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Ironically, we have been too bullish
on the prospects for the current year, while we have clearly and correctly
stressed both systemic financial problems and the ongoing mania for paper
assets, especially stocks. We can claim with complete accuracy
that we called the derivative crisis. Our previous reports
have all been archived and paid subscribers have access to all newsletters
published since December 2002. See the January
2008 issue of Pictures of A Stock Mania for a list of archived issues
that discussed derivatives in detail. Write offs for financial companies
now exceed $500 billion and we believe at least another $500 billion is
likely to vanish. Incredibly, the beat goes on for stocks.
Despite the background of a slowing economy and a credit crunch, the sheer
velocity of stock trading continues at levels never seen before.
The only good news we can report for investors
is evidence that the derivative crisis may finally be taking a toll on
the stock market, exerting a modest drag effect on the velocity of trading.
Our thesis is quite simple; the higher the velocity of trading, the less
effective the rationale for investment. Data through July indicates
the annualized rate of total Dollar Trading Volume (DTV) has contracted
by 5% from our previous report of a yet another new record pace in May.
The bad news is DTV remains on an awesome growth
track. Since 2002, when stock prices bottomed after suffering their
worst bear market in decades, DTV has been rising at an annualized rate
of 19.3%. Gross Domestic Product (GDP) in the first six months of
the year grew to over $14.2 trillion. At the current pace,
DTV will total close to $53.4 trillion this year, 367% greater than the
size of the economy. What is more important, the stock market or
the economy? It's not even close.
The last year that GDP exceeded DTV was 1996, very
early on in the period that witnessed the greatest stock market mania of
all time. In fact, prior to 1996, DTV had only been higher as a percentage
of GDP in 1928 and 1929. The mania known as the "Roaring Twenties"
was then followed by a 64-year stretch in which DTV averaged less than
17% of GDP. Nevertheless, the country survived, grew and prospered.
However, in the modern era, much of our growth has stemmed from the expansion
of our financial arena and our prowess in manufacturing financial structured
products rather than industrial products. "Product" no longer means
autos or televisions, but means exchange traded funds or swaps agreements.
Our goals seem to have taken a full one-hundred-and-eighty degree turn
and in this Editor's view, we are finally beginning to feel the effects.
Step back and look around.... despite an excellent five years from the
October 2002 bottom to the October 2007 top, stock prices as measured by
the S&P 500 and Nasdaq remain mired well below their 2000 peak.
The S&P 500 represent close to 80% of total stock market capitalization,
thus stocks have essentially gone nowhere.
The 2000 peak was undeniably,
Now look at 2007 and 2008
Our Speculative Fervor chart below attempts to
measure overall levels of speculation by simply dividing the annual changes
of both DTV and GDP. If GDP is growing more rapidly than DTV, there
is a lesser focus on stocks. If DTV is growing more rapidly than
GDP, there is a greater focus on stocks and thus, a presumption of
speculation. Clearly, the peaks in 1999 and 2000 represent
a veritable mania. If you remember the period, you will recollect
that Nasdaq was on everybody's lips and probably everyone you knew was
buying growth issues at a huge and unsustainable multiple of earnings.
At one point, the Nasdaq Composite index traded at 250 times earnings,
a level never seen before, or since.
Incredibly, Speculative Fervor spiked again in
2007 after "resting" for three years at levels that still exceeded the
Roaring Twenties and remains at extremely high levels to this day.
A bubble has been followed by a bubble "echo." Given the rather pathetic
outcome of the "bubble," we are not optimistic about the resolution and
dénouement of the "bubble echo."
Final and compelling evidence
of the extent of the mania is clearly visible above. Margin debt
as a percentage of total stock market capitalization was substantially
HIGHER in February 2008 than at the peak (see yellow bar) in March 2000.
The red bar represents year end levels expect for the current year, which
is shown through July. Oh, and that other huge red bar spike?
That's 1987, the year the stock market crashed.
Is it any wonder that stocks
are finding the upside difficult?
Stock market capitalization
is roughly $15.7 trillion.
The expected 1% reduction
in margin debt equates to net outflows of $157 billion.
All signs point to a significant
contraction in speculation ahead.
The following article is reprinted
from the June 2, 2008 issue of Crosscurrents.
We regard this article as
one of the most important to ever appear in our newsletter.
"Four Hours, Eight Minutes
& 40 Seconds"
Last September, we presented a piece entitled "The
Death Of Investment," wherein we portrayed the immense and stupendous turnover
in a half dozen selected Nasdaq issues along with five popular exchange
traded funds. We termed our lead chart of ET turnover, "without any
reservation, the most stunning we have ever presented in these pages."
Through 1187 words and three pictures, we attempted to establish beyond
any doubt that the investment arena had been totally transformed in the
modern era. A metamorphosis, if you will.
We believe this process undermines the consideration
of fundamental values as a measurement for price. The public holds
a large fraction of their retirement wealth in stocks through mutual funds,
IRAs, 401k plans and the like. For the most part, they are content
to have professional money managers do the hard work of earning the security
for their retirement by investing in the right companies and at the right
price. However, in the modern era, trading is paramount, not
investment. The psychology of managing stock assets has changed
radically and has degenerated into something that cannot be accurately
termed investment. Whereas years ago it may have been prudent for
managers to invest for results over the long term, the competition for
assets is the greatest in history and immediate results are
required for survival. Those who post the better results over shorter
periods are those most likely to survive. Results are advertised
with increasing frequency and increasing scrutiny. Managers are now
too impatient for the big payoff, thus academics and institutions have
given us new methodologies to “play” the market and to even utilize black
box formulas and arbitrage opportunities of every description and size,
including the almost infinitesimal. The smallest differentials in
stock prices can now be multiplied sufficiently against derivatives for
profits to be constructed. If the process is repeated
often enough, profits can be enormous. Whereas most stock was once
purchased for investment using tried and true fundamental factors, most
stock is now turned over too quickly for those factors to even rate consideration.
As a consequence, for the most
part, stocks are not fairly valued per se.
Clearly, we can make the case that the more a company's
capitalization trades, the less the company's stockholders are interested
in a long term driven by fundamentals affecting the company's future.
If a company's capitalization turns over once a year (or less), perhaps
we can safely assume investors are aboard and banking on longer term prospects.
However, if a company's capitalization turns over rapidly, we can probably
assume it is only the moment that counts. The longer the holding
period, the more likely fundamental prospects are important. The
shorter the holding period, the less likely fundamental prospects are important.
Cases in point; prices were so overvalued in 1929 that there was no point
in holding positions, thus turnover was enormous. The same was true
in 2000. In both cases, dollar trading volume tripled in the three
years to the top. Extremely high turnover equates to OVERvaluation.
By contrast, total turnover during the entire period of 1940-1954 was minimal,
less than in the single year of 1928. Dividends averaged 5.5%.
Stocks were incredibly UNDERvalued.
Values remain hidden when trading
slows to a crawl
and value is no longer even
considered when trading overwhelms investment.
Rather than purposely “selecting” individual issues
for examination as we did last September, we choose today to highlight
the annual turnover of the top ten issues trading in the Nasdaq QQQQ Trust.
The top ten issues represent 47% of the entire trust and total over $1
trillion in market capitalization, clearly a significant portion of the
entire U.S. stock market. As our featured chart illustrates, investment
has been left far behind by trading. The largest issue of the top
ten is Microsoft, which sports a market capitalization of $273 billion,
a relatively staid and stodgy companion to some of the more high profile
high flyers. MSFT is surely a linchpin of many a mutual fund, IRA,
401k and the like, yet even “softees” entire capitalization trades almost
twice per year. In what must go down as the most fickle market in
all history, the average of the top ten trades its entire capitalization
more than five times per year. Incredibly, the entire capitalization
of Apple (AAPL) and Research in Motion (RIMM) turnover at a pace more rapid
than once per month.
However, these astonishing rates of turnover do
not even remotely compare with those of the most heavily traded exchange
traded funds, where holding times are best expressed in terms of days,
not months. As illustrated below, despite promotional advertising
touting many ETFs as “investments,” nothing could be further from the truth,
patently visible to even the blindest of observers. Three of the
ten most heavily traded ETFs turn their entire capitalization within the
span of one day. In fact, by 1:38 pm, both the Retail SPDRs and the
Financial SPDRs are likely to have turned over their entire capitalizations
from the market opening at 9:30 am.
A grand total of only four
hours, eight minutes and 40 seconds
will have elapsed from the
opening gong heralded by the New York Stock Exchange!
The words “heavily traded” are insufficient to
define or describe the sheer velocity at which many ETF shares pass from
one owner to another. At current rates for the ten issues shown below,
close to $12 trillion in dollar volume will be traded this year.
The S&P SPDRs alone are quite likely to be responsible for over $8
trillion in dollar volume. Three of the issues are short their
respective sectors and will trade nearly $1 trillion in dollar volume.
A list of the top 25 most heavily traded ETFs also includes three additional
issues that trade their entire capitalizations in less than one day; the
Retail HOLDRs (RTH), Ultra QQQ Proshares (QLD) and the Oil Service HOLDRs
Bear in mind that each long trust holds shares
of the underlying companies in the respective index or sector and those
that are short the respective index or sector are short either the shares
or have derivative positions that equate to the short side. In the
case of those that own put options, bear in mind that market makers retain
the right to short shares without locating shares that can be borrowed.
As a consequence, they are likely to fail to deliver shorted
shares, creating additional supply out of thin air, since each shorted
share necessarily must wind up as a long share “entitlement” in a customer's
account. The U.S. stock market has been totally transformed by this
institutional lunacy, wherein investment has taken on a far smaller role
than anytime before.
We can only reiterate the obvious; the more stock
trades on a short term basis, the less relevant are fundamental valuations
and corporate prospects. Subsequently, individual stock prices have
a smaller correlation with their prospects and a larger correlation based
simply upon their relative position in a sector or index. Pricing
inefficiency is far more likely to result in overvaluation, rather than
under valuation, since holding periods are so brief. The shorter
the holding period, the less risk is incurred, thus the more risk can be
accommodated. The result for the modern era has been a perennially
overvalued market. Those who only two months ago cheered as the S&P
500 P/E ratio fell to the lowest level in years (!!!), have now been blindsided
by earnings shortfalls that have ballooned the P/E back to a grossly high
22.9 P/E. Never mind that the historical median P/E ratio of 15.2
has not been seen in nearly two decades!
Below, it is no wonder that mutual fund inflows
continue to contract relative to assets. The new era of sponsored
institutionalized velocity means less relevance for long term investment,
hence less reason for investment in mutual funds. Exchange traded
funds are winning the battle for assets and in the process, may have mortally
wounded the investment arena. Annualized net outflows occurred only
twice before in the last two decades but as of the end of April, net outflows
are again in view.
The most striking aspect of
the chart is the long term trend.
As long as turnover is the name of the game, as
long as short term trading takes precedence over long term investment,
mutual fund inflows will continue to contract relative to ETFs. Worse
yet, mutual funds may experience constant outflows.
In either case, prices must
The measurement of fair value
for corporate prospects requires
a far longer time horizon
than four hours, eight minutes and 40 seconds....
The following article is reprinted
from the July 21, 2008 issue of Crosscurrents.
The charts below (updated)
is one of very few we have ever shown that is not our own.
Please visit the source, Bespoke
Investment Group for more stunning analysis.
It has long been our view that the SEC exists not
to serve the public, but to serve the financial industry. Sadly,
the SEC has absolutely no handle on the metamorphosis of the U.S. stock
market from an arena of investors to a veritable menagerie of traders who
believe the capital formation system is meaningless. We have rendered
the rationale of investment useless and bankrupt. The mechanical
methodologies and short term tactics that rule today's arena ensure that
value is no longer a significant factor in the price of securities.
Incredibly, even the number of shares issued by a corporation to trade
on the exchanges is now in question. Corporate capitalization can
no longer be trusted.
The Depository Trust & Clearing Commission
(DTCC) is the keeper of the vaults; a private corporation that is actually
owned by banks, brokers and dealers. As such, the corporation has
little incentive to protect investors but much incentive to protect its
owners. We have reason to believe the corporation's clearing operations
are suspect. The opacity of the DTCC's business is beyond disturbing.
They are responsible for keeping track of all shares owned and shorted
and our measures of trading velocity offer evidence that the system is
so overloaded by transactions it is likely impossible at any point in time
to determine with complete accuracy who owns what. Most importantly,
we have reached the point at which the industry must recognize the short
sale mechanic that previously served us well, is now broken. While
the circumstance that initially catalyzed our critique was the huge number
of phantom shares generated by failures to deliver shorted stock that were
never legally borrowed, it is now clear that the mathematics of short
sales cannot support the wholesale and widespread shorting that occurs
in today’s radically metamorphosed stock market. Re failures-to-deliver,
if a short sale is not backed by a borrowed share, then no bona fide
can possibly be delivered to the buyer on the long side of the sale.
How can we possibly assure the buyer that any genuine value
has been received? The "share entitlement" placed in the buyer's
account is not a real share of stock, nor does it receive
dividends nor does it receive a real vote on corporate matters.
Disturbingly, even the delivery of properly shorted and borrowed stock
results in a “security entitlement” for at least one participant.
The result is at least two “owners” displayed by brokers for each shorted
share. The creation of a share "entitlement" is essentially
nothing more than an open-ended futures contract. Importantly,
listed companies purposely set and limit their capitalization for many
reasons, not the least of which is to ensure the possibility of raising
additional capital in the future. The ability to raise said capital
is lessened with each shorted share.
We believe the continuation
of wholesale shorting cannot possibly benefit the public.
The process, if utilized on a massive level, as
it is today, harms the market. One of every 17 shares in the
S&P now has more than one “owner.” Given that total short
interest is skyrocketing, the ratio will likely be worse tomorrow, next
week or next month. In little more than two years, total short
interest has more than doubled. Interestingly, there appears
to be a correlation between the phenomenal increase in total short sales
and the phenomenal growth in ETFs, some of which are short sectors or entire
indexes and in relation to derivatives, such as put options. Bear
in mind that neither individuals, nor hedge funds, nor ETFs need short
actual shares to take bearish positions. Bear bets can be placed
simply with the purchase of put options. However, these transactions
have the potential to generate massive naked short sales by market makers
in order to hedge their positions. Under current SEC regulations,
market makers can short stock without borrowing shares. In
essence, they can create phantom shares where none should be. What
is the point of establishing a set number of shares authorized to trade
when the set number can be so easily circumvented and inflated?
Can there be any benefit to
Where does it end?!
For Bear Stearns, it ended rather poorly and so
abruptly that there has been considerable speculation about a contrived
crisis. Trust took a huge hit in March as rumor mills operated 24/7
Although the SEC is scouring trading data surrounding the rapid collapse
be shocked to see any indictment of manipulation. Simply put,
it is in the SEC's and Wall Street's interest to sweep the incident under
the rug, like all others before, lest the public lose confidence in the
U.S. stock market or the supposed venerable institutions that run the show.
Importantly, if John Olagues' take on the Bear
collapse is to be believed (http://tinyurl.com/5vqght),
the U.S. stock market is as corrupt an arena as we could ever fear and
our complaints about a broken short sales system has always been right
on the mark. Given Mr. Oleagues' ten year background as a stock options
"market maker" on the Chicago Board Options Exchange and the Pacific Options
Exchange and a reputation as one of the foremost options market makers
in the world, his opinions deserve exposure. The story has only received
attention on the internet and has not been covered by the major financial
media, yet the facts presented are so bizarre and so controversial that
one can only wonder why the SEC is unable to crack down.
Then again, as we have said on many occasions,
SEC's mission statement is a fraud. Protection exists only for Wall
St. and not for the public. Oleagues' March 23rd comments
centers on the charge that the collapse of Bear was engineered.
The evidence is in the options arena, catalyzed by the creation of highly
suspicious out of the money puts.
These puts were so far out of the money with
so little time left to expiration
that logic demands we consider a deal had
to have been arranged beforehand.
There is also considerable speculation that the
deal was put into place to save the much larger JPMorgan at the expense
of Bear shareholders. Bear in mind, while Bear’s shares opened trading
at $53.95, put options to sell the shares at $5 commenced trading!
Worse yet, the tremendous increase in trading velocity
seen in today's stock market almost guarantees that the DTCC has lost the
ability to track the multitude of transactions, including short sales.
Case in point; although the iShares Russell 2000 (IWM) is an exchange traded
fund, it nevertheless is a trust wherein the shares of the various Russell
2000 constituents have been deposited. There are 150.65 million of
these trust units, each backed by shares. However, when we include
the ETF shares “owned” by those on the long side of each short sale, banks/brokers/dealers
can count amongst their customers, "owners" of at least 304.22 million
units of the trust. The requirement that "shares" be borrowed before
they can be shorted has quite obviously been effectively avoided in this
circumstance. Then again, the IWM is not the only case. Try
the iShares Dow Jones U.S. Real Estate Index Fund (IYR) on for size, if
you will. There are 22.3 million "shares" outstanding for the trust,
yet the venerable NYSE counts 66.6 million short in its most recent tally,
times the theoretical maximum.
If you continue to doubt the importance of this
matter, please refer once again to the chart above. Note that at
mania’s peak in 2000, slightly more than four billion shares were tallied
as short. Despite the relative absence of short sales at that time,
the S&P 500 managed to be sliced neatly in half.
The supply created by an additional
14 billion shares
counted long in customer accounts
ensures continued long term
pressures on prices.
The common wisdom is short stock positions must
eventually be covered and are thus, bullish indicators. Nothing could
be further from the truth. Both long and short positions can remain
open indefinitely. Incredibly, speculators need not even short shares;
all they need to do is open put positions in whatever size they desire
and which will tend to force market makers to short a like number of shares,
however large in number!
The short sale mechanics of
are huge and burgeoning threats
to the long term viability
Decade long returns have finally succumbed to the
great secular bear market that commenced in March 2000. At left below,
our ten-year annualized measure of Down gains ex-dividends is now down
to 1.74%, the lowest in over 25 years. However, at right below, the
20-year annualized measurement still clearly benefits from the surge in
prices experience during the years 1995 to 2000. Ex-dividends, the
Dow has gained 8.61% annualized for a generation.
If 20-year annualized returns
are destined to fall to 5%,
either a good deal of downside
is in store or
it will take years of consolidation
to achieve the historical average.
Just going sideways for the
Dow will take another six years and eight months.
At Dow 10,000, it will take
another five-and-a-half years.
We have reduced our upside
targets for the remainder of 2008 by approximately 5%. It appears
that there is neither sufficient time nor firepower for stocks to recover
to the extent we previously anticipated. Bear in mind these are best
To see a free sample copy
of the Crosscurrents newsletter, CLICK
High Targets for
2008 (best case scenario)
- odds 30%
13,000 /// SPX 1440 /// Nasdaq Composite 2585
the highs are likely to occur in December.
Most likely end
of year rally targets - odds 50%
12,450 /// SPX 1380 /// Nasdaq Composite 2480
Our Low Targets for
2008 were nominally exceeded.
projected lows are STILL viable targets in the September/October time frame!
10,827 /// SPX 1200 /// Nasdaq Composite 2155
correction occurred as we had forecast.
OF THE ENTIRE WEBSITE ARE COPYRIGHT 2008 CROSSCURRENTS PUBLICATIONS, LLC
I hope you have enjoyed your visit and please return
again. If you know anyone who might be interested in seeing what
we have to offer, we'd be happy to have them visit as well!
Alan M. Newman, August 25, 2008
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All information on this website is
prepared from data obtained from sources believed reliable, but not guaranteed
by us, and is not considered to be all inclusive. Any stocks, sectors
or indexes mentioned on this page are not to be construed as buy, sell,
hold or short recommendations. This report is for informational and
entertainment purposes only. Persons affiliated with Crosscurrents
Publications, LLC may be long or short the securities or related options
or other derivative securities mentioned in this report. Our perspectives
are subject to change without notice. We assume no responsibility
or liability for the information contained in this report. No investment
or trading advice whatsoever is implied by our commentary, coverage or