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Death Spiral Phases

March 23, 2001

Trench warfare . . . dominated the front-lines of the stock market's battlefield; while back in the bunkers there is a decidedly more mixed (and interesting) combination of forces arrayed. While some of the broad Indexes made new two-year lows today, the greatest pressure was right where we expected it: the Dow Industrial Average. With so much money playing the old (and now discredited, we think) momentum approach of the '90's, by buying stocks that were still near their highs (or crowded into after the pummeling elsewhere), there was an invitation for the Dow to 'catch-down' with most of the real market. That's what we've been talking about with respect to certain drugs, many basic materials, or household goods companies, that remained very levitated.

Is this a characteristic of a bottoming process? Sure can be, and in fact capitulation in the old-line companies can mask the general exhaustion in other market sectors. For sure, combining all this doesn't make timing a trading low any easier, which we fully realize, and is why our intraday efforts have included a willingness to be short more than once Wednesday and even Tuesday, since we expected firmness in-front of the Fed meeting, and a selling wave thereafter (as outlined that for several days). Now it surely isn't terribly easy to attack hourly, but our hotline (900.933.GENE) has done its best in that regard, and we are especially satisfied with the scalping moves of late. To be sure, there is the same melancholy about that portion of our accounts in equities (as no professional is ever completely in cash or even short), though modestly glad to have opposed full-boat approaches or margin leverage, when visibility is so clouded.

The main point is that we expected a post-FOMC decline, and more pressure in over-owned Dow-types, than big technology sectors, while NASDAQ merely eroded a bit. That it is not as great elsewhere simply affirms our view about rotational selling hitting right in the heart of the 'perceived safer havens' of sectors we've warned about, while theSemiconductors (SOX) and the Nasdaq 100 (NDX), were relatively stronger. Of course we do not mean to suggest the NASDAQ won't break 1800; after all that was a measure long ago suspected for a bearish alternative; and overruns are common. It is our suggestion though, that any break below that would be emotional overruns and likely to be retraced on the upside within a fairly reasonable period of time. Observed recently about 'tax time' was the thought that some pressures may resonate beyond this month, and there's no change in that prospect. However, it's not impossible that a fairly robust short-covering rally occurs between now and then first; fairly soon now that 'confirmation' of weakness, and even breaks below Wednesday's midday lows, produced another leg down; the feasible possibility outlined in the morning's remarks.

Death spiral . . . behavior certainly characterizes the big-cap Senior Averages at the moment; though whether one chooses to blame the Fed's conservatism or not, tends to be a completing (not initiating) phase of such downside pummeling. Basically one's looking at liquidation as many investors cut-and-run while they have sizeable portions of portfolios still salvageable (of course typically not an optimume time to do so, or at least one would think so, with the sole exception of the 1930's, which this Country in no way needs to be heading into; though with excess conservatism, can risk doing), and of course there are the requisite margin calls for leveraged traders, along with a slew of shorting efforts, roughly correlated with every intraday overbought condition.

While we have spent sufficient time in the past criticizing the Fed's hesitancy (and we do not just mean this year, or our admonition about their stubborn delays last year on top of continuing to hike for far too long), and observed the short-term yield inversion that continues to exist (can the Fed not understand what this means?), we will note it took more than the historically-relevant 3 moves to shifts directions in modern times.

For instance, on the way up, it took 4 hikes before the market took the Fed seriously; and it could take 4 declines to get back to where we were before the reactive Fed did their mischief last year (though it was needed somewhat initially to cool speculation). Remember this is the same Fed that refused to move even in the face of the LTCM debacle in 1998 until the (then-head of the New York Fed) McDonough intervention. This is the same Fed that overdid it in the early '90's, when a more aggressive stance could have shortened that post-War (Persian Gulf) recession considerably. So this is the same Fed now that probably will only get a favorable response from the markets somewhere between the 3rd and 5th cuts; which means coming sooner or later here.

We point this out because too many analysts and commentators are emphasizing the success of those 'fighting the Fed', where supposedly after 3 cuts that can't work. Not so; as it did on the way up and the way down; but not once you got to 4 or 5 moves in the opposing direction. That means that 'Fed fighting' is not an art form, but it is valid to say that the 3 steps and reverse hasn't been true in modern times; but 4 or more is essentially a meaningful retracement, though may correlate with overconfidence from the bearish camp, who increasingly believes they can challenge the rate trends with a type of impudence that won't have a price to pay. So, sure, we can say that glimmers of light at the end of the tunnel so far have been of an oncoming freight, but that from history (of this Fed not those of antiquity) we know that shouldn't be the case for long.

In the interim, you'll have more talk about bears 'raiding' the mutual funds; talk about a 'crash' (which we contend we've already had), and talk about the end of bull market structures (which we called for all the way back in the Spring of 1998 to develop with a narrow concentration of strength in a few stocks obfuscating the initial downside) by some technicians. Remember; confirmations of major-trend strength (especially when PE's and investor euphoria are high) can warn of a conclusion to upside, while heavy market conditions accompanied by 'confirmations' of major-trend weakness, can lead (especially when PE's are again high, due to low earnings, and investor despair is the dominant mood) to capitulation and liquidation, the latter being the phase we're likely now in. This phase (which we call the 'death spiral' by the way) usually concludes it. I suspect that because of the duration until earnings improvements across-the-board, it is not impossible that we get (longer-term structural forecast reserved). While that is possible overall action for the Senior Averages, some areas (including some better chips we suspect) won't be making lower lows; already has been the case for awhile.

Daily action . . . on Wednesday saw lots of guideline shifts, including short-sales, on our (900.933.GENE) hotline efforts, as the guidelines discussed (all day) that emotion could generate another 'leg-down', if we broke the morning lows; and we got that. By the time all was said and done, gains for the session in June S&P efforts (yes gains; though mostly on the short-side) were around 3000-4000 theoretical points, and that depended on a couple factors, and occasionally ability to engage in scalping rapidity.

As of early Thursday, we are attempting a speculative long (with stop disciplines) out of an early hole around the 1120 vicinity of the June S&P. The 900.933.GENE hotline will adjust accordingly, as best able, depending on the volatility (or lack) that unfolds.

Overall . . . the post-cut selling on Tuesday was not a surprise at all; but in fact was a repeat of the 'buy the rumor sell the news behavior' plus a whole lot more. The hit Wednesday afternoon was a leg measured as being essentially equivalent to the loss from Tuesday's high to Wednesday morning's lows, so that leaves a bit more ahead. We'll have to play Thursday as it unfolds, and cannot assume the low as being at any particularly quantified price level; as emotion and other liquidation factors are at work.

While this may not be a popular view, that the Fed did not cut more than 50 points in yesterday's move, was the general idea (as was the ensuing decline) and actually is a decided plus for their strategy. That they included a Discount Rate cut of the same level is equally important. Had the Fed cut 75 basis points or even a full point, with a market response also equivalently negative, then the flexibility of the Fed, as well as it being saddled with the mantra of responding to markets, would rise. In this case we are looking at a Fed that will have no problem cutting again in the weeks just ahead, with the total accrual of rate cuts being essentially the same, though now more may in fact be necessary, by virtue of the sluggishness to more in unison with other areas of Government to stoke the economic backdrop.

The strongest thing the Congress (it can be a player if it dare) could do would be to cut Capital Gains to something lower, like 10%, though that's probably wishful thinking (though it would be a powerful factor to offset what we've felt for years was an appropriate emphasis back on one's home, by virtue of the last major Tax Act's primary residence capital gains exclusion clause) for a Congress that's torn between opposing any cut, and their (newly brilliant) ideas of small incentives that hit the mainstream sooner (how about big incentives helping everyone, including tax credits for capital expenditures; that would do the trick).

At the same time, the main problem is not interest rates (other than how they helped to break things over the previous year); it's profits recessions, as outlined before. (We are reserving most of this section.) Again; you should not have the Yield Curve still inverted on the short-end if rates were being cut sufficiently or aggressively enough. At the same time, short-term growth of the Money Supply is out there, but is (for the moment) not yet able to overcome the evaporation of equity valuations. That as yet.

Remember, the Fed took unusual steps of including a reference to the market in their 'statement' of condition, along with deteriorating consumption; even some mention of foreign conditions (a particularly unusual reference). (Balance of this is reserved.)

In any event, you're starting to also get a sense of invulnerability discussed before on the bears side, similar to excess exuberance bulls felt over a year ago. Liquidation to pay taxes may be a minor part (we've noted that); selling in parts of April and May is not out of the question; though we do want to make a point that selling is becoming the opposite of unsustainable parabolics of '99-2000. Look for short-term turn efforts.

Technically . . . you essentially have 'confirmation' of about every type of post-drops seen in modern history, with the sole exception of the Depression era from the '30's. While we cannot say that nothing like that is possible, we can say it's not likely. Also, we can observe that while yesterday's and today's selling in the wake of the Fed cuts were surprising to nobody we know, it does tend to drain any remaining morale from the stock market; which is an ongoing component of price behavioral psychology.

Now, while we would have preferred that the 1800 NASDAQ level, or even Dow 9600 or sub-1000 levels for the S&P be seen before now (with less series of movements), it is nevertheless part-and-parcel of how one works towards exhausting a generation of players, who in many cases have barely had an interest in continuing involvements with the market. We cannot dwell on the overrun to the downside (though tardy from a time standpoint has not overrun our estimates for the Averages from a year ago or even before); we cannot dwell on anything about who didn't heed warnings right here for eons when many thought us too bearish (and now probably too optimistic), and do not expect the world to end; though fright factors are absolutely a mighty sword here.

In summary . . . in the wake of excess excitement ahead of the FOMC meeting, we did get an orderly (less than extreme) move by the Fed. While the Fed doesn't want to surrender itself to the markets, it remains aware of the worldwide situation, and a need not to repeat the Japanese experiment of turning a blindsided attitude towards those needs, only to react too late. We suspected nothing more from the Fed, and we did expect a post-cut decline. However, the hook would be to arrest that drop shortly.

McClellan Oscillator data turned back down towards recent lows, with the NYSE once again almost as heavy as last Friday's -187 on Friday; now at -178 or so. For NASDAQ, the reading is around -42; after mild deterioation (a minus 4 reading which often suggests more for the near-term, which occurred yesterday). As noted, until it's proven otherwise, all rebounds must be contratrend in nature (against a primary and vicious downtrend); but it must be emphasized that the bulk of downside moves are already history; with exceptions in the overpriced defensive sectors; generally as we warned were no place to hide. That's why it would be interesting to see it come back later in the week; despite with no particularly visible event to spur any such reversal.

It would be illustrative to again look at the VIX (Volatility Index) levels, at pressures that are often associated with lows, whether those low are interim affairs or more. If it is necessary to search for more sources of tension, look no further than the shortage of power impacting California agriculture this Summer, or the expulsion of Russians today, which along with slightly increased strains with China, contribute to the feeling of unwinding of a supposed riskless world (never was) of recent years. These things tend to move cyclically, and this cycle in the market has been unwinding for years, so the key will be to finesse the ragged conclusion of the downside, which probably will give us another (maybe even impressive) rebound soon; though not very sustainable.

The most important factor may be the little-noticed expansion of the Money Supply at a time when the destruction of asset values tends to obscure that; a classic deflation sign. Regardless, the evidence of a Fed in motion (after being too off-key for too long a time) is real, and at minimum a short-term turnaround is probably off in the wings.

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