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
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
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 Globe.com. 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.