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We have bad news. We're not sure how much
longer we will provide our tallies for Dollar Trading Volume. Most
importantly, there is so much noise now from sector and index ETFs
that we can hardly know how much trading is generated by real, live investors
and how much is generated by black box computer programs. Our point
in illustrating activity all along has been to show how immersed the public
was in stocks. At this point, although we still very much believe
the public remains fully immersed, our DTV measurements have become quite
suspect for our purposes. It may be entirely possible that we missing
the point - that all of the trading now generated in sectors and indexes
show even more emphatically, the extent of the mania.
However, in the future, we may instead elect instead
to show a different series; that of total stock market capitalization versus
gross domestic product. We're still mulling that decision over.
Ken Safian of Safian Investment Research and Jim Bianco at www.biancoresearch.com
have long championed this perspective and it may be high time that we follow
in line. Meanwhile....
$30 Trillion in Frenzied
We are sufficiently confident to show the chart
below as a reasonable estimate for year-end 2005 [chart may
be updated again next week]. Clearly, activity remains at
manic levels, despite prices well below their peaks of six years ago.
Imagine how much churning has been required to bring prices back from their
nadir! In the last three years, $12 trillion in activity has been
required to generate a $4 trillion increase in market capitalization.
Another $4 trillion in market cap would result in a brand new record for
the U.S. stock market, but if another $12 trillion in activity is the only
way to get there, DTV would also trade at a brand new record. What
are the odds that the greatest stock market mania of all time would break
all the records again a few short years later? We would guess
the odds are zero.
Vis-a-vis total stock market capitalization, we
are already quite close to the manic peak as volume in sector and index
ETFs has exploded in recent years. The lower blue arrow points to
the end-of-year data. The higher pink arrow points to the pace of
activity at the very top in March 2000.
For a startling perspective of today's activity,
consider the following: one of every $16 trading in the U.S. market is
in the S&P Spiders. The Spiders, the Nasdaq QQQQs, The Dow Diamonds
and the Russell 2000 ETF (IWM) trade a total of roughly $3.6 trillion,
close to 12% of all activity and over 28% of GDP! In accomplishing
this absurd feat, the Dow Diamonds are the laziest of the four indexes,
but still manage to trade 9.3% of their capitalization each day.
The IWM is the busiest - unbelievably - trading nearly one of every four
shares outstanding each and every trading day! As a result of the
phenomenal growth in sector and index trading, program trading has soared
from less than 20% of NYSE volume a few years ago to close to 60% now.
"Traditional" investing and
trading has slowed perceptibly.
[Below, an excerpt from
the February 13, 2006 issue of Crosscurrents, illustrates our point.]
The strangest aspect of the U.S. stock market is
the constantly heard theme that valuations are at acceptable (perhaps even
attractive!) levels. This near Pavlovian conditioning (see http://tinyurl.com/brzxf)
has in our view, been the carefully planned result of the financial industry's
attempt to garner and control assets. In the process, sectors and
indexes have been morphed into salable products rather than investments.
Like toothpaste or cola, the packaging changes or is "improved" from time
to time in order to attract new and more consumers. Exchange Traded
Funds (ETFs) are the most popular theme in packaging. Unlike mutual
funds, they trade on exchanges just like stocks and can be bought and sold
with tremendous ease. But the simple fact remains, as
measured by the S&P 500, which represent better than 80% of the market,
stocks are overvalued and have been for nearly all of the last eight years.
Nevertheless, ETFs continue to grow like wildfire,
reining in assets at an average pace of 42% per year over the last half
dozen years [note: chart estimates data for 2006]. Assets in mutual
funds have grown at only a 3.4% pace since 1999. Last year, ETF assets
rose 31% to very near the $300 billion mark and at the same pace are on
target to reach nearly $400 billion this year. Assets in the Spiders,
which track the S&P 500 index, rose to $58.4 billion and the number
of ETFs rose from 144 to 190. As ETF assets have grown, so has the
pace of program trading. And as the pace of program trading has increased,
traditional trading and investment has declined considerably. Traditional
trading and investment focuses on fundamental and valuation considerations
of individual corporation prospects. Can ETF sector or index investors
do the same? Would Graham & Dodd ever approve of this style of
Although there are certainly undervalued constituents
in each sector or index, if the sector or index trades at historically
high valuations - as now - it is very likely that a majority of constituents
are overvalued - some by a wide margin. Ironically, as long as the
trends away from traditional trading and towards sector and index trading
continue, this dichotomy can only worsen. We are very much in a phase
where fundamentals and valuations for individual companies are quite meaningless,
except at the most macro level still practiced by a dwindling number of
value oriented money managers.
Even in this pursuit, many managers are forced
to participate in the accumulation of overvalued sector and index constituents
to compete and survive.
The chase into paper assets has culminated
in a complete repackaging of the product.
Despite the "new and improved"
we see the opposite for traditional
Caught Up In A Frenzy -
FROM THE DECEMBER 19, 2005 ISSUE OF CROSSCURRENTS]
In our last issue, we offered the insights of JP
Morgan strategist Jonathan Golub, who claims investors are "mentally anchored"
to the peak prices of the mania and are unable to comprehend the scope
of the three year rally from the October 2002 bottom. To repeat,
Golub believes the Fed’s accommodation resulted in another round of "speculative
behavior.” The strategist cited two statistics; companies in the
S&P 500 that have lost money have risen close to four times as much
as the index and companies that have had executives indicted have risen
close to five times as much as the index. Our question: need one
even look for further confirmation of extreme speculation?
Judging by other sentiment measures, such as the
Investors Intelligence survey of newsletter writers, the mutual fund cash-to-assets
ratio, and the Rydex fund ratios, there is every reason to believe that
participants are caught up in a frenzy - again. But since prices
still remain far below their all-time highs, the common wisdom is that
the bull market has a lot of room on the upside. Furthermore, three
years of higher prices unaccompanied by any substantial price correction
are sufficient to convince participants that no price correction will be
forthcoming. The circumstances have again enabled rampant speculation,
albeit certainly not on the same scale as the fateful manic peak.
Nevertheless, current valuations have only been exceeded four times in
market history; 1929, 1973, 1987 and 2000. Each of those occasions
were followed by rapid and momentous declines in stock prices. Exactly
how much additional evidence do we need to claim that investors are in
a similar position of risk, as they were at the four prior major peaks?
More evidence of frenzy: margin debt at NASD clearing
firms rose to yet another new high in October, more than 5% above the manic
peak of March 2000. Although margin debt at NYSE clearing firms fell
in October by 2.4% and combined margin debt fell a nominal 2%, total market
capitalization also decreased by roughly the same amount, or 1.8%, in October.
Thus, total margin debt as a percentage of
total market capitalization remained near where it was in September and
close to the same inflated level it was just before the huge price collapse
commenced in March 2000.
The odds clearly favor at the
very least a prolonged time out as occurred when last year’s rally concluded.
Insider Selling Continues
FROM THE DECEMBER 5, 2005 ISSUE OF CROSSCURRENTS]
As Nasdaq kicks up repeatedly
to new highs for the year, insiders continue to aggressively sell their
holdings. Every few months, we examine ten of the top Nasdaq issues
to monitor the confidence insiders maintain in their stock. Apparently,
not much. Given the ratios of sellers to buyers and shares sold to
shares bought, there can be no question that insiders rate their company
stock as tremendously overvalued.
For the current go-round,
there are only nine stocks in our analysis, since information on the tenth
issue, Comcast, is currently unavailable. Suffice it to report that
the top nine issues in QQQQ index are valued by the market at a hefty $932
billion, a fair sized chunk of the entire U.S. stock market and close to
40% of the QQQQ Trust, the most popular speculative trading vehicle ever
Our last look in the May
23rd issue of Crosscurrents, found a seller/buyer ratio of 31.6, up from
18 to 1 back in September 2004. Although the ratio has fallen nominally
to 29.1 to 1, we would certainly not rate this small decline as encouraging,
since close to 2000 shares were sold for each share purchased. Ebay
accounted for four of the nine buyers overall but it is extremely difficult
to put a happy face on insider buying when you compare the 15,000 shares
of Ebay purchased versus nearly 120 times that number, or a total of 1,793,000
The average P/E ratio for
the top nine Nasdaq companies was 33.4, up from 29.3 in our last tally.
Dividends of course, are next to nothing, so those who remain in their
company's stock are quite dependent upon the share price to add to their
wealth. And clearly, they are selling stock in sufficient quantity
to dispute any notion that any continuation of a rising stock price is
One "excuse" we often hear
is that insiders are selling shares in order to "diversify." However,
we are positive that “diversification” does not involve purchasing other
shares in the QQQQ. And given that insider sales appear quite robust
outside of just Nasdaq, we'd be very surprised to see any of the proceeds
going into stocks at all. Thomson Financial shows an overall dollar
sell/buy ratio of 22.2 for the month of November, the third highest ratio
of the year. After both the July ratio high of 28.7 and the March
ratio high of 25.8, stock prices fell.
So, you say, insiders are
still massive sellers yet Nasdaq and the QQQQs are up in price? Why
should we believe continued selling by insiders has any relevance?
Well, for one thing, it sure did in March 2000. But most obviously,
if insiders are selling in massive quantity, why would you or anyone want
to place their pension money in the same stocks? If they were such
wonderful long term investments, why wouldn’t insiders tend to be holders,
instead of sellers?
One answer we have harped
on for several years is indexing. Charles and Louis-Vincent Gave
and Anatole Kaletsky wrote recently that, “The more money flows into indexation
strategies, the more capital gets invested according to size, and the more
capital is misallocated. This can only lead to a lower return on invested
capital, which, in turn, can only lead to a lower growth rate and, more
often than not, to huge disturbances in price levels. As the late 1990s
craze showed, indexation is a guarantee for capital to be wasted, which
automatically leads to lower growth and lower long term returns on the
stock markets. So we could have a very paradoxical result: indexers might
keep outperforming but the long term returns of the stock markets will
fall, as a sign that the economy's structural growth rate is falling.”
The top Nasdaq issues all
have a prominent place in the S&P 500 index. Just a few weeks before
the 2000 peak, Microsoft was #1, Cisco #3 and Intel #6. The subsequent
dénouement in our view, was concrete proof that indexing does not
work. Although there is plenty of evidence that the mania itself
was responsible for the bloated valuations in the three companies, we must
accept the fact that more than 10 cents of every indexed dollar was nevertheless
destined to buy additional shares of those overvalued companies.
In the September 26th
issue, we covered a similar view of the top semiconductor stocks, claiming
that the principle reason insiders were dumping their own shares was the
companies traded at six times sales, far beyond reasonable valuations.
The top nine Nasdaq issues trade at over seven times sales, an even more
only assume insiders know what they are doing....
Exuberance: Act II
FROM THE DECEMBER 19, 2005 ISSUE OF CROSSCURRENTS]
The second edition of Irrational
Exuberance is now on the bookshelves. Yale’s Robert Shiller’s first
edition hit stores at almost the exact same time the mania peaked in March
2000. He was certainly on the mark at that time. Even though
prices are well below the manic highs now, professor Shiller still believes
they are way too high. Investors, both private and professional are
still irrationally exuberant.
Shiller’s primary thesis
centers on a ten-year moving average of earnings, using the S&P 500
Price/Earnings ratio. The ten-year average ratio is roughly 25, tremendously
higher than the historical long term average of 15. Even the current
multiple of 18.9 is considerably higher, strongly suggesting that valuations
are extremely high at this time. Just one quote from page four tells
us a lot. Shiller writes, “….[higher prices] have created a sense
among the investing public that such high valuations, and even higher ones,
will be maintained in the foreseeable future. Yet if the history
of high market valuations is any guide, the public may be very disappointed
with the performance of the stock market in coming years.”
Everything we view leads
us to the same conclusion as Shiller. Participants are convinced
that a brave new world exists and that the new order will prevail, despite
the terrible fall out from 2000 to 2002. In other words, all the
lessons the mania offered have been ignored.
Below: from the S&P
Barra website), we were able to create the chart below showing the
S&P 500 P/E, including negative earnings back to 1977.
2006: A Return To Average
[REPRINTED FROM THE JANUARY
9, 2006 ISSUE OF CROSSCURRENTS]
If there is one aspect of the last 20 years that
has impacted investor psyches more than any other, it is the presumed permanence
of gains. The longest bull market in history resulted in a unique
perspective, it didn't matter how poorly you invested, the long term would
always bail you out. Note that even a two-year halving in the S&P
500 did not temper investor's appetites. More Americans now own stock
than ever before and total assets of mutual funds are at a record high.
Ironically, the investment of choice for many is indexing, a methodology
that can only afford average performance, since it replicates the most
significant stock market "average."
John Bogle has been called "the Father of Indexing."
Bogle is the founder of Vanguard Group and the Vanguard S&P 500 Index
fund is the largest and thus, the most successful fund of all time.
Of course, the Vanguard S&P 500 Index fund has garnered its huge success
by NEVER once beating the market. What a strange world. We
couldn't make this stuff up if we tried.
On the other hand, Bill Miller runs the Legg Mason
Value Trust, which has outperformed the market for 15 consecutive years.
The odds of Miller's success being due to luck alone are roughly 930,000
to 1. It would seem that the manager knows a thing or three.
However, Bogle claims that Miller's success is, "the greatest tribute to
indexing we have around," explaining "....if only one person can do that
out of 5000 mutual fund managers, it would suggest the odds aren't great."
Our question is should one ever expect a money manager to outperform the
S&P for 15 consecutive years? If one outperformed the average
in only seven of 15 years with less drawdown and higher overall returns,
wouldn't that be sufficient? Are we just supposed to cull Peter Lynch,
John Templeton, Warren Buffett and other successful managers from the investing
hall of fame, and relegate their reputations to luck or randomness alone?
It is painfully obvious that if one chooses to
instead go the route of the index, one is necessarily relegated to "average"
performance. Can that really be the best option? The venerable
index closed at 96.47 in 1967 and closed at 96.11 in 1978, earning investors
less than the dividends they received over 11 years. The index closed
at 71.55 in 1961 and closed at 68.56 in 1974, earning investors zero, zilch,
nada, nothing at all after 13 years. We could go on with examples
but what's the point? The point is that the "long term" guarantees
nothing but the passage of time. Investing in an index guarantees
poor returns if the market does poorly. And if history is any guide
at all, long periods of outsized returns are always followed by periods
of meager or even negative returns. Clearly, the two periods of super-sized
gains from the secular bull markets leading to the 1929 and 1973 tops were
followed by long periods of disappointing "average" performance.
The process is called "reversion to the mean."
Given that history has shown that even 5% over
the long term is reasonable, perhaps a reasonable investor's expectation
should have been for lower rates of gains into the late 60s and mid 70s.
Gains over the last twenty years are an amazing 10.1% annualized,
Since gains have been so robust in recent times, perhaps we should be thinking
that "average" will not be so generous for the remainder of this decade
and possibly even further out in time.
As our chart below illustrates, returns for stocks
as measured by the Dow Industrials have been below 5% (ex-dividends) a
startling 78% of the time, far more often than most observers, including
professionals, would guess. Given the extremely long time frame represented,
it would appear logical that the 5% reference point is fair. Can
the brave new world of the 21st Century imply a far higher rate of return
for stocks? Why would it? If there is a common thread throughout
the decades, it is the cyclical nature of demand for all asset groups,
including stocks. Stocks were the only place to be for 18 years,
from August 1982 to March 2000, and have been the place to be since October
2002/March 2003. Only one time out of roughly three years in a 23+
year span. Phenomenal. Not only has the span of good times
been the longest in history, it has been the best performing by far.
Even if we were to assume a brave new world exists and returns will remain
above the 5% mark more often than below for years to come, a reversion
to the 5% mean should still represent a very real risk on the downside
Note that the regression line currently stands
at 8483, down 22.6% from today. This line will rise to only 8899
by the end of the year. We believe the line represents fair long
term value for the Dow Industrials and it is difficult to comprehend how
it will not be touched repeatedly as the cycle for paper assets loses favor.
Are we being unfair to stocks in our analysis? Considering that the
Dow remained below the 5% regression line every week for 60 years from
January 1939 to January 1996, we do not. The only time since January
1996 that the Dow has even touched the regression line was for precisely
one minute at the absolute lowest print on October 10, 2002.
Although there are reasons for us to suspect that
year-end prices may look similar to where they began the year, somewhat
like 2005, we do not believe the intervening months will resemble the boring
non-volatile environment of the preceding year. The cyclical bull
market that commenced in October 2002 (or March 2003, depending upon how
you look at the charts), is already quite old. Plus, all bull markets
are punctuated by significant price corrections, and that has yet to occur
in this cyclical bull. During the Twentieth Century, there were 68
instances of price corrections measuring 10% or more, one every 1.44 years.
Thus far, since stocks bottomed in October 2002 and March 2003, the largest
price correction has been roughly 8.7% and a 10% or larger correction,
equivalent at present to roughly Dow 9863 and SPX 1156, has not occurred
since 1999. A 15% or larger correction, equivalent to Dow 9315, SPX
1092, occurred on average every 2.23 years in the last century, implying
that even a decline of that magnitude should come as no surprise at this
stage. A 20% or greater correction has occurred every 3.77 years,
implying that a window of extreme danger opens anywhere between June 2006
and the end of the year. Thus, whether we believe that the bull will
endure OR that the next leg of the secular bear begins, we should expect
a significant decline at some point this year and above all, finally, a
considerable expansion in volatility.
2006 also marks the second year of the Presidential
Cycle. Although the cycle has proved favorable since 1950, averaging
gains of 5.7%, the cycle itself has been quite volatile. Of the 14
second-years, six have witnessed gains of 15% or more but four have seen
declines of 10% or more. The last two declines were in 1974, down
27.6%, and 2002, down 16.8%, and both years were in the midst of bear markets.
Given we are in the continuing secular bear market camp, we think a downside
episode this year is not only quite possible, but probable. However,
our long held downside target of Dow 6400 for the secular bear market now
seems improbable. We are not giving up entirely on the thesis for
a return to the poetic justice of the level at which Alan Greenspan pondered
"irrational exuberance," but clearly, the odds have diminished substantially
for a resolution of that magnitude. Simply put, it is extremely difficult
to now imagine a catalyst on the horizon capable of generating a more than
40% collapse in prices. If a downside of that magnitude was going
to occur, the catalyst should have been unfolding well before now and impacting
stock prices. Moreover, 2007 will be the third year of the Presidential
Cycle. The last 14 third years have all been positive, averaging
18.5% gains, and we expect to be modestly bullish before the end of the
year. Thus, we are running out of time for our worst case bear scenario
and a more likely bottom for 2006 would appear to be a modest dip below
our regression line to somewhere above Dow 8000.
Stocks remain on overdrive.
As we claimed in our last report, although prices remain far below their
peak, confidence is off the charts.
ratio of mutual funds
tick away from its all-time record low.
margin debt is higher than it was at the end of December 1999,
ten weeks before the manic peak.
debt at Nasdaq clearing firms is at an all-time record high.
Total Dollar Trading
Volume = $32.65 Trillion
Total Stock Market
Capitalization = $16.09 Trillion
Gross Domestic Product
= $9.54 Trillion
Dollar Trading Volume = $30.09 Trillion
Stock Market Capitalization = $14.36 Trillion
Domestic Product = $12.74 Trillion
We have now
established a new secondary secular bear market low target, corresponding
with the regression line in the chart above. Dow 8000/8500 - SPX
980/995 - Nasdaq 1750/1775, between 20%-25% lower than today. Caveat:
these levels could be achieved several times in the next few years
and it might be another decade before a new secular bull market is capable
of taking all of the major averages above the peak achieved in 2000.
Targets for 2006
Dow 11,400 /// SPX
1312 /// Nasdaq Composite 2350
Targets for 2006
Dow 8000-8500 ///
SPX 995 /// Nasdaq Composite 1775
Low targets for 2006
may now represent
the worst case scenario
for the next two years
OF THE ENTIRE WEBSITE ARE COPYRIGHT 2006 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, February 18, 2006
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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,
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