Mind The Gap (Part II)    

8/31

The valuation dichotomy of today's market does present the possibility for multiple outcomes (no pun directly intended) in market direction in the months ahead.  Clearly an implosion in the macro credit backdrop could ignite a paper firestorm.  Alternatively, we may see an attempt at a valuation gap reconciliation as this aged market just finds it too difficult to push the 800 pound gorillas uphill anymore (despite what happened today).  In a final attempt at overall market survival, the lower tier stocks just may receive attention.  Here are the "devil's advocate" rationales for why the total market may not be on the verge of complete collapse (only parts of it):

    The Average Stock Is Not Overvalued

It's simply too simplistic to argue that the current historically high valuation multiples on the major averages argue for a total market collapse.  Liquidity starvation may argue for a total market collapse at some point, but certainly not valuations alone.  Most of the major averages are simply a mirage.  The capitalization weighted nature of the S&P and the NASDAQ argue against generic analysis.  The dichotomies that exist make generic analysis fools gold.  To say that S&P stocks sell at 28-30x's earnings only describes a weighted average and does nothing to delineate component analysis.

The fact is that the valuation gap is huge.  The over owned tech favorites sell at ridiculous levels.  Valuation is a joke.  For the second tier has-beens, it's another story.  Steve Leuthold recently reported that the median P/E for all US stocks with market caps above $200 million (3000 stock sample size) is 14.2x's.  Clearly the S&P 500 average that is dominated by the super caps has an aggregate valuation twice that level.  The NASDAQ weighted P/E is nothing short of a moon shot.  Historically, common stocks have averaged roughly an approximate 13x's multiple, so these numbers really do say that the typical or average stock in the US is not overvalued.

Just for drill, we have prepared the following tables for the S&P and the NASDAQ. You probably already know what we are about to present anyway (P/E numbers based on '00 eps) :

TOP S&P ISSUES BY CAPITALIZATION

TOP NASDAQ BY CAPITALIZATION

As you can see, approximately 46% of the total S&P is accounted for by 29 stocks whose average P/E is 56x's.  For the NASDAQ, 46% of the average is accounted for by 15 stocks with an average P/E multiple collectively of 139.4x's.  Undoubtedly these above listed issues are "carrying" the major averages.  They are also where the bulk of market risk resides.  They are also massively over owned institutionally.  Still feel good about index funds?  After all, they are sooooooo diversified.

    Perceptions That The Fed Tightening Is Over

In the old fashioned world of ancient economic analysis (anything pre-1998), a downturn of the LEI (Leading Economic Indicators) was suggestive of a potential for recession on the horizon.  Well, that little old-wives tale was successfully invoked with Wednesday's LEI report.  Of course in the new era, these economic trivia tidbits are good for a chuckle or two.  We seriously do not subscribe to the three dips and a recession rule ourselves.  Clearly, new era monetary policy has changed the rules (at least temporarily).  Today's little factory orders number (largest drop on record) also goes a long way in terms of influencing perceptions.  Although it does suggest a slowing (which is ultimately bad for corporate profits), as we suggested Tuesday, the "crowd" chose to view it as a positive in terms of future monetary policy inaction.   What we do point out is that this is the very type of news release that reinforces the "fed is done" chant.

Does the Fed have a few more interest rate hikes left in them post the election?  That's our bet.  Severity of rate increases ahead is still an open question though.  If the stock market does not deflate under it's own weight, we'd have to believe that the Greenspan policy of gradualism in terms of bubble deflation will to be resumed.  But that's it, just gradualism.

In the meantime, we have virtually three months of uninterrupted monetary bliss ahead.  Equities have the potential to stay relatively afloat pre-election, all else being equal.  In a perverse way, further interest rate increases may actually be good for value or second tier oriented issues (and we are serious about this).  Maybe we are just being old-fashioned, but the higher interest rates ascend, the worse growth stocks appear on a discounted earnings or cash flow basis.  Especially the tech issues promising to make a zillion dollars in the far distant future.  Ultimately rates going too high upsets the whole apple cart, but money should logically flow to value in a higher rate environment.  As you know, though, logic is also an ancient market concept discarded somewhere a few years back.

    The Individual Investor Has Not Blinked

Although they have had sand kicked in their eyes a few times this year, individual investors have not flinched.  Mutual fund inflows this year have been strong.  Through July, the number is close to $185 billion, which is an approximate 70% increase over last year on a comparable time frame basis.  We have only counted two weeks in the entire year when flows went negative.  It's not axiomatic that mutual fund holders have to sell for the market to collapse (although it would help).  Nonetheless, lack of redemption's puts a lot of power and flexibility into the hands of the mutual fund complex in the aggregate.  (As you know, redemption's dictate action.)  Clearly the fund complex does not want to see the market unravel.

According to ICI, US focus fund managers invested $38.4 billion in net new money during the 2nd quarter.  As per the folks at ICI, this was only 60% of what they actually received.  Can you blame them?  For a minute there it appeared that the new era was meeting a classic old era finale.  The quick math indicates that as of June month end, about $25 billion of excess dough was sloshing around sector fund coffers as a result of manager temporary paranoia.

The continual weekly flow of cash into mutual funds provides a cushion for this market.  As you know, at some point this flow will be meaningless and ultimately turn into a landslide of redemption's (of what assets are left, that is), but for the moment it's a crutch.  Could individual investors actually decide that they should pump money into value oriented funds?  It's a possibility.  If the media hound dogs at organizations like the CNBC's of the world told them to they would.

    Technical Indicators

On many fronts, the technical condition of the Gap dichotomy has experienced a bit of a bounce over the last few months.  Advance/Decline for the NYSE has decided to arise from its death bed.  Supply/Demand measures such as Lowry's have recorded buying pressure.  Measuring stocks bought on upticks versus those sold on down-ticks also points to improved demand.  Short term technical indicators are so very often temporary and fleeting.  They say nothing about the long term merits or attraction of the financial markets or individual issues themselves.  Nonetheless, there has been improvement as of late.

To sum up this little two part special, we again reiterate that as contrarians we are bound by decree to look at both sides of any situation. Our gut tells us that any closing of the macro valuation gap in the current market environment would be temporary primarily due to the fact that the big money owns the big cap stocks.  They have no efficient way out.  They have no effective means of orderly reallocation.  Over the years we have heard far too many cries that the small caps were "ready to rally".  "It's time for the cyclicals".  Just stop it.  In our minds, the bloated ownership of the super nova caps by the institutional investment community needs to be reconciled before any other sectors or cap ranges can come into their own.  Period.

As a parting shot, the only nearby quasi example we have of a domestic US market situation very comparable to our own at this time is the 1973-1974 top/bear.  The Nifty Fifty were wildly inflated and wildly over owned.  The smaller tier issues had taken on gas for years.  The NYSE Advance/Decline was nothing short of a crime scene at the top of the market. The Gap was massive in terms of valuations.  That structure ended with the big cap Nifty issues imploding upwards of 40-60%.  Unfortunately the smaller and second tier issues also dropped another 10-20% after already being depressed.  At that point the smaller tiers began to outperform.  Maybe, as we've heard it said, it's different this time.

Neither A Buyer Nor A Seller Be, Just A Broker For A Fee...Well in this case Credit Suisse must believe that the underwriting cycle has a long way to go from here.  Just think, and here we thought every company conceived on the back of a napkin (and with the financial strength of a napkin) had already been ushered to the public trough in this bull market.  There must simply be a plethora of future dotcom Chapter 11 candidates yet to partake of the public cup.  Who knew?  $11.6 billion in cash is one hefty fee to pay for what is essentially a very highly leveraged financial organization.  As of 6/00, DLJ had about $4.5 billion in equity so goodwill here is sizable.  It's just a crying shame they had no in-process R&D that could be written off.  Oh well, thank God there are always employees that can be written off.  (We told you perceptions regarding labor pressures would be positive before the election.)  The players continue to consolidate.  UBS and PaineWebber recently.  MONY group and Advest on their heels.  And these are only just the latest.  Talk about future commodity orientation in the delivery of financial services.  Are we there yet?

When we look back over what has happened in the delivery of financial services, primarily investment management, in this country over the last three decades, our ultimate faith in cycles is reinforced.  After a good amount of consolidation in brokerage and financial outfits just prior to the '73/74 bear market, the bear caused a shake out of the best and brightest minds who pulled up stakes and started their own investment firms.  From the conglomerate financial behemoths leapt the next generation of investment management entrepreneurs.  Shunning the shackles of the bureaucracies.  It's simply ironic that most of these 1970's conglomerate refugees/entrepreneurs who prospered in the 1980's and early 1990's have just sold their own investment businesses back to the new era financial behemoths.  Just to repeat the cycle all over again?  Our bet is that is exactly what will happen.

The Moment Of Twooth?...Be beary, beary careful, bear hunting season may be "breaking out".  Get the picture?

As we mentioned a few weeks back, the "commercials" (the smart $$$$) have one of the largest short positions ever.  These are the guys/gals who slug it out in the pits to put bread on the table for their kids.  This is serious business.  They are not often wrong in a tremendously big way.  If that short position needs to be covered because of an upside run, well...you can guess the outcome.  

Just For Laughs, Sort Of...We mentioned on Tuesday that it was time for the KGB (Kudlow, Galvin and Battapaglia) to show up and sing the "Fed-is-done-new-era" fight song.  Guess who is guest host on CNBC tomorrow (for the wonderful new era employment report)?  Lead off batter Kudlow.  Isn't that special?      

Back To Market Observations     

Copyright 2000, ContraryInvestor.com