Stock
Market In Bottoming Process
By Alexander Paris, editor
The Alexander Paris Report
Although
uncertainties remain and we have yet to see what looks like a
sustained rebound, we sense a growing feeling among investors
that the worst of the stock market decline is behind them, even
if they are not ready to jump in headlong. In recent publications,
we have been compiling a growing list of the factors currently
present that generally mark bear market bottoms and repeat some
of them below. Most are technical in nature and only provide
growing evidence of at least a short-term bottom soon. The bottom
is likely to be an elongated one as a new base is built rather
than a one-day turn. The keys to a sustainable new bull market
are more fundamental in nature.
The economic recovery
being a slow one should come as no surprise to readers of The
Alexander Paris Report. A very slow-growing economy is more
vulnerable to temporary shocks and another modestly negative
GDP quarter is possible, although in our opinion not likely.
Even so, it would not likely have much impact on the stock market
since it has not been discounting much. Ironically, the weaker
than expected second quarter GDP and, more importantly, the government's
revisions that showed not one, but three negative GDP quarters
in 2001, may become a positive for the stock market. Many investors
were confused by the very modest so-called recession in light
of a major downturn in the manufacturing sector, a record contraction
in most sectors of capital spending, a record inventory liquidation
and lower consumer income growth last year. It became very difficult
for investors to discount a strong economic rebound when there
did not appear to be much correction from which to recover. Consequently,
instead of leading the economic recovery the stock market has
been lagging it. Now, the news is out. There was a more significant
recession and there is now a recovery to start discounting. It
may have been a coincidence, but on July 31, with a significant
negative surprise on the GDP, a lackluster Beige report and a
sharp drop in the ISM Chicago purchasing managers' index, the
economically sensitive DJIA rose in the absence of any other
significant good news. Could the stock market be reverting to
its traditional role as a leading indicator?
If investors are going
to pay more attention to looking over the economic valley to
the expansion beyond it, they should also start paying more attention
to the fact that corporate earnings hit bottom in the second
quarter. They may even show a modest year-over-year comparison
for the first time since the fourth quarter of 2000. There is
still a question of how rapidly they will rise in the period
ahead, but comparisons will clearly become more positive.
Accounting/Corporate Misbehavior
Since the accounting irregularities and corporate malfeasance come to bear on investors' confidence in and uncertainty about underlying earnings, we would also include it under fundamentals. However, between the Democrats doing the best to politicize the subject for election benefits in the fall and the news feeding frenzy by their natural media allies, it has become a major emotional issue in the market this year.
This is not to say that most companies
do not always like to depict their earnings in the best possible
light. Although they do it within what are generally accepted
accounting principles at the time. The bigger the preceding boom,
the more rascals are discovered during the subsequent collapse
that went well beyond those principles. Not surprisingly, most
of the high-profile rascals this time around were big players
in the technology bubble years. Did some break the law? Certainly
and not surprisingly, they broke existing laws. We do
not need a lot of new laws; only better enforcement and stiffer
penalties, which we are receiving in the new corporate reform
legislation. Did aggressive option practices contribute significantly
to the bubble excesses? You bet, and they should probably be
eliminated completely and replaced by other incentive alternatives.
We should also note that the vast majority of public companies
did not break any laws and generally stayed within the realm
of generally accepted accounting principles. However, you can
bet that they will be even more careful in the future and respect
their shareholders more.
There will be continuing
repercussions of the misdeeds and subsequent reforms. However,
we believe this major negative is in the process of disappearing
as a major market factor. First of all, as a negative influence
each new corporate revelation has to be bigger to have the same
negative impact on investor psychology. We have a difficult time
seeing what can be done for an encore that will shock investors
much more. Second, the government quickly passed a corporate
reform act that will satisfy many investor concerns. Investors
lost a lot of money in technology and telecom stocks, primarily
because of their own greed. However, they should feel better
now that there is legislation, indicating that someone else can
be blamed and punished. Third, by August 14, key officials of
the 945 largest companies will attest to the accuracy of their
financial statements and make any major restatements before that
time. That should be another blow against the negative impact
of this subject. Finally, politicians can all go off to their
fall campaigns, with assurance to the investor/voters that they
have helped to wreak revenge for them on their corporate tormentors.
If not beforehand, it is a safe bet that corporate malfeasance
would disappear as a political factor the day after the fall
elections, as politicians in both parties begin seeking corporate
contributions to their campaign treasure chests. While we are
clearing the air, there have been numerous comments from the
media that European investors have been concerned with the quality
of U.S. corporate accounting and behavior and may, as a result,
pull money out of our markets for that reason. However, they
are having their own troubles with stock markets and corporate
revelations. We have seen a couple of studies recently that confirmed
our long-standing opinion about foreign accounting, formed after
a number of sad experiences.
They pointed out that
of all the major countries in the world, the U.S. is number one
in terms of clean accounting and reporting.
Signals Of A Major Market Bottom
We
are not nearly as comfortable talking about technical analysis
of the stock market, but we have collected a fairly long list
of bottoming indicators from a number of sources, which we have
mentioned over the past few weeks. Some may have longer-term
implications, but most testify only to the likelihood of at least
a short-term bottom.
High Volume: Volume
tends to be very high at major market bottoms, especially around
capitulation or climax selling. NYSE volume was of record proportions
during the week ended July 26, exceeding 2 billion shares during
four of the five sessions.
Magazine Covers:
While seemingly unscientific, bear market bottoms are frequently
made just about the time that they become the most advertised
by appearing on the front covers of a large number of magazines.
When the existence of the bear market becomes so evident even
to the media, it is usually about over. The same thing applies
to other subjects. Remember the black cover years back on a major
magazine with the question, Is Growth Dead?, just before
the market started a major bull market in growth stocks. Similarly,
over a decade ago major magazine covers called the Midwest the
Rust Belt, referring to the utter defeat of U.S. manufacturers
by the invincible Japanese, about the time U.S. caught up with
and surpassed the Japanese, even with the recent industrial recession.
Well, recent covers of such magazines as Time, the Economist
and BusinessWeek all had pictures of bears with appropriate
messages. This indicator may not be as unscientific as it sounds.
By the time a bear market is so well recognized and advertised,
most of the selling is done and short positions have grown, setting
the stage for stronger markets with any kind of increased demand.
Sentiment Indexes:
Just about every technical analyst has his favorite sentiment
index he swears by, all based on the contrarian principle that
when opinion gets too crowded on one side it is time to move
to the other side. With few, if any, exceptions, all the sentiment
indicators were flashing bullish signs. To name just a few:
Both Mark Hulbert and
Investors Intelligence track market-timing newsletters
to discern whether they are preponderantly bullish or bearish
at any given time. By the week ended July 26, both reported a
very heavy bearish weighting of the letters which, according
to the contrarian principle, would mean it is time for the market
to turn up.
Put-call volume ratios
have been very lopsided toward puts during recent heavy selling.
Recently, less than
10% of S&P 500 stocks have been above their 10-week moving
average.
New low lists have
been huge during heavy selling days.
Nothing is Sacred
Selling: For much of the year, most of the heavy selling
was deservedly in the technology sector and, eliminating technology
from major averages like the DJIA and S&P 500, they had not
declined much. By June, investors began selling many attractive
Old Economic stocks that had held up well to lock in profits
or meet margin calls. The selling eventually spread to the small
and mid-cap averages that had strong relative performance for
the last two years. This is the kind of throw-in-the-towel selling
prevalent around major bottoms.
Mutual Fund Liquidation:
Individuals have turned to heavy net liquidation of equity
mutual funds lately, another kind of behavior we would expect
to see at market bottoms. According to AMG Data, net mutual fund
liquidation by the third week in July had reached over $30 billion,
after a net outflow of over $18 billion in June, the third biggest
outflow on record.
Market Undervalued:
After a long period of hand wringing about high P/E's, most
valuation systems such as the popular Fed model, which relates
earnings yields on the S&P 500 to the yield on 10-year Treasury
notes, indicate the stock market is substantially undervalued.
Take out the high-priced technology stocks, and the market would
look even more undervalued. In another similar signal, the dividend
yield on the S&P 500 recently crossed over the yield on the
3-month Treasury bill, only the third time in the last 32 years
this has happened and each was followed by a significant rally.
Enough is Enough:
Finally, before talking about a major bottom, we have to
ask ourselves has there been enough pain to warrant a bottom?
At recent lows, the current bear market, in our opinion, qualified
as the longest and most painful of the post-war period, edging
out the devastating 1973 1974 bear market. In that one, the S&P
500 fell 48%, which was just about matched recently. Importantly,
the 75% plunge in the Nasdaq, the worst of any major average
since the Depression years, was enough to push the current bear
market into post-wear record territory.
A little searching
would find a number of additional indicators that are flashing
signals similar to those at previous major bottoms. That still
says little about the extent and longevity of any market recovery.
As mentioned, that depends more on the underlying fundamentals.
There will be more debate about the economic outlook but, no
matter how slow the economy may be in the near-term, the foundation
for an extended recovery is already in place. More directly related
to stock prices, corporate earnings hit bottom in the second
quarter and may be up around 1% to 2% from, a year ago, according
to First Call. Although analysts have been rightfully reducing
earlier over-enthusiastic second half estimates since April 1,
they are looking for increases around 13.5% in the third quarter
and 25% in the four quarter. Even with further reductions, those
results represent a substantial acceleration in year-over-year
earnings comparisons, which the stock market is clearly not discounting.
There has been a lot of damage to the stock market psychology
and we may not see advances similar to a few years ago. However,
this is clearly not the time to be selling and is the time to
start rebuilding portfolios, with some good fundamental stock
picking.
