|Act II of
the mania is clearly in progress. Over the last ten weeks, investment
advisors have averaged 56.7% bulls and only 19% bears, one of the longest
strings of extreme optimism we can remember. Wall Street strategists
have never veered from their bullish path and have kept stock allocations
near record highs. Clearly, television media coverage pays homage
to the "new bull market" and hardly mentions more than the merest possibility
of a "pullback." As for analyst stock recommendations, you would
not believe how things have changed in the last two months but you can
read about it in the July 28, 2003 issue of Longboat Global Advisors Crosscurrents.
If you are not a subscriber, we will eventually place that story in our
September/October update of Pictures of a Stock Market Mania. Seems
the bull is pretty much taken for granted, a circumstance that leaves us
flat when weighing the evidence we see. But you already know how
we feel and hopefully, we can at least add to the mix in this report by
quoting a few other sage observers as well.
Since our last update, Dollar
Trading Volume has risen modestly to 174.4% of Gross Domestic Product and
remains at nine times the levels associated with "normal" stock markets,
that is all years excluding the mania years of 1928-1929 and 1995 to the
present. To show the extent of the mania on several occasions in
the past, we have cited the daily trading of one stock issue or another,
such as the many fine days when Cisco Systems was in full bloom and traded
as much as 20%-25% of the GDP generated on those days. Despite the
subsequent collapse of Nasdaq, the wheel continues to turn. Drawdowns
in volume have been nominal as the worst is assumed to be over. Ironically,
although the top 100 stocks on Nasdaq are still obviously very aggressive
vehicles for investors, they have grown enormously in popularity via the
QQQ Trust. On June 6th, close to $4.4 billion of the QQQ Trust was
traded, equal to about one-sixth of daily GDP. So, here we have a
case of a derivative product based on a speculative sector of the market
that now trades with the same velocity as the most actively traded individual
stock issues! Unbelievably, some institutions are using the QQQs
as a proxy for the market. Below, a snippet from Alan Abelson's column
in the July 12th issue of Barron's:
other words, it's an action market and buyers, big and small alike, hedge
funds, mutuals and, yes, Jane and John Q, have been going where the action
is. Suddenly, the whole world is a momentum player. Man, does that ever
smack of '99 and early 2000.
Bernstein, a sharp observer of the market scene from his lofty perch at
Merrill Lynch, in one of his recent musings takes note of this more frenetic
market tempo. "The pressures put on money managers to shorten their time
horizons," he relates, "are getting more and more intense. Even those who
claim to have a quarterly time frame really do not."
managers become increasingly addicted to a trading mentality (it helps,
of course, that for the most part they're managing other people's money).
Or, as Rich puts it, "money managers are increasingly looking at higher-frequency
data and less at companies' fundamentals." And, he goes on, "the highest-frequency
data are stock prices themselves."
Somehow this doesn't
strike us as the stuff of which enduring bull markets are made.
But it is precisely
what you might expect in Act II of the mania.
When $1.74 in stocks are
traded for each dollar spent on goods and services within the economy,
we can fairly assume that stocks have taken center stage and are more important
than any other facet of the economy. One of these days, we hope to
take the time to include the derivative markets as well, to illustrate
the entire scope of the U.S. stock market and how it relates to the economy.
Ironically, even though $6 trillion in wealth has evaporated, reliance
on the stock market is clearly as important that it was at the highs in
Comparing mutual fund data
back to the Roaring Twenties is problematic since mutual funds did not
yet exist. However, huge investment trusts did proliferate on the
New York Stock Exchange and at their peak, constituted about 8% of total
market capitalization versus as much as 26% today for stock mutuals.
After the great depression, the trusts simply disappeared. In 1970,
more than 7% of the market was represented by mutual funds but the debacle
of 1973-1974 killed investor enthusiam, cutting total investment nearly
in half on an absolute basis and more than half relative to GDP.
Given the two prior periods of excessive speculation, we believe that eventually,
enthusiasm will be cut somewhat similarly. To date on an annual basis,
total assets have fallen substantially but remain far from our target,
which would at the very least, confirm the loss of faith in stocks that
we believe will eventually occur. Note that after the 1974 bottom,
our line travels even further south and hovers at similar levels for an
entire decade as the circle turned. For months on end, net outflows
from stock mutual funds were common. That would also be our expectation
here; that the ratio fall further and remain lower still for probably five
to ten years to come accompanied by a long term of net outflows.
Mutual funds hold cash at absolute and relative
levels. Both are important to consider the potential buying power
available for stocks. For instance, huge absolute hoards can prevent
or end market corrections while relatively low levels of cash can mean
a peak in prices. The reverse is true as well, since low absolute
levels may be construed as bearish while high relative levels may indeed,
be quite bullish. Each of the two indicators is capable of rising
or falling. The most bullish circumstance would be if absolute levels
of cash were rising while relative levels of cash rose as well. In
the first third of our chart, rising levels for both indicators are plainly
visible and it is this circumstance that may have catalyzed the bull market
and subsequent mania. Then, while relative levels of cash fell precipitously
until the manic peak, it is clear that rising absolute levels of cash enabled
stock prices to continue their merry way. But now the last portion
of our chart shows that both relative and absolute levels have fallen and
are still trending downwards.
We interpret this as an extremely bearish
Not only has absolute cash fallen 45% from its
peak, relative cash levels are sufficiently near record low levels to assume
that mutuals do not have a great deal of flexibility. We note with
great alarm that the long term decline in relative cash levels coincides
with a far greater acceptance of indexing by both professionals and private
investors. By definition, when one places money in an index fund,
100% of the investment goes to work. Clearly, actively managed mutual
funds have been trying to play catch up with full investment over the years.
In the process, they are losing flexibility every day. The trend
is acutely visible and is leading to zero percent cash.
We wonder, at that point, whom
will be left to buy?
How big is the stock market? Still VERY big,
judging by our next indicator [source:biancoresearch.com]. Note how
the indicator exploded in 1929 from lows approaching the current manic
levels to the worst extreme in 74 years. Even at the 1974 and 1982
bottoms, M2 as a percentage of market cap rose dramatically. But
money is no longer as important as it once was. Stocks are now the
most important facet of our economic life. The obvious answer to
the question "where did M2 go?" is "to buy stocks." The obvious answer
is also quite visible in the mutual fund cash chart as well! If the
secular bear market continues to unwind, this indicator should rise substantially
as it has before at the end of two prior secular bull markets. If
we are correct, M2 must eventually climb versus market cap. If we
conservatively place M2 at 100% of total stock market cap at the conclusion
of the current secular bear market and further assume that the bear has
five years to run, accompanied by an annual rate of expansion of 10% in
M2, total market cap will fall by 14.4% to a figure below the October 2002
low. If instead M2 expands by only 8% per year and the indicator
runs as high as 125% (still well below average), total market cap will
eventually decline by 37.5%.
[PORTIONS OF THE FOLLOWING TWO PARAGRAPHS
AND CHARTS APPEARED IN THE JUNE 30th ISSUE OF CROSSCURRENTS]
Marty Zweig always said, "Don't fight the Fed,"
and it worked for years, actually for decades. But if there's one
thing that is certain, it is that the market is a changeable beast and
is never easily read. If enough participants believe something is
true, it probably isn't. Our next featured picture points out the
most glaring divergence in history between the stock market and a "friendly
Fed." The highlighted portion of our chart depicts the 31 months
since the Fed began lowering rates; the most incredible easy money period
we have ever seen, yet stock prices languish below where they were when
Fed commenced easing. As well, investors are still losing money using
the financial industry's most potent weapon for buy-and-hold; dollar cost
averaging. Thirteen rate cuts have taken rates to negative in real
terms and to their lowest level in 58 years. During that period,
the stock market has not only not gained any ground, the major indexes
are all lower and substantially so. But then again, it took a veritable
mania for some to realize that the U.S. stock market has morphed into something
quite grotesque as we have gravitated from "owner capitalism" to "manager
capitalism." Isn't it ironic that this development was catalyzed
by the same higher prices the Fed encouraged by totally ignoring the reality
of a growing stock asset bubble? The theme is forward by Vanguard's
John Bogle and you can read his views at the Vanguard
web site. Bogle also decries the metamorphosis of "financial institutions
from being stock owners to being stock traders." The Greenspan Fed
has done nothing to stem the tide towards speculation and is running scared
as the loss of $6 trillion in wealth continues to reverberate throughout
The only solution we understand is a return
to low P/Es and high dividend yields.
That could be years away.
Gold has lost some of its luster of late but we
have great confidence that the yellow metal is still in the nascent stages
of a bull market. Our view is that central banks worldwide have been
anxious to create a fiat world, one where only paper money counts, backed
by the full faith and credit or sovereign nations. However, as the
debt of nations around the world continues to expand at alarming rates,
the notion of "full faith and credit" becomes a little more difficult to
fathom. Plainly put, there are limits and it is possible that those
limits have been at least, temporarily achieved. On the other hand,
Gold has been a storehouse of value for thousands of years. We do
not expect that this alternate purpose for "full faith" has yet expired.
In the decade before the stock market mania bubbled into existence, the
ratio of the Dow to Gold averaged about 5.4 and then ran eight times higher
as stock prices soared to the heavens. In our view, the move since
has not been corrective but represents the first stage of a bull market
that will at some point, take the Dow/Gold ratio back to levels seen a
generation ago. The ratio did not "break out" until shortly after
the mania commenced and the "breakout" level is our best guess for a reasonably
low target for Gold's bull market.
At present levels, this would require either
a double in the price of Gold,
a halving of the Dow Industrials or far
some combination of the two that would place
the ratio at approximately 10.5-1.
As an example, if the Dow trades down to our long
held target of 6400, the ratio target would equate to Gold at $610 per
ounce, notwithstanding the possibility of a price correction or two along
the way, perhaps even now. As a high side target, one might be persuaded
to go with the pre-mania average ratio of 5.4. If this process took
five years and the Dow was still at 9000, Gold would then be $1667 per
ounce. At Dow 6400, Gold would trade at $1185 per ounce.
The state of Illinois, strapped for contributions
for their pensioners, floated bonds and placed the money in stocks, based
on the bogus theory that the long term will satisfy assumptions that stocks
rise will 8% or 9% per year out as far as the eye can see. As our
next featured picture clearly illustrates, long term returns like those
Illinois is depending upon, need not be anywhere near what is required
to fund the pensions of future retirees. Ex-dividends, 20-year returns
averaged only 4% from 1917 to 1995, before the mania commenced, and have
been below 4% almost half of all rolling 20-year periods, including the
present mania. If dividends were as robust as they were at the three
bear market bottoms in 1974 (5.9%), 1982 (6.7%) or 1990 (4.8%), we might
expect Illinois to at least approach their goals, but dividends are relatively
scarce at 1.7%.
How long can the bear market continue and in the
process, disappoint the state of Illinois and everyone else who has fallen
in love with stocks? Using a Dow 5000 target as the eventual low,
it will be April 22, 2007 before the 20-year annualized average drops to
4%. Why do we arbitrarily select the 4% level? Because it accounts
for half of our visible history! If we instead choose our current
target of Dow 6400, the 4% annualized average is not achieved until November
17, 2010. If we just elect to consider the Dow trading sideways from
it's July 17, 2003 close, the 4% level is not achieved until April 3, 2015.
It looks like a long haul to
As well, the bond proceeds will ultimately have
to be repaid. Thus, what makes this development so truly frightening is
that it amounts to Illinois buying their pension beneficiaries stock on
margin, mortgaging both the future of the beneficiaries and of the state.
Incredibly, on the one hand, we have Alan Greenspan urging consumers to
take better care of their finances in TV commercials and on the other hand,
we have the states buying stock with borrowed money. There is something
seriously wrong with the logic that permits fiduciaries to act in this
manner! The top ten issues by market cap account for roughly 25%
of total stock market value, so we should assume that Illinois' billions
cannot be spent without placing a like percentage into the largest issues.
The renewed institutional aspect of the mania is destined to force the
lion's share of inflows into the most engorged entities, the market cap
monsters of the index funds. If those issues are already overpriced,
they must become even more grossly overpriced. P/Es for the Dow,
the S&P 500 and the S&P Industrials are now respectively 27.5,
33.8 and 44.1. The top 100 stocks of Nasdaq, as popularized by the
QQQ, are trading at a rather lofty 225 P/E. Price-to-book and price-to-sales
ratios are off the charts as they have been since the mania really took
hold. Just what is reasonable about the decisions of pensions to
invest into equities at this point? On December 31, 2001, Barron's
showed our featured table, a striking portrait of what bear market bottoms
are supposed to look like. Incredibly, the October 2002 low, the
alleged bear market "bottom," would instead appear as a tremendous mania
blowoff top to a time traveler from the past. Is the future destined
to be so radically different from the past?
Of course, bulls would have us believe that extremely
low interest rates allow today's valuations and allow the possibility of
valuations a even higher extremes. Incredibly, this bull camp makes
no acknowledgment of the low interest rate environment that that existed
throughout much of Japan's 14 year super bear market. Despite the
recent huge rally in Japan, the Nikkei index still trades more than 75%
below the peak.
We expect that U.S. stocks will remain well
their early 2000 peak for years to come.
Much lower valuations are necessary
to end the secular bear market.
There is so much wisdom in this business!
Pity that we are privy to too few, very brief but acutely brilliant thoughts
uttered by a only handful of stalwarts.
Don't take our word for it!
It's still a Bear Market.....
"Despite three years of falling
prices, which have significantly improved the attractiveness of common
stocks, we still find very few that even mildly interest us. That
dismal fact is testimony to the insanity of valuations reached during The
Great Bubble. Unfortunately, the hangover may prove to be proportional
- Warren Buffett, Fortune magazine,
"The idea of resorting to the hair of
the dog that bit you is both the oldest known remedy for a hangover and
a longstanding pillar of Fed policy. There are inherent and obvious dangers,
of course, in using moonshine to alleviate the aftereffects of too much
moonshine. Not the least of them is ending up with a worse hangover, and
that's an evident risk whether the hair of the dog happens to be a magnum
of the bubbly or another stock-market bubble.
- Alan Abelson, BARRON'S,
June 9, 2003
"Everything looks great about this advance
except for one item. But this one item has been the very basis of
Dow Theory, and, of course, I'm talking about VALUES. Every bull
market in history has started from a base of stocks at great values.
Great values, historically, have been characterized by two phenomena -
low price/earnings rations and high dividend yields. Neither of these
has been present either at the October 2002 lows of the March 2003 lows.
Thus, based on my Dow Theory studies we have not seen anything even suggesting
a bear market bottom."
- Richard Russell, Dow Theory Letters,
"The stock market is broken, and it will
take some time, maybe years, to repair it. Mass media, especially TV today
is so short-term that few in its audience grasp the lasting damage and
corrective impact which will continue to linger from the greatest financial
crash in world history. It would be unlikely that the bear market
is over when the American stock market is only down about 30%, when in
the biggest boom ever, it had been up 10 times over where it had been years
earlier. . . . Following such a large increase, a 30% decrease is small."
- Sir John Templeton, Equities Magazine,
Note: our Mania reports
are now a bit shorter than we are used to presenting but the demands on
our time have increased greatly in the last few years. It is our
intent to cut back modestly on the free content presented on our website
and to concentrate more on the materials we offer to our valued subscribers.
In retrospect, we were clearly mistaken
to reduce/adjust our high side targets presented earlier in the year.
Those targets were Dow 9200-9600, SPX 955-999,1500-1600 Nasdaq and we reduced
them modestly to Dow 8728-9160, SPX 948-990 and raised targets modestly
for Nasdaq to 1550-1630 Nasdaq. Thus far, closing highs have been
Dow 9323, SPX 1011 and 1754 Nasdaq, respectively 1.8%, 2.1% and 7.6%
above our high side targets. No pinpointing this time but no disaster
What is of intense interest to our
analysis is that our high side targets were not based upon a return
to as much bullishness as we have seen in the last few months. It
is quite easy to misjudge emotions within a mania. However, despite
the consensus that a new bull market is underway, we believe the rally
since October '02/March '03 represents the equivalent of Act II of the
greatest stock market mania of all time.
Dow 9352-9400 ///
SPX 1015 /// Nasdaq Composite 1776
(all print basis -
Our forecast for 2003
places the lows for the year at:
Dow 6400 /// SPX 680
/// Nasdaq 1000-1100
These low side targets
will be adjusted upwards within several weeks
if supports at Dow
8871, SPX 962 & Nasdaq 1598 do not fall.
OF THE ENTIRE WEBSITE ARE COPYRIGHT 2003 ALAN M. NEWMAN
Alan M. Newman, July 26, 2003
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