The Bulls vs. the Bears

By: Henry To | Thu, Jul 13, 2006
Print Email

Just a Note: I just want to ask each one of you to refrain from making religious references during the course of our discussions on the market in our discussion forum. While this author definitely does not have any problems with it, this may not be true for all our readers. Thank you in advance for your cooperation!

Dear Subscribers,

This will be my second-to-last commentary before I bring in the guest commentaries during the time I will be relocating to the Los Angeles area. After my mid-week commentary this week, I will most probably not write a full commentary again until July 30th. Again, I will attempt to send you some "ad hoc" emails in between - with probably an abbreviated mid-week commentary on the morning of July 20th. Don't worry - I will continue to monitor the markets while I am on my road trip as well as respond to emails while I am not moving or driving. More details to come in our next commentary.

We entered a 50% long position in our DJIA Timing System on Thursday morning, June 8th at a DJIA print of 10,810. We then became more aggressive and shifted to a fully 100% long position on the morning of June 12th. In a real-time email that we sent to our subscribers, I noted to our subscribers: "We have just shifted from a 50% long position to a 100% long position in our DJIA Timing System at DJIA 10,800. The NYSE intraday ARMS index just touched a hugely oversold reading of 2.46 while the VIX spiked up another 15%." Based on Friday's close of 11,090.67, our 100% long position in our DJIA Timing System is on average 285.67 points in the green. Again, readers who are interested in our historical signals can see more (and learn about our rationale behind those signals) at our MarketThoughts DJIA Timing System page.

As of Sunday evening, July 9, 2006, this author still has no intention of shifting our 100% long position in our DJIA Timing System - even though the upside breadth and volume has been quite weak since the June 13th bottom. Any selling decision should most probably not be made until after the end of earnings season, as I asserted in our latest mid-week commentary and as I will assert again in the early part of this commentary. We are leaving our stop loss point at DJIA 10,805, as this author is willing to give the market more leeway in light of the historical volatility during earnings season.

First off, a conversation on the long bond. For readers who were looking to buy the long bond, please review our June 25, 2006 commentary ("Long Bonds Starting to be a Buy") on the topic. Moreover, Bill Gross of PIMCO has just officially declared that the most recent bear market in bonds is now over - after its worse half-year performance since 1999. At this time, however, our sentiment indicators on the long bond haven't turned very bearish yet, but now is probably the time to start nibbling on bonds for those who had wished to go long.

In our latest mid-week commentary, I asserted that given the dearth of information in both the marketplace and in stock prices in our heavily regulated environment (thanks to Sarbanes-Oxley and "Fair D"), the upcoming earnings season will be very important for determining the future direction of the stock market. Moreover, this upcoming earnings season is doubly important given the following:

1. The uncertainty surrounding the economy - whether the Fed is done with hiking interest rates and how much the economy is going to slow down. Some well-known investment figures - such as George Soros - have already publicly stated that a recession is already in the cards in 2007. As for the slowing housing market and the potential impacts, even Robert Shiller (who had been preaching about a housing bubble for the last few years) isn't willing to make any predictions at this point. We do know, however, that famed investment manager Bill Miller of Legg Mason has been buying homebuilding stocks hand over fist during the last couple of quarters. The upcoming wave of earnings reports will serve to clear up some of this uncertainty.

2. Based on corporate profits as a percentage of GDP (which is now at its highest level since the fourth quarter of 1966), and based on the huge run of corporate profits over the last three to four years, there is a good chance that profit growth of U.S. companies will slow down significantly in the coming quarters. The $64 million question is: Has the market already anticipated some of that slowdown? Note that during the last corporate profit cycle, both corporate profits and corporate profits as a percentage of GDP had already peaked in 3Q 1997, and yet the market continued its ascent until 1Q 2000. Again, the next wave of earnings reports over the next several weeks (along with guidance) will give us a very good idea of future earnings growth going forward. Following is a quarterly chart showing corporate profits vs. corporate profits as a percentage of GDP from 1Q 1980 to 1Q 2006:

Corporate Profits & Corporate Profits as a Percentage of GDP (1Q 1980 to 1Q 2006) - Both corporate profits and corporate profits as a % of GDP rose to a new secular high in the first quarter of 2006 (with corporate profits rising to an all-time high). Please note that corporate profits as a % of GDP (at 10.9%) is now at its highest level since the fourth quarter of 1966. Given the slowing economy, and given the rate of ascent in corporate profits in the last three to four years, it seems like the easy money has already been made here. Remember: In the long-run, corporate profits of domestic companies can only grow at the same rate as U.S and world GDP - with periodic over and understatements in between.

3. Japanese corporations have signaled their intent to again significantly boost capital spending for the rest of this year and into the first quarter of 2007. As a matter of fact, large companies as a whole have indicated they will boost capital spending by 11.6% in the fiscal year to March 2007 - representing the strongest rise in capital spending since the bubble era days of 1990. This is bullish for U.S. large caps such as MSFT and INTC - the latter of which derives 12% of its total revenue from Japan. Moreover, this author still stands by my views that capital spending will get a significant boost once MS Windows Vista is released in the first quarter of 2007. Whether this is true (and whether this has already been going on), however, will be made much clearer once we receive the latest earnings results from both MSFT (July 20th) and INTC (July 19th).

The Bulls vs. The Bears

Getting away from earnings season, this author would now like to tell you what I am trying to come to terms with as regards to the current stock market. As our commentaries have implied over the last several weeks, there are now two distinct bullish and bearish forces squaring off in the stock market - each with their own valid arguments. I will now reiterate what they are - and hopefully use these arguments to come up with a clearer picture of where the market may be heading going forward. Following are what we believe are the various "conflicts" which the bulls and bears are fighting against one another:

Bulls vs. Bears Conflict # 1

As I stated in our most recent mid-week commentary, Lowry's has already declared we are in a bear market - citing the lack of demand from investors and the lack of broad-based strength in many industries and individual stocks. However, please keep in mind that Lowry's does not analyze its "buying power" or "selling pressure" indices separated/based on each class of individual investors, such as corporate insiders, hedge funds, or retail investors. Looking at mutual fund inflows over the last 12 months, it is obvious that the retail investor has continued to shun domestic equities - and thus we know that retail investors have been directly responsible for the weakness in many of Lowry's technical indicators. On the other hand, TrimTabs claims that corporate managements have been buying back their own shares at a record pace. Combined with the record amount of cash acquisitions in recent months and the lack of IPOs, and you have a wildly bullish leading indicator - as corporate insiders have historically been much "smarter" than retail investors in predicting future stock price trends. The question now is: Will retail investors continue to exit the market and if so, will it crash the major market indices?

Should retail and foreign investors continue to shun U.S. domestic equities; will insiders and private equity funds have enough firepower to keep stock prices afloat? Given the amount of cash held by corporations, and given still relatively low financing rates (by historical standards), as well as the fact that M&A activity still hasn't reached the late 1990s peak, there is a good chance that both cash acquisitions by both U.S. corporations and private equity investors, as well as share buybacks by corporate management will continue to prove robust going forward. Following is a chart showing that M&A activity is set to continue (courtesy of the Bank Credit Analyst from three months ago). Please note that this story still remains valid three months after the fact:

Merger & Aquisition Activity as percentage of GDP

Unless crude oil rises to $90 a barrel or unless there is bird flu pandemic, there is a good chance that the liquidity coming from both corporate insiders and private equity investors will continue to provide a reliable floor for the stock market - despite a continuing exodus by retail and foreign investors (who are both historically great contrarian indicators). Again, we will continue to monitor this situation going into and through the 2Q earning season. Should corporate management fail to announce any significant share buyback schemes during the latest earnings season, however, then look out below.

Bulls vs. Bears Conflict # 2

With the exception of the 1994 to 1995 rate hike campaigns, the U.S. economy has always had to endure a recession soon after the end of its latest rate hike campaign - and which has typically been accompanied by a severe underperformance of the U.S. equity market. Most notably, the 1960s and the early 1970s U.S. stock market has almost always gone up while the Fed is on its rate hike campaign, and does not usually correct or crash until after the Fed is for the most part done. Could we see another repeat this time around?

Bear Sterns certainly thinks so. The position of Bear Sterns is that the 1960s and the early 1970s U.S. stock market is and remains the best comparison to today's stock market - given that today's stock market environment is no longer supported by a continuing disinflationary environment (which is essentially the 1980 to 2000 environment when the yield of the long bond embarked on its historical secular decline). But unlike the late 1960s and early 1970s, however, the U.S. economy today isn't mired by unprecedented inflationary pressures or expectations either (the ECRI Future Inflation Gauge readings have been benign for four months in a row). Case in point: While the stock market did crash during the December 1968 to May 1970 and the January 1973 to December 1974 cyclical bear markets only after the Fed was done, it really did not decline substantially until the country realized inflation had gotten out of control. By that time, the effective Fed Funds rate had already hit 8.67% and 6.58%, respectively. If the Fed is able to stop hiking at a Fed Funds rate of 5.25% and 5.50%, then the market does not need to necessarily decline. Please see the following two charts showing the average monthly Fed Funds rate and the DJIA during those two fateful periods:

More follows for subscribers...



Henry To

Author: Henry To

Henry K. To, CFA

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

Copyright © 2005-2009

All Images, XHTML Renderings, and Source Code Copyright ©