ContraryInvestor - Market Observations

MARKET OBSERVATIONS

CAPPING OFF A HORRIBLE HALF YEAR? HARDLY

MARKET OBSERVATIONS - 7/5

The Usual Suspects...We marveled in our last discussion that there appeared to be no month end mark up occurring in what had been a rather dismal quarter for equities that ended last week. Finally the window dressers got off the dime in the last 45 minutes of trading on Friday. As you would imagine, the usual suspects were levitated. The big cap tech darlings, the GE's of the world, etc. The big holdings in the big funds. You may be aware that Canadian authorities recently charged a few money management "professionals" north of the border with fraud for largely doing what amounts to end of period mark up of asset prices. For many moons now, too many bears have been asking "where is the SEC in all of this?" It's become so blatant that you'd expect some type of authoritative investigation. Although it won't come until well after a devastating bear market, we're wondering where the public outcry is in this type of trading activity. After all, the mutual fund money belongs to the public, not the SEC. The funds are spending the retirement and investment money with which the public has entrusted them in what are often futile and expensive attempts to temporarily jack up individual stock prices. After today's little drop in many of the previously jacked up favorites, the example of wasted capital is staring us in the face. We sincerely wish we could find or derive data on the dollar cost involved in mark up activity during these month end and quarter end periods. We have the feeling that the absolute capital wasted in this often quixotic exercise would be nothing short of sickening, even to us.

Been Down So Long It Looks Like Up To Me...Another look at unweighted equity performance can be seen in the Advance Decline lines of the major indices. You've probably all heard the new age pundits and strategists extolling the thought that we have seen a bottom in the advance decline experience of the major averages over the past few months. "The market is broadening" has been caught on the everlasting memorial of CNBC videotape more than a time or two in the recent past. Oh really? You be the judge:

There is no question that there has been modest improvement in the NYSE AD line in the past few months, but it's still a bit premature to be calling for a long term bottom. The New York composite tape today is roughly where it stood a little over 12 months ago. Unfortunately, the AD line is off 20% over the same period of time (and up only 4% off its early March 2000 bottom). This chart is directly supportive of the fact that the top quintile of the S&P continues to grow in importance both for index return reasons and, more importantly, for broad investor perceptions of the health of the overall market as gauged by the singular index returns. Another chalk mark for widespread complacency, especially on the part of public mutual fund investors.

The NASDAQ crime seen isn't any better. In fact it's much worse:

Over the period that the NYSE composite A/D line has dropped 20%, the NASDAQ A/D line has dropped over 50 %! That's right, over 50 %!!!. (As you know, prior to the early 2000 NASDAQ blow off, the NASDAQ composite had doubled while the NASDAQ A/D line dropped 50%.) Moreover, the NASDAQ A/D line is down over 30% YTD. Of course the year-to-date investment performance for the NASDAQ composite through June is down (2.5%). Once again, this is graphic representation that the top cap stocks in the NASDAQ (and you already know who they are) have been illusory band aids covering the deep wounds underneath the index numbers.

Not that you need us to tell you, but any true bear market will not allow the top capitalization S&P and NASDAQ stocks to escape alive. In the stealth bear market we have lived through in the last few years where issues below the top quintile (or really decile) in the S&P and the NASDAQ have been badly damaged, the public seems to have remained perceptually immune to the growing cancer. Clearly the overwhelming preponderance of broad based investment money in this country is caught in the top decile and quintile stocks. We've discussed before why the rise of the mega dollar mutual fund families have structurally skewed exposure to big cap issues by necessity (overwhelming asset size of the large funds and the need for liquidity per individual position). As you can see from the charts and table above, a bear market in top capitalization stocks hasn't even begun to be played out yet. If the history of human nature is any guide, the inevitable destruction of the bloated market caps in the top decile/quintile of the indices lies in our future. As we have seen in the past, this is usually the last group to go.

Look on the bright side, once the top decile/quintile "resolution" is out of the way, you can count on us (at some point) to move to the wildly bullish side of life.

Out Of The West Texas Town Of El Paso...Not only is the NASDAQ setting volatility records not seen since 1929, but the political volatility in Mexico has hit a seventy year high in terms of the governing party. As you know, the Opposition party has won the recent elections, effectively putting an end to the official government administration domination by the PRI for the last seven decades. It has been heralded in the press as quite significant for Mexico both culturally quite possibly economically. A change in the economic fortunes of the country will clearly be something to be assessed over time. Since Mexico is one of our largest trading partners, an economic increase in the standard of living should be a big positive for US trade, right? The knee jerk and substantially correct answer is yes. But alas, what about the law of unintended consequences.

Potentially important indicators to watch along with a grassroots economic resurgence in Mexico will be US labor availability, especially in California and the border states, and the labor costs in the maquiladora manufacturing facilities in Northern Mexico. Can you imagine what would happen to the already imploding availability of labor in California if Mexican nationals decided to return to their home country given the current change in the Mexican political climate? (Not to fear though, we're sure the Bureau of Labor Statistics would find a way to "adjust" for a potentially unpleasant California labor market experience to please financial market participants far and wide.) If the perceptions of positive economic change in Mexico became broadly viewed as plausible and likely, wouldn't global capital find potential economic rates of return in that country an attractive alternative to US ventures? None of this will transpire overnight, but the Mexican situation may be a source of incremental change for US financial markets. For US consumers, now accustomed to importing deflation along with every inbound freight container loaded with retail items, perceptual and absolute change lies ahead, albeit incremental change.

Hold The Line...For foreigners long dollar denominated assets, they better hope the dollar holds. Have a look at the following chart:

Technically, it appears that the dollar is sitting on the line of ascending lows started last October. The MACD reading (moving average convergence divergence) likewise suggests trouble ahead. As we've already pointed out far too many times, the dollar is a critical piece of the new era puzzle. A serious break in the dollar clearly heats up inflationary pressure. As you can see in this little two year dollar retrospective, the dollar sold off in 1998 and 1999 between July and October. Forget the calendar similarity, what is important is that in each instance the equity market direction followed the dollar, with both the dollar and equities bottoming in October. If the dollar breaks down technically from the current level, do you really expect stocks to rise? History clearly says "don't bet on it". Will the Fed be forced to raise interest rates to defend the dollar given the inflationary pressures it would exacerbate on a sharp decline? The dollar conundrum isn't something that has just magically appeared. It is emphatically the result of allowing a trade deficit to balloon as a matter of policy, allowing the money supply to expand in excess of GDP growth, and allowing credit creation outside of the banking system to proliferate beyond any reasonable measure. Undoubtedly you've heard the term "between a rock and a hard place". Ultimately the Fed will face the impasse head on. Keep a sharp eye on the dollar (as if you don't have enough to worry about already).