Stopped Clocks?

By: Ed Bugos | Tue, Jun 18, 2002
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Quick, check your watch!

Yes, careful, it could be that time on Wall Street when the proverbial watch that doesn't work actually gives the correct time… bring out the bananas, it's gonna be a party... a short one, but maybe it'll be fun.

We're here for a good time... not a long time (Trooper).

Joe Kernen, one of CNBC's more rebellious henchmen, admitted today he didn't know there was a "deep throat" (alias for the informer that helped the press blow Watergate open and whose identity only one person knows, to this day I think), and in the same breath wondered why we're still talking about scandals 30 years old. I wonder why. The world must be a better place otherwise the free press, which is freer today than ever, would tell us it wasn't.

An upbeat earnings forecast from McDonald's sent the bulls racing during a lull in the bad news on Monday, or so it was reported. McDonald's said the weaker dollar is helping its foreign currency earnings. That was important for the bulls because they have been looking for a reason to get bullish on a weak dollar.

The bulls worked themselves into a lather over the spin they could potentially attach to all of the various stocks or sectors ahead of the second quarter. They agreed the market was oversold, after falling for four straight weeks, and also that there was a ton of money in money market funds on the sidelines (they have been in agreement on those issues for some time - sort of like a stopped clock actually) waiting to invest in shares. So they went on to bid almost everything up except for gold and tobacco shares, which suffered on the excitement that even spread to the bank shares.

US averages finished at their highs for the day. The Dow was up 213 points, or 2.25%, while the S&P 500 closed up 2.9% in a surprise bull raid. Advancers outpaced decliners almost 4:1. Volume on the big board was 1.4 billion, which was lighter than Friday's volume.

Citigroup, JP Morgan, and American Express were the Dow's best performers Monday after a crack of key bullish support in the Dow on Friday. In the rest of the market, it was the software, biotech, insurance, and semiconductor (Intel) sectors that led the way higher. What we're seeing here, I think, are the bulls punching back after being pinned on the ropes for four straight rounds.

Fly butterfly, fly.

A recovery in bank shares is bearish for gold markets. On Friday we felt that the Dow's recovery fell short of the kind that would lead to more gains this week, barring a swift one or two day respite (correction in sentiment). Perhaps that is all Monday's rally was.

If it is more than that, we'll need to see it extend through 9800 for the Dow; for the Nasdaq composite that resistance is at 1600, and 1048 for the S&P 500. These are short-term resistance points that ought to help us determine the significance of this rally, and guide our perspective. Technically we have to take it day by day. So far, there's nothing to suggest it can't be just a good round for the bulls before the knock out punch finally ends the match tomorrow or the next day.

For fundamentally, this argument is about valuation, specifically whether stocks are cheap relative to how they will be valued in the future.

For two years the bulls have not been able to buck the interest rate hurdle, but now, at 40 times earnings for the S&P 500 they're going to attempt a rally on stronger commodity values, higher rates, as well as a weak dollar. Good luck.

It's a sucker's play, because the bulls want to bid up stock values ahead of a quarter that could turn out to be disastrous if McDonald's is the only one to report good news (that's a joke sort of). By disastrous I don't mean that earnings will be lower than expected. I don't know. I would bet they will be, but current equity valuations still reflect high expectations for earnings. Whatever those expectations are, I doubt they've fully accounted for the impact on profits as well as on the valuation process from the confluence of macro events, whose upside has perhaps already been discounted today.

To get stock values to sustain these levels or to expand, the bulls need to come up with an argument that can overcome both the prospects for a weak dollar as well as the prospects for rising interest rates.

In other words, a weak dollar, higher interest rates, and higher commodity values are ingredients that can affect not only profits for most participants in the economy as we know it, but also alter the way that the market values financial assets relative to other assets, commodities, and money. The equity risk premium as it stands today continues to suggest that stocks are at or near the top of the individual's subjective value list. The bearish argument is that this premium should rise to better reflect the uncertainty in corporate earnings streams. Bears (at least we do) argue that the factors that have contributed to the low ERP are not sustainable despite ongoing policy efforts to extend their influence. Such an outlook means that shares are still overvalued today.

If, for instance, the market is valuing yesterday's earnings at 40 times, which we all know is a historical extreme, in a benign interest rate and price environment, what will it value tomorrow's earnings at (per share) if prices and interest rates rise tomorrow? Those earnings better come in good, that's all we can say, speaking for the bears.

Before the bull market peaked visibly in 2000, the averages would often run up ahead of the start of earnings season (after the end of each quarter). When they did they would often correct during or after the end of the profit announcements. However, each pre season run up ended at higher levels than the prior quarter's run because it was a bull market. Consequently, the risk to playing this game of betting on earnings was low, at the time, and so confidence grew and grew, quarter in and quarter out. Every future bet would take into account prior bullish outcomes before being assessed and laid.

S&P 500Today we're in reverse. Since mid 2000, the S&P 500 rallied into earnings season 4 times (out of the past seven quarters): the summer rally of 2000, the May/June rally in 2001, the post 9-11 rally that ended once 4th quarter profits for 2002 were being announced, and the February/March 2002 blue chip rally we dubbed the "Wind Up" at the time. While the correction in stock prices after the fourth quarter ended did not force the bulls to give back all of their profits from the post 9-11 bubble, the Wind Up that began ahead of the last quarter culminated in lower lows, as did all the others since 2000.

The point is that confidence in this betting game is probably increasingly impaired as a consequence of poor betting outcomes in the recent past. I think it will take more than McDonald's to bring confidence in this game back, at today's valuations. The purpose of assessing this is for short term players wondering whether or not the bulls are going to be able to sustain a rally into July.

Foreign currency profits! That's the new line. To be sure, bank stocks probably saw impetus from a bounce in the tech sector as well as the overall market. Stocks that had been trashed in recent sessions bounced the most, leaving McDonald's, or one of the Dow's few better performers this year, in fifteenth place (of the 30 Industrials) on Monday.

Although we can rarely tell how far these kinds of rallies will extend when they start, the bears haven't relinquished the reigns quite yet, fundamentally or technically.

The only damage that has been done to the bearish case is that the Dow recovered key bullish support at 9529, after closing below it on Friday for the first time in seven months. That was the technical significance of Monday's action. If bulls can hold that fort, they can neutralize the bearish momentum for the time being. Note that we're not saying they could or can't. We're just stating a supposition.

I think they'll (the bulls) fail at that, but will be on watch to reassess that judgment if needs be.

For the moment we can suggest that matching or beating expectations in the 2nd quarter is likely to be a moot case for the bulls at this point.

At any rate, the enthusiasm on Wall Street for the better earnings outlook in connection with the weaker dollar resulted in a stronger dollar Monday. The dollar's biggest support came from gains against the Rand and Australian dollar.

Otherwise the dollar index was up only marginally - hardly enough to count for much so far. But Wall Street's rally was enough to splash some cold water on gold bulls.

I felt it first thing in the morning. For, we know that any convincing bull run on Wall Street is likely to drag the dollar up with it. That's the correct ball to keep your eyes on if they're not already there - in our opinion.

Gold prices finished a touch lower at about $318, while most gold indexes gave up from three to five percent on Monday. All the gold indexes finished near last week's lows but (gold) bulls were able to hold those lows for now.

XAUThe rally in US shares closed at its highs on Monday, leaving the global share merry-go-round to bid up enthusiasm further overnight. Japan was off more than 2% Monday morning as well, and barring typical bear market news to spoil the moment the Dow rally could put that slide sharply in reverse in Tokyo by morning.

If Tuesday's open looks strong in New York it is possible the correction in gold shares could deepen. The short-term patterns in these charts appear to have a bearish bias developing at the moment, and if last week's lows are taken out, these shares could drop by another 10 to 20 percent before the swoon ends.

If that kind of drop in value would hurt then it would be prudent to sell some shares sooner than later. We are increasingly confident of the inverse relationship between gold shares and the Dow, but any investor must realize that if the Dow were to crash tomorrow the equity risk premium could rise across the board so that the gold stocks would get it too.

It's important to be in a position where one can be comfortable with corrections like that at times when the outlook is not entirely clear. Our outlook discounts (as in forget about it) a significant Dow recovery, and portends a further rout after the indexes tap nearby resistance levels, plus or minus. There is no reason to reduce our 30% allocation in gold shares unless our outlook for the Dow and/or dollar changed in the near or long term.

One thing to watch out for is dollar intervention, despite the controversy surrounding dollar policy in recent months. Nobody expects it, perhaps because of that.

The fact is that the stakes are high, if only because the Plunge Protection Team must increasingly have a lot of paper to get off. Anything could happen, and anything might be tried.


Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of, one of the original contributing editors to and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

The editor is not a registered advisory and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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