ContraryInvestor - Market Observations

MARKET OBSERVATIONS

MARKET OBSERVATIONS - 2/17

At The Margin...We briefly mentioned the dramatic rise in the margin debt numbers released earlier this week in our Tuesday commentary. January of this year saw a 6.5% increase alone. This follows double digit months in both November and December of 1999. In the last three months alone, margin debt outstanding in this country has risen by 33+%. We have continued to complain over the years that in spite of these mind-boggling numbers, Greenspan and friends simply refuse to raise margin requirements. You're most likely quite tired of hearing us chant the continually same tune. Upon some reflection, possibly we've been missing the fact that if margin requirements were increased, the speculators and hedge community may be induced to purchase/create even more derivatives to lessen the impact of all of a sudden needing actual additional capital for trading activities. Why not create it with alternative forms of debt and derivatives? Quite possibly an additional derivatives boom would be unleashed (not that a veritable mushroom cloud doesn't already exist). If indeed this is the case, is Greenspan truly backed in a corner regarding deflating the financial bubble that has been created by increasing margin requirements? Does this mean that short term interest rates will have to climb to exorbitant heights before actually deflating the financial markets (and severely hurting the real economy)? The following chart (courtesy of MTA) depicts the magnitude of margin increase in the latter part of 1999.

As you remember from our piece on Bank Derivatives a few weeks ago, the creation/use of derivatives has also picked up dramatically going into the third quarter of last year (latest available data). It now seems to us that it may becoming a damned if you do, damned if you don't scenario. As margin debt increases, the use of derivatives increases. In like manner, if margin requirements increase, derivatives would mostly likely also increase to compensate for additional capital requirements. Question: What will stop the increasing rise in outstanding debt and derivatives in this market? Answer: A good old fashioned crash, of course. In other words, reconciliation the hard way.

A few last comments on margin debt. It goes without saying that margin debt is a bullish prop underneath the current market - a least part of the market (tech, biotech and Internet). Margin debt will only become dangerous after the market has fallen enough to start triggering margin calls. That's when we face the possibility of a waterfall event. Given the simply extraordinary/unprecedented current market focus strictly/myopically on the broader technology sector, we have to believe the probability of a waterfall experience is higher than at any time in the last half decade or so. Possibly triggered by a sharp fall in the NASDAQ, as you would imagine. Our old buddy Easy Al looked the camera in the eye today during his HH testimony and declared that he had given the margin requirement issue a lot of thought. He had come to the brilliant conclusion that he simply couldn't raise margin requirements because "it would hurt the little guy". He had concluded that if he raised margin requirements, the "little guy" would have no other access to credit with which to purchase glorious equities. We just guess that Al hasn't been receiving any solicitations for credit cards, mortgages, lines of credit, etc. Make no mistake about it, the 33+% rise in margin debt in this country in the last three months is nothing short of reckless and dangerous. The piper will ultimately be paid...this time in blood.

Slick talkin'...We're sure most of you watched Slick try to create a slick yesterday. As you know, we are talking about Clinton trying to jawbone OPEC to increase production. HA! The price of oil is finally getting bad enough that the ultimate Administration/Fed/Treasury heavy battle armor is being brought to bear - sound bites. It works like a charm on Wall Street. Fallaciously, the Administration thinks it will work on OPEC. Fat chance. Do you think the following chart has at last reached the desks of Clinton and Greenspan? Or, is Hillary preparing to run for Senate on the "heating oil platform"?

We have inventories at record lows. The "consensus" believes that oil prices are simply not sustainable in the mid-to-high twenties. We have improving global economies. A perfect time for OPEC to prove "them" wrong. Our guess is that at worst, OPEC wants to see prices level off in the mid $20's. Not enough to snuff out economic growth worldwide and not too low for OPEC to stop being the recipient of a gusher of foreign dollars. If our little scenario comes to pass, this should ultimately prove fortuitous for oil and energy service company earnings starting in two or three quarters. Who knows, we may even be near a nice little bull run in energy stocks. Conversely, most all young fund managers of today have absolutely no experience whatsoever with a bull market in energy (or any other sector except technology for that matter).

Has The PPI Gone Up In Smoke?...That's the burning question of the moment. Once again, the all is well on the inflation front bell was rung loudly and clearly this morning. Declining prices for smokes was the manna of the morning in supposedly causing a benign PPI report. The futures immediately ascended skyward as what appears to be the somewhat diminishing herd of lemmings started to party. It's just a shame that within hours that was all wiped away. We continue to live with incredible volatility. At the close today, we now have the NASDAQ and Dow roughly 20% apart in relative performance over the last 6 week run. The disparities accelerate (into the ultimate conclusion?). We continue to question these "official" government numbers. Intermediate components measures within the PPI are screaming opposite messages from the official PPI numbers themselves. The charts below simply say it all. Total intermediate prices have simply gone skyward.

There's no question that energy is a huge part of the equation:

But it's definitely not the entire story by a long shot. Excluding energy, the upward trajectory in intermediate PPI components is unmistakable:

We just have a hard time trying to make sense out of the facts (so what else is new?). If intermediate prices have turned upward significantly and there is apparently no pricing power/price inflation in the system, how can corporate earnings be blowing the lights out? Where's the margin compression?. (Of course the bulls will answer with productivity, but we all know that the productivity numbers are completely skewed by the influential factor of measuring chip speeds against computer prices within the overall calculation. Is it simply debt driven stock buybacks that are holding up earnings per share?)

Mystery Quote Of The Day...Thanks to Jim Stack and the folks at Investech for the following insightful quote from a noted government official:

"The excess credit which the Fed pumped into the economy (in the late 1920's) spilled over into the stock market, triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up excess reserves and finally succeeded in breaking the boom. But it was too late! By 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence."

Wondering who this clear headed thinker was? Why that little old money printer himself, Alan G. (quoted in 1966 - the old era economic period).