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Mixed Signals

(March 3, 2002)

The Dow rallied more than 260 points on Friday to a closing high level of 10,368 that has not been seen since late August. The action was not totally surprising. What would be surprising is if any further meaningful rally develops from here.

Lately, everyone has been calling for an economic recovery. No doubt, denial still reigns supreme. According to Stephen Roach at Morgan Stanley (one of the few economists that we respect), "over the 28 quarters of the past six recessions, housing and consumer durables, combined, lowered annualized real GDP growth by an average of 1.2 percentage points per quarter; by contrast, in the final three quarters of 2001, these same two sectors actually boosted GDP growth by 1.2 percentage points per quarter." Throughout the current recession, consumer spending has remained strong. If anything, the consumer has been spending with utter recklessness, fueled by money from mortgage refinancings, incentives from the likes of Ford and General Motors, a lack of incentive to save, and the not-so-obvious warm winter.

Unlike any other post-WWII recession, the culprit of the current recession, of course, has been business capital spending. As we speak, the layoffs and the lack of demand continue. Oracle warned after the close on Friday-blaming the lack of demand on Asia. Since Asia only represents 14% of Oracle's sales, obviously, domestic demand isn't so hot either.

The obvious question is: if consumer spending remained so strong, what would be the spark to a sustained economic recovery that everyone is now calling for? More spending, more debt, and less savings? With the highest consumer debt load and the lowest savings level in the history of this country, we doubt this would be the case. If anything, we believe the fourth quarter of 2001 represents a temporary spike, a spike from the gloom-and-doom mentality immediately after September 11 and driven by unsustainable factors (what next? $5,000 cash back for a Ford Focus?) described above. To make matters worse, the consumer most probably did all their major spending in the fourth quarter, and the continuing layoffs would seriously undermine consumer spending going forward.

Moreover, it looks like housing will be the next shoe to drop. Seasonally adjusted new home sales for January 2002 declined 15% from December of last year. While seasonally adjusted existing home sales rose 16%, non-seasonally adjusted existing home sales actually declined by 17% (all because of the warmest winter on record). Using the same adjustment factor, non-seasonally adjusted new homes sales would have declined by a staggering 40%! Moreover, as we discussed last Wednesday, it looks like both HD and LOW is about to break down. The Dow rallied 260 points on Friday and both failed to rally. LOW even managed to decline by 2.8%. Does this signal trouble ahead for the housing industry? Here, we leave it to our readers but if it does, then you definitely have not seen the worst of the recession yet (not by a long shot).

Meanwhile, the S&P trades at a staggering 44 times earnings (28 times earnings per S&P - after a revision to "operating earnings"). The Nasdaq is still priced for perfection. The Dow? Well, you decide for yourself:

DJIA Price and NYSE Volume Information (November 1, 2001 to March 1, 2002)

Volume remains mediocre during the latest rally. What's untroubling to the bear case, however, is that the Dow Jones Transportation Index has confirmed the high, by making a new six-month high at 2,897. To our readers, we pose the following question: What do you think about stocks such as JPM, C, INTC, MSFT, and IBM? How about MCD, T, HWP, SBC, and KO? The question to think about is to determine whether they have bottomed and are truly moving up from here. These are the stocks that have broken down from their recent highs and are now bouncing. In a normal, secular bull market, I would say buy them here but no, this is not a secular bull market. Not by a long shot.

And conflicting signals indeed! In the meantime, both the Nasdaq and the S&P 500 are still below their 50-day MA's and short-time wise, the charts don't indicate any potential to break out of the 50-day MA.

We believe our INTC, MSFT, and IBM put options in our model portfolio looks all right for now. The April DJX 94 position, however, may be running a bit close. We will continue to evaluate the market action going forward and if we see anything that will further break our convictions, we will get out. For now, we will continue to hold short. We would not be surprised if this (short-covering) rally ends abruptly in the next few days. Check back tomorrow for further comments.

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