MARKET OBSERVATIONS

AT THE MARGIN

MARKET OBSERVATIONS - 3/28

Contrasts...After all, what is the current market all about if not dramatic contrasts?  Contrasts with the past.  Contrasts with what may be considered basic economic logic - namely profit and loss.  Contrasts in investor perceptions.  Contrasts in "the old" versus "the new".  Dramatic contrasts in stock performance among  individual sectors and issues.  Although the following comparison could be amassed from many different names, the folks at UAS Asset Management draw together a diversified group to contrast against the current "symbol" of the new, new thing:

Compared to what?  Compared to this:

Does this mean that Cisco is wildly overpriced and surely destined for a fall?  Maybe, but it's certainly not definitive by any means.  It's simply a study in contrasts.  It's a reflection of perceptions.  It's an expression of confidence, or in the case of the top table, lack thereof.  It may also simply be a case of widespread investor innocence and naiveté.  How else could it be a mania in technology stocks if it were otherwise?

At The Margin...No, this won't be another soliloquy on the subject of margin debt.  We want to spend a few minutes talking about the concept of change "at the margin" and how the forces of incremental change can be so important in determining major market turning points.  As you know, most all the major tops in our market throughout history were not triggered by any singular "event".  They were toppled by the multiple attacks of many small armies of incremental change.  The 1929 and the 1973 secular tops have no definitive singular catalysts.  In 1929 it was excessive monetary expansion, excessive confidence in the equity market, dislocations in foreign currency markets, and ultimately a shift in perceptions broadly.  In 1973 we had OPEC worries, a nifty fifty predecessor environment, an infatuation among the public with go-go mutual funds, etc.  None of these characteristics was enough to spark a topping in the equity markets individually.  Collectively, they were the levers that were able to coincidentally move the formerly immovable object.

For many bears today, there is a real temptation to want to believe in having identified "the" catalyst that will spark the equity carnage.  Being too early is a terrible curse, continually frustrating, and can, if you are not careful, take you "out of the game" (both from an emotional and monetary perspective).  The key is pacing and patience.  Easy to say and tough to live with when you view the markets on a daily, if not hourly or continuous basis.  Imagine having lived through 1928-1930 in the US or 1988-1990 in Japan.  Topping markets are a process, not singular events.  We view our role in writing this Market Observations piece as one of highlighting the small events that we believe are levers that will ultimately change the direction of the overall equity market.  We can't tell you the timing.  We can only verify that the contrary levers exist, are in place, and are exerting pressure against what seems for the moment to the immovable object.

Sorry for the tangential diatribe.  Let's take a look at what may be a new change agent in the evolving "Greatest Stock Market Story Ever Told".  Last week's testimony by Treasury Undersecretary Gary Gensler regarding the GSE's (Government sponsored enterprises) may just be the imposition of yet another lever with incrementally negative consequences for the broad equity market.  The testimony is not "the" spark and not "the" catalyst, but it is another in a series of contrary levers.  If you have followed the saga of the GSE's over the last decade or so, you know that the topic of unfair advantage (implicit government debt guarantee) has been raised again and again.  In each instance, the politically connected management's of these agencies have quashed any thoughts of legislative change.  Although we strongly doubt any near term legislation has a ghost of a chance of "making it all the way", it just may be that this time is different.

What clearly is different this time is that GSE debt is enormous.  You know the numbers.  We've reported them far too often in looking at the quarterly Fed Flow of Funds report.  Sometimes the pictures help:

The last few years have been an explosion.  As we have said before, we are convinced that the GSE's helped ride to the rescue and bail out the mortgage-backed debt market in the 1998 LTCM crisis.  Without question, they have been a source of liquidity in the US financial markets over the last few years.  As we have said a million times, our best friend is rate of change.  If the GSE's slow down their debt financing/mortgage liquidity activities ahead, there will be an important "change at the margin".  An important underpinning of liquidity in the broader financial market will meet with change.  Clearly, most US citizens/investors don't even realize what FNMA, FHLB and Freddie do for a living.  In this case it simply does not matter.  These same citizens/investors have been the beneficiaries of this liquidity underpinning, whether knowingly or not.

The second important or significant agent of possible change is that the US banking system is a massive holder of GSE and GSE guaranteed debt.  At the current time, US banks hold $210 billion of direct GSE debt and $355 billion in mortgage-backed securities guaranteed by these same agencies.  In essence, a huge chunk of US banking system equity is dependent on GSE health.  Again, we would loudly stress that the GSE's are not going to go bankrupt or really come near any serious financial trouble.  The US Government would never allow it.  Never.  Nonetheless, there is change in the air regarding financial deregulation.  The GSE balance sheets stick out like a sore thumb.  Perceptual change regarding GSE debt just may prompt US banks to reevaluate their own lending practices in what may be considered speculative or aggressive areas with newfound concern regarding a significant portion of the asset side of their balance sheets.  

You can see that raising questions regarding the GSE's could potentially be characteristic of "incremental change" in terms of broad financial system liquidity.  Liquidity from both the GSE's themselves and from the US banks that own so much GSE paper.  Remember, this is not the singular catalyst, but it sure looks to us like another change agent lever is being applied.  Add this to the list of the small armies that have already infiltrated the Bull Market front lines.  Don't worry, we won't let the Bull Market know it's completely surrounded until all of the troops are in place and ready to fire.  Shhhhhhh.  It'll be a sneak attack.

Konspiracy Korner...Once again, it's time for Konspiracy Korner.  Do you think Gensler's testimony had Greenspan's blessing?  Sounds a bit loony, right?  Isn't Gensler just a loose cannon?  Maybe not.  After trying to talk the market down, Greenspan has met with dismal failure.  Five interest rate hikes (and counting) later and nothing doing.  In fact, Fed actions have seemed to incite an effect opposite of that intended.  We all know that Greenspan and friends are simply running out of weapons and ammo.  Before setting off what may ultimately be the financial nuclear bomb - raising margin requirements - could it be that Greenspan wanted Gensler to incite questions of credit quality and liquidity?  What better way to shout "wake up" than to have the Treasury question one of the prime forces of liquidity in this country over the past few years?  Possibly Greenspan was hoping Gensler's comments would motivate a change in perceptions enough to dampen liquidity and credit creation a touch.  Just maybe, the Greenspan fan club is using every trick in the book before being forced to invoke "the Manhattan Project" to stifle the speculation.

Dear Blabby Update...We find it simply laughable that "astute" market commentators such as those featured on Jack Welch's financial used car lot - CNBC - blamed today's little "buying opportunity" on Goldman's Ms. Cohen dropping her equity allocation by an earth shattering 5%.  Another gutsy call from the Queen of the Bovine Brigade.  It's interesting that Goldman alum's and those on the current roster have been taking "one step back" from this bull market recently.  First Bob Rubin (whose comments were summarily ignored) spoke of financial danger in his speech at the London school of economics.  Then Goldman alum Gary Gensler dumped all over the GSE's.  Now "guru" Abby takes a few chips off the table.  Don't worry.  You'll know there's real trouble brewing if Goldman rushes a secondary of it's own shares to market.  Relax.  (At least that's Abby's standard advice.)

Divergence...It just hasn't happened all that often, but Tim is showing you that it's happening now.  We suggest you take a good look:

In all seriousness, this is one hell of an important chart.  The NDX and the NASDAQ itself have been kissing cousins for far too long.  They could virtually be twins...up until now.  We've seen the big cap techs be marked up (until today) for quarter end, but during the recent blast off, the former biotech and B2B darlings on the NASDAQ have been carried off the field.  Clearly a few less seats in the ultimate game of musical chairs.  Last week, Tim gave us the long term channel on the S&P and pointed out that we were near the top with distribution in order.  As you know, that's exactly what we are seeing in the S&P department.

We believe that last week marked one of the greatest weekly inflows to mutual funds ever.  As you know, the public never buys the dips, despite what passes for information in the financial press.  They always buy new highs.  Always.  You saw the volume last week.  You know this is true.  Wouldn't it simply be a fitting characterization of the top of the greatest bull market in US history.  

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