Tuesday, July 13, 2004

Sucker's Rally? Buttonwood Screams Fire!

In a classic market zig-zag the rule is that there is generally after a steep drop a short rally, the so-called "sucker's rally", that sucks the last of the oxygen out of the market before a truly precipitious drop. In reality there is often more than just one "sucker's rally" as a stock rallies occasionally even when it declines to the penny stock level. Really.

The oldman was thinking of a nice way to put this when he noted that the DJIA was edging back toward 10k after having touched it a few weeks ago. No need. Buttonwood in The Economist slaps the panic button for me.

Sell now while stocks last

Jul 13th 2004
From The Economist Global Agenda

Stockmarkets look set to follow corporate profits down. Technology stocks are already showing the way

BUTTONWOOD leaves fiddling with technology to his two young daughters and investing in it to those who make them look mature. He is, in other words, utterly mystified why anybody should want to pay extreme sums for shares in companies that might be around in a few years but probably won’t. So when he reads in his morning paper that these have taken a tumble, there is a spring in the step, a lightness of heart, even though he is a little ashamed of this touch of Schadenfreude.

Earnings season is under way in the United States, and the proximate cause of the latest tech tumble was a series of dour pronouncements from the industry’s great and good. Veritas, a software company, was the worst-performing of the world’s big stocks last week, but many in the sector that used to be known as TMT (technology, media and telecoms) have announced results that have disappointed investors. Even some of those who have yet to post their results have been treated harshly: Intel and a clutch of others fell after Merrill Lynch downgraded the entire semiconductor sector. Nasdaq, home to many a tech favourite (and soon to be home to Google, much to the chagrin of the New York Stock Exchange) has fallen by 5% in recent days.

This may be because the shares in the index were priced at levels that would have made Icarus wince. Even after this latest tumble, the price-to-earnings (p/e) ratio on Nasdaq is around 60, a level that could be justified only if you thought that profits would continue to climb at a vertiginous rate. The question, of course, given that the broader stockmarket is scarcely a giveaway—the S&P 500 trades at a p/e ratio of about 21, far above its historic average—is whether the treatment meted out to tech stocks foreshadows something nasty for the stockmarket as a whole.

How's that for blunt? Sell now while stocks are high! Of course the oldman, generally being ahead of the curve three to six months reliably already told people he knew to sell in late January already. In fact the oldman called up a friend (a former fellow investor in a brief lived venture) whom he hadn't spoken to in over a year just to suggest to him selling. As for the oldman's aged mother who responded that she didn't know the password to her financial portfolio online account, the password having vanished into the ether when the oldman's father passed away last year, the oldman merely comforted his aged mother and began contemplating changing his career. Being an idealistic teacher of science is a great thing until you need to contemplate helping support your old mum in her dotage. Of such little things are life choices made.

Needless to say, the oldman thinks that Buttonwood is right on if a bit early (though less early than the oldman compulsively is ahead of the curve). The markets aren't likely to be prepared to take a dive for a few more months. Nonetheless trading sidewise until then isn't likely to bring any profit except to day-traders. So get out while you can. The only comforting thing is that with interest rates going back up money market funds (assuming they have no derivatives in their portfolio - check don't assume or it'll make an ass out of you) will begin returning a decent rate of return on investments, especially if they diversify among multiple currencies to hedge against a drop in the dollar. It's probably the safest place outside of an FDIC insured account you can have your money in for a typical investor (who has no inclination or ability to stockpile gold bullion in a truly paranoid but profitable scheme). If FDIC evaporates we are all going to have bigger problems to worry about than retirement. Like maybe elections. Or the lack of them which will indicate either tyranny or civil war, perhaps a dosage of both.

Finally the oldman would note that Buttonwood also turns to the Inventory stocking dynamics as evidence of his sentiments.
For elucidation on this last, intriguing thought, David Bowers, a strategist at Merrill Lynch, suggests turning to something that Buttonwood spends less time looking at than perhaps he should: America’s inventory-to-shipment (I-S) ratio. This, says Mr Bowers, is at an all-time low, largely due to a very rapid growth in sales. But it is set to rise. When it has done so in the past, he writes, “bonds have been a ‘buy’, earnings growth has been scarcer, industrial pricing power weaker, and high-yield credit spreads wider. Ignore this indicator at your peril.”

Suitably admonished, Buttonwood read on. Shipments, it turns out, have been rising exponentially. And when things are flying out of the factory door at such speeds, factories stock up. Inventories, says Mr Bowers, could end the year 6-8% higher than they started it. Which would be fine if shipments followed suit. They are unlikely to do so because exponential growth is simply not sustainable. When final demand starts to weaken, the I-S ratio will rise, dramatically weakening corporate pricing power and (one assumes) profits.

Which is where we get back to technology. Inventories have already started to rise sharply at Intel (by 29% year-on-year in the first quarter), Texas Instruments (30%) and Cisco (47%). Possibly, this is a foretaste of a broader problem, for America relies on demand from consumers who have, to be frank, consumed to the max and done so with borrowed money. In the 13 quarters from 2000, household debt surged by $2.5 trillion, writes Kurt Richebächer, an extreme bear (perhaps, then, a polar bear?). Of late, for the first time in history, consumption growth has exceeded growth in GDP. Against such a backdrop of tiny household savings and huge debts, the Federal Reserve has started raising interest rates. Small wonder, perhaps, that although consumers say they are confident, they are starting to rein in their spending. Car companies and retailers are already suffering as a result. At some point, so will the stockmarket.

I'm not sure where people optimistic about the economy are getting their numbers. Every classical indicator is going off in warning. The pool of positive indicators is getting smaller and smaller. Of course in every long cycle, institutional memory of market crashes and the cognitive errors that precede them are lost. That's why market crashes can happen in the first place. People forget that hubris is not just an element of greek tragedy, but long-term economic cycles.


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