MARKET OBSERVATIONS

WITH A TELESCOPE, NOT A MICROSCOPE

MARKET OBSERVATIONS - 6/1

    Bull markets end in the throws of optimistic euphoria.  Bear markets end in the depths of human disappointment and disgust.  We're at neither end, but somewhere in the middle at the moment.  It's probably safe to say that the peak of optimistic euphoria has been seen for this cycle.  We have yet to hit the depths of despair.  Long term market bottoms are fulfilled in despair, not at near all time highs being recorded in consumer confidence.  This despair remains in our future.

    Bear markets end when cash is recognized as a viable alternative asset.  In fact a preferred alternative asset.  Prior bear market bottoms have seen mutual fund cash levels reach double digit levels.  Sellers are washed out.  We have just the opposite condition at the moment.  Mutual funds are currently sitting on one of the lowest cash reserve levels in history.  We have memorialized to you many a time that pension funds (both public and private), life companies and individuals have one of the highest allocations to stocks ever in their collective histories.  This is not a bear market asset allocation.

    Bear markets end when sentiment is dark.  The 1982 Business Week article entitled "The Death Of Equities" virtually called the bottom of the market in 1982.  There were few believers at the time.  A contrarians dream.  Today also happens to be a contrarians dream for all of the opposite reasons.  The recognized "talking heads" of Wall Street are virtually unanimously bullish.  Their bullishness will need to be discredited before we can call this a true long term stock price bottom.

    Bear markets end when assets are cheaper to buy on Wall Street than they are to build or purchase in the real economy.  Despite the recent fall in the NASDAQ, the P/E multiple still stands at approx. 175x's.  This also incorporates nothing short of glowing earnings estimates ahead.  Financial assets as measured by the major indices are currently anything but inexpensive.

We believe that one of the keys to surviving in the current environment (we are talking about psychologically as well as financially) is pacing.  Rome wasn't built in a day, as the saying goes.  And neither was it burnt down in a day.  Quite unfortunately, the following chart of consumer confidence is truncated in 1997.  As you know, the number reported earlier this week was north of 144.  The reason we show the chart is that it is a dramatic example of the process of confidence creation.  This is not just for confidence in the economy, but confidence that stocks "are the place to be".  At the risk of repeating ourselves ad infinitum, bear markets are a process of confidence destruction.  They are the flipside of what has happened to the chart of consumer confidence since 1992.  Clearly this says nothing about where the averages will close tomorrow, but maybe it does say something about where they may be six to twelve months down the road.

Despite a 40+% drop in the NASDAQ and what has been a pretty violent month-end and beginning of the month rally, we make the following observations:

    The US trade deficit is as bad as it has ever been in recorded US history.

    Household debt as a percentage of GDP is at all time highs.

    Non-financial corporate debt as a percentage of GDP is the highest in over 60 years (stock buybacks).

    Stocks as a percentage of total household financial assets are at the highest level ever recorded.

    Institutions (insurance and pension funds) own more stocks as a percentage of their financial assets than ever before.

    The Federal Reserve Valuation Model for the stock market is easily at a three decade high.

    Margin Debt is very near all time highs and easily 13x's higher in absolute terms than where it began the decade.

Again, despite the recent "correction", none of the above mentioned facts have changed in the least.  Does this suggest to you that we are on the verge of a new and extended bull market?  Patience friends, patience.  After the first collapse in 1929, the Dow did an approximate 40% retrace over the next 4-5 month period before investors were again thrown overboard. The following chart that is again Tim's wonderful chart work distinctly shows you the pattern.  So far the similarities with the current NASDAQ experience are nothing short of eerie.  Don't allow day-to-day market volatility to play havoc with your emotional well being.  View the macro environment with a telescope, not a microscope.

Sound Bites Du Jour...In addition to month end institutional antics in stock land, the economic reports of the last few days have added fuel to the stock market rally fire.  Today's NAPM number and many of its associated components showed a bit of unexpected weakness.  As you know, this was enough spark to allow the bulls to put on a little fireworks show.  One of the biggest drops inside of the NAPM was the prices-paid index which is heavily influenced by the price of oil.  Unfortunately, most prescient market pundits failed to connect the fact that the price of crude has rebounded since the month ago drop that influenced these numbers.

With A Telescope, Not A Microscope...The month-over-month numbers do show a slowing in economic growth, but hardly what could be termed a dramatic reversal in trend.  In fact, we prefer to view the numbers from a few thousand feet above the maddening crowd.  Year-over-year numbers tell a much different story.  As part of the report, operating rates for manufacturers showed the highest number in two years.  The fact that this is up while deliveries are slowing may suggest that bottlenecks are developing.  Hardly signs of a sustainable slowdown.  Likewise, year-over-year commodity prices are definitely higher, and not just oil.  The intermediate goods PPI number has increased from (1%) to over 5% in the last year.  The slowdowns month-over-month are small signs of incremental change in the rate of continued macro economic growth.  These are far from trends.  Do you really think that the economy will magically slow down if the stock market continues to boom as it has since last week?

The Lithium Prozac Market...We've used this phrase before to describe the overall character of the market lately, but this time we really mean Prozac.  And not the market, but rather the participants.  Thanks to one of our readers for pointing out the following article on the potential effect of psychotropic drug use on investor behavior written by Randy Nesse, M.D. of the University of Michigan.  The article is called The Third Culture.  Maybe Etrade should consider dropping the $75 dollar bonus for new account sign ups and consider free one year prescriptions for Paxil.

Dog Gone...The body count grows.  Today Petstore.com announced that it was forced to lay-off an unspecified number of employees.  They had 200 at the beginning of the year.  A company spokesperson was quoted as saying that they "were in a belt tightening mode".  Thank God it wasn't a noose tightening mode...yet.  In a profound commentary, the Petstore.com spokesperson opined that "the financial markets have changed".  Luckily the canine company mascot Bandit has been retained.  Funny, we thought Bandit was the name of the venture capital groups who cashed out on the IPO.

In a related follow-up, Boo.com who went into liquidation mode just two short weeks ago had its domain name, trademarks and content acquired by Fashionmall.com today.  No terms disclosed.  (By the way, Fashionmall.com priced at $13 twelve months ago currently fetches south of $2.5 per share.  Oops!)  What was disclosed is that Boo's "technology" was sold to Bright Station, plc for $375,000.  Since the company burnt through $135 million in capital since inception, we wonder whether this sets the standard for the new era definition of return on equity?  We'll just have to wait until we can compile more data on dot.com "garage sales" before we can answer that one definitively.  The way things are going, that won't be too far in the future.  We'll keep you posted.

At The Wire...The folks at AMG data reported a $7.5 billion dollar inflow to equity mutual funds for the week ended May 31.  It's basically a complete reversal from the large $7.6 billion outflow we saw last week.  Some of this is probably month-end 401(K) allocations and other non-taxable contributions.  A certain portion must also be individual investor reaction to the "bottom is in hype" blasted in the media on Tuesday and Wednesday, coupled with the record percentage move in the NAZ Tuesday.  The NO FEAR environment continues...for the moment.  

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