropping. Look back in history, all bull-markets are eventually
stopped by rising interest rates, and restrictive monetary policy.
Now, let me briefly describe who it is that is expressing this ominous
warning. This is not a perpetual bear that has been calling for the
"end of the world" forever. Just the opposite is true. Until early in
1998, we had many refer to us as the perpetual bull. That irked us,
because it was far from the truth. For instance, in May 1973 we
turned very bearish, and remained bearish until August 1974. We
were a major seller of stocks in June 1983, right at the top of that
huge rally. There were many times in that ensuing period that we
took money off the table, but in general we remained with a very
bullish bias from August 1982 until early 1998. That turned out to be
outstanding advice for our clients, even though this bullish stance
was often derided by the skeptics throughout many of the bumpy
periods of the super-cycle.
Even since that juncture early in 1998 when our asset allocation
model started to send some signs of impending trouble--which
allowed us to predict the April peak of last year and raise very high
cash levels before that ominous peak--we moved back to a fully
invested posture on September 7, 1998. We did this despite our
misgivings, because all of a sudden the three shock absorbers had
been quickly repaired in that wicked decline. But by February of this
year it became obvious that the shock absorbers were falling back
into disrepair. And that was just the beginning. In the last 5 weeks,
the monetary shock absorber totally collapsed as our monetary
composite dropped to the weakest posture in the last ten years.
In our opinion, the bear market started in April 1998. I know, I know,
all the indices that have any of those nifty-50 big cap, blue-chip
stocks have made substantial new highs, but when you look at the
typical portfolio you will see very little progress, if any since that April
1998 peak. When you look at the cumulative advance/decline line,
you see declines from those peaks that are absolutely astounding.
When you look at the number of new stocks that have made new
52-week highs, you see that number has never come close to
equaling the flurry of new highs at that April 1998 peak.
But rather than argue that thought, let's concentrate on the
conditions of today's market. As we expected, the last two weeks
have brought the first real sobering up of some of that bullish
sentiment. Three months ago, the bullish sentiment measured by the
Investor's Intelligence had screamed above 60%. This was the
highest level since before the 1987 crash. It was obvious from this
and other sentiment indicators that the psychological "wall of worry"
had certainly been destroyed. That shock absorber had been
removed.
From a valuation point, our valuation composite that compares the
earnings yield of the S&P 500 based upon year-ahead earnings
expectations to that of the 10-year note moved to a 46% overvalued
state--the highest in history. That shock absorber was definitely
destroyed.
We also noted in late 1998 that the huge glut of excess money that
the Fed threw at anyone who would take it during that August 1998
debacle, was starting to be withdrawn. This condition continued to
ebb, and finally in mid-February began to impact interest rates
negatively. The major indices continued to rise, almost like a
conceived camouflage, but internally more and more stocks started
showing signs of fatigue.
So here we are, a bull market with no shock absorbers. It is only a
guess whether a bump will appear in the road, but from many
decades of watching the markets, I know that bumps tend to appear
in this August-October period. If you notice, the rumors of bump
sightings have picked up in the last few days. It has to worry anyone,
whether technically inclined or not, to see the Dow Jones
Transportation average and benchmark stock Merrill Lynch break
down through significant support levels.
And I guess in my mind the most obvious culprit to produce the
biggest pothole has to come from the burgeoning derivative market.
As the yield gap widens, as interest rates move up, the rumors are
flooding the market of potential victims. Let me quote from a recent
article from David Tice. I will preface this quote by warning you that
Mr. Tice is known as being very bearishly biased, but the facts are
widely accepted as being accurate and unbiased, so you can be the
judge.
He relates a recent Greenspan testimony, in which he pointed out
that US commercial banks ended 1998 with outstanding derivative
positions of $33 trillion, of which $29 trillion were privately arranged
over-the-counter (OTC) contracts, hence, outside of government or
exchange regulation. This compares to about $460 billion of total
equity for the American commercial banking industry. Greenspan
also estimated that total OTC derivative positions globally then likely
approached $80 trillion, having grown at a 20% compound rate since
1990. Estimates how have total derivative positions at over $100
trillion. And, from a report issued in June by the Bank for International
Settlements we see that there were $50 trillion of interest rate
derivative contracts outstanding at year-end.
I hope you are astounded at the $50 trillion estimate that Mr. Tice
points out, because as he mentions, with liquidity rapidly
disappearing, rising rates only leads to greater dislocation and a
greater probability of a Russian/Long-term Capital Management type
of derivative collapse.
So, I am very nervous. I am expecting a 2-week sabbatical, but
listen, is a possibility of a 2-week sabbatical before the possibility of
further serious panic attacks worth taking a risk for? Don't be too
cute, or expect too much from this rally. If we are right, that serious
trouble awaits the market in the next two months, the rallies in a
beginning bear market are never enough to give investors a chance to
get out, only enough to bait the trap once again.
If it follows the 1998 trend exactly, as it has to this point, the
sabbatical will last until the extreme oversold level of the McClellan
oscillator moves back up to the zero (neutral) level, before the next
bump in the road appears. We will have to watch carefully, but our
watching will be done with very generous levels of cash in the safety
of treasury bills. |
