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May 31, 2003

Eastern Meditation

The Really, Really Smart Guys?...There is an old saying in certain market circles that goes like this. "The public lost their money in 1929 and 1930. The smart guys lost their money in 1931 and the really, really smart guys lost their money in 1932." Of course the basic message of this little quip is that bear markets do their best to strip virtually everyone of their hard earned wealth. It's just the nature of the game. As folks like Richard Russell have pointed out a million times, in bear markets of generational importance, the winners are those who lose the least amount of their capital. Sure, that sounds a bit doom and gloomy, but it is well worth keeping in mind.

You might remember that in our May discussion, we suggested that both monetary and fiscal support for the financial markets and the economy were about to be taken to championship levels. In the merry month of May we witnessed the passing of a significant tax package. The third in three years. (We simply can't remember the last time something like this happened.) We experienced significant flattening in the Treasury yield curve and a corresponding spike to near new all time highs in mortgage refi activity as actual mortgage rates hit a multi-decade low. Year over year growth in the money supply accelerated nicely in May. We've seen a good amount of recent Fed open market operation activity, although that's really nothing new for these folks. And we've apparently seen the Administration decide that a lower dollar as a potential domestic economic stimulant may not be the worst thing in the world. And to top off all the excitement, a fair majority of equity market participants have raced headlong into the process of convincing themselves that a new bull market has been born. After all, the technical charts are a guarantee of brighter days ahead, in spite of the fact that April witnessed the smallest amount of insider purchases in eight years and May recorded some of the greatest insider selling in a few years at least.

Bear markets are never easy. Then again, neither are bulls. But maybe it becomes especially difficult when the back to back bull and bear markets are of historical magnitude. Almost ironically, the bears became exhausted trying to call the top of the prior equity mania. In like manner, we would expect the bulls to also become exhausted trying to pick the bottom of the equity bear at some point. But so far, the bottom picking challenge is alive and well. Whether what we are living through at the moment is yet another sharp bear market rally, albeit a rally not to be taken lightly, or something of greater magnitude and longevity certainly remains to be seen. A truly new and sustainable bull market from here would be an event of historic proportion as it would have been launched from the highest macro valuation levels ever witnessed in recent history.

As we mentioned, the Fed and the Administration pulling on all the levers of stimulus simultaneously can go a long way toward helping the stock price levitation cause short term. Much like late 1999 and early 2000, excessive stimulus and liquidity literally had no other place to go except the financial markets. Based on the reality of virtually non-existent corporate capital spending of the moment, it's a good bet we are experiencing a bit of a similar situation today. But what has surprised us a good deal lately is that a relatively large number of folks have become absolutely convinced that the technical charts are almost an infallible guarantee of a major cyclical shift in the macro equity markets as of late. Don't get us wrong, we are absolutely convinced of the necessity to marry fundamental and technical analysis in approaching any investment activity, but the almost dogged religious fervor surrounding belief in recent price breakouts above 200 day moving averages, golden crosses of the 50 day moving averages up through 200 day moving average lines, upward crosses on the monthly MACD charts, etc. theoretically confirming an all new bull market gives us a bit of pause. Enough pause to at least suggest being open to exploring historical experiences of similar technical nature in post bubble environments.

Eastern Meditation...Certainly momentous rallies are all part of the game in equity bear markets of significance. In discussions past, we have chronicled the rallies that took place in major equity bear episodes such as the 1930-32 Dow and the in process Nikkei reconciliation of the last 13 years. These corrective rallies were big double digit return affairs, at least for a while anyway. As we contemplate the current technical charts before us, we thought it might be helpful to look back at the Nikkei roughly three years past its own price peak as being the most recent global example of a major market equity bubble burst. Before comparing family photos, remember that we're not trying to equate what happened fundamentally in Japan over the last decade to what is unfolding before our eyes stateside. The two economies are very different, each with their own sets of significant and unique problems as well as government sponsored post bubble environment economic stimulation remedies. The mechanisms for self correction in Japan and the US are worlds apart.

The payroll data alone tell us that the US economy is rather ruthless in seeking self correction. In like manner, unlike Japan at the time, the US domestic economy is also extremely dependent on a leverage bloated US household sector. And so far the anecdote for healing offered by the domestic powers that be is for this sector to take on yet more leverage in support of consumption. The bubble top credit cycle in Japan was largely centered in the corporate sector. In the US, it has been both the corporate and household sectors that drank the leverage accumulation kool-aid in the most recent credit cycle. Although many believe the Japanese monetary authorities were too slow in acting to shore up their economy in the fallout period post the equity bubble top, the following chart clearly suggests they weren't exactly light years behind the current quick on the draw Fed. Fallout from a popping equity bubble elicited a distinctly similar response in terms of monetary accommodation.

But we believe it's important to note that in looking at the technical charts clearly reflective of human decision making, there are striking similarities between what happened in Japan three years into their own financial and economic bubble reconciliation period and what is currently happening in the US markets.  Remember what follows are merely graphical representations of human greed, fear, hope, anticipation and anxiety played out in shorter term equity price movements. Specific factual macro economic and financial circumstances may differ, but it's the same human animal making the decisions. In the notable words of Jesse Livermore, "Nowhere does history indulge in repetition so often or so uniformly as in Wall Street".

One of the huge rallying cries as of late has been the fact that the major equity indices have broken their 200 day moving averages to the upside. Both technicians and fundamentalists alike have come to embrace this indicator as proof positive that a new bull market has begun. What we believe is quite interesting to note is that in March of 1993, three years past its own peak, the Nikkei did exactly the same thing. The repetition in timing post the Nikkei peak is almost in exact parallel with our current experience.

In our minds, the similarities in the two indices shown in the chart above are almost uncanny. After flirting with it's own 200 day moving average literally since the peak in December of 1989, the Nikkei finally crossed into the above the 200 day moving average promised land at about exactly the same time distance we have now put in on the S&P since the peak, give or take a few months or so. When the Nikkei first moved meaningfully above its 200 day MA post the price peak in the index, it was accompanied by a technical golden cross - the 50 day moving average breaking the 200 day moving average to the upside. The S&P accomplished this same corroborative bullish move in May.

Although we just don't have market related sound bite anecdotes from the early 1990's at our fingertips, we have to believe that the April 1993 Nikkei was getting the attention of technicians as well as fundamental investors in much the same manner we now see in our own markets. What makes the action possibly more convincing or intense in our own markets is that we also have the Dow and the NASDAQ as confirmatory barometers. Remember, it is well worth keeping in mind that at least in part, many of the same stocks move the major US indices in tandem. So, for now anyway, the S&P, Dow and NASDAQ have all crossed above their 200 day moving averages and have likewise seen the 50 day MA upward move through the 200 MA day golden cross also be completed.

Stepping back a bit further, it's not just the short term charts that have the technicians as well as convert fundamental players counting on the pictures to come through for them at the current time. A number of longer term monthly charts are also flashing buy signals that just don't come along every day. These longer term indicators are not to be shrugged off. Especially as they are occurring in concurrent fashion with the strong shorter term technicals. Specifically, the monthly MACD charts are suggesting a larger window trend change to the upside for the major equity indices. After absolutely correctly suggesting the Dow, S&P and NASDAQ be sold in early 2000 (mid to late 2000 for the NASDAQ), the monthly MACD readings for the S&P and the NASDAQ are now on buys, with the monthly DOW MACD reading inches away from kissing the crossover buy line as we speak. We won't put these charts up as you can find them most anywhere, but what we will show you is what happened to the Nikkei back in early 2003.

Much as we are experiencing the simultaneity of monthly MACD buy signals and shorter term 200 day moving average suggestions of doing the same in the major equity averages, so did the Nikkei have this exact same experience in early 1993. As you know, these pictures of human action are dramatic examples of a concept we have beaten into the ground over the last "x" years - non-linearity. Nothing ever goes straight up or straight down on Wall Street. As you can see in the chart above, what these very strong technical signals were really saying in early 1993 Japan was that the Nikkei was about to enter an approximate eight year very well defined trading range (ultimately to be broken to the downside), as opposed to a new bull market in the manner most folks would expect. What the Nikkei was saying in early 1993 was that the equity market was finished relentlessly pounding wounded and bloodied equity investors. But much like a cat, it was now time for the market to play with the wounded mice, letting them possibly believe they still had a chance for survival.  It was not necessarily ready to kill them quite yet, but rather just beginning the process of completely wearing them down.

From the Neck Down...As you might imagine, the historical similarities don't end with what you see above. A few more charts if you will indulge us. Much like the obvious Himalayan-like head and shoulders chart formation in the current S&P 500, the Nikkei's own head and shoulders "neckline" largely contained that broad equity index for at least a decade (and still counting).

As is obvious above, the spectacular Nikkei head and shoulders formation neckline has really contained the index for a good decade now. And certainly there were temporary upside breaks of this neckline. Probably just enough to reinvigorate bullish animal spirits for a time. As you know, we closed the month of May at a critical juncture for the S&P. We're now in the vicinity of both the S&P 500 major head and shoulders neckline as well as pushing the to date bear market declining tops trend line in the index. For what it's worth, the Nikkei broke the declining tops trend line just before blasting through its own 200 day moving average in early 1993. But as you can see above, the most recent near neckline test in early 2000 resulted in the Nikkei subsequently dropping close to 60+% at the recent lows. And that's after an already in place 10 year bear market. For our current rally to really be something more than just a rally in a very big bear market, the S&P is going to need to convincingly close above the head and shoulders neck line on a sustained basis. But as the Nikkei demonstrated so well for years, breaking it to the upside for a time simply wasn't hard to do.

From the department of more just for fun than anything else, here's a little comparison of the Nikkei and the S&P 500 with their peak monthly close prices equated. Again, just pictures of human judgment, greed, fear, anxiety, etc. Interestingly, we only equated the peak price, but it just so happens that what is a little over two years prior to these peaks also matches up to a tee. That of course being the starting price we chose for the graph below.

Lastly, there is a final coincidental experience worthy of mention. We've said it before, rallies in a bear market can be dramatic, especially when viewed in hindsight. Although the current rally story may not yet have fully been told, the following bear market experience of the Nikkei in the early 1990's may yet act as a guideline. As you'll see in the following chart, from a sharp August 1992 intra-day 14,194.4 low on the Nikkei through to early May (21,224.8), this index produced a 49.5% rally. Convincing? Clearly enough to get the blood of both bull and bear alike boiling. What we find quite interesting at the moment is that the QQQ's have experienced virtually the same rally since the intra-day July fear stricken lows of last year. There have been a lot of technicians who have very correctly pointed out that most every major bear market in US history contained at least one 50% rally. As stated, in terms of the QQQ's, it has just happened again. The bigger question surely being, does it also have to happen to the Dow and S&P?

Again, maybe all of the technical similarities we have pointed out between the Nikkei of 1993 and the S&P of 2003 are simply sheer coincidence. Or maybe it's repetition of action in human decision making during post bubble environments. One last anecdote. Post the May '93 high, the Nikkei had a whole lot of trouble exceeding that level for three years, and only then did it briefly marginally exceed that price area a few times over the next decade.

For those who believe we are witnessing a very special or unique set of technical circumstances coming together to suggest that the US equity bear market of the last three years is definitively over, we hope the above offers a little food for thought. A few meditation points. It just may be that for the bulls and the bears alike, the toughest part of this ongoing equity bear market lies dead ahead. By that we don't necessarily mean price destruction. That's already happened. But rather we mean a significant increase in confusion and frustration. For many a technician, being on the right side of the market during the bearish interlude of the last three years has almost been a piece of cake. In like manner, the bull mania of the late 1990's was almost a walk in the park technically. Talk about the trend being your friend, it just doesn't get any better than the mid-to-late 1990's blow off. Simplistically, the 200 day moving average and the monthly MACD measures alone have kept technicians on the right side of the market throughout the bull and the bear of the last five to ten years. Is it now time for technicians to begin the whipsaw experience as has been the lot of many a fundamental adherent over the last few years? Is it time for some of today's really, really smart guys to have a tough go of it? Those both fundamentally and technically oriented?

We believe the above hammers home the case for adopting a trading range mentality in a period of post bubble reconciliation. In what may lie ahead, trailing stops may just be a bull's best friend. In like manner, the bears need to remember that they cannot will the market to go where they believe it should over shorter periods of time. Picking spots to be short will now become much more of an art as opposed to a short and hold decision. Election year 2004 lies dead ahead and Bush's strongest political opponent of the moment is the economy. All the stops are and will continue to be pulled out to ensure at least the perception of a better economic environment. In terms of Fed action, we've approached the end game of the cycle. The headline "crusade against deflation" will probably make most any Fed action justifiable in the eyes of the majority. Nothing will surprise us in terms of overt or covert Fed action. As we stated last month, we expect extremes in accommodation to be reached and maintained. For hardened bulls and hardened bears, the worst and the best may be concluding before our eyes. Over shorter term time periods, we need to teach ourselves to become more agnostic in terms of bull or bear leanings than possibly ever before.

The Ultimate Beta Test Site...It is clear to us that up to this point, the equity rallies post the July '02, October '02 and early March lows have been driven in large part by hedge and shorter term performance oriented money. As we have related to you in the past, the public began backing off equity mutual fund purchases almost one year ago. Except for very short term bursts of contributions, such as was seen in April during the weeks leading up to the tax filing and pretax plan contribution deadline, they have not been a factor in providing buying power to the macro equity markets. In like manner, again as we have documented to you in the past, cash in the equity mutual fund complex has really ranged between the low and high 4% level over the last year. For all intents and purposes, equity funds have remained fully invested. For them its been more a game of sector rotation. And rotate they have. The tell tale sign of hedge and short term performance money significantly moving the markets at the margin can be found in the action of high beta stocks relative to the broader equity averages as a whole.

Moreover, many a large equity fund has become much more defensive in orientation as a natural reaction to the slaughter in technology. In the subscriber portion of the site, we recently detailed asset allocation in what Morningstar categorizes as "blend" equity funds. These are some of the largest equity fund behemoths walking the planet at the moment. In studying only those funds with asset in excess of $2 billion, the following table details the average sector weightings of the this group at their last reporting dates relative to the respective S&P sector weights as of 4/30. This is what we found.

To cut to the chase, many a large equity fund is currently underweight tech. A completely logical stance given both the performance disaster of this group over the last few years coupled with the fact that fundamentals remain questionable at best. The recent news out of TechData and Ingram Micro should have sent shivers up the spines of tech investors everywhere. These two aren't just important members of the channel, they ARE the channel in terms of tech sales. A run in tech would be an underweight tech equity fund manager's worst nightmare right about now. And that's exactly what's happening. In reviewing big-boy blend fund Magellan, this little excerpt from Morningstar basically says it all:

"In years past, manager Robert Stansky has adeptly bought tech when it got oversold and trimmed when it rallied. However, he's not biting at this point. At year-end 2002, the portfolio was little changed from June 2002. The fund continues to hold less tech than the S&P 500 because Stansky doesn't see a rebound around the corner. Tech valuations remain high, in his view, and revenues aren't about to spike higher. Instead he prefers steadier firms that still produce respectable profits despite the sluggish economy."

Get the picture? The broader techs (biotech, hardware, internet, software, etc.) are currently running because they are high beta stocks being moved by heat seeking performance oriented money. Fast money has been taught that in bear market rallies you jump on high beta stocks and ask questions later, if at all. This lesson has been reinforced in each significant rally to date in this bear.

Coincidentally, it has taken major institutional equity representation a good three years to become underweight tech. So the current environment becomes basically a perfect world to relive a few old memories. Memories of the late 1990's when everyone and their brother simply could not own enough tech. Those in the equity fund business that did were simply fired. That lesson is fresh in portfolio manager minds. Although we have absolutely no idea what will happen, as we look to the month ahead we have to believe the institutional performance pressures are nothing short of acute.

Also, back a month or so, Barton Biggs at Morgan Stanley penned a relatively optimistic piece on the equity market based largely on the fact that a lot of pension funds he was speaking with were underweight their benchmark allocation to equities. These pension executives were naturally scared and preferred to "wait until conditions turned more favorable". After all, the pension underfunding spotlight is burning brightly by this point. Like equity mutual fund managers, the pension executive crowd are not paid to think independently. They are paid to perform relative to their peers and appropriate asset class benchmarks, or they're fired. Any questions? Certainly this equity rally has struck a good amount of fear in the hearts of many an institutional equity participant. Participants little concerned with news from TechData, Ingram Micro, or any other corporation for that matter. Participants very concerned about lagging benchmark investment performance and perceptual peer performance. One last humble observation. Isn't this exactly how the large pension funds in this country got into under funding trouble in the first place? By blindly following the herd? You bet it is.

Big institutional money scared into buying for performance reasons will need liquidity. Unlike the hedge crowd, they can't chase Expedia at 13x's sales or 60x's this year's estimated earnings. Even a Yahoo at 86x's or a Juniper at 176x's isn't going to do the trick. IF the averages move higher into early June, there just may be one significant fireworks show left before the quarter end due to outright institutional terror. Blind fear at potentially being left out of the crowd. It would probably happen in the large cap names. And, of course, this would also be occurring at what is perceived as a critical technical juncture. At least for the S&P, anyway. Interesting, no?

Amidst all of the noise, confusion and anxiety that will surely be created if the S&P breaks the proverbial neckline to the upside, we'll leave you with one last thought on which to meditate. Just how do you think domestic Japanese institutions and other institutional investors with investment interest in Japan felt when the Nikkei rose 23.9% between March 1 and April 30 of 1993, as the equity average convincingly broke through its 200 day moving average for the first time since the bubble top? Paniced? Demoralized for possibly missing the vertical two month price run? Scared for their jobs unless they aligned themselves with the new trend immediately? It's just a shame that all that anguish was wasted on an equity index average that never experienced a level beyond a percent or two above that April close for almost three years. It's simply too bad Japan didn't have Greenspan at the time. He could have taught them a trick or two, right?

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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