MARKET OBSERVATIONS

MARKET OBSERVATIONS - 1/11

We fibbed...In our last discussion, we mentioned we would be discussing the potential perceptual investment mistake of a generation - mistaking a credit cycle for a business cycle.  It's coming on Thursday.  We promise.

The Manic Depressive Beast (Or the Lithium-Prozac Market)...It seems we just can't go fast enough these days, both on the upside and the down.  In our view of life, the structural imbalances that have been created in weighted sector holdings, leverage, and the derivatives markets explain a lot of what is happening.  (For better or for worse.)  We all know that roughly 30%-plus of the S&P (it's much higher in both the NAZ and the Russell) is accounted for by technology holdings.  It's truly breathtaking to watch capital try to reallocate away from technology and into other sectors such as pharmaceuticals or consumer stocks.  Witness last week's move in Bristol Meyers and Proctor and Gamble.  Bristol had a stunning approximate 15% move on Friday alone.  P&G popped 14 points in two days.  At this point, sector reallocation of capital will be anything but orderly.  With the massive mismatch in sector weightings within the major indices, it's like trying to reallocate the weight of a bowling ball (technology) into a pea (many non-tech sectors).  It's our guess that given where we are now, sector reallocation of capital can only be violent.  As you know, mutual fund and hedge managers do not patiently wait their turn in the sales line or in the purchasing department.  They all rush for the cashier at once.  Ka-ching.  (Or maybe Kerplunk.)

The leverage...   The potential for reallocation away from tech is clearly and will continue to be clearly exacerbated by leverage.  We want to know which hedge funds in this country weren't loaded to the gills in levered tech and Internet positions going into the end of last year?  Even the Soros crowd couldn't keep their hands out of the cookie jar.  The hedge gang was there, the MO crowd was there, the big mutual funds were there and surely (whether knowingly or not) the indexers were there.  For the hedge fund and MO players, leverage cuts a very destructive path when the transmission is thrown into reverse unexpectedly.  They don't wait around too long.  Last week's action was merely an appetizer (the main course still awaits).  The incredible increase in margin debt during 4Q 1999 speaks to the fact that trading decisions will be made with a mere modicum of reflection and introspection.  We have to believe that trading decisions will largely be based on stomach acid.  Once set in motion, all players will be looking for the nearest fire escape.  As Don Hays has quipped, "momentum and hedge players buy breakouts, not breakdowns".  How true.

The derivatives...The last, and probably most important, piece of the puzzle is the derivatives markets.  Especially at this time of the year.   As Dave Tice has aptly pointed out, there was an incredibly significant increase in CBOE open interest during 4Q 1999.  It's really no surprise given the ramp in the NASDAQ, the singular institutional and hedge community focus on tech stocks, and the wild increase in margin debt.  What may be lesser well known is that it appears that liquidity among the CBOE "locals" is starting to dry up or become more scarce.  Assuming you were a local writing calls anywhere during the fourth quarter of last year, just how do you feel about risking your capital now (that is, what's left of your capital)?  We're hearing that options makers are simply walking away when big orders suddenly "show up".  This is not a good thing.  It has the earmarks of discontinuity at some point.  We have to believe the condition of the underlying derivatives market is supporting/causing some of the wild index swings we are now witnessing in the cash index numbers.  It's ironic that this is happening at a time of the year when demand can naturally rise in derivative land.  As you know, the Wall Street community is expecting the year-end cash flow tidal wave in the next few weeks - profit sharing dough, bonuses and 401(k) contributions.  To prepare for this, the futures business is usually brisk.  Witness last Friday's runaway futures action in the last 15 - 30 minutes.  Mutual fund managers simply can't get the money to work fast enough, so they cover the exposure (to cash) by buying the futures.  The simple use of derivatives to become fully invested.  If there is lack of liquidity on the other side of the trade, futures prices move in a gap fashion.

    We've all known for some time that leverage in the derivatives arena simply has no precedent in modern times.  You can bet your last dollar (literally) that Greenspan is fully aware of this (we hope).  Unfortunately, the more credit that is unleashed in "the system", the greater the demand for derivatives.  The more derivatives, the more the potential for significant market volatility.  The more market volatility, the greater the perception of profit potential.  Hence, the more demand for financial market credit.  The more credit financed financial asset purchases, the more the demand for derivatives...  It's getting so enormous and circular that we wonder at some point will there simply be no one to take the other side of the derivatives trade?  We can only believe that the leverage in the system has become so unwieldy that Greenspan is truly scared to raise margin requirements.  He has clearly chosen to do battle with the beast by raising interest rates and effecting the broad real economy.  He has chosen to protect the leveraged speculating community at the expense of mom and pop America.  Quite unfortunately, the leveraged speculators are snickering at Al behind his back.  Tee-Hee.

    On last comment on this discussion point tangent is that we will not be surprised at all to see increased volatility ahead.  As you know, we experienced the five single largest point days in NASDAQ history during just the last seven trading days, three down and two up (see, we're breaking records already this year).  The NASDAQ moving four or five percent in a day is a wonder to behold.  Scary on both the up and the downside.  We'll bet that we see a 7-10%+ day before it's over.  At the risk of repeating ourselves, we can only find one other time in history where this kind of wild volatility was seen.  For your approval:       

    Admittedly, extreme volatility in and of itself does not guarantee a market decline.  What it does guarantee, though, is that long term investing is about the last thing on the minds' of performance oriented investors (hedge, mutual fund, institutional, daytrader, etc.).  Investment decisions will be reactionary and based upon emotion.  Market participants will shoot first and ask questions later.  Does this make you feel good about your 401(k) and IRA accounts?  (Do yourself a favor and don't put any down payments on a Florida retirement condo quite yet.)   

Anatomy Of A Bubble?...You've all seen the year-end performance number for the S&P.  But have you really seen the numbers?  Thank you Morgan Stanley for the following work:

    It's no surprise.  The table essentially says it all.  Technology was close to responsible for the whole shooting match.  As a note, don't be fooled by capital goods - you are looking at the heavyweight influence of GE.  We guess the folks at S&P just haven't picked up a GE annual report lately to notice that 60-70% of operating profits are driven by some type of financial services.  Like we have stated above, "who doesn't own technology?"  

Where Credit Is Due...The $ 15.6 billion increase in consumer credit for November was only 240% greater than the trustworthy consensus forecast had expected.  Only a slight near-miss.  The previously reported credit number for October was also upsized by 24%.  Thank heavens for accurate forecasting and reporting.  It makes forming sound investment decisions so much easier.  Consumer credit through November is running well above the 1998 comparable period.  Given the Christmas consumption boom, December's number should also be an eye-opener.  Normally this type of consumer credit increase would have sent shivers up our spine, but this time it's easily explained away.  After all, with those pesky mortgage rates now 100-plus basis points higher than twelve months ago, who wants to yank more "savings" (refi) out of their homes?  Nobody, especially when consumer credit is so easily and readily available as a quick substitute.  Additionally, with the growth in personal wages seen over the last year, revolving credit defaults are not shooting higher.  This gives those wonderful consumer lending institutions all the more gumption to lend aggressively (at least according to the Fed's 4Q Senior Lending Officer Survey).  In case you hadn't noticed, some of these companies such as Capital One, Bank One (and let's not forget the Net lenders like Nextcard) have seen their stock prices swoon over the last 12 months.  We can't have that, now can we?.  Lend, lend, lend.    

The Broken Spigot...We have been commenting on the weekly Fed credit/money creation scorecard for some time now.  The spigot is no longer on full blast.  It's simply broken off of the pipe and the high pressure stream is flowing completely unchecked.  The bulls would have you believe all of the Fed credit and money creation over the last few months was in prep for Y2K.  Now that Y2K has proven to be the ultimate non-event (at least for now), why hasn't the high pressure monetary pipe been capped?  (Forget trying to take back or sop up the excess liquidity.)  Witness last week's $18.1 billion increase in Fed credit.  Another $6.6 billion in additional currency.  The two week St. Louis Fed reading on the adjusted monetary base is an increase of $16 billion - a 2.7% increase in the total monetary base in just two weeks.  Clearly this is about something other than Y2K.  You guessed it, time for another another happy ContraryInvestor readers choice questionnaire.  Al and friends are feverishly printing money because:

    1.    The leveraged speculating community has increased its daily dosage of methamphetimine margin debt and needs a new "supplier".

    2.    Someone or a few someone's are being bailed out.

    3.    Gore is behind in the polls.

    4.    "It's just like eating peanuts.  Once you start, it's hard to stop."  (Actual Greenspan quote upon being re-anointed supreme leader.  Thank you Bill Fleckenstein.)

    5.    The financial system is careening out of control and increased credit is the only thing that will keep it from crashing immediately (while "they" try to come up with plan B).

    It could be any or all of the above.  Greenspan's recent "early" re-uping with the Clinton Administration is a clear sign to us that the Greenspan agenda is quite politically sensitive.  If the money keeps flowing, the wildest part of this market finale may lie ahead of us.  At worst, the Clinton-Greenspan "team" has zero tolerance for a significant market setback or a recession.  (The new 2000's version of the "zero tolerance" law, in case you were wondering.)  It's just simply comforting to know that our fearless political leaders still have the backbone to insure the integrity of the US market mechanism and financial system.  In many other countries, it's nothing more than a rigged game.  Simply comforting.

Jack Be Nimble, Jack Be Quick.  Jack Jump Over The S&P Candlestick?...For the bulls out there, you better hope so.  We're indebted to a reader for the fine chart that follows.  Do you think this is saying "buy me" to the leveraged momentum players?  After all, they haven't really had any time to do any real selling...yet.

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