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January 06, 2003

The Sacred Geometry Of Chance

The Hidden Law Of A Probable Outcome...Well there you have it. 2002 was indeed the third consecutive down year for the DJIA in many a moon. And just when so many of the Street's highly paid visionary cognoscenti had predicted quite an opposite outcome just twelve short months ago. The Lords and Ladies of the venerable Barron's Roundtable were simply blindsided, now weren't they? And the cacophonous consensus of the Ruykeser elves in the early part of last year once again suggest to us that perhaps the most productive interludes for investment thinking are often spent within the context of silence.

Of course it simply goes without saying that we will now be treated to the roars of Wall and Broad that a fourth consecutive down year is a near impossibility. As you will see in the following chart, there have only been four times in the prior 105 calendar year history of the DJIA that three consecutive down years have occurred. But there has only been one four year consecutive period price decline. And that decline came during 1929 through 1932. A period characterized by economic depression. An economic characterization academically dissimilar to the picture painted by current governmental economic statistics.

As you would imagine, despite the fact that we have only experienced one four year consecutive decline in the DJIA over the last 105 years, we have a number of alternative viewpoints relative to Wall Street's handy use of blindly optimistic statistical analysis. In a way, this is more for fun than anything else as no one really knows where the equity indices will travel in the year ahead, let alone having any kind of ability to pinpoint with any certainty the closing index prices twelve months hence. That's guesswork. But we do hope our comments are helpful in terms of keeping macro risk in perspective. After all, probably the key to any type of investment activity is having a sense of relative perspective regarding probabilities of successful outcome.

In the graph above, we have used DJIA data from 1896 (the first annual year rate of change being 1897) through to the 2002 close. Over this time span there are 102 consecutive four year periods. Given that only one of these four year periods experienced the infamous four consecutive down years for the DJIA, is the probability of a current fourth year negative run less than 1% (1 occurrence divided by 102 sample periods)? That is certainly one perspective. A perspective the Street will surely cling to in putting forth forward 2003 predictions. Alternatively, given that first having three consecutive down years is a mandatory precursor to the possibility of experiencing a fourth, maybe the probability of four straight years of decline is much greater than 1%. Prior to the 2000-2002 consecutive three year decline, there were only three experiences of this type of time period decline over the past century. One of those instances, 1929-32, experienced a fourth down year. From this perspective, when one encounters the instance of three straight years of DJIA decline, history suggests that there is a one in three chance of a fourth year decline to follow. So is the probability of 2003 being a down DJIA year really 33%, given the already established rare occurrence of three consecutive down years through 2002 ? As you know, we can play with the numbers in a myriad of patterns. And so can those making predictions. The fact is that three straight years of DJIA price decline is something special. Something out of the ordinary. The broader and possibly more important suggestion is that current experience resembles nothing seen in the post-war calendar year history of US financial markets to date.

Only In Understanding Where We Have Come From Can We Know Where We Are Heading...As our final comment on trying to draw conclusions from the wonderful world of equity index numbers manipulation, maybe turning this conceptual "consecutive down year" historical analysis on its proverbial head will help us gain some additional perspective on what has already come to pass and what might happen in the financial markets ahead. Every bear market is a process of correcting excesses built up in the prior bull run as opposed to being an absolute rate of return swan diving championship. How far down is often a relative reflection of how far previously up. Extreme to extreme. In an attempt to shed some light on this notion and help us understand just where we have come from, in the following graph we track the moving consecutive three year compound rate of price change in the DJIA since 1896.

Despite the tortured screams of the financial media concluding that we have never experienced anything like our current equity bear market, with the exception of stock market action during great depression, that fact is not totally accurate. At least in terms of the Dow. In fact, as measured on the basis of the sacred geometry witnessed in the DJIA moving three year rate of price change, it's far from accurate. The recent compound three year price change in the Dow is reflective of significant secular bear market activity, but it is far from unprecedented.  This type of three year price change was last seen as recently as the mid 1970's equity bear.

But what is truly special and we believe much more significant about the current period is that the preceding moving three year DJIA price change upside peak was the second largest three year rate of change price peak in financial history dating back to 1896. In fact, we suggest it is really the largest consecutive three year rate of DJIA price change in history as the three years ended 1935 were simply a cyclical snapback from the depths of the 1932 Dow bottom. Hardly characteristic of a secular bull market peak, as surely was the late 1990's. Although the Street seems ultimately concerned with and obsessive over the recent three year consecutive DJIA decline, it's our contention that they should be much more concerned with the meaning and ultimate reconciliation of the consecutive three year rate of price change peak in 1997. A peak that is the key signpost of excess created in the previous cycle.

In the following table, we numerically document the greatest three year compound consecutive DJIA price change peaks of the last century:

Of the four consecutive 3 year historic peak return periods listed in the table above, we really dismiss 1935 and 1906 has having meaningful significance. In both instances, these returns were generated within one to two years of prior bear market bottom moving three year rate of return lows. They were simply price snapbacks. Only 1997 and 1928 occurred within the context of peaking multi-decade secular equity bull market episodes. Prior to the 1928 moving rate of return top, one has to go back a decade to find the moving three year rate of return number in negative territory. Prior to 1997, this same time period gap is close to two decades. The next time you hear financial pundits pounding the table regarding three consecutive down years in the Dow being an extreme, ask them if they happen to know anything about three year Dow return extremes to the upside. This bear market is not about counting years, it's about correcting excesses. For now, we have nothing but respect for the assessment of risk and probability of future outcomes within the greater sacred geometry of chance.

Comfortably Numb...On Wall Street, as in life, safety is often perceived to be found in numbers. Not always in quantitative numbers that may represent fundamental or factual reality of the world around us, but rather in the emotional warmth that can be found in numbers of like minded folks. The comfort of being part of a crowd. The folks at Business Week recently polled some of the who's who on Wall Street regarding their thoughts on both the equity markets and the economy in the year ahead. Just a few quick highlights in the spirit of the notion that the financial markets usually do their best to prove the consensus incorrect at most all points in time (with the exception of raging equity mania interludes, of course).

Of the 67 equity market clairvoyants polled, only three expected the Dow to close below its 2002 closing price. Only three expected a lower S&P close. Only three expected a lower NASDAQ close. As an average, the group expected the Dow to be up 18.3% in 2003, the S&P up 19.2% and the NASDAQ up a respectable 27.5%. You know, the stuff of which baby boomer dreams are made. When asked to pick their favorite stock sector, only one picked basic materials and only one picked energy. Of course the bulk of the remaining pundits were snuggled safe and warm in health care, tech and financials. Of the 62 participants who chose to throw darts at the economy, only 2 expected real GDP to fall below 2% (the average was 3.2%). Only two of these folks thought corporate earnings would actually decline in 2003, although according to the Commerce Department 3Q GDP and prior period revisions report a month or so back, that is exactly what has happened over the last three quarters in a row. The average guess for 2003 operating earnings increase was 9.7%. As you know, those who veer far from the consensus social norms of society are either criminals or labeled as crazy. Those on Wall Street who veer far from the consensus have a very good chance of ultimately being labeled unemployed.

Rather than accepting the collective wisdom of the Business Week Wunderkinds, we suggest that an important exercise in the year ahead will be to monitor macro equity market capital flows. As we mentioned in our last monthly discussion, the monetary powers that be have made it crystal clear that an inflate at all costs policy will be the order of the day marching forward. Last month we suggested that corporations and domestic consumers were going to have to play along in the borrow and spend game to support a reflating of the economy. Conceptually, the same holds true for the equity markets. Ample liquidity may be available domestically, and globally for that matter, but it will be up to individual sectors of the investment community to choose to put that liquidity to work in equities specifically. Although it sure appears that the "invisible hand of the market" decides to show up on the scene at what are usually some pretty critical points these days, longer term, important segments of the investment community are going to have to make an active choice to carry the ball.

But what we suggest is critically important for the equity markets of the moment is that recent data intimates that certain sector buyers that have been major supporters of US equities during the in process equity bear to date are beginning to step away from the game. Surely both domestic equity fund flows and global capital flows will be critical monitoring points in assessing probable outcomes for the stock market of tomorrow.

In the following table, you are looking at net purchases of US equities by major sector over the last six quarters. Clearly, the two most important buyers all the way down in the equity bear have been the foreign community and buyers of domestic equity mutual funds, in large part represented by the public. (Please be aware that the household sales of equity numbers you see are largely driven by corporate insiders. Yes, they are counted in the household category.) An important third runner up are Life companies, but as you know, we are really looking at sales of variable annuity and other equity backed life products here. Retail products much as are equity funds.

What is apparent in the table above is that the equity purchasing patterns of the foreign community and the public (equity funds) have changed noticeably over the past few quarters. Foreigners are clearly slowing their purchasing of domestic common stocks on a rate of change basis. At the moment, the foreign community owns a little over 12% of the total US common stock market. Their importance as a source of demand is highlighted in the graph below as respective calendar year foreign ownership of US common stocks has increased since 1999 and 2000. Most certainly, the decline in absolute dollar foreign ownership of US common stocks in the aggregate over the last few years is related solely to price contraction as net buying by this contingent has been positive in each and every quarter since the bear has come to visit on Wall and Broad. In the recent October report of foreign net purchasing of US financial assets, equity purchases increased $2.1 billion. Excluding September of 2002, the foreign sector net equity purchase number for October is the lowest monthly reading since late 1998. Change is afoot.

On the home front, we have been documenting to you that net equity redemptions have now become the order of the day. A net redemption trend that really began in early June of 2002 continued throughout the remainder of the year with little interruption. Calendar 2002 will now mark the first year of net domestic equity fund redemptions since 1988. Funny that post the decline in 1987 it took individual investors about 3 months to become cautious on US equities. During this cycle, it has taken over 2 years. From our vantage point, a testimony to the belief in the sustainability of excess and the larger generic belief system built up around the buy and hold mentality. Given the now current circumstances of the last few quarters, maybe we should rephrase that to "former" belief.

Since June of last year, about $110 billion has been yanked out of domestic equity funds on a net basis. A streak literally without precedent in absolute dollar terms, yet still nothing alarming relative to the total market capitalization of equity funds in aggregate or the capitalization of the equity market as a whole.

But what is most important to us as we peer into 2003 is the broader picture slowing in rate of incremental change in funds flowing into equities from all sectors. Two of the major sector purchasing supports to equity prices of the prior bull, to say nothing of their important activity since the equity index highs almost three years ago, appear to be taking one major step backward. Who will fill their shoes ahead? Are the Business Week pundits taking into account the basic laws of supply and demand pretty darn obvious in the current numbers when guessing as to what the future holds for stock prices? Hmmm. At the end of the day, the weight and direction of money flows is a force to be respected.

Lord Don't Leave Me In This One Horse Town...The behavior we find interesting in the historical net equity purchase flows seen in the above table is that of apparent lagged response. Real selling didn't even begin until the S&P was already down at least 40% from its former highs. For the NASDAQ, it was closer to a 70% plunge before the equity fund net sales light bulbs popped on. Who knows, maybe the foreign community and domestic equity fund buyers will flock back to the domestic stock market in early 2003 for all we know. But for now it seems pretty obvious that a change in perception has descended upon both of these important sectors. Although we never want to count out human greed in terms of the masses chasing a potentially Fed blessed liquidity pop in equities at any point in time, the lagged response behavior that seems very apparent in recent equity fund redemptions, along with the marked slowdown in foreign purchases of US equities, prompts us to at least question the possibility of potentially further lagged response behavior for the real economy as a whole as we move forward. Given that those same retail equity fund buyers have really been supporting the real domestic economy, and tangentially the global export driven economy, could we be facing lagged response behavior in terms of consumption relative to the contraction in household net worth ahead? Certainly the drop in equity prices has thrown a roadblock into domestic equity fund purchasing activity. Will there be a lagged response in terms of the drop in household net worth ultimately throwing a roadblock into consumption? The soft anecdotes suggest it may have already started.

Recently we have heard tales that Christmas in retail land was the worst in decades. The final verdicts await soon in 4Q results. The high end of the hardware market (Restoration Hardware) and the discount end (Home Depot) have reported upcoming earnings misses in almost simultaneous two part harmony. Residential mortgage refi applications soften noticeably from the recent highs and new purchase mortgage activity continues to trace out a clear downtrend, despite mortgage rates seductively lingering in the mists of multi decade lows. Although auto financing incentives flash their neon siren call to consumers on a 24 hour time clock, actual units being driven off of showroom floors in the past three to four months are declining in rapid fire fashion on a rate of change basis. The clear implication is that financing incentives are no longer enough to sway the ultimate consumer purchasing decision. On a quarterly moving average unit sales basis, the auto industry appears as if it may have just entered its own recession. (In the following chart we have included the recent December sales figure.)

A chart we believe speaks volumes about the hurdles in front of this economy is the very simplistic picture of historical personal consumption expenditures. Both absolute dollar and year over year rate of change:

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Simple question. In a period of consumer credit ease and consumption based financing incentives most likely unparalleled over the past three decades at least, why is the year over year rate of change in personal consumption expenditures near a three decade low?

It would seem that implicit in the action of net equity fund redemptions is at least some conviction that equity prices will not rebound to any significant extent any time soon. By extension, are consumers also beginning to make the connection that growth in household net worth will remain subdued over the foreseeable future? And are they beginning to take notice of the fact that since the equity index peaks of early 2000 household liabilities have grown approximately 13.8% while household net worth has contracted by (8.7%) (despite the positive impact of real estate price appreciation)? The lagged response in equity selling at the very least suggests a lagged response played out in potential forward deceleration in the rate of change of consumption is a real possibility. If nothing else, it would represent consistency in thought and behavior on the part of households relative to wealth and respective consumption.

Over the last few years at least, the global economy has been somewhat of a one horse town. The star thoroughbred, of course, being the US consumer. Just who emerges to take their place if they decide to consciously put themselves out to pasture for a time? From the most recent Fed Flow Of Funds data, we'll leave you with a last few perspectives characterizing the workhorse upon which the global economy has made an all or nothing daily double bet. Relative to total wealth and personal income, US households have galloped at full speed throughout the global economy slowdown.

Market Observations
ContraryInvestor.com

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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