ContraryInvestor - Market Observations

MARKET OBSERVATIONS

DRIP, DRIP, DRIP

MARKET OBSERVATIONS - 5/16

Good To The Last Drop?...Bear markets can often be an exercise in frustration. Frustration for both the bulls and the bears. Both sides can have a tough time making money. Both want a conclusion, obviously for different reasons. Often the process of perceptual change can be slow. The market almost seems to move in slow motion at times. Often taking on a feeling of being surreal. We have become accustomed to rapid fire movement and reaction in virtually one direction only and all of a sudden this changes. It's disorienting. (Even for the bears.)

The key to any bear market occurrence is the erosion of investor confidence. Plain and simple. Sometimes the dam bursts and the valley of confidence is washed away in a matter of minutes. Not even any time to warn anyone. None of the valley's residents escape alive. Other times the confidence erosion happens slowly. One drip at a time. A stalagmite bear market. Microsoft may be split up. Drip. Cisco is a potential "house of cards". Drip. Productivity comes in less than expected. Drip. Credit market spreads are widening to levels seen during financial crisis periods. Drip. The ECI confirms that inflation is seeping into wages. Drip. The Fed is forced to crank up the interest rate lever to slow an accelerating economy. Drip. Procter and Gamble's earnings are vulnerable to higher costs. Drip. The undersecretary of the Treasury reiterates that GSE debt is not backed by the full faith and credit of the US Government. Drip. Julian Robertson hangs up the gloves and the Soros crowd takes one giant step backward. Drip.

As Bob Shiller pointed out in his recent book, "Irrational Exuberance", the media clearly plays a large role in shaping perceptions and confidence among the investing masses. We're starting to feel drops here and there as the rain clouds gather. Since the Barron's article on Cisco a few weeks back, usually bullish "platforms" have floated bearish Cisco trial balloons. RagingBull.com questioned Cisco's diluting of shareholders in their acquisition activity in this piece at www.ragingbull.com/articles/kerr/05-11-00.html. Likewise the San Jose Mercury in this article at www.mercurycenter.com/svtech/columns/front/docs/sh051500.htm. Lastly, the recent Forbes presents an article on the significant vendor financing being carried out by the likes of the Cisco's and Lucent's of the world. You'll find it at www.forbes.com/forbes/00/0515/6511052a.htm. Drip, drip, drip.

(Is the media finally waking up to the fact that being bearish also sells copy?)

Sending Out An S.O.S. ...Speaking of a slow drip, the NASDAQ Advance-Decline line has been slowly dripping for years now. Much like the Yosemite Valley, the slow erosion has carved out a deep valley wall. In celebration of the fact that the NASDAQ A/D line just made a new low, here's the current view from the valley floor:

The Advance-Decline line has meant nothing to the NYSE composite for a good while now. Even longer for the above NASDAQ.

Seeing Double?...Certainly there are other periods in US financial history where the Advance-Decline Line of an index experienced a slow drip. Let us think for a moment. Just a minute, it will come to us...

Chart Source: Courtesy of DecisionPoint.com

Confirming The Obvious...Monday's Industrial Production and Capacity Utilization numbers did just that. The following chart shows that industrial production growth in April was the highest monthly growth number in many moons.

Source: Dismal Scientist

Capacity Utilization is also clearly trending higher. Are these numbers the end of the world? Hardly. What they do point out, though, is that inflation risks are to the upside for now. The case for higher interest rates is intact.

The Verdict Is In...And it's still out. The market put on its best face over the last few days, trying to make believe that interest rates just don't matter to the NDX 100 or that maybe this will be the last one. To us, until economic growth slows to the 2-3% range, the Fed is not finished. They may go on hold after the June meeting, but the final verdict is still out. Greenspan and the Fed surely realize the imbalances that still exist in the system. The philosophy of gradualism has most likely done more harm than good. The perceived relaxation in the CPI and PPI numbers have more to do with non-core items than not. The price of oil will again rear its ugly head in the months ahead as it works its way back into the economic stats. Although we have already said it too many times, most likely the stock market holds the keys to the kingdom. We know the G team has explicitly said that it is not targeting the stock market, but, since the economy seems to be so heavily influenced by movements in the stock market, a significant rally from here will ensure that this is not the last tightening move.

The Out Of Body Experience...To say that the past few months have been eventful is probably an understatement. The rhetoric, the hype, the hope, the lessons, etc. create a lot of noise and confusion. Although technical analysis is an important arrow in the quiver, it's easy to get lost in the forest full of moving average, island reversal and 3rd wave trees. It's time for the financial "out of body experience". Stop listening to the noise for a few quiet moments. Float above the landscape and have a simplistic look below. For what it is worth, here's our attempt to narrow it down to a few bullet points that shape the macro (regardless of 50 basis points or not today):

For many companies, the quality of earnings is questionable.

Bond market spreads are at or near record levels. Liquidity is clearly a problem in many parts of the bond market.

The record trade deficit has the potential to create a very unstable US dollar on a moment's notice.

The Fed is in tightening mode.

Technology stock fundamentals and valuations have problems. The big cap darlings still look extraordinarily expensive even after the recent "correction".

Wall Street and Main Street are now one street. What happens if something goes wrong for either party involved?

Public expectations are still too high. The mantra of "buy the dips" lives for now. The bulk of current public investors have never experienced true fear regarding financial assets.

Inflation is a concern in the here-and-now.

The leverage now seen in the financial markets, the corporate sector, the government sector and the public sector is without precedent in US financial history.

Simple Enough?

Having said this, prepare yourself for all potential scenarios in your investing activities in the months into and through the summer. Here's one for you. The Fed pops rates 25-50 basis points in June and officially calls it quits for six months, taking a wait and see attitude. Mysteriously the economic stats turn super favorable for the markets all the way into the election. Exactly the oxygen necessary to cause a smoldering bull market to flame for a while. It's a good thing this was just a dream. Or was it?

Directly Up Ahead...Tim's longer term channel barriers have perfectly defined the near term "potential" for this market for the year-to-date period. Barring any kind of serious market attempt to address true economic and fundamental specifics, we suggest you strongly listen to the message of the market on the occurrence these major barriers are broken on the up or down side. Tim's cogent comments are quite pertinent.