I Made All My Money Selling Too Soon

120-second Summary:

J.P. Morgan’s observation remains as insightful at the beginning of Anno Domini 2004, as the day he uttered that sentence.  Rewards have been heaped upon speculators in the last quarter of 2003. Stocks tripped through sell limit levels with regularity not seen since 1999. Some believe a phase of market consolidation will materialize where a trading strategy will best a buy and hold strategy. Our work tends to support this approach, ceteris paribus.

The attention given to market sentiment indicators has grown to levels unlike any we can recall. Wall Street soothsayers read tea leaves on no less than three different dimensions of market action; a bet on a bet on a bet, as it was. This work refers to one analysis made at the price level (e.g. the S&P 500), one at the option level (e.g. the Chicago Board of Exchange) and one at the sentiment level (e.g. the OEX sentiment level). What one finds is that “analysis of an analysis of an analysis” creates a “new math” that makes less relevant comparison to past analysis of market performance. A phenomenon was explored in 1927 when physicist Heisenberg turned the science community on his head when he proposed his uncertainty principle. He contended that “the more precise the measurement of one position, the more imprecise the measurement of another, and vice versa” (The American Institute of Physics, 2004). In terms of investment management, this concept translates to ‘the more precise the measurement of a stock price’s independent variable, the more imprecise the measurement of the stock price (dependent variable).’

Applying this notion to the stock market can lead one to build a case for potential investment returns possibly residing in more risky stocks which have already experienced significant price appreciation. “While the market may be overvalued from a fundamental standpoint, sentiment indicators as a whole are not showing that the market is overvalued” Schaeffer opines. “Short interest on Nasdaq stocks growing by 3.3 percent in December is not indicative of an overvalued market.”

Let the Data Do the Talking

Biderman fingered three sources of fuel for rising stocks prices in 2003.

Hedge funds funneled “about $200 billion into equities.”

Pension funds funneled “roughly $100 billion into stocks since the end of March.”

Individuals poured “about $130 billion into U.S. equity funds since the end of March.”

The first two are spent and the individual investor is the left to support funding of equities, according to Biderman.

Tax law plays a role. Capital equipment purchases, for instance, spurred by a complete write off of the first $100,000 may have pulled 2005 spending into 2004, according to Contrary Investor. This tax legislation will sunset in December of this year.

Liabilities continue to mount:
Existing Home Price: Avg. Family Income (last record 305% early 1980s)
Annual growth rate of Pension Liabilities at S&P 500 cos. (per Newman)
Total Debt per man, woman and rug rat in America ($34 trillion total)
Price fluctuation could be driven by shifts, perhaps significant, in investor sentiment.

One would expect sentiment to shift as various market imbalances slow or reverse course. Contrary Investor suggests these imbalances include foreigners’ purchases of dollar denominated assets, excess global liquidity and dollar devaluation.

Do not forget increased program trading has led to increased volatility in the past and program trading is increasing at roughly 35% per year. Program trading “will overtake all other trading by March 2005,” according to Newman’s calculations.

Who’s going to Tell You to Get Out?

Though less probable than the scenarios noted above, the biggest surprise which could occur in the first half of 2004 would be for the market to move lower in the first half of the year, according to Katz. Indeed, this possible scenario existed in early 2003 as well. When an imbalance of this sort occurred in the past, we enjoyed wide positive out-performance of the indices. To be sure, trillions of dollars of investor assets vanished under the tutelage of Wall Street strategists.

Newman reports that Bearish strategist advice outnumbered Bullish strategist advice only 9 weeks out of the 190 weeks since the Bear market began in December 2000.

The Jeweler’s Eye

Inflation: A Debtor’s Best Friend

Wiggins reminds us that debtors do indeed have friends. As the indebtedness of the United States escalates, one can surmise the question is not “If inflation will rear its head?” but “When will it rear its head?” One could base this comment based of a self-serving need.

Over the past three years in these pages, we have drawn out possible paths for stocks and bonds in the event of a collapse of economic growth in the United States. As a supporting corollary to that work, we propose that in the event the Federal Reserve’s loose rate policy is able to continue to fan the embers of economic growth inflation may become an obstacle to stock price appreciation.

In order to “size up” the current level of indebtedness in hopes of making a case for inflation’s value to the United States’ policy, we turn to Hazlitt’s work in the area.  Hazlitt stated that “It is true, no doubt, that an artificial reduction in the interest rate encourages increased borrowing.” Bonner illustrates current debt trends

In the 1960s, Americans borrowed $1 for every $3 of extra income they earned.
In the 1980s, they were up to borrowing $1.50 for every $3 in new income.
In the 1990s, they borrowed $4 for every $3 in new income.
By October 2003, they borrowed $9 for every $3 in new income,
Richebächer notes.

Historical stock price performance demonstrates that inflation is no friend of bull markets. As such, one should carefully monitor price reports over the coming year in order to discern the extent to which inflation may be used to offset the country’s debt burden.

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