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Typically, at his time of the year,
we would detail our analysis of stock market seasonality in this feature,
but the April 23rd issue of Crosscurrents covered the subject in far too
much depth, including five charts, for the limited space we have available
on this page. We will be happy to provide readers with a copy of
the issue upon request.
If there is a single salient truth about the U.S.
stock market, it is that 2007 is a record setting year from almost every
aspect. While there are a few rare exceptions that place either 1929
or 2000 in the spotlight instead, our overall impression is that the mania
for stocks appears to be at least as emphatic now as it has ever been.
We have repeatedly illustrated margin debt extremes and the historically
low mutual fund cash-to-assets ratio as evidence, but the best picture
of the continuing mania for stocks remains the sheer volume of trading.
Not only is the volume of trading at a historic high, the velocity of transactions
have exceeded the previous highs with such ease that one's only choice
is the assumption that a veritable mania is still in progress, and in fact,
really ended. Apparently, the collapse and bear market that
endured from March 2000 to March 2003 was only a corrective phase to the
greatest stock market mania of all time.
We make the distinction of a "corrective phase"
rather than a bear market due to the observable fact that we cannot find
one instance of back-to-back stock manias in the past. Perhaps the
semantics and definitions do not work for some, but nevertheless, we find
it extremely difficult to dispute that the mania never really ended.
Even at the nadir in 2002, Dollar Trading Volume was still at a level that
equated to a 18.3% rate of growth in velocity from 1995, when we posit
the mania actually commenced. This seven year path would have been
extraordinary sans the final manic peak and subsequent collapse!
As it now stands, DTV has grown 18.1% from last year's
record total and exceeds the fateful year of 2000 by 28.1%. Compared
with Gross domestic Product and total stock market capitalization, we are
close enough to record extremes to posit the possibility that a similar
outcome to 1929 and 2000 should eventually be at hand.
DTV is more than three times the size of
for only the second time in history.
DTV versus market capitalization is 223%,
only nominally lower than the 228% registered in the Roaring Twenties.
If there is only one salient truth about the stock
market today, it is that the mania remains largely unrecognized by professionals
and the public, who blithely continue without concern, taking larger risks
with greater exposures than ever before, while denying investments in favor
of trading, per se.
We define Speculative Fervor as the one-year differential
in DTV compared with the level of GDP. A market that trades an additional
$2 trillion while GDP rises by 3% is more speculative than a market that
trades an additional $1 trillion while GDP rises the same 3%. Although
Speculative Fervor has not reached the levels registered in 1999 and 2000,
this indicator has remained at "Roaring Twenties" levels for four full
years. It is easy to posit that recent high levels have reinforced
the notion that stocks can do no wrong, hence the game is still played
to the hilt. We believe it is imperative to note that Speculative
Fervor remained between +15% to -10% for a stretch of 64 years (!!!) from
1933 to 1996, equating to the historic norm. A return to these levels
will result in a huge dénouement for traders and investors.
In our view, this outcome is inevitable. We do not expect an identical
collapse such as occurred from 2000 to 2003, but an initial shock followed
by a consistent and steady disenchantment with the inability of stocks
to recover over the long term.
Stocks are overowned and clearly,
The following article is reprinted
from the March 12th issue of Crosscurrents.
"Buy, Do Not Hold"
Justin Lahart's February 26th WSJ article, which
can be viewed at http://tinyurl.com/335jrf,
pinned down one extremely important reason for a disconnect between price
and valuations quite aptly as the journalist posited, "Investors are trading
so quickly they may not see the risks in the market for the speed."
The accompanying chart really tells the story, showing that as of mid-2006,
the average holding period for stocks was only half of what it was five
years ago. Although the holding period has lengthened a bit in the
last year, the trend is clearly to shorter holding periods. Lahart's
article goes on to cite that even in 1999, a time when the day trading
mania was rife, the average holding period was a year. Worse yet,
the last time the holding period was as brief as it was a few months ago
was in 1929. Whoops. Why is this occurring? There are
the obvious reasons such as the proliferation of derivatives, like options,
the phenomenal growth in Exchange Traded Funds and hedge funds, but all
of the reasons point to only one consequence. Investment has been
dis-incentived in favor of trading. In an environment where performance
is now measured on a monthly basis for hedge funds down to a daily basis
for programs, the fundamental analysis of individual corporate prospects
has become far too time consuming and far too expensive. Thus, companies
are now less likely to be priced on their individual prospects and are
more likely to be priced upon their relationship to one another, to an
index, or to a sector.
The end result is that to a large degree, individual
issues suffer gross pricing inefficiencies. The process spreads to
entire sectors, entire indexes and finally, the entire stock market suffers
pricing inefficiency. We can only reiterate that the present market
fails and scores a D or worse on every valuation measure history has proved
valid in the past. Explaining the lack of volatility, Lahart correctly
deduces, "It may be that the combined effect of all the sophisticated trading
strategies in place today have put the stock market into a state of dynamic
tension, where all the tugging and pulling effectively cancels each other
out, muffling price movements." Lahart finally concludes, "stop loss"
strategies may have eventually have an outsized influence with the potential
to "overwhelm the market." We cannot argue with that logic.
Since there is apparently no long term horizon for investors anymore, why
would anyone hold when the trend finally, as it eventually must, turns
When we turn the perspective to Exchange Traded
Funds, holding periods become almost laughable for their lack of duration.
The five ETFs pictured below were the five most heavily traded domestic
ETFs last year. The Dow Diamonds were the tamest but still managed
to turn over more than 26 times during the year, an average holding period
of 9.6 days. The vaunted Spyders were turned over 40.8 times, or
every 6.2 days. And the phenomenally popular QQQQs turned over 54.2
times, or every 4.6 days. An average holding period of less than
We’ll say it again, since it bears repeating: investment
has been dis-incentived in favor of trading. Under the circumstances
that prevail in the U.S. market today, there is every reason to believe
that value is no longer a consideration in how a stock is priced.
At last report, there are at least 8000 hedge funds trading more than $1.5
trillion in stocks, while 4800 mutual funds manage $6 trillion. Competition
and performance amongst hedge funds is far more intensive than for mutual
funds. The financial industry fought very diligently for years to
convince investors that the long term would bury all mistakes, that the
buy-and-hold philosophy was the road to riches. However, all that
has now changed. Despite the advice of Wall Street to buy-and-hold,
any rationale for confidence in the long term has completely evaporated
as turnover has risen.
All that now matters is the
For those knocking at the door
hoping to find value, forget it.
No one’s home....
article is reprinted from the May 14th issue of Crosscurrents.
"A Record Setting Market"
Record new highs in the Russell indexes, record
new highs in the New York Exchange Composite, record new highs in the Dow
Industrials. Stunning. Truly, a record setting market.
But you cannot get from there to here in a vacuum. Other records
have been set and must be duly noted.
On April 26th, the Investment Company Institute
(ICI) released statistics for equity mutual funds and Exchange Traded Funds
(ETFs) for the month of March. More eye openers. The cash-to-assets
ratio of mutual funds dropped to an all-time record low of 3.7%.
Assets in ETFs and the total of ETFs both rose to new record highs.
In this issue, we intend to examine what these new records portend.
While the impact over the short term may be beneficial for prices, we maintain
the longer term impact is likely to be disastrous.
Many months ago, we forecast a high probability
that the relative cash levels of mutual funds would continue to fall as
portfolio managers attempted to compete with the rapid growth of ETFs.
By definition, ETFs are virtually all stock and zero cash. In an
environment of rising prices, such as the current cycle measured from the
lows of October 2002, any entity with a significant sum of low yielding
cash reserves will tend to appreciate at a slower rate than stock prices
in general. Thus, the temptation for most fund managers to spend
down cash reserves has been impossible to ignore. It is, in fact,
a matter of survival. Funds that cannot keep pace lose investors
and just as importantly for the fund managers, the fund managers lose their
jobs. Worse yet, since relative performance determines success, portfolio
managers are inclined to take more risks than in the past. Simply
matching the gains in one of the major indexes will not do. If out
performance requires a selection of riskier stocks or strategies, so be
The cash-to-assets ratio has actually been skiing
down a steep hill since the beginning of the January 1991 bull market,
roughly the same time that index funds really began to make their presence
felt. Like ETFs, index funds are all stock and zero cash. Relative
cash levels have continued to decline as active managers hold less cash
in order to compete with index funds and ETFs. However, as our featured
chart clearly illustrates, extreme levels appear as clarion calls of impending
and major market turns. The most significant reason your Editor turned
bullish in the early days of January 1991 (see Reuters interview, http://www.cross-currents.net/marketcalls.htm)
was "substantial amounts of cash." We mentioned the opposite extreme
in our February 28, 2000 issue (see page 3, http://www.cross-currents.net/cc022800.pdf,
warning: poor quality .pdf file), the same issue we predicted a Nasdaq
crash by mid-April. Months ago, we cautioned that even though relative
cash levels had achieved extremes, they were likely to fall still further
before the bull market concluded. Data for the month of April will
not be released for another two weeks and it is entirely conceivable that
the pictured extremes will be even more pronounced. We know that
the S&P 500 surged higher by 6% in April. It appears likely that
cash was spent at the same rate as in March, possibly more rapidly.
If so, the cash-to-assets ratio will have fallen to perhaps as low as 3.5%,
by far the lowest in history.
This was the level we first forecasted might end
the bull’s run. Despite the momentum of recent weeks that promises
to deliver still higher prices, the most obvious take away is that the
lower the relative level of cash, the less firepower is available.
That said, the potential for a reversal is still impeded by absolute cash
levels of close to $226 billion, the twelfth highest on record, thus our
bear leanings are tempered somewhat.
Moreover, we must add the continuing push into
ETFs as a substantial factor aiding net demand. As we see below,
growth in ETF assets and the number of ETFs has not diminished; quite the
opposite. If anything, the pace has quickened dramatically and threatens
to go parabolic. In the first three months of the year, the number
of ETFs soared from 357 to 454, an increase of 27%! The seven-year
growth rate of 45.4% is possibly the most amazing phenomenon this writer
has ever seen in four decades of observing the markets. Given the
tax advantages of owning ETFs over mutual funds, given the lower overall
management fee structure and ease of trading, it appears this impetus still
The competition is forcing funds into a corner.
In our view, one of the most important stories of the year surfaced on
February 21st in the WSJ, with Eleanor Laise explaining how "Mutual Funds
Adopt Hedge-Fund Tactics." The article's subtitle tells you all you
need to know, "To Bolster Returns, Firms Seek Approval to Pursue Short
Selling And Other Higher-Risk Strategies." Just what Americans' pension
money needs, exposure to additional risk. The article is a must read
Stock mutual funds now comprise over $6 trillion in assets, roughly one-third
of total market capitalization. Despite the fact that hedge funds
outperformed traditional mutual funds over the last five years, transactions
using borrowed money, short selling and the use of derivative instruments
are inherently riskier and cannot possibly be suitable for the majority
of investors, who do not have the experience nor sophistication required
to comprehend these sea changes, particularly since they are relying on
professional expertise. As we have seen all too often in the last
decade, professionals are capable of making errors in judgment on the grandest
of scales and in our view, errors will proliferate at a higher rate and
could conceivably lead to a cataclysmic outcome as the competition for
assets forces the adoption of riskier strategies.
More and more, we are convinced the U.S. stock
market has metamorphosed into a monstrous beast, incapable of valuing corporate
common stock fairly and unable to act prudently in the interests of investors.
Our best guess is that $40 billion in net inflows for April and May have
been coupled with a very modest spend down of available cash, resulting
in a current cash-to-assets ratio of 3.4%, a full half percentage point
lower than in January 1973, the beginning of the second worst bear market
Caution has become passé
and totally irrelevant.
Is 5% A Fair Return? History
Anyone studying our next chart of the Dow's progress
dating back to 1897 would be hard pressed to find any problem with the
notion that stocks are bound to return in the approximate neighborhood
of 5% per annum, ex-dividends. One would require blinders to miss
the fact that our line remained below the 5% level for more than 65 years,
from October 1930 to January 1996. Equally obvious, the 5% average
appears due solely to the enormous gains of the Roaring Twenties and the
current mania, only two brief periods in the 110 year history of our chart.
Thus, we posit that a fair level for today's Dow is 9093, the 5% regression
line dating from 1897 and 32.3% lower than today. The good news is
that the regression line rises over time, in this case, roughly 8.5 points
per week, so that our posited "fair" value rises over time as well.
As of today, the Dow Industrials remain far, far above the regression line
but one glance at the chart should be sufficient to convince even the most
bullish observer that another trip to the regression line should be possible,
even probable, at some point.
Here's a sobering thought; if the journey
is accomplished by the end of May 2009, the Dow will trade at 10,000, 26.9%
lower than the recent record 13,767 close.
Here's another equally sobering thought;
the record close of 13,767 does not meet our "fair" posit for the Dow according
to the 5% regression line until October 2015.
Can't happen? The historical average annual
gain, which is now actually above 5%, has been buttressed by the outsized
returns of the mania, now going on a dozen years at 11.74%. Consider
the following; from 1907 to 1995, when we believe the mania for stocks
first began to take shape, Annualized returns for the Dow were a mere 4.37%.
It can happen.
We consider a return trip to
the regression line a given.
The only question is... when?
Since our best
target for the eventual and secondary secular bear market low target for
the secular bear market is the 5% regression line, it is clear that our
target is actually rising modestly week after week. That level, as
seen above, is now Dow 9093, which approximates to SPX 1021 & Nasdaq
1743. It is conceivable that as much as another decade might elapse
before a new secular bull market is capable of taking all of the
major averages above the peaks achieved in 2000. While the Dow recently
traded at a record new high, the SPX failed to achieve a new high and Nasdaq
remains trapped at little more than half its all time high.
Our prior 2007
high targets have been exceeded but with our consideration that risk is
extreme and the present unfavorable seasonal effects, we can only posit
modest upside progress - if any - from here, before the expected correction
unfolds into the autumn.
highs for 2007 may have already been achieved (40% odds)
Dow 13,676 /// SPX
1539 /// Nasdaq Composite 2613
UPSIDE POTENTIAL LIKELY
TO BE NO MORE THAN 1%-2% HIGHER
Targets for 2007
Dow 11,600 /// SPX
1300 /// Nasdaq Composite 2200
view, the odds greatly favor that a 15% correction from the highs will
occur by the autumn of 2007.
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Alan M. Newman, June 11, 2007
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