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11/23/98 Market Commentary

Once again, a remarkable transformation has occurred in our little town on the Hudson over the past   six weeks.  Our local weatherman has changed the forecast, and denizens of our village have been whipped into a frenzy trying to take advantage of the more favorable outlook.  The dark storm clouds of August and September are just a lingering memory.   The sun once again shines eternally bright on the street.  All around us, every house has hired an interior designer to redo the motif in colors that complement the new mood.  Even the youngsters have been caught up in the new mood.  High school students who once devoted their web space to pictures of Ferrari sports cars and musical groups have now turned their thought to developing stock market web sites.  The smallest children are busy writing to Santa Claus, who is equally busy replying, "Yes Virginia, there is a Bull Market".

It seems that the gloom and despair that resulted from the squalls of late summer was only a localized event.  On Main Street the average citizen never lost faith in the PermaBull.  During the U.S. market's  mid-July to early October tumble, the individual investor kept his eye focused on "being in it for the long term" and "buying on the dips".   This belief in the eternal nature of bull markets helped to stabilize the averages during their darkest hours.  It was the pros who were  feverishly selling stocks and shedding their bullish skins during the market's dive.  The very same pros and experts  whose "long term market outlook" changes with the direction of each day's market close ( thus providing an endless supply of sound bytes to the sensationalistic financial television networks).  Sentiment among investment advisors and newsletter writers has now come full circle.  Bullish sentiment among investment advisors has risen to its highest level in almost seven years. There is renewed talk of a "new paradigm", of a recession proof economy, of an unstoppable bull market.   The short lived realization that the U.S. operates as part of a still ailing global economy (and not in isolation from it) has been all but forgotten by many market participants.  Market players now feel the need to take part in the rally at any price because they are afraid of missing out on the start of a new bull market.   Thoughts about mundane little details like valuation levels and earnings have been cast aside in the rush to jump on the bull market express.  Internet stocks have been bid up 160% since October's lows as analysts issue buy ratings based on such astute analytical reasoning as "It's one of the few profitable internet companies therefore it's definitely a buy."  Unfortunately for the followers of the American PermaBull,  and unless several hundred year of financial market history are about to be rewritten, the current levels of bullish sentiment are not congruous  with sentiment patterns normally seen at the onset of bull markets.  Rather, the current degree of bullishness is historically consistent with those levels that in the past have been foreboders of the end of an upward run in equities. 

The extreme levels of bullish sentiment now held by many market participants has resulted in large part from a myopic view of recent Federal Reserve rate cuts.  The current consensus is that the rate cuts will act as a stimulant to an economy that is showing signs of underlying weakness. What has been overlooked is that the three rate cuts have actually resulted in an almost 1/2 percentage point gain in 30 year treasury rates.  Mortgage rates have increased since the onset of Fed rate cutting.  The jump in long bond yields could actually reduce economic activity in the coming months.  The main beneficiaries of the recent cuts in the fed funds rate and the discount rate will be the financial institutions whose inept wholesale dispensing of loans to fundamentally unstable emerging markets and large exposure to derivatives precipitated the crisis in the first place.  The Fed's emergency midday mid October rate cut should have come as no surprise to market participants since it occurred just before many derivatives were due to expire.  Many investors are still unaware of the severity of the crisis that occurred in mid October. According to the latest available government figures, the U.S. banking system had over $26 trillion in derivatives exposure.  The Fed's rate cut was thus a calculated effort to save financial institutions from facing the consequences of their poorly planned risk management policies. 

Derivative exposure aside and if one looks beyond the isolationist barriers through which many Americans choose to view the world, the recent success rates of  a policy of  rate cutting and rapidly increasing the money supply has been anything but a success.  The Japanese have been employing such a policy for much of the 1990's to no avail.  The Japanese economy is in the depths of a severe recession (some would say depression) and its stock market has made no headway this decade.  The Japanese economy is still burdened by overcapacity and the resulting lack of profit growth. 

Like the Japanese market and many of the world's economies, the U.S. economy is burdened by overcapacity.  The results have been a lack of corporate pricing power, narrowing profit margins, and slowing earnings growth.  The Fed's 3/4% cut in the Fed Funds rate will do little to ease the global overcapacity problem and the resultant deflationary forces that have made themselves felt this year.  The effects of the rate cuts will not be felt in fourth quarter profits which will show a continuation of this year's deterioration in earnings growth.  The market has been soaring on the coat tail's of the Fed's moves, and we suspect it will be faced with a severe reality check when earnings warning season rolls around next month.  The market's underlying earnings fundamentals have deteriorated since July's highs and the current extreme overvaluation of many stocks leaves little room for disappointments.

With the major averages approaching their old highs and likely to  set new highs on the back of the current overwhelming bullish sentiment led upward spike, the risk is now much higher than it was in July.   Sentiment has shifted dangerously to a bullish extreme, and the underlying fundamentals are considerably weaker than they were at the last peak.  While there is a very real chance the market's current momentum will carry it past its old highs, the stakes are much higher this time around.  This is a rally to be played by traders only, it is not a long term buying opportunity for the buy and hold investor.  There is a very real chance that sentiment, and the U.S. market, will take a sudden shift to the downside when fourth quarter earnings figures force investors to face the facts of a dangerously overextended market with deteriorating earnings. 

Investors wishing to participate in the start of a new bull market will not do so by buying a market that is trading at historically high valuation levels.  There is better value to be found elsewhere in the world.  The Asian markets, while short term overbought, are still trading at extremely  low valuation levels.  A long term buy and hold investor will do better on a 3 to 5  year basis buying quality companies in the undervalued markets of South Korea, Singapore, Indonesia, and Thailand than he will by betting on overpriced tulips like EBay or The  Similarly, markets that are heavily resource dependent like Chile, Australia, and Canada offer better profit potential when the global economy starts to recover than the overvalued U.S. market does.


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Last modified: April 16, 2001

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