| "Among the world's races … Americans are most prone to misinformation. This is not the consequence of any special preference for mendacity, although at the higher levels of their public administration that tendency is impressive. It is rather that so much of what they themselves believe is wrong." |
| -- John Kenneth Galbraith |
ORD HAS IT THE BEAR'S ARRIVED on Wall Street. Recently investors have reported citing the usual suspects: Large sell-offs (at least in terms of points) without being followed by the expected "buying on the dips". Technical indicators such as market breadth (yes, that's with a "d") have turned negative for the large as well as small cap stocks. Stalwart bulls such as Ralph Acampora (almost rhymes with "Make 'em poorer") have turned bearish and, with the help of CNBC, have turned their predictions into self-fulfilling prophecies. Analysts are trimming (pruning? hacking?) their third and fourth quarter earnings estimates. Asia continues to suffer, Russia's Ruble is more like rubble, and all this continues to be a drag on U.S. markets.
So is it time to pay some capital gains and find a good money market fund? Or is all this fear of the bear just a bunch of bull? Obviously no one has a crystal ball, but it might help to look at the facts. Let's start with the basics: Bear Markets are usually defined as a decline of 20% or more from market highs. Corrections are declines of at least 10% from market highs. All bear markets start as corrections, but not all corrections are the beginning of bear markets. In fact, corrections usually hit the market about every 3 years. The last was in 1994 and prior to that was 1990 and 1987. You could make a pretty good argument we're due for one.
As of early September, the Dow Jones Industrials and the S&P 500 were still not 20% off their July highs. Smaller stocks were already in traditional bear territory. But there's one more important fact the bear hunters are ignoring: investor sentiment plays a large role in defining a bear market. You shouldn't confuse a strong correction in an overvalued stocks with the beginning of a bear market. Markets correct when stocks are overvalued but bear markets start when interest rates are rising.
How Low Can You Go?
Rates certainly haven't been rising. In fact, they're as low as they've been in thirty years. In a roundabout way, this would seem to support the bear-phobes' argument, after all, once you approach the bottom, the only way to go is up. It's difficult to imagine how rates can go any lower when the difference between the 30-year Treasury bond and the ultra short-term Federal Funds Rate is .10-.15%. Without an actual Fed easing rates are probably as low as they'll go. And don't count on the Fed to lower rates since they're already worried about inflation and "irrational exuberance" in the stock market.The bearmeisters fear the Fed's vigilance in fighting inflation Where do they see inflation? Well General Motors just got through a strike and union contract negotiation. Northwest Airlines is currently dealing with some of the same. Wages are on the rise and the inflationary spiral may be ready to uncoil. Bear market, anyone?
Asia to the Rescue
But wages are only one half of the inflationary spiral. Let's do something radical and look at the facts. Commodity inflation is currently commodity deflation. With European and U.S. financial markets on the rise, precious metals have lost their luster as stores of value. The upcoming European unification and the promise of a strong currency further damp gold's appeal. Rumor has it that certain central banks may be selling some of their reserves, which only serves to increase the supply on the market. Sluggish Asian economies reduce the demand for precious metals in jewelry and base metals (e.g. copper) in construction. Oil prices continue to remain weak.In essence, any wage inflation is being offset by tame commodity inflation. In addition, wage increases can only ignite inflation if the cost of higher wages is passed through to the consumer. But that isn't happening. Pricing is tight; companies fear losing market share and associated revenues if they unilaterally raise prices. Instead, they are absorbing any additional labor expenses thereby reducing margins.
Which brings us to the two reasons why the Fed won't be raising interest rates any time soon. We can thank Asia -- most especially Japan -- for both. First, since pricing and margins are already tight, and there's little demand for U.S. exports, a Fed tightening could actually risk sending the domestic economy into a full-blown recession. At this point, the threat of recession seems much more real than the possibility of significant inflation. As long as Asia is slowing the U.S. economy, the Fed doesn't need to.
Secondly, higher interest rates would actually prolong problems overseas. A major cause of Asia's woes is the "de-monitization" of Japan. Although Japan 
has a high savings rate (especially when compared to the U.S.), those savings are leaving the country. They're headed for the U.S. and Europe due to the difference in nominal interest rates. If you were a Japanese saver, wouldn't you rather receive 5.5% in an American bond than 1.5% domestically? Evidently a lot of Japanese would -- foreign investment has been one of the major factors behind the stellar performance of the U.S. markets. By raising rates, the Fed would only make this problem worse and further delay Asian recovery.
Even in Federal Reserve Board Chairman Alan Greenspan's seems to feel more comfortable leaving rates alone. According to him,
| "In the spring and early summer, the Federal Open Market Committee was concerned that a rise in inflation was the primary threat to the continued expansion of the economy. By the time of the Committee's August meeting, the risks had become balanced, and the Committee will need to consider carefully the potential ramifications of ongoing developments since that meeting." |
| September 4, 1998 |
Evidently the Fed has abandoned its bias toward tightening in favor of a more wait-and-see approach. In the near term, this probably translates into steady rates.
Relatively Right but Absolutely Wrong
To a bear hunter, stable interest rates draw attention to earnings, and here they see more bear tracks. The presumption is that if interest rates won't help the equity markets, improved earnings are the only thing that can keep them moving upward. But analysts are falling all over themselves to lower earnings estimates for the third and fourth quarters. As earnings fall, so will the market.Fortunately this is just a case of garbage in, garbage out. There's a big difference between earnings declining and estimates declining. For most companies, earnings vs. comparable quarters will continue to improve in the third and fourth quarters. Even the analysts agree with this. What they're lowering is their estimates of the size of the improvements.
For example, Airborne Freight Corporation's second quarter earnings came in at 67¢ a share vs. 59¢ in the comparable quarter. But Wall Street had expected a few more cents than that so immediately lopped 32% off the share price. Earnings improved, just not as much as predicted…
So why are analysts having to revise their estimates? Because they always do. You've got to remember that for the most part, these folks work for sell-side organizations. If they don't make rosy predictions, their firms can't sell stocks and their own profits are hurt. Analysts always start the year too optimistic and then have to lower estimates as the year progresses. This year is worse than most because analysts' predictions were more optimistic than usual. The consensus called for 14% earnings growth on the S&P 500. As the year progressed, it's been cut back to more realistic levels, but company performance had almost nothing to do with it -- the analysts (for whatever reason) were simply too optimistic. Earnings continue to expand, just not as dramatically as forecasted. This really isn't the basis for a bear market, is it?
Experiencing Technical Difficulties
Which brings us back to the final argument, the bear's Asian heritage. While earnings may only be slowing this year, Asia's continuing effect on the U.S. economy may actually turn them negative in the coming quarters. Realizing this, investors have started to sell-off stocks before it's too late. After all, as we've frequently remarked, the market is predictive.Technical indicators clearly display this change in sentiment. Market breadth has turned bearish. The advance/decline line for the Dow Industrials has 
recently reversed it's five-year upward trend indicating the large caps are about to encounter the same correction/bear market experienced by the broader market. Historically, bear markets have begun when the "negative divergence" between large and small cap stocks (technician talk for "they go in different directions") ends in the large caps rolling over. Bear spotters think that happened in August and have sold accordingly.
Do as I say, Not as I Do
Whoa, that's scary! But you know, if investors really are selling because they're worried about the effect Asia will have on profits, they've been selling the wrong stocks. That's right. All year small and even mid cap
stocks have dramatically lagged behind the blue chips. But they are precisely the stocks least affected by Asia. Small and mid cap companies don't have nearly the exposure or dependence on foreign markets as large, international companies. Even after the August 4th 299-point drop on the Dow, it was only 12% off its July 17 high. The S&P 500, another measure of large caps, was only 9% off its high. But the Russell 2000, a measure of small cap stocks, was off almost 20% -- bear market territory.
The sectors being sold don't make any sense either. Financial, healthcare, and energy stocks, with little Asian exposure, were off 12.2%, 9.3%, and 18.5%, respectively. On the other hand, technology issues which are heavily dependent on foreign markets, were off only 8.0%. As the correction continued through August, the S&P and Dow Jones have remained in positive territory while the Russell has crossed into the bear's habitat. These are the facts. What's wrong with this picture?
The facts are right, the interpretation is wrong. The bear hunters have mistaken the hoof prints of a slowing bull for bear tracks. Sure the market's been volatile and selling pressure is growing. Who would have thought otherwise? Large caps are overvalued by almost any standard measure. Investors feel they have to be in the market because any other alternative pales in comparison. Yet they're nervous and the least bit of bad news serves as an excuse to take profits. That's what happened to Airborne and the market as a whole. Professional traders are still on vacation and the thin summer market only exaggerates any short-term action.
Analysts will soon turn their attention to 1999. Early consensus already calls for 17.4% earnings growth on the S&P 500. While this number is coming from deep left-field, it does show that the same analysts who are trimming their estimates for the remaining quarters of this year are optimistic about the next. No, Asia won't heal itself overnight, but it will eventually come around. The U.S. fundamentals are still positive.
With earnings confession season in September and the annual tax-loss selling in October, the next two months will be rough. Volatility will remain high and triple digit sell-offs may occasionally occur. Since the major sell-offs in August, we've already retested our lows and in each case have recovered nicely. Until there's positive news from across the sea, the stock market will probably continue to meander around. This is actually healthy as the market needs to establish a base for the next move up.
But heaven help us if low inflation, low interest rates, and expanding earnings are the harbinger of a bear market. No, it's much more likely that this is the much needed correction to bring the large caps back into line. Let's not confuse the vaccine with the disease.
| Homepage | Return to Top |
