11/28

PAGES TURNING

Pages We Were Years From Learning...Or so most modern day investors thought.  Bear markets not only separate the greatest amount of people from their money as possible, but also serve as a potential education for the greatest number who care to listen.  An education for those who have not yet taken the time to study the history of financial markets and human decision making over time.  As you may remember from your own academic pursuits, very little is retained over the long term by simply participating in a "crash course".  Bear markets, much like an engrossing novel, play out one page at a time.  The longer it takes to complete the study, the more burning and long lasting the educational retention.

That 70's Show...We really have no exact idea how this current interlude in financial market history will play out.  For steady readers, you know we will have plenty of guesses and perspective to offer along the way.  Although financial market cycles can "rhyme" from generation to generation, nothing ever repeats in exact measure.  The reason we bring this up is our reflections on the current market and similarities to the 1973/74 bear market.  As you know, mutual funds were also the craze at that time.  A few select managers like Fred Carr and Gerry Tsai were idolized much as hot fund managers of the moment have become media celebrities today.

More importantly, the dreams and certainty of the then Nifty Fifty environment (new era) did not die without a fight.  The '73/'74 bear began in early 1973 with an incredible up down saw tooth pattern that lasted two-thirds of the year.  After a valiant attempt at a rally (of course coming up short of prior index highs) in the third and early fourth quarters of the year, the market gave way in November of 1973 and just about never looked back straight into the October bottom of 1974 (chart below).  Investors were hurt in 1973, but little did they know that the worst was yet to come in 1974.  Have a look at the numbers:

It is interesting that the performance numbers we are experiencing today are not far off what happened during the first year of the bear in 1973.  There are clear differences between today and twenty seven years ago, but there are also many distinct similarities.  The NASDAQ was only a baby in 1973.  Two years old.  Unlike today, the NASDAQ did contain the real speculative end of the market.  Certainly we could characterize a lot of the NASDAQ today as speculative, but the current NASDAQ also contains many Fortune 500 mainstream names that are staples in the portfolios of the present.  Largely the gunslingers owned NASDAQ tech in the 1970's.  Today, mom and pop America are devotees.

The country was facing an energy problem during that period.  We've stopped short of calling our current situation a crisis.  Who knows what the future will bring.  It is almost ironic to note that current Saudi Crown Prince Abdullah was also a voice in terms of Saudi decision making during the 1970's.  A series of what can be considered in some circles as anti-American commentary has been attributed to him over the years.  You may have noticed that he recently called for other Islamic countries to sever relationships with Israel.  The Saudis are also claiming that the US bears a certain responsibility for the current melting of the Mid East peace process.  Additionally, Saddam is now threatening to stop Iraq's daily exports of oil if his demands on the UN in renegotiating Iraq's UN imposed monetary sanctions are not met.  It's not an energy crisis...yet.  (In all sincerity, we certainly hope it does not degenerate from here.)  Secondly, inflation was set to take off as the stock market buckled in the '73/74 period.  The market correctly anticipated that corporate earnings growth in the subsequent years would be heavily influenced by the nominal effects of inflation as opposed to the real effects of economic growth.

Today's commodity inflationary pressures are largely found in the energy complex, leaving paper assets and real estate aside for a moment.  A real bear market in US equities would probably have an effect that leaned in the direction of deflation as opposed to inflation, given the existing leverage in the system.  But it must be remembered that given a choice, political bodies have always chosen inflation over deflation as the preferred paper combustion fuel of choice.  Only in hindsight would we know which path the equity market was predicting if a bear truly develops from here.

Give Us This Day Our Daily Breadth...One of the most striking similarities with the 1970's market and the one of the present is that the bull run into the peak was narrow in terms of breadth.

Chart courtesy of DecisionPoint.com

The shining house of the stock market was being eaten by termites for a good while before the exterior started to crumble.  All one had to do was squirm around in the crawl space of the equity world to find out that the supporting beams of the house were giving way under the weight of the few issues perched on the roof.  Such has been the state of our market over the last few years.  Well before the peaks in the major indices.  Breadth was clearly one of history's early warning signals then as it appears to have also been in the current environment:

Everybody, Do The Tighten-Up...Lastly, although similar in concept, but quite different in degree, the Fed was tightening into the beginnings of the 1973/74 bear cycle.  The Fed Funds rate more than doubled from the market top in early 1973 until the Fed began to ease again in mid-1974.  Talk about a Fed willing to get out in front of inflation!

We bring this up because from the time the Fed began easing until the market (using the S&P 500) finally bottomed, almost three months and a further 27% decline transpired.  Admittedly, the S&P did recover this 27% decline over the following six months after the October 1974 bottom, but the initial drop in rates could not turn the stock market on a dime.  In fact, the S&P 500 saw the same price level that existed at the first rate cut after the Fed had taken back all of the rate cuts initiated throughout 1973 and 1974 - a 100% retracement in Fed policy.  As we have argued too many times, we believe that the real test of the current bear market may come with the first Fed ease at some point.

Will our current market play out as did 1973/74?  The correct answer is no one really knows.  There are many striking similarities between the two environments.  We can't attest to rhyming as of yet, but we'll be damned if we can't here a little haiku off in the distance.

"Minivan, mortgage,
Kids, steady income, comfort.
Complacent thinking."

Certifiable...And it's not just in the US.  Globally, political turmoil seems to have all of a sudden blossomed.  And this time around it's not third world countries being spotlighted as undergoing stress, but rather their big-brother G7 nations instead.  With the sheer weight of lawyers and media personnel converging on and covering the US Presidential election ground zero in Florida, we're surprised the state hadn't cracked off the mainland, of course thereby negating the need for any further recounts.  Prime Minister Mori of Japan narrowly survived a no-confidence vote in Japan last Tuesday in what is a battle for control of Japan's dominant political party (essentially the controllers of Japanese economic policy).  Romano Prodi, President of the EU, recently insisted on vesting more power in the Brussels-based non-elected EU officials (taxation, etc.).  The Middle East situation, recently overshadowed by Florida election recounts whereby candidates were being allocated additional votes that could essentially be counted with the fingers on one hand, is darkening.  (We described above the response of the Saudi's to the current trouble between Israel and Palestine.  The response is not positive for global geopolitical harmony, let alone energy price stabilization/"normalization".)

Financial markets detest uncertainty.  Both financial and political uncertainty.  After all, certainty is a key construct for assessing the level of "risk premium" appropriate in the price of an asset as academically quantified by the capital asset pricing model.  This leads us to a little walk down US dollar memory lane over the last 30 years:

The dollar and US political uncertainty have not exactly been best friends over time.  Probably more critical now than at any time in the last thirty years is global confidence in the dollar (for the sake of those holding dollar denominated assets).  With friends we have spoken with in Canada and Europe recently, the US Presidential election antics have been fodder for conversation over a few pints.  At some point it's not a joke anymore.  That point happens to be where rate of return is effected.  As you know, we recommend the vigilance of a hawk when it comes to watching the US dollar these days.  After all, it's one of the largest keys to the magical global paper kingdom at the moment.

Let Me Tell You Brother, You Can't Have One Without The Other...Clearly no discussion of the 1970's would be complete without addressing the action of getting high on drugs.  It's time to lift the lid on this joint, cut through all the smoke of bullish snorting and put this group through the acid test.  In all sincerity, price and volume in many of the major pharmaceuticals are diverging.  Maybe this means nothing, and maybe it means something.  We own these in client accounts and have been concerned for some time about currency issues and the growing sentiment against what is perceived as high drug prices (in spite of Gore).  Is the anticipated Bush victory the high point for the drugs for a while?  Only time will tell.  Quite frankly, we're getting itchy trading fingers here.  If this bear market continues to broaden, the clock is ticking on the pharmaceuticals.

Faded Pages Open In The Sun...Shouldn't the NASDAQ mania chart of the last decade have been a clear black and white case of parabolic euphoria in the eyes of investors earlier this year?  The faded pages of market days gone by multiple decades ago were in plain view.  Pages torn and tattered often offer the best education in enhancing current understanding.  Unfortunately, the pages being written at the moment are tinted black and blue.  Ultimately destined to once again fade in the open sun over time?  Well, not for a while yet.  Especially if the ending is anything like past stories of similar nature.