HAGER TECHNOLOGY RESEARCH
Been Down So Long...
Mary Redmond
Tuesday, August 28, 2001
The only thing that looks good about the market now is that nothing looks good.
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In the years which have followed a 20% total return on Treasury bonds, as we witnessed in 2000, the S & P 500 has historically rallied over 15%. In addition, historically each time the 10-year Treasury bond yield has dipped below 5% this has proven to be a profitable buying opportunity for stocks. Most people are aware that the market has historically rallied following every post 1930 rate cut cycle in history. So when will the broad averages start to rally?
Liquidity is one of the key ingredients necessary for a strong and prolonged market rally. The liquidity fueling the markets can come from many sources. If retail and institutional investors sell some of their holdings of the trillions of dollars stored in government and corporate bonds, this money often finds its way to stocks. If investors decide to withdraw some of the trillions held in CDs, savings accounts and money market funds, this often indicates that they are leaning toward the market. Market liquidity can also come from corporate share buybacks, and corporate cash takeovers.
Conversely, liquidity can be drained from the market when investors sell stocks, and when an excessive level of initial public stock and bond offerings attract money away from the stocks which are already traded on the exchanges.
In order for a strong rally to ensue, we may need to see institutional investors committing money to the market. This will be indicated by heavy volume on the NYSE in the range of 1.5 billion shares per day, and on the Nasdaq of 2 billion shares per day or more. If individual investors begin to contribute money to stock mutual funds again, buying may continue.
Despite the loss of stock market wealth, which occurred over the last twelve months, there is more than enough cash held in money market funds to fuel a strong rally. The Investment Company Institute’s latest figures show that over $2.1 trillion is deposited to money market funds, which is approximately 15% of the Wilshire 5000, and the highest percentage cash level on record since 1991.
In addition, the levels of mortgage refinancing are way up this year, due to the low long term interest rates. Mortgage refinancing adds cash to the consumer’s pockets. The total mortgage debt in the U.S. is approximately $6.8 trillion, and refinancing can help to stimulate economic growth almost as well as a rising stock market.
Institutional investors have two basic goals: To preserve capital and to earn a return on capital. During the hey days of the 1990’s, the competition among money managers and fund managers to outperform the indexes was so intense that many were forced by necessity to chase the only stocks which were rallying, which meant the big cap, liquid technology stocks, in which fund managers can buy millions of dollars worth of stock each day without disrupting the trading volume.
Institutional and retail investors have been purchasing bonds and depositing money to money market funds over the last several months. Money market funds have taken in approximately $200 billion in cash so far in this calendar year. But, money market fund rates are declining, and treasury bonds have had such a significant rally, and have experienced such a substantial drop in yields, that investors may be forced to enter the stock market to earn competitive returns.
Many of the indicators that market technicians use are telling us that the markets are oversold. The TRIN, or Arms Index, which is a highly accurate market indicator, showed a 10 day moving average of 1.5, which has signaled that a strong rally could ensue. The volatility indexes, and the put/call ratio all reached high levels this week. Yet, the markets can remain oversold until buyers come in.
Investors who have a higher risk tolerance and often partake in short selling strategies may also determine at some point in the near future that the downside profit potential is becoming more limited than it was last year. How much lower can the Nasdaq go? Theoretically, it could drop another 500 points, but the odds of that occurring, based on technical analysis, are fairly low. The Dow seems to have found strong support at 10,150, as each drop to this level over the last few weeks has rebounded. The S & P 500 index found a low point in April just slightly under 1100, but this is only approximately 6% below current levels.
Eventually investors will venture in to the market, but last year’s star sectors may end up becoming doormats, as sector rotation has been prevalent in full force in the last several years. The safest and best performing sectors in 2001 have been small caps, financials, certain cyclical and defensive stocks, and health care stocks. It is possible that defensive stocks have had their run, and may now be wallflowers as investors are increasingly attracted to more dynamic sectors.
In addition, investors may need to evaluate their concept of what “the market” really is. Since the mid 1980s, so many companies have been brought public that the stock markets are far more diverse and complex than they were decades ago. Last year, we witnessed a brief bull market in large cap technology stocks to the exclusion of almost all other sectors. This year, we are seeing a rally in certain small cap value and financial stocks to the exclusion of the broad based large cap indexes like the Nasdaq and the S & P 500. Since the Dow, Nasdaq and S & P are all market cap weighted, this means if the big caps aren’t rallying these indexes will lag.
Taking a look at some of the key sectors in the market demonstrate which ones are showing technical strength and which ones investors might be wisest to avoid.
A chart of the Dow shows that a reverse head and shoulders pattern may be occurring. A drop below 10,000 could negate this pattern.
The Nasdaq started to form a pivot point on Wednesday and Thursday of this week, but we will need to see further confirmation of this before bullish traders can comfortably step in.
The S & P 500 found support at a level of 1150. The index appears to have formed a bullish pattern, but we need confirmation of this with a strong breakout above current levels. Ideally, we would like to see this index break out above 1200.
The semiconductor book to bill ratio of 0.67 was released this week, and helped to bolster the Nasdaq. The book to bill ratio is still weak, but has shown significant improvement from last months’ 0.54 level. In addition, Triquint Semiconductor management stated that they were seeing a pickup in demand for cellular communication chips. If additional semiconductor stocks release optimistic news, this sector could help carry the Nasdaq higher.
The networking index is the weakest on the Nasdaq from a strictly technical perspective. Many of these companies will have a long, hard battle to regain lost market value, and some of them may never return to the previous high levels. The biotechnology sector was the strongest on the Nasdaq this week, and helped to buoy the index.
While the stock market indexes have been falling during August, the economy has actually showed some signs of improvement in the last few months. However, it is much easier for the Fed to knock the economy’s growth rate down by raising rates than it is to undo the damage which has been done.
The rate cuts help the economy in many ways. The most important effect may be the fact that rate cuts stimulate business investing by lowering the cost of borrowing. While the Fed’s rate cuts have removed the shackles on the high yield debt market by narrowing credit spreads, the Fed cannot remove the damage done by excessive borrowing in recent years by cash strapped companies which are now paying the price for the capital market’s overindulgence.
The Bear in the Bushes is still alive and well, and flaunting its strength with malicious pleasure. We have hurdles to overcome in both the economy and the markets. The Fed cut rates by 25 basis points and the market yawned. At this point, the rate cuts no longer have the magic effect of causing brief explosive rallies. The Fed has done its work, and the markets should be able to respond when the corporate profit expectations are more optimistic. While the tax cut may help to stimulate consumer spending to a small degree in the months of August and September, if the layoffs continue into the fall, and the business environment does not improve, it will take more than a $300 check to boost consumer confidence.
Will the bear stay forever? Some analysts seem to think so, but it seems unlikely. During the Nasdaq bubble when we watched this index rise to 5000, we heard many theorists state that this was a new paradigm, in which the old rules of valuation and business cycles no longer applied. Now, we are hearing from the Permanent Bears who are trying to convince us that the healthy stock market returns we have experienced most of the post world war two expansion, which occurred over the last five decades are no longer attainable.
The most likely scenario seems to be what is occurring right now. Small cap companies will experience a higher growth rate than large cap companies, capital in the stock and bond markets will become available, but selective, and companies will be valued according to their real earnings growth rate. The recommendations of securities analysts will be scrutinized more carefully by the public as well as the regulators, and the financial markets may experience less of the extreme volatility in share prices which we have seen in recent years.
Some investors think the S & P 500 and Nasdaq are still overvalued because the P/E of the stocks in these indexes are high by historical standards. However, comparing the P/E of a stock to the typical P/E of a stock 10 or 20 years ago does not always give viable results. The primary factors which contribute to corporate profits and stock market gains are free cash flow and return on equity. The return on equity of the companies in the S & P 500 is currently averaging 20%, versus the average of 10% in 1980.
What is there to be bullish about now? Not much, except the fact that a lot of the really big money long term has been made by investors who bought when everyone else was selling, and when the economic situation looked so bleak as to be almost insurmountable. Realistically, the downside on the major averages has to be fairly limited from here unless they are destined to go to zero. One of the world’s greatest investors of all time, Warren Buffet has been doing a little retail shopping lately by buying shares of Office Depot, Honeywell, Gap Stores and others.
We are in more than an economic slowdown. We are in an economic transformation in which the basic business model upon which many companies were founded in the late 1990s is not currently applicable. The glut of issuance in initial public stock offerings in non-profitable companies has dried up and will probably never return any time soon. Profitability is now in vogue, and demanded from individual investors as well as corporate financiers and investors. The gross distortions from the laws of nature and speculative excesses which occurred in late 1999 and early 2000 will be worked off, and the lessons learned will be long remembered. |
