10/10

A Beautiful Day In The Neighborhood ?

Won't You Be My Neighbor?...Is it still a bull market?  Has the big bad bear finally arrived?  Are we sitting on support levels ready to bounce off and retrace an upward path (at least to some extent)?  Are we breaking key long term support lines that portend impending disaster (or, more correctly, continued disaster)?  Day to day, it's simply anybody's guess.  Clearly, "investment professionals" largely make the world go around each hour of the day and each day of the week, but overlaid on top of frenetic short term trading activity in the current environment is a much more important force of nature - the actions of the public.  Step back for a second and look at the big picture.  There is simply no question that Main Street America has been the driver of the current bull market over the last 3-4 years.  Or, more correctly, they have provided the vast majority of the fuel.  Foreigners have aided the cause recently, but mom and pop America have voted with their retirement savings accounts and individual pocketbooks their belief that equities are the place to be.  We're not talking about the public day traders here, at least those that are still participating.  We're talking about the everyday "Joe and Jane's" who have entrusted their financial net worth's to the mutual fund industry.  

The belief in stocks as the place to be has been tested a number of times over the past two to three years.  The Asian/Latin American economic crises.  The LTCM debacle.  The dreaded Y2K imaginary e-disease.  So far no blinking.  As we have shown you before in the numbers, despite popular rhetoric, the public never really buys the dips.  They do buy the recoveries.  But, the greater message is that they have never really sold.  Never in the last half decade or more has there been any sustainable net selling in equity mutual funds.  Of course there is the odd week or two, but absolutely nothing sustainable.  The public has sold sectors of the stock market before (within the mutual fund complex), but the money has largely been reallocated to other sector funds.  It was only one month ago that we showed you the following table:

  ($ in billions)

See what we mean?  From Income Equity and Growth and Income funds to Aggressive Growth, etc.  The money has recycled, but not left the equity fund complex on a net basis (except for that money that has unfortunately gone to "mutual fund heaven", of course).

Public Enemy Number One...The jury is still out on whether the public will become involved as active sellers.  Collectively involved.  Simultaneously involved.  We have always believed that given the Pavlovian, media reinforced mantra of "be a long term investor", real public selling would not start until the market was already down 25-30%.  Clearly that kind of a drop is not yet in the Dow or the S&P, but the NASDAQ qualifies for the position.  Moreover, belief in equities in general has revolved around the collective belief that technology was transforming our economy and society.  We would guess that if this market is to unravel into one of the greater financial debacles this country has ever seen, the public must become actively involved in selling their mutual funds.  Your next door neighbors must become your greatest enemies from a financial standpoint.  Professional investors can, do and will panic, but it would be forced selling by the public that would be responsible for a sustained and long lived bear market (we're talking multiple years here).  One where stock price liquidation would seem simply endless.

Apocalypse Now?...Why do we bring all of this up?  For perspective.  We've heard a lot of financial doomsday scenario talk lately.  A crash would not surprise us by any means.  All of the ingredients are there.  Both macro economy and stock market specific ingredients.  Yet we have to remind ourselves that instantaneous crash events, along the magnitude of 30-50% market declines over a period of days or a few weeks, are low probability events from an historical standpoint.  Everyone refers to 1929 as a crash, but the true top to bottom crash event took years to play out.  1987 comes closer to the definition we posit.  Who knows.  Anything can happen.  Every time is different in its own way.  We just caution against literally betting the personal financial ranch on a crash.  Puts, shorts and maybe even some gold in a well diversified dark side portfolio holding plenty of cash is one thing, but betting your financial net worth on short term, significantly out of the money index puts is quite another.  Just like betting the farm on a Net stock or two is insane bull market decision making, putting all of your chips down on a crash bet can result in "the horror".  The horror...

As readers know, we at ContraryInvestor.com have been bearish for some time.  In fact more bearish than the a-ver-age bear (Mr. ranger, sir).  Remember the key word here is bearish, not piggish.  If the public decides to unload, or even partially unload their mutual funds, there will be liquidity trouble as far as the eye can see and it will take time to reconcile.  There will be plenty of opportunity to make money on the downside.  Keep a sharp eye on public fund flows as a potential key to severity of downside market action ahead.  Just as it was tough to keep emotional control when Internet stocks were gaping 20% higher by the day, try to maintain objectivity and focus on the numbers during downside breaks as we have experienced in September and early October.  Our primary focus as investors is on not losing money as opposed to correctly picking the lotto numbers for the week.  We try to be investors in upside environments.  Likewise we want to be investors when the market turns down, not gamblers.  Dark side investments are something altogether different than betting on crashes.  We're not any less bearish.  Just simply trying to be realistic.  We checked our emotions and egos at the door a long time ago.  (We just hope we can still find the claim ticket at some point.)

The one question we would leave you with in terms of dark side crash bets is the following.  Greenspan, the political administration, G7 powers, etc. immediately rode to the rescue during the Asian/Latin American problem.  Greenspan and friends dropped interest rates three times to dull the effects of a singular hedge fund blow up.  Liquidity was sprayed all over the Street to fight the imaginary dragon of Y2K.  Do you really expect the greater vested Street interests and governmental powers to simply stand back and let the US equity market go into a free fall without as much as raising a finger?  We didn't think so.   Bearish?  Yes.  Financial apocalypse?  Probably not overnight.  

Backdraft...In addition to the tinderbox of potential mutual fund sales by the public, clearly the accelerant in any significant downturn from here will be margin debt.  At least through August, it seems to be the only index that hasn't corrected.  As you can see, it is still trading very near an all time high:

As we have talked about over the past two months, the market stands at a perilous crossroads.  The public stands at a crossroads of confidence.  A crossroads of belief, faith and trust.  Both the domestic and global economies stand at the same juncture in the financial pavement, being so dependent on the perceptions of "financial wealth" for their real world health.

Sport Utility Vehicles...As you may know, the utilities are the best performing S&P sector group through the nine months ended September.  After the pounding they took in 1999 coupled with some scared money looking for shelter from the storm this year, is it really a surprise?  Add in a few scare stories on electrical generation shortages, a few scattered dividends here and there and you have the makings for not inconsequential positive total rate of return.  We thought it would be instructive to take a little look at the group, for which we have chosen the Dow Utility index as a proxy.  Have a peek (numbers as of 10/9):

These are some of the largest cap electrical utility stocks in the domestic market.  Despite the S&P sector leading performance for the year, the utilities have let very few new investors come along for the ride.  Just as the descent of the techs has let very few out along the way.  It's a matter of capitalization and the ability to move or reallocate money efficiently.

As you know, despite Enron's prominence in the gas and foreign utility businesses (EOG, the trading operation, foreign operations, etc.), the stock trades with a new era scent given it's announced intended forays into broadband (plus broadband trading).  Williams Cos. has much the same aroma.  Even including Enron and Williams, the total market cap of the Dow Utility Avg. is $233.5 billion.  For perspective, the trip from $75 to $39 cost Intel investors $242 billion, a sum greater than the entire market cap of the Utility average.  The following table should make it perfectly clear as to why it's so hard to allocate money away from today's current favorites into overlooked and underrepresented (institutional sector weightings) sectors such as the utilities in an orderly fashion (numbers as of 10/9):

GE, CSCO, MSFT, INTC, ORCL and SUNW have a collective market cap eight times greater than the entire Dow Utility Index.  And this is today, after a period of some serious market cap loss in the techs and gain in the utilities.  The imbalances created in the past few years will not allow anything near the orderly reallocation of capital among disparate market sectors in the aggregate.  We've watched in amazement this year as investors have run to the utilities as a group with what appears to be a lack of coordinated thought. Up until now, there has been little differentiation between utilities that are capacity constrained and those with excess capacity.  We were stunned that Pac Gas was ascending almost daily at the exact point when it was being forced to pay exorbitant rates for summertime shortage wholesale power that was essentially not allowed to be passed on in retail pricing given its currently regulated rate structure.  When it finally screamed for rate relief to the California State PUC, investors awoke from the blind allocation fog and dropped the price 20+% in a matter of days.

We bring this up merely as a reminder that because carnage is being wrought on particular groups in the market and institutional money is attempting to reallocate on almost a panic basis, blind momentum following into groups alternative to mania favorites can be dangerous without some thought and preparation.  There are never any easy answers.  Do your homework.

Memories...Light the corners of the chart.  Thank you Tim for the following education in parabolic movement and the immutable forces of financial gravity:

Maybe we should have skipped the commentary and just published the picture.  Worth one thousand words?  Well, maybe in this case, 3240.54 words.