Repeat Performance

July 15, 2002

On July 5th, the Dow Jones Industrial average soared more than 300 points on light volume. Weekend television commentary immediately seized the opportunity to encourage investors that the worst was likely to be over. This was a sign that investors had regained confidence despite an obvious expansion of the corporate accounting scandal. By Monday, analysts and experts were citing improving economic statistics and the lack of a terrorist attack as the catalyst for a stock market recovery.

For me, this week has been a continuous déjà vu. Since the market began its decline in March 2000, I have repeatedly asserted that the Dow Industrials could easily sink to 7000...and still be overvalued by historical P/E ratio standards. In addition, analysts refuse to incorporate inflated earnings into the P/E formula. For example, a $3.1 billion overstatement needs to be deducted from earnings before deriving the ratio. Hence, virtually every ratio on the street is open to question.

Yet, stock market pundits insist the end has been in sight since the first dip more than two years ago. While all evidence points to a continuing decline, those who earn their livings selling stocks insist on the same rhetoric, "Buy now while prices are cheap." Nothing beats stocks over the long run.

The problem is that "long run" is never defined. As I have pointed out, the long run is headed toward some new demographic hurdles. It should more appropriately be called the "long jump." Within the next five years, Baby Boomers will be withdrawing savings to pay for college and retirement. Since the U.S. savings profile has been heavily skewed toward stocks over the past two decades, we can expect to see a net withdrawal from equities.

It stands to reason that these savings will be used to purchase goods and services that, in turn, can boost the economy and return to stocks as investments. However, this cycle will have a lag. We can see how the economy might continue chugging along while stocks flounder. This obvious causal correlation is absent from television commentary and print media. Admittedly, I have not read every newspaper or magazine and I have not watched every television commentary. Yet, those I have reviewed, conspicuously exclude the potential for a more extended equity meltdown.

Months ago I visited the floor of the New York Stock Exchange to appear as a guest with Ron Insana on CNBC. The primary focus was on gold and related investments. I stated then (as I do now) that gold stocks and funds were a better place to wait out stock market turmoil because there was a high probability investors would regain interest in a hedge against paper asset failures. This was well before the expansion of the accounting scandals. Ron asked for my Dow target and I told him 7000 was highly probable. At that point, the Dow remained above 10000.

In 1987, a 12000 Dow was considered a stretch even by the year 2000. In fact, some believed the Dow could drop below 2000. The unprecedented speculative frenzy that drove the market to incredible highs is over. Investors need to return to reality. Decisions will be based upon actual earnings potentials and dividend results. If we seek a 3% minimum dividend return, the Dow needs to make some serious adjustments. Of course, this is not simply true for the Dow. Everything from the S&P 500 to the Russell 2000 or Wilshire 5000 needs to reflect reasonable returns as well as appreciation potential.

The Dow fell below 9400 support that is now resistance. Today, it penetrated 8900 support to set up a test of September lows. With daily ranges exceeding 200 points, a dip below 8000 is not as far away as we might assume. While I am not looking forward to such a decline, it is important to keep the possibility in perspective.

Unfortunately, the Friday rally was far greater than I anticipated when adjusting our stop. We were taken out with an $1,100.00 profit that would have grown into more than $7,000.00 based upon today's action. Still, it's better to take a profit than a loss. In the meantime, gold retraced approximately 50% from its high above 33000 if you consider the December 28000 low as the breakout. Technically, gold is guilty of presenting a confusing picture because prices turned down from the late May peak and both the 20-day and 40-day averages confirmed the directional change. I was seeking an opportunity to repurchase gold on a dip to 30800/30700 after gold began its swoon. As Murphy's Law would expect, the downward trek was not consistent and anxiety forced me to jump back in before the correction had run its course. Gold provides a clue to analysts' overall psychology. For subscribers who frequent CNBC, CNN, Fox News and similar stations, consider how quickly everyone is looking for the end of gold's forward momentum and the beginning of more robust stock market performance. The two go hand-in-hand. Yet, the gold sector has been performing well despite recent price weakness and the yellow metal remains the last resort if, and when all else fails. All of this generates a repeat performance of encouraging investors back into a dangerous "overbought market." Despite the carnage, individual investors are still holding their stocks. Even with massive volume, the shuffle has been among large institutional entities. Look at the street interviews. Everyone waits for the recovery.

Interestingly, accounting scandals have raised another question about corporate income taxes. If WorldCom overstated income by $3.1 billion, will taxes be adjusted accordingly? Enron allegedly paid no tax because it accrued stock option liabilities as offsets against revenue. How will the IRS treat this? In other words, the ripple effects of bogus accounting have not even been considered...yet.

Interest Rates

The flight to quality continues pushing longer-term rates lower. This has been a major Fed objective and remains a weapon against weakening real estate. Although investors have lost trillions in stocks, they have been able to enjoy modest appreciation in real estate values. Unfortunately, this value can only translate into cash if it is sold or borrowed against.

Real estate financing remains brisk, but represents additional exposure should the recession spread to this sector. While home sales are up, commercial properties are suffering from lost leases. Major markets like New York, San Francisco, Dallas, and Houston are watching commercial occupancy rates rise as small to medium size businesses trim rental expenses.

As I write, September T-notes have reached 10910, just 14/32nds shy of my 10924 final objective. Many traders are anxious to sell notes because they view the market as highly overbought. Both the relative strength indicator (RSI) and stochastic indicated a potential turning point more than a week ago as the price slope leveled off. But neither indicator was able to foresee the problems we have in equities. Those who sold the overbought signals need deep pockets for now. On the other hand, my attempt to achieve 10924 may be overly optimistic. In reality, I was looking for a trading range consolidation to establish the short strangle between 109 and 107. It appears the Fed will be forced to maintain the status quo until present interest rates finally influence stocks. This could be a longer wait than originally anticipated, extending beyond this year's Christmas season. According to fed fund spreads, no action is expected until December. Even the last quarter could be skipped if the economy fails to positively respond moving past Labor Day. I perceive a slowdown in consumer spending and even a decline in consumer credit needs. As consumers feel the pinch of a diminished "wealth effect," the need for buying new will morph into a requirement to rehabilitate old. Since the bear market began, we have not see a significant decline in consumer spending. If this year changes the pattern, the bear will be alive and well into 2003.

China is poised to become world's biggest gold consumer.