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Sea Changes


I have not written in a week or so, as my daughter was out on vacation and I found I could not send an e-letter correctly. That will never happen again, as this old dog is going to learn a new trick or two.

One of my readers wrote that my last e-letter took a long time to reach the conclusion that I had no clue, but that he appreciated my honesty. I hope I can satisfy him today as I take a leap and take a position.

Sea Change

I have been talking about positive Investor Sentiment for the last few months. The market has been like the Little Engine That Could. It has been trying to rally back to Bull status. It has failed.

Starting last week, an ominous trend began showing up in our Investor Sentiment data. At first, I thought it would be just a few days, but it has persisted. The bias has shifted from Bullish to Bearish.

Problem: The Big Boys are not coming to the market, and the mutual funds must be having real outflow problems. Normally, these two segments of the market make up about 50% of the buying on the NYSE. Over the last week, that has slipped to about 43%. In real terms, that is a HUGE difference. Further, the Big Boys are turning bearish.

I think it means two things. The mutual funds are experiencing large outflows this month. The institutions are concerned about a recession, have just about finished their repositioning and are starting to hunker down. They know that recessions tend to drop the stock market significantly.

You can write the NASDAQ debacle off to the irrational bubble bursting. Indeed, up until a few weeks ago, most of the damage to the stock market was in the tech and telecom sectors, as I have reported. Now, that is changing. The broad market stocks are getting hit. Not a lot, but enough to concern me.

First, let me remind you I have been bearish on tech stocks for over one year. I have been telling you to sell on every rally. It is not too late, as they are going lower (see below).

I have also been touting value stocks and bonds, and they have been doing well.

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My position was that we were not in a broad bear market, but only a tech stock bear market. The broader world was holding its own or trying to rally.

In essence, the data I look at suggested investors were in the position of believing we were in a bull market correction in the broad markets. The problems were concentrated in the tech/telecom world.

For the following reasons, I believe we are getting ready to enter a bear market in the broad markets. The trend is now down. Any upward movements will be bear market corrections.

First, I have repeatedly said that if the mutual funds stopped buying, the markets were in trouble. That has happened. Until that pattern changes, I do not see any sustainable rallies.

Secondly, the "smart" money, that is the big money, is not coming to the market. They must feel we are going into recession. If they were thinking bottom, they would be buying with both fists. They are not. Yesterday they were selling with vigor, far more than any other segment of investors. They did not come into the market on the buy side in the last hour.

Third, the mutual fund redemptions are going to force selling of a large number of well known stocks.

I re-print this chart from the Street.com, which they developed from Morningstar. It repeats what I have read from numerous commentators. In 1998, as investors moved from value funds to growth funds, the net redemption in value funds forced them to sell their value stocks. That is why 80% of the stock market in 1998 and 1999 did not rise. The only growth was in the tech sector, as investors and growth mutual funds piled on. The reverse is happening now, as with each day we see more redemptions but no buying. Cisco went down almost 10% yesterday. It was almost 10% of the total volume of the NASDAQ with 177,000,000 shares trading! The big tech names, as you see below, are concentrated in tech funds. As these funds see more redemptions, what will they sell? And to whom?

Down, But Still Expensive

The 10 biggest tech funds' 10 favorite stocks: Down 32.7% on average this year, but most are still far from cheap.

None of these stocks are value stocks, by any stretch of the imagination. As investors start to say, "Forget the cheese, I want out of the trap!" and redeem their tech funds, the selling in these names will only get worse.

Case in point: Oracle. Oracle is a great company. Their P/E ratio using last year's earnings is less than 15, yet the chart above shows a forward P/E of 38. That means even though the stock has dropped over 40%, its forecast earnings have dropped even further. I like to use the rule of thumb that a stock's P/E should be the equivalent of its earnings growth rate over the next few years. Does anyone really think Oracle is going to grow earnings at 38% annually for the next few years? The bear market in these stocks is far from over.

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Fourth, earnings are going to get worse, and not better. And not just in the tech stocks, but across the board. Why do I say that? I am assuming the big boys are right, and a recession this way comes. I can see no other reason for their absence at the table. Recessions mean consumers spend less, and that means less profits. Admittedly, we saw a rise in consumer sales in January, but it was because prices (and thus profits) dropped. It was not the result of some large pent-up consumer demand.

Ford and GM have reduced their inventories, but at what price? They are giving away cars.

If Peter Lynch is right and earnings drive the markets, then lower earnings are going to drive the markets lower.

Fifth, we have not seen any panic selling or the normal things we see at the bottom of markets.

Sixth, Greenspan does not get it. Consumer confidence drives this market and the world. He should have cut rates last week or the week before that, and then again at the next meeting. Admittedly, he needs to appear confident, etc., but he raised rates too much, and now he needs to get them back down ASAP. I simply cannot fathom what the purpose is in waiting. My Dad always told me that once you decided to do something, then go ahead and do it. There are jobs on the line, as well as an economy.

Unless they cut more than 50 basis points next week, I think the response from the markets will be very tepid. 50 basis points will not bring the Big Boys back to the table. Maybe they will come back for 100 points.

Seventh, the rest of the world will catch pneumonia if we get a cold. Deflation is a definite danger. Japan is already in a deflationary recession. China is getting ready to enter the World Trade Organization, and their low manufacturing costs will be a HUGE drag on prices and help keep inflation in check, if not bring on outright deflation. More on that in later issues.

*******************

I could go on, but you get the picture. I think now is the time to hunker down and reduce your exposure to the stock market. Get defensive. Next issue I am going to write about bonds in much more detail, as I think they will offer a good opportunity.

Now, this is triple-witching week on the stock market, as options, futures and index options all expire on Friday. That normally means a lot of volume and volatility. Anything could happen. But what I think is that we will see this market go somewhat lower over the days and weeks before it makes an attempt at a real rally. Use the rally to sell. Especially if Greenspan cuts rate more than 50 basis points, as that should produce a solid rally for a day or so.

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I do not like writing these words. Even if I prove to be right, there is no pleasure in bear markets. I have been through a recession or two and know what it means to people. I know that it does not make for the best of times.

That being said, I do my best to tell you what I see in the data. And today I see trouble. I hope I am wrong. I hope yesterday was the bottom and I have to eat crow. But I think today's "rally" was a dead cat bounce and not even the beginning of a bear market rally - not yet. Over the next few weeks, we are going to look at some bear market strategies. There are profit opportunities, and places for you to invest besides money markets.

Starting my Book

I know I have been threatening to write a book on investing for some time now. I keep gathering notes, and the scope of the project keeps expanding, but I now have a clear direction. The only problem is that I have a blank computer screen.

In my youthful past (i.e., up until I was 40), I would re-read Tolkien's epic fantasy, The Lord of the Rings, before I started any new project. It always seemed to inspire me. I started the book again for the 14th time this weekend. It is a powerful tale of courage and duty, and I highly recommend it. If Frodo can face Sauron in the depths of Mordor, I think I can work up the courage to stare down a blank computer screen. I will be releasing parts of the book as I go along, in addition to my weekly market musings.

Your "triple-witching" bearish analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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