T'is The Season For Folly           
Stock Market Massacre Could Be Nearing

By Brady Willett

The Nikkei continued to fall overnight for the fifth straight session.  Sparking the dump was tech shares, and in particular Hitachi.  Hitachi previously warned of an upcoming loss last Friday, and announced a new round of layoffs. Today its share price fell by 10.3%, or its daily limit of 100 Yen to close at 874 Yen.

The Nikkei could potentially follow in the Dow's footsteps and bust below 10,000.   Japan will report GDP results this Friday.

There are numerous reports to consider for the upcoming week including the NAPM index (Aug), 2Q01 productivity revisions, and the jobs report (Aug). Of these reports the employment situation should received the most attention from market participants. It arrives on Friday.

 Nasdaq
The true test for tech stocks will only arrive when April's lows are touched – will this spark buying or force more investors to give up hope? To pontificate beyond this point may be absurd as every rally since April have failed, and inventory issues will take more time to work themselves out. Inventories are important because signals of a reduction are just that: signals. What these signals do not do is predict exactly when, if ever, unbridled demand for tech will arrive and give companies back margins. In sum, while a reduction in inventories stops the bleeding it does not guarantee new life.

While some companies remain optimistic few are willing to elaborate on the numbers: the numbers (earnings) are going to be ugly this quarter (3Q01) and next (4Q01). Can the markets sustain a rally in anticipation of a 2002 rebound?

1619.58 (April 4, 01 - Intraday)
1777.11 (August 30, 01 - Intraday)
2000/3,000/4,000 (psychological battle zones)
4,475.20 (April 10, 00)
5,000 (Maniacal Resistance)
5,132.52 (You can tell your grandchildren about it)

Dow
Blue chips rallied strongly last Friday morning and hit a high of 10036.94. But the Dow soon lost grasp of 10,000 after selling began shortly after 10:00 AM. Last Friday is a good representation of the volatile nature of the market we are now in: in less than ˝ hour the average jumped by more than 100 points simply because enough technical programs, and investors began to feverously anticipate/follow a supposed market 'bottom'. With this in mind, if the Dow cracks above 10,000 there is reason to believe that a strong rally could ensue. By contrast, there is also sufficient reason to believe that a quick sell-off can arrive at any moment if the economic situation does not readily improve. This is the long-winded way of saying buckle up…

The last four months of the year should, indeed, be volatile. Moreover, serious bouts of trading as we head into October (3Q01 warnings) could possibly provide multiple periods of market disallocation: or times when the market action becomes so unstable that making sense of the movements becomes entirely contrarian: prices shot higher so they will soon shoot lower – prices have collapsed so they will soon rebound (get ready for this string of logic to take over the airwaves).

Those who argue that the Dow is now a 'bargain' may be highly delusional.

Dow Jones Industrial Average -- August 31, 2001*
Price-to-Book:   4.61
Price-to-Earnings: 26.76
Price-to-Sales:    2.44
 Dividend Yield%: 1.75%

While it is true that a perfect measure of 'undervaluation' does not exist, the above statistics are not even nearing 'fair' value historical normality's, let alone displaying any undervalued characteristics. Over the last 42 years (Leuthold Group) stocks have posted on average a price-to-book ratio of 1.4-to-2 (normal band), and through out history the price-to-earnings multiple has  averaged well below 20 (15-17 dependant upon which index you care to look at). Furthermore, to put the above numbers into a different perspective, in the early 1930s the average dividend yield on the Dow surpassed 15%: companies increased dividends to offer appeal to shareholders as using cash to increase future capital spending programs was not an alternative. As such, it is difficult to argue that a reading of less than 2% is appealing on the Dow especially since undervaluation, which when apparent can often times can lead to capital gains, is essentially non-existent.

Will investors continue to buy blue chips solely for capital gains? Will investors continue to disregard historical yardsticks in favor of speculating of an imminent economic rebound? In sum, an analysis based upon the theory that 'the worst is over' is not an analysis per se; rather it is a cop out. The worst that could potentially happen, that being a regression to normal/fair price levels or lower levels, has not yet begun…

 Dow Crash = Economy Killer
If the worst does arrive the equity markets will find themselves becoming the leading indicator for consumer confidence, economic growth, and future monetary policy initiatives. While economists estimate that roughly 5 cents every dollar created in stock market wealth if put towards consumer spending, these estimates are unsophisticated -- no one has the ability to determine beforehand what the impact of deleted stock market wealth has on the consumer. As well, and in light of last week's uptick in consumer expectations, the stock market, and housing market must be monitored closely to determine confidence levels going forward. Incidentally, Greenspan estimated last week that 10-15 cents on every dollar made from capital gains on housing sales is spent by the consumer.

Home on the range
7513.40 (Jan 9,98) - Intraday)
9106.54 (Mar 22, 01)
9869.14 (Aug 30, 01 - Intraday)
10,000 – Psychological Support/Resistance
----
11350.05 (May 22, 01)
Key Resistance: 11,425 (April 12, 00 - Intraday)

*These statistics are a crude collection of the most recent Dow stats. To be sure, price-to-book levels are much higher when excluding certain intangible numbers on the books, and in some cases price-to-earnings multiples would be higher when including GAAP numbers (or all costs).

Conclusion
 The markets are not cheap, and we are entering two of the most tumultuous months in history. While on average September is the worst month for the markets it is October that carries the 'crash' label. Suffice it to say, a crash in October would be unsurprising – one of the main reasons being that the new economy was backed by the ability of consumers, businesses, and investors to applaud Fed interventions. To date 7 interest rate cuts have been largely ignored.

What we should remember is that media, Wall Street, and the average fund investor are all biased, and those who aspire to study market history may present a more honest representation of sentiment going forward.  With this in mind, back in March 2001, and again in July 2001 a survey conducted by the Museum of American Financial History showed that 80% of participants think that a stock market crash is coming within the next six months. Suffice it to say, the amount of press that covered this, or the pervasive 'overvaluation' in the markets in general, is limited. Question is, were the people surveyed by the MAFH on to something?

Is the crash near, or shall new investment ideologies and speculative yardsticks persist?

Brady Willett
September 6, 2001



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