Breathless or Out of Breath

By Duru

June 8, 2003


"Breathless" - that is what best characterizes my impression of the American financial markets right now. I would have left it at that had I written this missive last Wednesday or Thursday as I had originally planned. However, Friday finally sent us some signals that this rally *MAY* finally be over. If you only looked at the final scores, you would have thought it was a ho-hum day. However, Friday marked some MAJOR reversal action in all the indices. After running up big in the morning, some high volume selling kicked in. The Nasdaq was hit the hardest - not surprising since it is the most volatile. Anyway, I have a sneaking suspicion we are not quite out of breath yet, but extreme caution is warranted here (like it ever isn't?!?).

I mainly wanted to take this opportunity to review where we are and where we might be going from here. Whether you are in this for the short or long-term, I hope to have some insights that can provoke further thought for those of you interested in your money. I also want to emphasize up-front that despite my continued long-term bearishness, I CONTINUE to see lots of short-term opportunities. So, do not let my sober words deter you...for now. In fact, I won't even cringe too much if you only pick out the positive, cheery parts of this message - wherever they might sneak in. :)

First, here are some very impressive highlights of what the markets have done to date:

  1. I never believed that we could break the trading range whose top is marked by those December highs (from my viewpoint anyway). The S&P and Nazz have crushed that top. The Dow finally cracked this top late last week. As I mentioned last time, a break from here could potentially be huge. It is not easy for me to guess where the most likely top of the trading range will be now.
  2. The long-term bear market downtrends for the Nasdaq and the S&P are now broken. Although not too many people have made much noise about this break, I consider it HUGE.
  3. Finally, the Nasdaq and S&P are now making year-long highs. This is something I never would have anticipated earlier this year.
  4. I read in an article the following: "According to Bank of America Securities, two weeks ago (week ending May 23) $1.7 billion of money flowed into domestic equity mutual funds, representing the 10th consecutive week where new purchases outstripped redemptions." In a sense, this rally has marked a triumph of sorts for the retail investor. We are often maligned as "the dumb money" - the folks who buy high and sell low - the folks "the smart money" looks to bet AGAINST. Back when this flush of money first started in celebration of the end of the incursion into Iraq, many of the "smart money" folks came out to decry this as evidence of the market having already begun to top out. Instead, the money has kept coming and coming and coming...

What I have described above in very basic terms are all the main ingredients for defining the start of a true new bull market. I could more easily be swooned if only there was at least ONE IOTA of evidence that the economy is soon going to make that vigorous turn for the better to justify this latest run in the market. Until I get those signs, I will continue to call this rally a bear market rally - strong and sweet - but fleeting nonetheless.

The optimists continue to be encouraged by a tired formula that has yet to work in this post-bubble environment: low interest rates + tax cuts = stimulated economy. Perhaps the battering of the dollar has provided something new to hang hopes on and justify the rally. Indeed the new equation looks something like this: low interest rates + tax cuts = stimulated economy AND low dollar = higher exports, THEREFORE since a stimulated economy translates into strong domestic demand then strong domestic demand + higher exports = jobs and prosperity for everyone! Wow. Amazing how you can work the best of both worlds.

Speaking of best of both worlds, what confounds some market watchers is that almost ALL financial assets are rallying right now. Supposedly something unheard of. Yet, the Fed is working its desperate magic to keep all the balls juggling in the air by claiming that it will keep interest rates low even as the economy makes that wonderful second-half turn. The formula above explains why bulls can feel justified in buying more and more stock. The bears are getting killed trying to short those same stocks (betting the stocks will decline), but they can win by buying US Treasuries (debt instruments the Federal government uses to keep itself operating) and by buying gold. Treasuries increase in value as interest rates continue to decline. They are also "safe-havens" if you think economic weakness will persist. Gold is great for those worried that paper money will continue to lose more and more value or even crash (severe devaluation). As long as the Fed continues its double-speak, all three trends could continue for quite some time. However, the threat of INFLATION provides an interesting twist. As I hinted in my last missive, I believe the Fed will sow the seeds for rampant inflation somewhere in our not too distant future if it truly gets serious about fighting deflation. Whether a more severe dollar decline specifically leads to inflation remains to be seen - after all, the Europeans may be getting serious about trying to deflate their own currency. And, admittedly, it is hard to imagine inflation coming from commodities when the global, post-bubble economy is still flush with too much productive capacity. Where ever inflation comes from and however it comes, it will likely spiral upwards higher faster than anyone with a right mind for these things could ever expect.


Regardless, we have what I will call a full-press, bum rush, liquidity event. In such an event, there does not have to be a legitimate reason for assets, particularly stocks, to get more expensive. They HAVE TO get marked up because all the money sloshing around in the system has to go *somewhere*! And it sure does not seem to be leading to further increases in consumption rates.

I will repeat my refrain that the bear market will not end until it delivers at least one last crushing blow that dissuades the majority from frenzied speculating for quite some time again. I previously thought the Iraq invasion would provide the classic trap as people bet on a quick, post-war economic rebound. Instead, what we got were more skeptics. Seems all the previous bear rallies have FINALLY taught a lesson to enough people that this last rally has been met with persistent skepticism all the way up to infinitydom. In fact, there seem to be so many skeptics that I am wondering whether my missives can even serve their initial purpose of deflecting the rampant and persistent over-optimism that had marked the bear market before this latest rally. If you want divergent opinion, you do not need to look far anymore!

Anyway, as people sell stock only to see those same holdings further increase in price, the reluctance to sell will be joined with the continued buying frenzy to provide a potent and seductive elixir that will help people forget three-years of bear market pain. As the market levitates on fumes, people will forget how much risk truly remains in the market. As the market revokes the laws of gravity, people will forget that hikes in the prices of assets must be married with a hike in the VALUE of those assets in order to last and be sustaining. By the time people remember all these things, the market will have collapsed - again. At this point, I dare not predict how far this next collapse will take us because it seems we could keep going UP for a few more months before any true correction ensues. But all it will take is, say, a 20-25% drop to cause some serious pain all around (depends on what index we care about). We no longer need a new bottom for the bear to make its presence felt.

I think a correction will be deeper and longer than expected because many of the skeptics are not hardcore disbelievers. Instead of disavowing this frenzied market altogether, plenty of people are instead watching and waiting for a "mild" pullback in the market to make "safer" purchases. Such sentiment tells me that people only dislike the rally to the extent they are not profiting from it and not because it makes no sense from a fundamental point of view. I am a believer that investments in good businesses are safer the CHEAPER they get, not the more expensive they get. Buying expensive merchandise is mainly an exercise in betting that a greater fool is right down the road ready to take the goods off your hands for even higher prices. Again, I am not outright telling you not to participate, just remember how these fairytales ALWAYS, don't get greedy. Please!

Finally, let us not forgot the political undertones (or overtones?) to the market's rally. This current reflation of the stock market will prove to be a key determining moment for Bushie's economic policies. If the President is truly skillful, he can work with the Fed to keep the rally going long enough to generate some kind of economic cover for his re-election bid. (This is not a partisan thing - ALL fist-term presidents work hard to make sure the economy is sound by the time they are up for re-election). If this stock market run explodes prematurely, that is, before people have already re-elected Bushie (or firmly decided they will follow him where ever he leads us - to the moon or into the ground), Bushie will instead be running for the cover of other issues. For example, he could re-emphasize and highlight his efforts at fighting terrorism. Scare tactics were very effective in getting people convinced that we had to invade Iraq IMMEDIATELY to avoid worldwide Armageddon. Speaking of which, what's harder to find than Iraqi weapons of mass destruction? A job in a post-bubble economy! What is trickier than dreaming up new and creative excuses for destroying Syria and taking out Iran? Explaining why it takes hundreds of billions of dollars to create a few jobs here and there! Finally, what runs faster than an Iraqi looter celebrating the onset of democracy? Of course, the comedians laughing all the way to the bank rushing to deposit their fresh dividend tax cuts!

All jokes aside, a cruel coincidence for a pop of this stock market run would be some kind of revelations on the *real* reasons for our stampede into Iraq. Of course, it will take more than that, because Wall Street only has fleeting patience for political intrigue. Until the magical catalyst comes, I do truly hope that you can find ways to profit from this continuing circus. If you insist on participating, just make sure to catch your breath from time to time. I know I am...


Ó DrDuru, 2003