Today's Market WrapUp 04.07.2003 Mon Tue Wed Thu Fri Puplava Archive
The
War Rally and Then What?
BY
JAMES J. PUPLAVA, CFP
Military
historians will be studying the US infantry's advance on Baghdad for
decades. No army in history has advanced this far this quickly. The
300-mile plus drive to Baghdad in less than three weeks is a
record-breaking feat. The decision to bypass Iraq's major cities, stay
in the desert and drive straight on to the nation's capital took
Saddam's forces by surprise. Now the U.S. military is in the nation's
capital and comes and goes as it pleases. Now there is talk of
installing an embryonic government in Umm Qasr as early as the end of
this week. The war in Iraq has gone much better, advanced much faster,
and has experienced fewer difficulties than most naysayers would
admit. From a military standpoint it has been far more impressive than
the first Gulf War. Of course, the war isn't over just yet. The
military is conducting mopping up operations that could last for some
time.
In response to the stunning victories of this weekend, pre-market futures were exploding on the upside even before the markets were open for business. The prices of commodities were falling, especially gold and oil. Money is jumping out of conservative assets such as commodities, defensive stocks, and bonds. Money is now rotating into stocks, especially the tech sector which has been one of the strongest sectors so far this year. The perception, and I emphasize that word, is that things will now get better. The only thing that has held back the economy and the markets this year has been the worries over war. With the war risk removed, we can get back to the rally mode. Even though many of the weakening economic reports have occurred prior to the war and many of the economic earnings reports were a result of other factors, the popular theory is that it is mainly the "war" that is responsible for current weak conditions.
The war rally that began with the first attack on Baghdad was temporarily interrupted when U.S. troops first had trouble. Now that the 3rd ID is in Iraq's capital the markets are back in the celebration mode. This morning's Wall Street Journal ran with a story of "How Stocks Are Revving for a Postwar Rally." Even Paul Desmond, president of market research for Lowry's and a former bear, has turned cautiously bullish. The main argument for the new rally in stocks is that few sellers and institutions are jumping into the market in a big way. Volume has picked up on days the market rallies while volume has been more subdued on days when the market falls. Another sign that bodes well for the market is that nearly half of the stocks listed on the NYSE are now trading at above their 200-day moving averages. We are also starting to see more new daily highs than new lows, and investor sentiment is moving more towards bullishness. The VIX and the VXN have also fallen to levels that would suggest complacency.
Therefore, what we now have are several factors that now bode well for the markets short-term. There are fewer sellers, more buyers, and plenty of money sitting on the sidelines that could move out of cash, and nothing terrible has happened as a result of the war. The war has gone exceedingly well and there have been no new terrorist attacks that have occurred as a result of the war. Interest rates are low and real interest rates are actually negative. With few options to choose from the logical choice are stocks. That is where the money is going regardless of valuations, scandals, and still bogus earnings reports. So this begs the question how high and how far will this rally take the major indexes? What will sustain this rally and what will be the impetus for remaining in stocks other than to simply trade this rally?
Viewing the economic weakness and the numerous earnings warnings, I remain skeptical of the rally’s duration and sustainability. The economy has been in decline since the beginning of the year. The view from Wall Street is that this economic weakness is strictly due to the war. The excesses of the bubble are believed to be over. Yet there is no evidence that any of these so-called excesses have been cleansed from the system. The labor market reports show that more workers are losing their jobs and those who have lost their jobs are finding it more difficult to find a job. Those that are now unemployed are remaining unemployed for longer periods. According Mark Zandi, chief economist for Economy.com, the true unemployment rate, factoring in underemployed, is closer to 12.4 percent. His figure for unemployment is up from 8.8 percent in April of 2000. Furthermore, many who have lost their jobs are no longer picked up by government statistics if they work part time or do small consulting work. Those that remain unemployed after their benefits run out are no longer considered unemployed according to the way the government measures unemployment. You become hypothetically employed once your unemployment benefits run out.
If you look at all economic measures whether it is the retail sector, manufacturing, or the service sector they are all in a steady weakening trend. Companies continue to warn on earnings this quarter and next if not the whole year. Layoffs have become weekly events. Even on a day like today McDonald’s announced it was reducing its capital spending budget, consumer borrowing is trending downward, and accounting scandals are still part of the daily headlines. Today it was Sara Lee, which announced it was suspending three salespeople who helped to inflate company sales. The Wall Street Journal also covered a story on how stock analysts at Wall Street firms are still putting their investment banking clients first. Wall Street firms consistently give higher stock ratings to stocks of their own banking clients. According to the WSJ investors still need to take Wall Street research with "chunk of salt."
This appears to be nothing more than a trading rally based on perception and hype. It is true that the stock market is a discounting mechanism. Nevertheless, there is nothing on the horizon, outside a massive fiscal and monetary stimulus, that would give the economy anything other than a temporary stimulative boost. At the expense of sounding repetitious stocks are still not cheap despite the daily buy recommendations by sell side analysts with a stake to say so. Bogus and fictional earnings are still with us and can be found almost daily in the headlines, today being no exception. The excesses of the mania are still with us and many other excesses have now been added to these excesses in the form of mortgages, real estate, and consumption.
"Times
Are Tough and Getting Tougher"
I had a chance to spend time at the shopping malls over this
weekend. I was struck by the transformation of my favorite mall from
when I last went shopping over two months ago. I had absolutely no
problem parking. Normally it takes me 10 minutes to find a decent
parking spot. Several of the upper end stores now close early Saturday
evening and are now closed on weekends. Some of the high-end specialty
stores have closed down or have gone out of business. Everything is on
sale or no one will buy it. I found several of the quality items I
usually buy were now offered for sale, something I have not seen in
over a decade. The sales people were eager to serve me. In one store
that I entered, I found more sales staff than customers. Almost
without exception, every store that I frequented told me the same
story: times are tough and getting tougher. It took substantial
discounts to bring in buyers. The only noticeable exception to what
the merchants were saying was the lines to get in the movies, and the
sidewalk café's, restaurants and Starbucks seemed to be doing a brisk
business.
Given what I see reported on the economic pages and what company CEO's are saying about current and future earnings, I believe this rally will be short-lived and unsustainable without massive stimulus and intervention. There is always the aspect of some unforeseen event that appears out of the blue and catches the market by surprise. Given the economic background of a bubble economy, speculative and frothy financial market, and a precarious geopolitical situation, provides the ideal environment for a ten-sigma event. The fact that no terrorist attacks have accompanied the war or nothing unusual has happened doesn't mean that terrorism or rampant financial speculation combined with leverage won't produce an unexpected surprise. A smart enemy always hits you where you think you are the safest and never at a time or in a way you expect it. That is a lesson that should have been learned by the events of 9-11. Terrorism isn't going away. It is only going to get stronger as terrorist groups proliferate. There are plenty of safe haven countries where they can rest, plan, and train. The U.S. is incapable of engaging them all.
Investing
in Today's Market
Therefore,
given these circumstances, how should an investor play this market?
That depends on one's risk tolerances and trading skills. If you are
an adept trader, then trading the exchange listed funds would be an
easy choice. They are liquid, and easy to trade in and out of. If you
are a long-term investor, I would stick with the trend in
"things" and especially commodities. Nothing that I see at
the current moment would dissuade me from the view that commodities
are in a new bull market, especially precious metals, energy, food and
water, and instruments of war. Most investors and analysts inside the
U.S. have a localized view of things as well as short-term memories.
However, there is a larger world that exists and is emerging in Asia.
The impact of China, which is one of the few countries experiencing
robust economic growth, is going to have a profound impact on the
world of commodities. Considering that almost all new excess
production of energy is being consumed by China tells me energy will
remain in a bull market throughout this decade and the next. Forget
$10 oil or even $18-$20 oil after the war in Iraq is successfully
concluded. There isn't the spare capacity to handle the needs of the
West and an emerging China without higher prices.
Besides investments in "things," there are other value plays at work in this market. I believe investors--as opposed to traders--would be wise to look at companies that offer attractive dividends or are selling at attractive price/sales ratios. I prefer dividends and sales measures because they tell you more about management of a company than they do earnings. Earnings can easily be manipulated. A dividend, on the other hand, is set by the board of directors and reflects long-term sustainable earnings trends. This is a more reliable indicator than a simple earnings figure. These days you don't know what you're getting when you hear or read about a company's earnings. Sales are another economic measure that is harder to manipulate but even here you still can get creative accounting through channel stuffing. However, relative price/sales ratios are a good measure of value when looking at growth companies.
Long-term investors should stick with a long-term horizon and forget the daily background noise that occupies so much of everyday investment decision-making. The price of paper is going up at the moment because the perception for papers’ fall is due to the war. Now that the war is going well you are seeing a countertrend rally unfold and nothing more. Because paper asset prices are going up, hard assets are falling. When do you buy? I would like to think you buy during countertrend rallies in other assets as investors sell off shares of hard assets. If we are in a long-term bull market you buy and hold and add to positions when they are offered to you at lower prices. A bull market in "things" is no different from a bull market in paper assets. There will be corrections and countertrends along the way. Try to think beyond what is said today or what will be said tomorrow. What is said today and tomorrow will be long forgotten in the months ahead. It would also be wise to watch the headlines on the economy and real earnings as they are reported. That will tell you more about the sustainability of this rally or if it really has legs.
Speaking of legs, this morning's jump in the futures pit, which carried over into the cash market, was not sustainable for long. The Dow, which opened up strong by rising 236 points, was unable to hold that position as doubts over profits led to a sell off in stocks. First quarter warnings indicate that there have been three companies warning of lower earnings for every one that raised them. According to Merrill Lynch chief investment strategist Richard Bernstein, two of the firm’s most important fundamental indicators have deteriorated in a major way. Of the firm’s 10 profit indicators, only three have advanced making the current reading the worst reading since 2000-2001. Right now, the markets are moving on hype and that is a dangerous thing.
Volume was unusually low today with only 930 million shares traded on the NYSE and only 980 million shares on the Nasdaq. Most of the activity was generated in the futures pit and an arbitrage play in the cash markets. Market breadth was positive by a 5-3 margin on both exchanges. The VIX declined by 1.07 to 31.73 and the VXN fell 1.41 to 41.44.
Overseas
Markets
European
stocks surged, lifting the benchmark Dow Jones Stoxx 600 Index to its
biggest one-day gain since the war with Iraq started, amid optimism
the conflict is nearing a conclusion. The Stoxx 600 Index climbed 3.4
percent to 194.79, with all 18 industry groups advancing. The Stoxx 50
added 3.7 percent to 2345.14. All 17 Western European benchmark
indexes rose
Japanese stocks rallied after U.S. forces moved into the center of Baghdad, spurring optimism that Iraqi leader Saddam Hussein may soon be ousted. Exporters such as Toyota Motor Corp. led the advance. The Nikkei 225 Stock Average climbed 175.86, or 2.2 percent, to 8249.98. The Topix index added 15.03, or 1.9 percent, to 810.58.
Copyright
© 2003 Jim Puplava
April
7,
2003
Charts courtesy of StockCharts.com
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