Something to watch...
This morning’s Wall Street Journal featured a story on history suggesting that the current rally may outlast the one we experienced this past summer. We are in that seasonal period of the year when traditionally stocks do well. From late October to late Spring has always been a strong period of time for stocks. Some may find this hard to fathom with today’s dismal news of lower earnings and a declining economy. Earnings and economic growth are less relevant to the health of the market than most people think. What is more important to the stock market is public psychology. As I have written on numerous occasions, the 1990’s were characterized by sub-par economic and profit growth. Yet the markets expanded and went through double-digit growth from 1995-99 as a result of an expansion of P/E multiples. Investors during this period of time were willing to pay more for a dollar of earnings than they were in the past. Most of the markets’ gains during this period were due to an expansion of P/E multiples and not earnings growth. Earnings topped out in 1997 and then headed downward, even though stock prices continued to rally for another 2 ½ years.

What gave the 90's rally legs was widespread participation by the investment public. The Internet, the proliferation of investment clubs, the popularity of day trading and other forms of speculation helped to create a media cult that furthered stock participation by the public. It was this influx of money by the investment public as shown in this graph of mutual fund inflows that provided the fuel for the final thrust of the bull market.

John Q Has to Be On Board
A sustainable new bear market rally will require public participation. Along these lines there isn’t any good news for stock market bulls. Unlike previous rallies, the public has been using short-term bear market rallies as exit points to bail out of stocks. During the late summer rally, a record $52.61 billion moved out of stock funds in July. That was a month when stock prices hit a new nadir. However, the month of August saw $2.91 billion exit the market during the middle of a rally. Instead of taking in new money that would support additional rally points for stocks, investors chose to exit the markets. We don’t have the official numbers yet for September, but the evidence points to it being another month of money exiting the markets. Even more disconcerting for Wall Street and the mutual fund industry was last week’s report by Trim Tabs that $9.7 billion flew out the door of mutual funds as of the latest week ending on October 16th. The previous week’s outflows were $4.2 billion.

Gap-Up May Be A Hiccup
In the middle of a highly erratic market and a rally that consisted mainly of three gap-up days, the public kept heading for the exit gates. In other words, they weren’t buying into this rally. This is important because without widespread support from the public, this rally will have no legs. Institutional investors and short covering has been responsible for most of the markets’ gains. Day traders have now hopped on board, but the public is still noticeably absent. John Q. is still putting money into bond funds as the bond market has now peaked and is in the process of breaking down, a subject that I’ll address in just a moment. Mutual funds may also be running out of bullets to sustain this rally. As shown below, mutual fund cash positions are extremely low, another contrary indicator.

MUTUAL FUND STATS

 ANNUAL REDEMPTION FROM STOCK FUNDS
(PERCENT OF AVERAGE NET ASSETS)

Redemptions over the most recent twelve month period as a percent of total net assets
at the beginning of the period. SOURCE: Investment Company Institute

Is This The Real Thing?
As you can see from above, mutual funds don’t have much cash left to sustain a rally, especially with liquidations running this high. In order for this rally to be carried to even higher levels will require public participation. There is over $2 trillion in money market funds just sitting there, not knowing what to do. Wall Street’s job is to convince the public that this is the real thing. However, the scandals in corporate boardrooms and the numerous scandals and conflicts of interest on Wall Street have left the public in a distrustful mood. After getting absolutely no warning from Wall Street about a bear market and hearing nothing but pro stock market talk for more than 2 years, investors have taken sizable losses. Most of them are just hoping to break even. At this point it would seem that confidence is waning. If the market rallies any further as institutions jump out of bonds and into stocks, John Q. is either heading for the exit gates or he is heading for the bond market. The recent surge of investor money into bonds is another sign of a bond market top. Individual investors are recent new comers to the bond markets. They have been coming in just as the bond market appears to have made a top. While money was flying out of stock funds, last week it was flooding into bonds. Bond mutual funds took in $2.3 billion last week on top of $2.2 billion the week before.

Booms, Bonds, & Busts
It appears that John Q. is late to the bond market party, moving into bonds as the bond market gets pummeled. As shown in today’s graphs, bonds are taking a beating. Yields have risen sharply; while prices have fallen equally as fast. Yields on the 30-year have now backed up from 4.63% on September 24^th to today where they are at 5.14%. The long bond lost another 1.25% on Monday after losing more than 5% last week. The 10-year note has backed up a yield of 3.569 on October 10^th to today’s 4.245%. The 10-year note lost 1 3/32 today after losing over 5% last week. The rise in long-term rates has more serious implications for the housing market, the refi consumption market and the economy longer term. The back up in interest rates may be the final blow to the economy sending it back into recession.

More importantly, a backup in interest rates may bring to a halt the refi boom and the consumer consumption binge it has fed into. The sharp plunge in bond prices looks like it has much further to go. It has already retraced 38% of its recent rally. A 61.8% or 76.4% retracement may take yields back up to 5.5%. The 10-year note has already retraced 23.6% of its advance. A 61.8 or 76.4% retracement will take yields back over 4.75%. For the mortgage market, this means that home mortgage rates may move back up over 7%. If that happens, you can say sayonara to the housing market and the refi/consumer borrowing and spending boom.

As Steven Roach points out in today’s missive, the US market and Japan 12 years ago are looking more alike. The Japanese equity market peaked in 1989; while the Japanese housing market peaked over 2 years later. The US equity markets peaked during the first quarter of 2000 and the US housing market has been going strong ever since. It looks like history is about to repeat itself.

Regarding the stock market, please view the graph of yields on both the 10 and 30-year note and bond at the top. Notice that during the last market plunge and subsequent recovery this summer, bonds rallied along with stocks. That is no longer happening. Bonds instead have started to break down and the US dollar is looking like it is about to head lower. American policymakers in Washington and the Fed are staring at an even bigger nightmare in the bond market and US dollar. The US needs to import $500 billion a year to finance its trade and current account deficit, so what happens to the US bond market and the US dollar is more important to our foreign constituency because that is where they have most of their money. The bond market and US dollar is much more important to sustaining America’s debt and spending binge than the stock market. The bond market and dollar bubble are keeping alive the housing market and consumer financed consumption. With the US now running record trade and current account deficits, more pressure should be put upon the dollar. It appears that the fifth element or the final foundational stone for the bull market in gold is about to fall into place.

Trading Places
Not shown today, but to be elaborated upon tomorrow, is the opposite technical formations for the S&P 500 and the gold markets. Both markets look like they are about to trade places. The S&P 500 and the Dow are showing a large topping out process exhibited by a huge head & shoulder formation. This spells trouble ahead, as if the stock market hasn’t already had enough trouble. The gold market, on the other hand, is looking like it is ready to break out of a large bottom head and shoulder formation. The two markets are showing just the opposite change in positions--one under distribution (DOW & S&P 500) and the other under accumulation (gold and mining stocks).

Today's Market
Monday’s rally drove stocks to their highest level in more than five weeks moved by hot new recommendations from Wall Street. Philip Morris and Coca Cola led the advance in today’s Dow. Stocks have risen in the last two weeks. 3M helped the Dow rally further after it announced that it experienced the biggest quarterly profit in five years driven by strong sales in Asia. Microsoft shares fell after the company’s CEO said the recent earnings gain was a fluke and not sustainable.

The problem investors have had this quarter is making sense out of all of the earnings news. Either the companies or the analysts, to make them look better, have spun most reports. IBM is a perfect example of how bad news can be made to look better. Companies can make their numbers in one of three ways. They can cut costs, which harms the company and the economy longer term, which is what most companies are doing. Just read the headlines of weekly layoffs coming from major companies. Another way is playing games with accounting principles by spinning the numbers or cooking the books. The only real way to make the numbers is through good old fashion earnings or growth, which very few companies are doing. Very little attention is being given to the large writeoffs companies are taking this year. Goldman Sachs estimates that writeoffs this year will be equal to about 60% of all S&P 500 earnings for the year. This isn’t talked about much when companies report their earnings. Chances are you will find that instead of real numbers according to GAAP, you will find the companies and the analysts talking about CRAP earnings, avoiding the mention of writeoffs. What you hear most each day is how companies are beating estimates that are now running 3.5% ahead of estimates. Don’t forget that those estimates have been lowered from 30% in January, 17% in July, and a little over 5% as of last week. Earnings have been lowered so much that you have companies such as Biogen whose profits fell 40%, but beat estimates by 2 cents.

In other news, the government’s chief forecasting gauge, the LEI, fell last month by 0.2%. It was the fourth consecutive decline for the leading economic index which forecasts economic activity six months out. Half of the index’s indicators fell with the stock market declining, unemployment claims rising, and orders for capital goods falling.

Volume came in at 1.43 billion on the NYSE and 1.57 on the NASDAQ. Advancing issues beat out losers by a 20 to 13 margin on the big board and by 20 to 14 on the NASDAQ. The VIX fell to 38.91 and the VXN fell to 52.34. The rapid drop in the VXX, VXN, and the CBOE Put/Cal ratio have fallen quickly which may signal an end to this rally.

Overseas Markets
European drugmakers fell and were the biggest drag on benchmark indexes after Bayer AG said it faces more lawsuits related to its Baycol cholesterol drug, and Roche Holding AG said first-half losses at its Japanese unit were wider than the company forecast. The Dow Jones Stoxx 50 Index shed 0.1% to 2603.57. Five of the eight major European markets were up during today’s trading.

Japan's stock benchmarks fell for the first day in six, led by chip-related companies, after a Nihon Keizai newspaper report said that Hitachi Ltd. may cut its annual profit forecast by about 35% as demand slows. The Nikkei 225 Stock Average lost 1.2% to 8978.41, ending a five-day, 7.7% rally.

Copyright © James J. Puplava
October 21, 2002