ContraryInvestor - Market Observations

MARKET OBSERVATIONS

The Chicken Or The EGG$$$$

MARKET OBSERVATIONS - 4/25

Fowl Play?...It was recently pointed out to us by a reader that we have neglected to address the role of the dollar in this unfolding financial melodrama on Wall Street. We must admit that given the rules, or lack thereof, in the "new era", we had just simply come to believe that the relationship between the dollar and the financial markets was coming to be characterized as the chicken and the egg. Would the stock market blow first and take the dollar down in its wake as foreigners sold dollar denominated financial assets right along with the "locals"? Or would the dollar blow under the weight of the trade deficit and take the stock and bond markets to the global cleaners? Which would happen first? Would they happen concurrently? At the moment, the stock market seems to have the causal lead in the southern valuation race.

As you know, we are currently running the largest current account (balance of payments) deficit on record in the US. It's a good bet that the trade gap grew to a -4.5% of GDP in Q1.

Again, relying on the broken crutch of "historical markers" attributable to prior periods, a ratio exceeding -3% has usually spelled trouble for the US dollar. That was then and this is now. Today the dollar is reflecting a number of counterbalances that have possibly acted to keep the dollar relatively firm, even in the face of the beginnings of a sell off in US equities. Clearly it's no guarantee that the dollar won't cave in tomorrow, that's for happy global holders of dollars and dollar denominated assets to decide. For the moment, the potentially false strength may be a contributory factor in a general environment of complacency. (Of course not quite as complacent as a month or so ago. Stiff upper lip, old chap.)

The Balancing Act...Just why might the dollar be ignoring a blatant warning from the current account deficit?

The Correlation Coefficient

Investing in foreign markets has been considered a cornerstone in the academic definition of institutional portfolio diversification for quite some time. Quite unfortunately, we now see the "global" stock markets as more highly correlated in movement than possibly at any time in stock market history. Since markets are tending to move in global tandem, there is not the significant advantage today of readjusting global stock portfolios. This would clearly tend to reinforce a globally stable dollar, even in a volatile equity period. Why sell US stocks when European and Asian issues are dropping just as fast?

Interest Rates

Quite interestingly, nominal interest rates in the US are some of the highest of the top G3 countries today. Japanese short rates should be pulling out of the "zero interest rate policy" dock quite soon. The ECB is at 3.5%. Not surprising at all is that short interest rates are supporting the dollar. Maybe the dollar story would be quite different if we hadn't had so much in the way of monetary policy over the last year plus. As a support mechanism to dollar value, higher interest rates are a natural, not an abberation.

The Dollar Is Not Wildly Overvalued

Have a look at the trade weighted value of the dollar. From a longer term, global perspective, it's not significantly overvalued from a historical context.

This perception is out there. The last time the US trade deficit embarked on a multi-year period of deterioration (1982-87: see chart on balance of payments), the dollar relative to foreign currencies and levels of trade, was quite sufficiently overvalued. In one sense, the non-negative regarding overvaluation can be considered a positive for the dollar. (In another sense, we haven't even brought up the subject of debt levels in the US economy and their ultimate effect on perceptions of dollar strength.)

The Dollar Recycling Program

Unquestionably, foreign trade dollars have found their way into the US financial markets over the last half decade.

The US has attracted foreign capital both to its financial markets and real economy. In 1997 and 1998 it may have been foreign financial scares that forced global capital to the US. Possibly even a bit of Y2K fear for a short while last last year. What has really done the trick in the last three years is the (formerly) ever rising US stock market. Over the past year or so, the additional support to foreign dough sticking with the dollar as been the ECB's benign neglect policy regarding the implosion of the Euro and Japan's "defense of the dollar" program relative to the Yen.

These make up some of the main rationales for relative abnormal dollar strength that we can identify at the moment. Will these conditions last? How soon will they change? As with the stock market itself, it's all a matter of perception. Perception on the part of the buyer and the seller. What should make things a bit interesting this time around is that a weakened US financial market, economy and dollar would likely precipitate like response in foreign markets and economies. Is it all a zero sum game this time around? Our bet is that this time, the financial markets, as opposed to the trade deficit, may be the spark that eventually dooms the dollar. Just like the advance decline line for the NYSE and the NASDAQ, just like common stock valuations, and just like consumer and corporate debt levels, the numbers have been deteriorating for years. Since the stock market indices have been strong, confidence remains high. The current account deficit is nothing new. The numbers have been deteriorating for years. Since the stock market was rising, did the dollar just choose to look the other way? (Clearly it's investors in dollar denominated assets that have chosen to look the other way.) A stock market and dollar swoon could easily be come a self reinforcing mechanism to the downside. Look no further than the chart of net foreign purchases of US stocks for an answer to how this may become so. We believe that globally, so much of what passes for confidence in the US dollar and financial system is rooted in the bull market for US stocks. What happens when that perception changes? You have no further to look than ahead.

Techs and Drugs and Rock & Roll...One day the market's on drugs, the next it's on to techs. Back and forth, the bungee cord jumper careening to both extremes. We continue with consistent volatility in the indices and the "big name" stocks. Up 5-6% one day and down 5-6% the next. We've heard the question "how do make decisions in this kind of market?". The answer is you don't, at least not intelligent ones anyway. There is only time to react to the movement of the moment. Stepping back for a moment, it is very hard to call what has happened in the NASDAQ a true bear market. It may be the beginning, but if so, we're nowhere near the end. The S&P and the Dow are so close to their all time highs that if you had been gone since the beginning of the year, you would wonder if anything had happened at all to these indices in the meantime. As has been central to our theme of the onset of a true blue bear market, the public must become involved. It simply can't be a professionals only shootout that lasts a few short weeks and then all is well. The public has exhibited no fear up to this point. No fear whatsoever. And who can blame them? They have been conditioned through years of vigorous training to sit tight. Buy the dips. The market always snaps back.

Mutual fund inflows for the week ended last Wednesday were $6 billion. Any redemptions have been papered over by new contributions. The public never sold. Fear was never truly present in a magnitude that would cause action (selling). Investor sentiment readings remain uncharacteristically high for the damage that has been inflicted in the markets. Reflex or snapback rallies are to be expected in this type of market. The reflex moves can be vicious. The NDX 100 was up close to 10% in the first half hour of trading yesterday. Is this long term investing? Of course not. This is action of the manic crowd. The next true bear market in this country will only be completed when accompanied by public fear. Fear of principal loss. Fear of capital risk. The absence of greed. On these counts, we haven't even begun. Notice how the Microsoft news was so quickly forgotten in the tech stocks today? Enough said.

Too Much Monkey Business?...The Fed conducted a number of "operations" that shot about $15 billion of total juice into the main artery of the financial markets today. That follows a little $28 billion term repo late last week. These are staggering numbers. Staggering. Does all of this dough find its way into stocks? Not exactly, but it does provide a certain boost to the liquidity of the overall financial system (and that's what counts). Why is this happening in large numbers and in such short proximity? We wish we had the answers. On second thought, maybe we really don't want to know. Raising interest rates and injecting liquidity. Raising interest rates and buying back Treasury bonds. It truly is different this time.

Paintball Wars...It's that time again. The end of the month is upon us and oh what a month it has been. You can bet that the tape painters have full cans this month given the heavy stock destruction that occurred during April. Today just may have been the beginning of the fling skyward for many a former(?) MO darling. (It sure felt like it anyway.) The real test of endurance may just come in May as the earnings cheerleaders retreat to think up new fight songs and the seasonal inflows of investor money (IRA funding related) cool a bit.

Picture This...The wild volatility in the indices is compressing the time it takes to bounce from the top of the channel to the bottom, as Tim's wonderful chart work graphically displays. New highs ahead for the SPX? Certainly possible, but we'll just have to see how it all plays out.

The destruction in the NASDAQ has surely made SPX converts out of a few former NASDAQ convicts. For what it is worth, we expect the NASDAQ to lead into the next bear market. The temporary tranquilizer effects of investments in the big S&P's and the Dow will wear off shortly thereafter. The following chart doesn't exactly suggest that it's safe to go back in the water.