MARKET OBSERVATIONS

MARKET OBSERVATIONS - 5/9

Cisco Fever...Overnight fever, night fever, they know how to do it.   Barron's, that is.  Yes, we've all heard about the cover story over the weekend.  Surprise, surprise.  Finally a mainstream publication put it in print.  (We were seriously wondering what was taking them so long.)  Now it's finally out in the open as opposed to being within the sole province of the bearish web commentators such as ourselves.  What we find important in the Cisco cover story has nothing to do with the story at all.  In bear markets, negative information that has plainly been in public view for years and has been summarily dismissed, all of a sudden takes on importance and a sense of truth.  It's when this "new found" truth translates into selling that you know the bear has arrived.  This, in our humble opinion, is the key to the future of Cisco as a stock.  We also believe that this could be a real conceptual lynchpin for the market as a whole.  If this new "discovery" acts to change perceptions of a market icon, it will be a much broader statement on the entire market environment.  Technically, Cisco was already beginning to limp anyway.  Barron's just came along and kicked its good leg.

You know that this is not the first time Barron's has dropped a factual bomb on a favored stock.  A few years ago, they did a very negative piece on GE.  Wildly overpriced, a financial services company in sheep's clothing, etc.  They did another eye opener on GE some months back.  In a wildly bullish market, none of that "behind the curtain" stuff even mattered.  GE skipped merrily higher on a sea of managed quarterly results and perceptions that GE's growth was truly eternal.  When less than optimistic company information that has essentially "been there all along" starts to matter to investors, change is truly in the air.  The final act remains to be played out in the confidence destruction derby.  One stock car at a time.  Don't worry, we all have front row seats.  Remember, bear markets are a process of confidence destruction.

Cisco's Friday purchase of tiny Arrowpoint simply added an extra dose of gunpowder to the Barron's journalistic cannon.  What is quite interesting is that CSCO purchased Arrowpoint just five short weeks after Arrowpoint came public.  The folks at Cisco aren't exactly asleep at the switch.  Why wait until after the market has pumped additional helium into the Arrowpoint balloon before buying the company?  Good for Arrowpoint shareholders.  Bad for diluted Cisco shareholders.  (You may remember that CSCO purchased Cerent just prior to the latter's own IPO.)  The only explanation we can come up with is that exorbitant prices are being extorted from CSCO for state of the art technology.  To be so near an IPO in Cerent's case must mean that initial attempts to purchase the company while private failed and that CSCO was forced to cough in the eleventh hour to stop an IPO from potentially ballooning the price further.  Obviously, if we are anywhere near correct, things did not go so well in the case of Arrowpoint.  To be forced to pay well above the IPO price just five weeks earlier, CSCO must have felt they needed Arrowpoint awfully bad.  Alternatively, if Cisco is anywhere near right in the value it paid, Arrowpoint should be preparing a lawsuit against its underwriters.  Clearly, making acquisitions is getting a lot tougher for CSCO.  

Show Us The Money...Throughout the course of our writings, we have always contended that the public specifically does not buy the dips.  They buy the recoveries.  This has been shown time and again over the last few years.  Our friends at AMG data (www.amgdata.com) document the flows each week.  Nothing is left to interpretation.  As we have mentioned to you over the last few weeks, the public did put money to work in April.  The numbers should approximate $23+ billion.  We were quite surprised.  If they bought the dip, then this was completely out of character for the public relative to past behavior.  Or was it?

In the spirit of full disclosure, we have lifted the data for the following table straight from Bob Adler's AMG Data website.  Have a look:

We have to believe that the bulk of the supposed "dip buying" in April was nothing more than tax year end IRA, profit sharing, etc. contributions.  You can see in the table that weekly inflows calculated on a four week moving average basis for the period ended 3/22 were much stronger than those for the period ended 4/22.  What this implies to us is that the public was not eagerly buying the dip at all.  They were sheepishly tossing their 1999 contributions into tax deferred vehicles at the last possible minute.  The big slowdown in the 4/22 four week average of contributions into tech oriented funds (inclusive of small cap and aggressive) is the clear giveaway.  The public could not buy this sector fast enough just prior to some very spectacular highs.  When this group of stocks promptly dropped like rocks, the allocation to the sector trailed off significantly.  By the way, for the one week ended last Wednesday night, AMG reported a rare $555 billion outflow from domestic equity funds in the aggregate.  (This was comprised of inflows to large cap and outflows from tech oriented funds.  Does this sound like buying the dip to you?)

All The Federales Say..."We could have raised rates any day.  We only let them go so long out of kindness, we suppose."

Looks like the time for being nice may be drawing to a close.  Our bet is that the Fed throws a 50 basis point monkey wrench into the out of control economic gears next Tuesday.  The question is will the wrench slow the gear mechanism or be shattered into many shards of metal?  Some chemicals, papers, and assorted "old economy" industries are enjoying their highest operating rates and unit volume growth in many years.  Wage inflation pressures continue to mount as unemployment numbers may be encountering a structural low point.  "Cost push" inflation is here.  Unfortunately for the Fed, the election is just up around the bend.  The time is now.  A 50 bp Fed Funds rate increase seems like a given for May.  June is still a toss up.  A flatish stock market coupled with continued strength in the economy seems to suggest 50 bp's in June also.  As you can see, the following chart confirms a recent breakout in the rate of change of GDP.  The Fed has to believe that it definitely has room to "maneuver" without destroying, given the white hot economy:

Before getting too convinced of the dark side to come in equities, remember that the market always anticipates.  The Fed fund futures already know there is 50 basis points of increase in our immediate future.  As the futures market begins to anticipate and price in a potential increase in June tightening severity, the stock market will also begin to look past it as the last tightening for a while.  Be prepared for potential market movement based on the thought that after June, the Fed will be on hold for a while.  We can hear it now.  Greenspan citing the lag effect between raising interest rates and a slowing economy as rationale for "going quiet" (until after the election).  Once the stock market convinces itself that the Fed will be on hold until after the election, the real test comes.  You already know the Pavlovian response.  Rally.  Rally.  Rally.  Just imagine if it was different this time.  Remain flexible in your outlook and investment posture.  Don't try to tell the market what to do.

Irreconcilable Differences?...One of the major imbalances that we believe does concern the Fed is the trade deficit.  We're just having a heck of a time trying to figure out how the situation can be reconciled in an orderly manner.  As you would guess, we would suggest it simply can't.  At the moment, we are running a $400 billion annual trade deficit as well as being the world's largest debtor nation.

We believe the trade deficit, the dollar, and the stock market are collectively caught in a vicious spiral to the upside that could easily be shattered and come unwound.  Likewise, all factors negatively reinforcing each other on the downside at some point.

We are convinced that the massive trade deficit we are now running was no financial freak of nature.  Early on it was a conceptual plan to bail out foreign countries from the financial debacles experienced two and three years ago.  We also surmise that the quid pro quo for the US allowing a ballooning domestic trade deficit was the understanding that exported dollars would be "recycled" into US financial assets.  Clearly the ECB and the Japanese had a vested interest in a stronger US dollar and a larger US trade deficit.  Somewhere along the way, what may have been a plan intended to be temporary has taken on a life of its own.  Domestic and foreign demand for US financial assets has acted to increase the wealth effect (eventually sparking inflation), which in turn has put upward pressure on interest rates.  The upward movement in rates likewise sparks increased global demand for dollar assets as foreign interest rates are much lower yielding alternative investments, to say nothing of the benefit of the currently appreciating dollar to a foreign holder of dollar assets.  Once again the dollar moves higher and the potential for trade deficit worsening becomes larger.  The cycle repeats itself.

Quite importantly, what truly is different this time is the trade deficit/dollar conundrum.  When looking at the peaks of historical bubbles in the past, we do not find the country hosting the bubble in such a precarious trade imbalance situation as we now face.  In 1929, the US ran a significant surplus.  You can see in the chart above that in the US during 1973, the trade deficit was simply a non-event.  In 1987 it was worse than had been experienced in the prior few decades, but nothing as significant as the present situation.  Lastly, in the Japanese experience of the late 1980's, the Japanese trade surplus was significantly positive.  The only comparisons we can draw are those of countries like Thailand, Brazil, Indonesia, etc.  Massive trade imbalances and bubble financial and real estate valuations a few years back.  You know what the ultimate results were in these countries.  The reconciliation was violent.  Capital fled indiscriminately when confidence was lost.  We see many look at the following chart and proclaim the the dollar is breaking out to the upside.

Conversely, we ask the question, "is the dollar really overvalued and due for a fall?"  We have to believe that a significant stock market decline puts the current dollar- trade deficit relationship in reverse.  Fast.  Not even a 50 basis point interest rate increase will support the dollar if domestic consumption slows as a result of a declining stock market.  We see many bulls point to the trade weighted dollar chart as a comfort.  What we do not see is any analysis as to why the dollar is here in the first place, given the existing trade deficit and US debt position.  Maybe these dollar bulls would be well served to study the Japanese experience of ten short years ago.  The yen was quite overvalued at the top of the Nikkei run in late 1989.  The only problem was that no one could "see" it at the time.

Wall Street Gulch...Be vaawe, vaawe quiet.  It's wabbit season.  Action on The Street has been eerily quiet over the last few days.  Today's volume was a bit better than yesterday, but not much.  It appears that we may have arrived at a perceptual fork in the road.  Is it time to buy?  Or is it time to sell?  Market participants have responded with a collective "who knows?"  To us, it feels like exhaustion.  Perhaps the extreme volatility we have experienced year-to-date has worn everyone out.  The bulls chant that the low volume is bullish.  There are no sellers!  Conversely, the bears are also correct in that there are no buyers.  Patience is simply not a quality that correctly characterizes the stock market over the last year or more.  We have a hard time believing this market can quiet down for very long.  As with any small child, when this market "wakes up", it's going to demand to be fed.  The question is, "is the baby bottle half full, or half empty?"  No matter what, count on Greenspan to quickly whip up some formula if the crying gets too loud.

The following graph shows the action of the QQQ's (NASDAQ 100) over the past few months. At the moment, it looks like a near picture perfect head and shoulders formation is being put in place. (Of course, the conclusion has not been revealed as of yet.) As you can see, the last rally from the April bottom was done on declining volume. For what it is worth, we find that certainly shy of bullish.

Tim has done another super job with a peek at the SPX in the following chart.  Let's face it, technically, a lot of the major indices are looking pretty shaky right here.

Can mom and pop live through another significant step down in the market averages and continue to truly convince themselves that they are in this for the long run?  The technical condition of the indices tell us that we may have an answer to that question in the not too distant future.  Unfortunately, we are convinced that real selling will only begin at much lower market levels.  When the process of confidence destruction is well underway.      

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