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The Case of the Missing Bottom


OK, it's Wednesday afternoon and I am writing an e-letter. Something wrong? No, just a few insights, some interviews and some articles which make things "click" in my mind, plus I am off to Puerta Vallarta Friday (my usual writing day) for a long weekend. My bride is already there, and I look forward to some rest before coming back to launch a new fund.

The Case of the Missing Bottom?

The recent market action has a lot of people scratching their heads. Of course, the cheerleaders tell us each move down is the bottom. And one day they will be right. But that does not explain the markets. After calling several of my hedge fund manager/trader friends, who are in the "pits" on a daily basis, I think I can make some sense of the market action for you.

First, let's remember a few basic fundamentals. For every seller in a bear market there is a buyer. I know from reading your letters and talking to clients that most of you are bearish right now, but not all of you. Some of you are quite positive about the markets. But given the negatives in the economy, the question becomes why is anyone buying stocks? Can't they see the potential for real problems that I have been writing about?

The answer is they see the potential for real profits.

My friend Jerry Tuma points out in his July Cornerstone Report, "According to Bank Credit Analyst, stocks lead corporate earnings during recession by an average of 11 months. On average, the S&P has risen 32% from the market's bottom before the earnings cycle bottoms out." Note that the rise does not begin after the recession is over. It begins usually at the bottom of the recession when things look the worst.

This rise comes before things turn around and before unemployment bottoms out. It begins when it looks like there is no end to bad earnings reports.

Seems easy enough. Just invest when blood is running in the streets. But the trick is to figure out when things look the worst. Are we looking for ankle deep or knee deep blood? Things may look pretty bleak today, but there is no reason they cannot look worse tomorrow.

And that, dear reader, is what our assignment is today. We are going to explore some of the signs that happen when things are at their worst. We want to know what month in the future earnings will turn up so we can subtract 11 months and jump back in the market BEFORE the 32% rise.

For that we go to what may be the best site I have found for economic data: http://www.yardeni.com. Dr. Ed Yardeni of Deutsche Bank and his team compile hundreds of charts, tables and graphs. Every now and then I go there and just spend an hour or two roaming through the site.

Today, we are going to look at the correlation between the Fed funds rate and various other factors. There are several items which are highly correlated with Fed fund rates. They are also highly correlated with stock market direction. And even more important, when you go back to 1990-91 and pay close attention, some of them even give us a hint at that most elusive of moments: The Bottom.

As you might expect, the direction of the Fed funds rate is closely related to GDP growth. In past recessions, the Fed funds rate only started to come down after GDP growth slowed down. But in our current economic cycle, we see Greenspan and crew cutting rates only shortly after the slowdown began. Faster than at any other recent period, but not soon enough in the opinion of many observers, including your intrepid analyst.

That is why so many analysts are bullish, because they see that chart and connect the dots which shows the economy and markets growing stronger next year. I think this "correlation" is tentative, at best. Betting my economic future on the effectiveness of rate cuts seems questionable, let alone on the likelihood that cuts actually produce magical changes in exactly 12 months. Not that I don't think rate cuts are important and will eventually have some effect. I do. I just think the exacting predictive power of rate cuts on the economy is dubious.

The Three Amigo Indicators

But where else to look? On page 4 of Yardeni's July 24 Fed Watcher, there are two powerful charts. They show the strong connections between capacity utilization and the NAPM price Index (National Association of Purchasing Managers) and the Fed fund rate.

Interestingly, capacity utilization bottomed in early 1991 and the stock market found a bottom a few months later. Ditto for the NAPM Index. All the other graphs show the correlation to the Fed fund rate with factors like industrial production, G-7 industrial production, profits, earnings, commodity prices, metals, etc. While correlated with the Fed fund rate, these did not seem to anticipate a turn around in the stock market prior to the actual rise. (I should note that these are my conclusions and are NOT to be interpreted as coming from Dr. Yardeni.)

Does capacity utilization and the NAPM Index sound familiar? They should, as I frequently cite them. It makes sense why they would tend to be a pre-cursor to a turn-around. Until factory production and purchasing turn around, how can we say we are at the bottom? Unemployment, earnings and such will still tend to look bad and get worse, even as the stock market and the economy rise from their graves, but as I keep telling you, something has to signal that we are at a bottom.

Remember my earlier point: as bad as things are, they can get worse? Until the indexes start to show some signs of life, things can get worse, and probably will.

That gives us three things we are watching: capacity utilization, the NAPM Index and ____? This is a test, class. What else have I been telling you I watch like a hawk?

I am SURE you remember me writing about how junk bonds, the current nuclear waste of investments, typically turn around at the bottom of a recession. Junk bonds are showing no signs of life. They really are getting treated like nuclear waste. I could quote some devastating numbers about how default telecom bondholders are only getting 12 cents on the dollar and about how many hundreds of billions of dollars of telecom bonds are still waiting for the shoe to drop, but I am sure none of my readers are in junk bond funds today. Well, at least I am sure none of the clients in our High Yield Bond timing program are in junk bonds. Someday we will be. I actually look forward to the day, as it will be a once in a cycle trade that we will get to brag about to our brother-in-laws. (Not that we would, of course, but it will be nice to be able to brag for a change, knowing that we have something about which we could, were we not humble.)

So, if there are no signs of economic life, and investors can read the same charts I can, then why is this market so volatile? Why don't we see the typical recession driven bear market crash?

Because there are forces at work in the market that are different than at any other historical period. As you know, I take great comfort and spend a lot of time looking at History. It seems like History is taking a severe beating as the broad market performs a magical levitation act.

Four Odd Facts

But something I read today triggered a brief epiphany. All of a sudden, the dots connect. A number of odd facts come together to make some sense.

Odd Fact One: We track dollar flows in my office with a proprietary piece of software. Every day we download every trade, tic-by-tic from the NYSE and the AMEX and then analyze it. Over the last six months, I have been telling you that the Big Boys, the largest traders, have been AWOL. The percentage of the market made up by big trades has dropped by 25% (which is a HUGE number), and the positive dollar flow from this segment of the market is decidedly less bullish than smaller traders and mutual funds.

The result is lower overall volume.

Odd Fact Two: I track hedge funds. Hedge funds come in scores of flavors, so you can't make generalizations unless you do some serious segmentation. In a segment I would call "opportunistic traders", there are several major players who are just not making the types of returns they normally do. I pointed this out a few weeks ago. They are not losing money this year, but the returns are anemic. For this group of traders which have in some cases decade long track records to suddenly go flat for almost two quarters is odd.

Odd Fact Three: I routinely touch base with a group of hedge fund managers. I always like to ask what trends they see. They all confirm the absence of large institutions. But one trader who deals heavily in options pointed out a new trend. Recently the put to call ratio has been rising, showing more investors are hedging their portfolios. Nothing new there. But he pointed out that the hedging has become very short-term. There are a number of investors or groups who are only interested in hedging their stocks for a few days or weeks. What does this tell us? That there are a significant number of investors who think we are near a bottom, but are not willing to bet we are at THE bottom.

My guess is that they are betting that after we get through earnings season with all the negative news, they are thinking we might see a recovery. They are afraid to not be in the market, so they buy. They believe in the Greenspan put, so they buy. But they are afraid we could see another short term drop or test of the recent lows. So they buy some cheap insurance.

Odd Fact Four: Bill Meehan of Cantor Fitzgerald ( a trading firm) writes "...short-term trading accounts for an increasingly disproportionate share of the action. If not for program trading, hedgies and day traders, the anemic volume would be nothing short of pathetic. Much of the really "big money" appears to be absent, and those who are here seem to be playing around at the margin. The QQQs traded almost as much volume as the six most actively traded Big Board stocks, indicating the speculative nature of the current market. Heck, the turnover in the QQQ float is measured in days now.

"Why is this important? The extended community of short-term traders is a relatively homogenous one, where the same ideas and actions are transmitted almost instantaneously. Like all small towns, news spreads very quickly, gossip and innuendo reign supreme, and few enjoy any privacy for very long. However, those being talked about are often the initial source of the gossip. In the absence of "real" investors and amid generally depressing news from corporate America, the impact of "hot" money cannot be overlooked."

While I doubt that hedge funds are that significant (equity funds are probably only $200,000,000,000 in total value, which is not that big in the grand scheme of things), Meehan makes a good point. There are a number of short-term traders working this market. If this hot money "takes a vacation", it could be very hard on the market very quickly. It could look like 1987 in an October minute.

OK, the Big Boys are decidedly less of a factor. Investors are nervous. Hot money is a bigger part of the market than normal. Even professional traders are having a tougher time making money.

That does not sound like a positive mix. Unless we see our Three Amigos come to the rescue.

Let's look at one more set of statistics: earnings.

Again, I go to Yardeni. He has been so right and so ahead of his fellow analysts this year. He has been consistently downgrading earnings, and has been on the low side of earnings expectations.

He has a very clear graph in his latest newsletter. It shows how average earnings for the S&P 500 for this year are tracking almost precisely the earnings woes of 1991. Quote: "The consensus earnings estimate for 2001 continues to track the 1991 downturn almost exactly. If this continues to be the case through the end of the year, then earnings this year will be $45 per share, down from $55 per share last year, and below my current estimate of $47 and well below the current analysts' consensus of $51."

What are Analysts Smoking?

The interesting thing is that the consensus earnings from analysts for 2002 is still a very high $60.64. That means, if I read the tables correctly, that analysts think earnings will grow almost $15 or over 30%! Let's get real here. That is not going to happen. No way. No how. That means we have more disappointments and lowering of estimates in our future. The bad news, as the cheerleaders try to tell us, is not all factored in. The reality is that they have not even begun to consider bad news.

By that I mean that if earnings grow 10% next year the average will be approximately $50. Another 15% on that takes us to $57.50 as forward earnings for 2003. At a P/E ratio of 22, which is somewhat higher than the average for the last decade, that would mean the forward looking earnings weighted average for the S&P this time next year would be: 1265.

That is roughly a few percent above where we are today. That assumes we are near the bottom in terms of the earnings recession. Not a lot of potential.

Earnings Suck

Let's go to some great points made yesterday by Greg Weldon. We catch up with him commenting on a recent Moody's Investor Services posting (emphasis mine):

"Regular readers KNOW we are already long US and especially EUR bond and money market instruments ... as well as being short nearly every stock index we can get our hands on. With that in mind, we came across a FABULOUS piece of research work (as usual) from Moody's Investor Service. We note some of the details related to the assertion by Moody's ---- an assertion we certainly agree with 100% ---- that EVEN with the STEEP sell-off in US stocks in the YTD ... they are now MORE "overvalued" than they were when the Fed began easing. The fact that this assertion can be made DESPITE the fact that the economy continues to plunge to new lows ... is testament to just HOW BAD things might have to get before a TRUE capitulation can occur. To date, WE have seen NO signs of ANY capitulation. The Moody's piece would validate that thought.

"Note (courtesy of Moody's) ----
--- Despite the 20% plus decline in the US S&P 500 in the year-to-date, the current P/E ratio (end-July 23) is 29.9 ... ABOVE end-June P/E of 27.1 ... and the average of 24.8 seen in the first six months of the year.
--- Comparatively ... the average value of the S&P 500 P/E ratio during the 1990-2000 period was 22.0.
--- Comparatively ... the average P/E on the S&P 500 during the period from 1980 through 2000 ... was 17.3."

(For those of you who are getting out your pencils: yes, the numbers disagree somewhat with Yardeni, but they are in the ballpark, and the precise number is not the point. When the train is going this fast it makes a big difference when you take the picture as to what the picture will show.)

Another negative note from Yardeni: "Most institutional investors I've met with in recent weeks share the Fed Chairman's ambivalence about the economic outlook. Everyone has been impressed by the resilience of consumer spending, particularly on housing and autos. Everyone seems to be wondering if this can continue much longer. My bet is that it will. But my Profits/Payrolls Model suggests that employment could tumble this summer. If consumers lose lots of jobs, we'll lose the consumer as the only major spending force keeping us out of a recession. In this scenario, the profits outlook would be grim and stock investors might have to endure another wave of selling."

He notes that most bears point to the negative wealth effect (large stock market losses), the negative savings rate and high debt burdens as serious factors weighing on the market. Of these, he is only worried about the debt burdens.

He points out that the average net worth is up 100% since 1991 despite an 8% drop in the last four quarters. While I am not sure that reflects the true anxiety from stock market losses, I agree with him that the negative savings rate is not a big issue. The official number does not reflect modern reality. For instance, employers contribution to benefit plans are included as current income and not savings, when clearly they are. If you are saving 10% in your pension plan, then you feel less need to save extra in a bank account. He notes that actual savings are closer to 6% in 1999 versus the "official" number which was zero.

But we both agree that debt burdens are high. Quote: "The ratio of household liabilities to assets jumped to 16% during the first quarter, matching the previous record high during 1994. The ratios of consumer credit to personal consumption, to personal income, and to disposable personal income are all at record highs."

Further, the Federal Reserve notes in its July report that the consumer debt service burden rose to a 20 year high (1991 again!). That "burden" is the minimum scheduled payments on mortgage and consumer debt. Loan performance is deteriorating. Delinquencies on credit card loans has risen noticeably.

If credit companies tighten standards and/or consumers stop borrowing and start reducing debt, then consumer spending collapses.

(I should note Yardeni has a positive spin on all this: Basically, the worse things get, the more stimulus the Fed will provide so the better the bounce we will get from the bottom.)

I detailed the global trade slowdown last week. I have written about the very real deflationary forces facing the world economy.

All in all, I think we are in for another quarter which will disappoint investors. If unemployment edges up, and I don't see how it can't, that means it is very likely that consumer confidence and consumer spending will drop. It will become a vicious cycle.

Let's go back to the beginning of the letter. I talked about the fact that a major part of the current stock market activity is driven by hot money. This money is basically traders and not long term investors. I also point out that a lot of longer term investors are getting in the market and buying very short-term puts as protection in apparent anticipation that we are at the bottom today.

It seems to me in looking at the economic data that we could see even more real disappointment in the coming months. If those disappointments caused that group of nervous investors to give up or capitulate it would also spook the "hot money". If the markets dropped to a more historical P/E ratio level of 20 that would mean the S&P would drop to between 900 and 1000!

Will it happen? Old History says it should. But Recent History says investors buy the dips. The market will only drop significantly when the fear of losses is bigger than the fear of missing the potential recovery.

The risk in my mind is still clearly to the downside. Until we see the NAPM Index, capacity utilization and junk bonds begin to turn up for several months in a row, the risk will be to the downside with the occasional and nerve wracking bear market rally.

If the bottom happens when the S&P is at 1200 and the Dow is at 10,000, we will NOT see a 32% bounce. But if we see a typical recession bear market, with the Dow going below 8,000 and the S&P in the neighborhood of 900, then it is entirely possible that we could see that 30% bounce.

I suggest patience. We are closer to the bottom now than we were six months ago. Unless we are in for a steep and prolonged recession, which I don't think we are, we should see the stock market bottom sometime this year. The US should lead the world out of recession. We just have to wait, be patient, and watch the important numbers. Yes, we may give up the first few percent of a run, but I don't think we will miss it all. And I for one can sleep better at night.

So, I don't want to surprise anyone when you get an e-letter in a few weeks or months which says: "The market is headed up. We have reached the bottom"! I expect to get letters from readers which point out all the negatives like unemployment, earnings, consumer confidence, etc. I get them now from readers which try to point out the positive and chide me for being bearish. (By the way, I read all letters and try to answer as many as possible. I do appreciate feedback, positive and negative.)

Just for the record, I am entirely short my equity portfolio and long US long-term bonds. (Confession and disclosure: There is one stock which I am not short. I could not sell one micro-cap stock last year for a variety of reasons [I really wanted to] when it was at an all-time high, up 400%. It is now down 50%. I call it my "stupid stock" which I am stuck with. I was stupid [read greedy] to buy it and the market is stupid in valuing it below physical liquidation. It is now a value stock. But it is still a stupid value stock. We all get our stupid stocks. I refuse to sell it below company liquidation value.)

Life is Good

My 12 year old son, Chad, got some new clubs last weekend. They added 50 yards to his drive. I wish I could find that kind of magic in some new clubs. It will not be long before he is beating his Dad. But it won't be this year. I can stave off that sign of deterioration for another year or two, at least.

I am off to Puerto Vallarta for a too-quick long weekend. You can fly from Dallas for just over $200 and the room rates are off-season. Reading, relaxing, golf, guacamole, listening to the excellent new Don Henley (of the Eagles) CD, cerveza and quality time with my bride. Life is good.

In few weeks, I will be reporting on my search for money managers for the average investor. Powerhouse hedge funds are easy to find, but they are not available to the average investor. It has not been easy if you have stringent guidelines. I have found one very interesting group and am finishing up the due diligence. I will post complete details on my web site.

Have a great weekend.

Your enjoying his life while the market goes sideways analyst,

John Mauldin
John Mauldin

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