Puplava sees Major Elliott Down Wave imminent
a chart displays his point
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Wednesday, August 21, 2002 Market WrapUp
What the ‘Experts’ are Saying
There are two words seldom mentioned when experts talk about the economy and the markets: debt and valuation. They are mostly ignored. Instead, experts talk about the stock market as cheap because of the tremendous pullback since the markets apex in Q1 of 2000. According to this line of reasoning, stocks are now cheap because the Nasdaq has lost over 72% of its value, the S&P 500 is down 40%, and the Dow is down 25%. In addition to lower prices and with interest rates this low, stocks are that much more attractive. I watched a panel of financial experts on a prominent cable financial show debate the current market environment. Every one of them recommended stocks. One expert went so far as to say that with interest rates this low and soon to go lower, an investor would have to be foolish to stay in cash. The consensus was that stocks were the place to be. They sighted as evidence the recent pick up in the financial markets since their July 24th lows.
Consumer Bubble
Regarding the economy, there was overall agreement the economy would improve with additional fiscal and monetary stimulus. Their hopes were based on the resilient consumer. In the recession of 1991 consumers pulled back on spending and rebuilt savings. In this recent recession consumers did just the opposite; they went on a debt and spending orgy that has taken their debt to record levels. According to Keynesian economic thinking, this is a healthy sign. Consumption was maintained with consumers responding to the impetus of lower interest rates by borrowing more money to maintain spending patterns. Not only did consumers continue to spend, consumption actually accelerated throughout the downturn. Spurred on by zero percent loans and low mortgage rates they bought new cars, newer and bigger homes, and took out more equity from their homes to go on vacation, buy TV’s, DVD’s and other consumable goods. This debt and spending binge is looked upon as a healthy sign of the resiliency of the American economy.
There is very little mention of deteriorating credit conditions. Credit spreads continue to widen instead of converge, which is a tell tail sign of stress in the credit markets. Credit intermediaries, such as AmeriCredit and Providian, are seeing a substantial increase in managed receivables, junk bond defaults are soaring, and more credit card lenders have to set aside more reserves to cover defaults. During this recession lenders abandoned traditional credit analysis in favor of growth in lending, which has led to a proliferation of lending to marginal borrowers in housing, credit cards and the installment debt markets. These borrowers are not only marginal but they are also more vulnerable to any downturn in the economy. Furthermore, the financial industry in their recent 10Q report to the SEC reported that the industry had increased its leverage and risk exposure as a result of lower revenues from traditionally more profitable areas, such as underwriting and brokerage operations.
Economic Boom/Economic Bust
The point to understand is just as debt contributed to the economic boom, it will conversely contribute in equal measure to the economic bust. The boom of the 90’s, as so often mentioned, was based on a debt and spending binge that has yet to unwind. Until it does it will exert a restraining influence on any recovery. Not until this debt is paid, or cleansed from the system will any meaningful recovery take place. The fact that consumers and companies continue to add and take on more debt is a more ominous sign of things to come. The next bubble to pop is going to be the housing market. When it does the optimism, which consumers still hold on to, will vanish as the credit system begins to implode. Just as we have seen the tech and telecom sectors implode due to extreme leverage and valuations, the next area to implode will be the financial sector, especially money center banks and financial intermediaries.
The slowdown in the latest economic figures, the slowdown in housing, the falloff in retail sales and the steep drop in the LEI (leading economic indicators) are already signaling the approaching recession. I believe when the economic numbers are revised, it will show at a quarterly growth rate of 0.25%, the US economy slipped back into a recession during the second quarter. With oil prices now over $30 a barrel, another burden has been levied on an already overburdened economy. The longer higher oil prices persist, the greater the danger that economic activity will contract even further. This is the kind of news that awaits the financial markets in the next few months. The second half recovery was a fantasy like all previous fantasies of the last three years. The harsh reality of another recession, lower profits and further stress in the credit markets are variables that haven’t yet been priced into the value of stocks.
Regarding the stock market, I go back to valuations. Nobody wants to talk about them. All we get is bogus pro forma earnings. Pro forma numbers are fantasy numbers and don’t reflect the bottom line for most companies, and will continue to deteriorate as profit margins get squeezed from higher costs and the inability to pass those costs on through higher pricing. Deflation through foreign competition is hitting US manufacturers hard, leaving no room to price in rising costs from labor, raw materials and regulation.
The problem with earnings today is investors don’t know what numbers to trust. Companies may have to certify their earnings results and new stiff penalties will discourage cheating on financial reports. However, none of this is helpful if analysts and anchors continue to talk about pro forma numbers. In this regard, investors will find using dividend valuations more helpful. There is a long history of their reliability as a valuation indicator, and they are more trustworthy. When a company pays a dividend, they have to have the cash flow and earnings to pay that dividend. Unlike earnings, which can easily be manipulated, dividends reflect real money. Dividends are spendable and bankable. In contrast, earnings can be manipulated, revised, restated or eliminated.
Dividends, therefore, are a more reliable indicator of value. Historically the markets become overpriced when the dividend yield falls below 3% and undervalued when they rise to 6%. Assuming that the current dividend of $186.13 on the Dow and $15.70 on the S&P 500 are maintained (which is a big if), the Dow would have to fall to 6,200 to arrive at fair value, and fall to 3,100 to get to undervalue. For the S&P 500, fair value would be at 520 and undervalue would be at 260. Once again, assuming that dividends are maintained is making a big assumption in this environment. If dividends are cut due to cash flow and earnings problems that result from a recession or depression, these numbers could go even lower, which is what I expect. When this bear market is over, stocks will be yielding between 6-7% reflecting historical risk premiums.
Given the amount of debt in the economy and the extreme evaluation of all three major markets, I expect a hard leg down, and in fact, a crash this fall or at least by the end of the year. However, before that happens, I expect the Fed will try to get the markets higher before they deflate to build some upside momentum. I believe they will do this is by surprising the markets with an interim rate cut of 50 basis points before their next meeting in late September. This could give the financial markets an explosive upside move that could last 3-4 days before the markets peak and the bad news this fall hits the economy and financial markets. The problem the S&P 500 and Dow now have is pushing through key resistance levels. A surprise interim rate cut would help do that as short covering carries the markets further. After that it is going to be hard down as today’s graph, courtesy of my friends at Elliott Wave, indicates.
In effect, the markets are providing you with two opportunities. The first is to get out of your overvalued stock positions, and the other is to pick up undervalued gold and silver stocks before they explode in their next route up. This assumes that the dollar gets into trouble, a key ingredient in gold’s next upside move along with the implosion of the financial sector. I must emphasize that this is a trader’s market. The current rally is nothing more than a bear market rally and nothing more. The momentum behind it has been terrible, which is further evidence of more trouble ahead.
Today’s Market
Today’s rally experienced two waves of concerted buying after spending part of the day in negative territory. Today’s move was broad based and cut across most sectors of the market. Market sentiment is getting more bullish again as negative news on earnings and the economy is ignored. The markets are now moving on hope and hype as they do in each rally of this bear market. Investors are returning to old favorites of the last bull market as the Nasdaq gained 2.4%.
Volume picked up today with big board volume coming in at 1.32 billion and Nasdaq volume increasing to 1.62 billion. Market breadth was broadly positive by 23 to 9 on the NYSE and 23 to 11 on the Nasdaq.
Overseas Markets
European stocks rose as better-than-expected earnings from Axa, Deutsche Lufthansa and Ciba Specialty Chemicals increased confidence in the profit outlook for companies in the region. The Dow Jones Stoxx 50 Index added 0.7% to close at 2814.14, advancing for the fourth day in five. Seven of the eight major European markets were up during today's trading.
Japanese stocks rose, led by Honda Motor Co. and Toyota Motor Corp., on signs overseas investors are buying automakers after a U.S. research company said demand in the world's biggest car market is recovering. The Nikkei 225 Stock Average added 0.2% to 9642.61.
Treasury Markets
Treasuries gave back most of the gains posted on Tuesday, with losses spread pretty evenly across the maturity spectrum. The 10-year Treasury note declined 14/32 to yield 4.20% while the 30-year government bond forfeited 23/32 to yield 5.015%.
© Copyright Jim Puplava, August 21, 2002 |
