MARKET OBSERVATIONS

HAPPY? NEW YEAR

MARKET OBSERVATIONS - 1/4

Happy? New Year...Despite the near unanimity of positive thought on Wall Street that we have entered a "new era", as we move into the new year and the new millennium, we do so with imbalances and anomalies in the financial markets that are without precedent.  Who knows what the new year will bring?  More of the same in terms of market character?  A secular change in enthusiasm toward equities?  A crash?  A further speculative melt up?  A continuance of unprecedented divergences in market sector performance?  It all remains to be seen, despite the action of the last two days.  We continue to believe that most modern market participants are making a quite serious error in that they are mistaking a credit cycle for a business cycle.  After all, it just wouldn't be a mania if the perceptions were clear.

    We continue to see the risks to this historic market ascent as the following:

   The US continues to be the beneficiary of the largest "foreign aid" program of all time.  Our monstrous $340 billion dollar trade deficit is being financed courtesy of our foreign friends and neighbors.  Likewise, this foreign aid program as had the effect of keeping domestic inflation under control so far.  As the global economies continue to improve, they will attract investment capital at the margin.  The dollar and the bonds have already figured this out.  We have literally become dependent on foreigners as a prop for our credit markets.

   We see as clearly unsustainable our massive exportation of dollars (essentially using profits from our own domestic economy to finance consumer imports) with our record low savings rate in this country.  Couple this with household and corporate debt at record levels relative to GDP and we are slowly painting ourselves into a financial corner.  We are relinquishing our future financial flexibility with every container ship docking on the West Coast and with every consumer confidence number that is reported.

   The Fed credit/money creation machine must also come to an end or slow at some point.  As of late December, the three month growth rate of M3 was annualizing at 16%.  You've seen us chronicle Fed actions weekly in terms of credit creation.  In fact last week was something out of a science fiction book.  Fed credit expanded $24.3 billion in the one week prior to year-end.  This is on top of multiple $10-20 billion weeks over the last two months.  With Y2K supposedly passing like a ghost ship into the night, if this type of action continues, something else is very wrong.  Couple this money creation with unemployment claims at a 26 year low and consumer confidence at a 31 year high and just what do you expect to happen to the general level of inflation ahead? 

   Investor Sentiment readings are pushing top end as we move into the new year.  We have heard many a market strategist speak of the pessimism surrounding Y2K and how the market is poised to springboard higher into the new year with all of the anticipated bonus, profit sharing and 401(k) money surely destined for "equity island".  To these strategists, we pose one small question.  "Do these numbers look pessimistic to you?"

     These are straight from Barron's.  Where were those pessimists again?

   Common stock valuations are sky high.  You know and we know that valuations have been a moot point.  Nonetheless, we've just lived through what we believe is a staggering acceleration phase.  The hallmark characteristic of every blow off mania is the second derivative (remember your calculus class?), the rate of change of the rate of change.  In mid-1995, the P/E multiple on the NASDAQ was close to 30.  In early 1997 it neared 40.  In mid-1998 it approximated 65.  We ended the year at 200.  Maybe it's a moot point.  And maybe not.

     (We've heard many a market participate decry valuations in our new era world.  P/E's don't matter.  Debt doesn't matter.  Cash flow doesn't matter.  Profits are for geezers.  Market breadth is moot as it has caused no disruption in the averages for years.  We need to be educated.  Just what does matter in today's market?)

     In conjunction with the NASDAQ P/E multiple, the upward trajectory of margin debt bears a striking resemblance.  Margin debt is up almost 50% in 1999 over 1998.  Here are the numbers:

   Institutional and household ownership of common stocks relative to total financial assets is at record levels.  Never before have equities made up this much of institutional and household financial portfolios.  To us, this suggests that market participants are relatively "fully invested".  As with any asset class, prices are determined by simplistic supply and demand forces.  They don't call it Economics 101 for nothing.  The concept is elegant in its simplicity.  Given where we have come to as a country in terms of stock ownership, "who is the next buyer?".  We're hoping for a simple answer, but so far it eludes us.

   The quality of corporate accounting and reported earnings continues to be a major concern (at least to us).  We wonder why, in a period of economic bliss as perfect as this is proclaimed to be, that corporations must use "every trick in the book" to enhance reported results.  With the pooling vs. purchase debate about to come to the final curtain call, the drumbeats are already pounding among street analysts for results measurement based on cash earnings.  Why aren't these same analysts screaming to back out stock options expenses from currently reported earnings to get a clearer picture of true operating results?

    We truly do hope this is a happy new year for all, but the nagging concerns we have discussed tell us that at some point, the last champagne cork will have popped.  After that, all that is left will be the popping of individual bubbles - one by one.

All QQQ'ed Up for the New Millennium...Speaking of champagne and bubbles popping always gets us thinking of our favorite bubbly index - The NASDAQ 100.  We thought we'd uncork the top components and their year end weights for your approval: 

      There you have it folks, less than one-quarter of the NASDAQ 100 is equal to 64.5% of the total index.  For 2000, we are proposing we shorten the list to the NASDAQ top 25.  Let's just stop fooling around here, OK?  (Do you hear the sound of bubbles popping?)

The Financial Inflow-sion...By now it's old news that inflows to equity mutual funds in this country skyrocketed in October and November.  $16 billion and $17.9 billion in these months respectively.  Here are a few fun facts.  In October and November, aggressive growth funds and sector (read tech/internet) funds took in $15.5 billion.  Over the last 24 months these two areas of mutual fund categorization were running inflows of roughly $2.25 billion monthly.  During October and November, conservative growth and income funds actually had net outflows of almost $2 billion.  Comparatively, growth and income funds had been averaging a $4.75 billion monthly take over those past same 24 months.  It is nothing short of astounding that at all time valuation extremes, mutual fund investors poured money into those areas exhibiting the most stretched valuation and speculation imaginable at a rate unprecedented over the past two years.  What may be even more stunning is that with the $17.9 billion inflow in November, actual mutual fund purchases of equities totaled $23-plus billion.  Investment strategists such as Tom Galvin and Joe B. expect all the sideline money to come pouring back into equities at the dawn of the new millennium.  With the cash to assets ratio for domestic equity funds currently registering 4.58%, our question is "what cash?" 

Deja Vu All Over Again?...We'll just have to wait and see.  Two days does not a market make, although the last two have been a bit of an eye opener.  We're sure you remember that Tokyo peaked on the very last day of December in 1989 and never looked back.  Could it happen here?  Sure it could.  Will it?  Stay tuned.  We've pointed out that distortions in our market are far worse than the Japanese situation of ten short years ago.  It all depends on the confidence of the public.  What it does reinforce to us is that no one rings a bell at market tops.  There usually is no defining "event".  Perceptions change.  Sometimes it's as simple as that.

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