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No Bull Exhaustion Yet

(March 1, 2004)

Dear Readers:

Excuse my absence from writing a commentary in the last six weeks.  William Hamilton, the fourth editor of the Wall Street Journal and one of the great Dow Theorists, sometimes let months pass by before writing an editorial - claiming that there were periods of time in the stock market when he felt he had nothing new to say.  While my writing does not come anywhere close to that of Hamilton's, I felt the same way during the stock market action of the last six weeks.

Since that time, the Dow Industrials and the S&P 500 has been virtually flat, while the Nasdaq declined approximately 110 points and the Dow Transports 130 points.  The buzz among the Dow Theorists (including that of the great Richard Russell) is the non-confirmation of the Industrials by the Transports on the upside.  The Dow Industrials made a new closing high of 10,737.70 on February 11, while the last high on the Dow Transports was 3,080.32 made on January 22.  Since then, the two indices have diverged significantly, with the former now sitting at 10,583.92 and the latter at 2,902.19.  Readers may find it easier to understand this divergence by looking at the following chart:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2003 to February 27, 2004)

Please note that a similar divergence happened in June/July of last year.  Since then, the Transports have confirmed the industrials on the upside - if a similar situation happens today, then the Transports (especially the airlines) may actually be a buy here.  I am currently betting that this will happen, based on my belief that this current bull swing will only die in exhaustion, and this swing is currently nowhere near exhaustion.

To begin my study, I will try to put into context the extent of the March 2000 to October 2002 bear market relative to all the other bear markets in the U.S. throughout the 20th century since the Federal Reserve was created:

S&P 500 Price Index Bull and Bear Markets 1914-2002 (Source: Global Financial Data, Inc.)

Market Top

Index High

% Increase

Market Bottom

Index Bottom

% Decrease

Elapsed Months of Bear Market

03/24/2000

1527.46

59.6%

10/09/2002

776.76

-49.1%

31

07/17/1998

1190.58

304.3%

10/08/1998

957.28

-19.6%

3

07/16/1990

369.78

67.1%

10/17/1990

294.51

-20.4%

3

08/25/1987

337.89

233.1%

12/04/1987

221.24

-34.5%

3

11/28/1980

140.52

61.7%

08/12/1982

101.44

-27.8%

20

09/21/1976

107.83

73.1%

03/06/1978

86.90

-19.4%

17

01/05/1973

119.87

73.0%

10/03/1974

62.28

-48.0%

21

11/29/1968

108.37

48.0%

05/26/1970

69.29

-36.1%

18

02/09/1966

94.06

79.8%

10/07/1966

73.20

-22.2%

8

12/12/1961

72.64

86.4%

06/26/1962

52.32

-28.0%

7

08/02/1956

49.75

267.2%

10/22/1957

38.98

-21.6%

15

05/29/1946

19.25

157.7%

06/13/1949

13.55

-29.6%

37

11/09/1938

13.79

62.2%

04/28/1942

7.47

-45.8%

42

03/10/1937

18.68

131.8%

03/31/1938

8.50

-54.5%

13

07/18/1933

12.20

120.6%

03/14/1935

8.06

-33.9%

20

09/07/1932

9.31

111.1%

02/27/1933

5.53

-40.6%

6

09/07/1929

31.86

408.9%

07/08/1932

4.41

-86.2%

34

07/16/1919

9.64

60.7%

08/24/1921

6.26

-35.1%

25

11/20/1916

10.55

59.1%

12/19/1917

6.00

-43.1%

13

     

October 1914

6.63

-37.5%

 

Please note the extent of the latest bear market both in terms of percentage losses and the duration of the bear market in the S&P 500.  The 49.1% loss ranks third, while the 31-month duration ranks fourth out of a total of 19 bear markets as defined by Global Financial Data, Inc. since October 1914.  This type of a decline in the S&P 500 has not been seen since the 1973-1974 bear market, a bear market which ultimately took the dividend yield of the S&P 500 to over 6% (and the P/E ratio to about six).  We are currently only 17 months into the latest bull swing, with the S&P 500 having gained "only" 49.0% at its peak on February 11, 2004 (at 1,157.76).

Relative to past bear market rallies, and in terms of both percentage gained and duration, the current bull swing is nowhere near exhaustion.  The most conservative and appropriate comparison would be with the 1966 to 1974 bear market.  Note that there were two bull swings within that bear market, the October 1966 to November 1968 bull swing (which lasted 26 months and where the S&P gained 48.0%) and the May 1970 to January 1973 bull swing (which lasted 31 months and where the S&P gained 73.0%).  The bear market decline which preceded the former bull swing took the S&P down 22.2% and lasted only 8 months, while the bear market decline which preceded the latter bull swing took the S&P down 36.1% and lasted 18 months.  These two declines pale in comparison to the decline which began in March 2000 and lasted into October 2002.  Consider also the amount of stock and financial markets intervention which we are also seeing today from the governments and central banks of the world - these interventions are also many times greater than the interventions that we saw during the late 1960s and 1970s.  Witness the intervention in the currency markets from the Bank of Japan and now the European Central Bank (which is now confirmed but was mentioned as a possibility in our last commentary).  The U.S. Treasury market is no longer a market, with a majority of the transactions now being coordinated by the various central banks around the world - with the most notable coming from the BOJ and from the Bank of China.  Whether they can keep control of these markets at some point down the road is another matter, but for now, this is washing the world with liquidity and is bullish for the stock market.  If the author has to make a guess here, my most conservative forecast would be for a top in the S&P 500 somewhere in the range of 1,250 and 1,350, and ending around September 2004 to May 2005.  Note that this is my most conservative forecast, as I would not be surprised if the S&P 500 makes an all-time high.

Another important indicator of potential exhaustion is the amount of margin debt.  It is said that history does not exactly repeat itself, but it surely rhymes.  This is especially true when it comes to the action of the stock market and the financial markets.  Any serious student of the stock market should always study history and his/her past trades, not your financial textbook (in fact, getting an MBA is the greatest waste of time, effort, and money when one wants to learn how to make money in the markets or in business).  That being said, following is a chart tracking the amount of margin debt outstanding during the January 1966 to December 1974 bear market.

Margin Debt (January 1966 to December 1974)

Note that during the bull swings within the 1966 to 1974 bear market, the amount of margin debt outstanding at the respective peaks have all made higher highs.  As of the end of January 2004, the amount of margin debt outstanding at NYSE member firms were $179 billion, a full $100 billion lower than the peak in March 2000.  If history is to repeat or rhyme, then the current amount of margin debt oustanding would need to be significantly higher in order to indicate exhaustion.  Also note that I have made this comparison assuming that we are currently still in a secular bear market.  If this assumption turned out to be incorrect, then the ultimate top should be even further out in the future.  The following chart clearly illustrates this:

Wilshire 5000 vs. Margin Debt

There has also been a lot of talk about sentiment - how newsletter writers are too bullish and how the VIX is now too low compared to its trading range during the last five years.  This article by Mark Hulbert on cbs.marketwatch.com clearly dispels the newsletter notion.  His own proprietary indicator, the Hulbert Financial Digest's Index (which focuses on the actual equity exposure of newsletter as opposed what the newsletter writers are saying) is indicating a lot less bullishness.  In fact, this index currently only stands at 29%, versus an all-time high of 79.7%.  As for the VIX, well, we have been through this before.  Let's look at a long-term chart of the VIX in order to get a big picture perspective:

CBOE SPX Market Volatility Index

For most of 1991 to the end of 1996, the normal range of the VIX was 10 to 20.  Since 1997, the range of the VIX has moved higher and become more volatile, with the trading range moving to 20 to 40.  Since the beginning of 2003, however, the character of the VIX has changed again.  Option writers are now clearly expecting much lower volatility going forward.  Are they correct and can this trend be sustained?  Whatever is the case, it is clearly not a good idea to bet on a market top here based on the above sentiment indicators.  In fact, a bull swing such as this usually ends in a barrage of good news, not with an endless worry about terrorism and the lack of worthy jobs.  The author is speculating that when the top finally does come, no one will be willing to sell since no one will be concerned about terrorism anymore and the unemployment picture will have improved dramatically.

During my last commentary, I devoted one single paragraph to an improvement in capital spending in the telecom sector.  The increase in capital spending should not be limited to just this sector, but should also apply to other sectors - more specifically to the oil service sector.  This report from Simmons & Company International makes an excellent case for why they are optimistic on a significant increase in domestic drilling activity in the next several years - citing, among other reasons, recent capital discipline (debt reduction - with debt to cap ratio now at the lowest in at least five years) and a collective disbelief of the sustainability of high oil and natural gas prices - which all diverted resources away from capital spending during the last couple of years.  A decrease in capital spending led us into the bear market in 2000, and any increase in capital spending here is a very bullish development.

Finally, interest rates should remain low for the time being.  The current consensus is that interest rates should increase this year.  This consensus is even more of a consensus of the consensus that the US$ is in a secular bear market.  The classic quote is that when everybody thinks alike, nobody is thinking.  Ask anyone on the street on where interest rates are heading and they will be telling you that they are going up - they are merely repeating what they hear on the financial news channels.  Clearly, nobody is doing their own thinking.  Long-time readers will know what I think when it comes to a "sure thing" in the markets.  The spot rate of the 30-year treasury is now sitting at 4.857%.  Can it go to zero?  Probably not.  But it can definitely go lower, maybe even lower than the lows witnessed during May and June of last year.  In fact, the current trend of the 30-year treasury yield is suggesting just that:

30-year treasury yield

The yield of the 30-year Treasury bond is now sitting below its 50 DMA and 200 DMA, with the former about to cross the latter on the downside.  This is a very bullish development for the 30-year Treasury bond (which has an inverse relationship to the yield) and is an on-going bullish development for the stock market.  The real estate market (especially here in Houston, where the author resides) should also continue to perform well.

Again, I believe the current state of the market is nowhere near exhaustion, and hopefully my arguments above have convinced my readers that this is still the case (of course, this does not mean the market cannot correct from time to time).  If you are still not entirely convinced, consider whether the current market is a good market to go short in.  Think about the following quote from Peter Lynch with reference to the stock of Fannie Mae in 1988 in "Beating the Street" but just change all references from "buy" to "sell" and vice versa.  Are you willing to risk it all by selling your house, car, and barbeque and using the proceeds to go short the S&P 500?  The market is relentless when it comes to punishing short positions put out at the wrong time, and if you are not 100% convinced that you should go short, then maybe the market is not ready to fall after all.  Quote from Peter Lynch:

There are different shades of buys.  There's the "What else I am going to buy?" buy.  There's the "Maybe this will work out" buy.  There's the "Buy now and sell later" buy.  There's the "buy for your mother-in-law" buy.  There's the "Buy for your mother-in-law and all the aunts, uncles, and cousins" buy.  There's the "Sell the house and put the money into this" buy.  There's the "Sell the house, the boat, the cars, and the barbecue and put the money into this" buy.  There's the "Sell the house, boats, cars, and barbeque, and insist your mother-in-law, aunts, uncles, and cousins do the same" buy.  That's what Fannie Mae was becoming.

Signing off,

Henry K. To, CFA

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