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1/12/02 Investment House Daily
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SUMMARY:
- Greenspan talks to bond market.
- Stocks fade on Greenspan's economic outlook.
- Economy: We are forgetting some important details in the renewed Washington wrangling.

Greenspan attempts to talk down interest rates.

Not many liked what Greenspan had to say on Friday. Investors were apparently looking for some words of economic encouragement in his first economic address since October 2001, but it was not forthcoming. Indeed, it was just what we expected, that is, just what his FOMC underlings were saying all week: while the "recent signals about the current course of the economy have turned from unremittingly negative through the late fall of last year to a far more mixed set of signals recently . . . I would emphasize that we continue to face significant risks in the near term." As we have noted, since before the 9-11 attacks, the economy was showing signs of turning up off the bottom. The speech acknowledged this, but also spend a lot of time discussing many downside risks still present that could send the economy back down.

In our reading of the speech and the prior Fed president statements, it is clear to us that the Fed is trying to talk down the bond market, pointing out that there is no lock on a short term recovery. Longer term bond rates have refused to stay down, and now that the home building and buying cycle is long in the tooth, it will take lower rates to sustain this important part of the economy during this recession. Contrary to some of the economically baseless talk of late, rates are not rising because of the elimination of the surplus (if that were so, rates would not have risen after the tax hike in 1993 for the next three years), but because economic recovery is being priced in. The Fed chairman was attempting to tell the bond market that the recovery being priced in was not nearly as certain as the bond market predicted.

It is a tough argument. Markets are very good handicappers of future events. The stock market has recovered some, the bond market has started to sell because of expected recovery and more demand for money and hence higher rates, and commodities prices have risen a bit, a sign of increased and anticipated increases in economic activity. As Greenspan found out in the mid 1990's, talking markets into a specific direction is difficult. The combination of the Fed presidents and the Friday speech worked some last week, particularly with short term rates (and those have not been the problem), but how long lasting will the words be? History says not very. If you are refinancing, lock in your rate this week as the window may be brief.

Other key speech points.

Greenspan was careful as usual not to appear too biased toward a particular fiscal policy, throwing each side a bone. He said that the continued phase-in of the tax relief already passed had and would continue to provide stimulus (we note also that he specifically mentioned Congress' failure to pass the recent stimulus package, but he mitigated the statement as well). In clear Greenspeak (oxymoron?) he was saying 'keep the tax cuts in place.' He also said that the rise in long term rates 'largely reflects the perception of improved prospects for the U.S. economy', a position taken by the republicans. In a nod toward the democrats, he also said "some of the firmness in long term rates probably is the consequence of the fall of projected budget surpluses and the implied less-rapid paydowns of Treasury debt." In typical Greenspan fashion he stated what he believed to be the case, but then mitigated the political ramifications by acknowledging the other side of the argument. That is one reason he has lasted so long in his position.

Much more interesting were the comments on the market and his skewed historical view of the 'disruptions of 1999 and 2000. One comment he made struck us as out of place: "Future wealth effects will depend importantly on whether corporate earnings improve to the extent currently embedded in share prices." First, he stated back in October that he was not even sure that there was a wealth effect caused by increases in stock prices, something he had based his entire rate hiking campaign on. Second and more important to today's action, he was apparently saying he felt stocks were possibly overvalued right now. If earnings had to catch up to prices, he is saying there is the chance that prices may be too high. However, that is how the market works: it prices recovery in before it actually happens, and Greenspan most likely was just acknowledging that is what the market has been doing. Thus, don't take that too hard.

The economic 'dislocations' portion is what really got us (yet again). In discussing the recovery of capital spending, Greenspan noted that growth in spending when recovered would not be as "frenetic" as that of 1999 and 2000 "when outlays were boosted by dislocations of Y2K." While perhaps not a misstatement, Greenspan again refused to acknowledge that he pumped the money supply up to huge, huge levels in 1999 ahead of Y2K, and that contributed to the surge in demand as that money was put to work (including being put into the stock market). The Fed then called all of that money back in March and April of 2000. Remember that? The stock market received its first major shock that set the bear market in motion. Investment capital dried up because it was called back by the Fed, and that wealth that was created was drained off as the market crashed ahead of the economic downturn that was coming because of the tampering that pumped it up too high and then yanked out the support after inflating it. Yes, there were 'dislocations,' but the cause is something that continues to be swept under the rug as just one of those things that happens form time to time. Yes it does, but it is usually our meddling that causes it.

THE ECONOMY

Now the market did not get what it wanted from the Greenspan speech, and it moved down once again. Not sharply, but down with disappointment. Is there more than that? We think so. Remember, we have been saying for over a month that the failure to pass the additional stimulus package that the market had priced in would come home to roost. Greenspan's speech seemed to drive home the point that the economy is still on the edge of a knife and that even though a recovery has started, we can louse it up. One of the three legs of the recovery was the stimulus package. It has been effectively cut out, and Greenspan reminded us of that in his speech. No commentator has mentioned it, but the market appears to be starting to factor that in.

The quickly forgotten lessons of Japan.

Just 4 months ago a lot of air time was devoted to how the U.S. was possibly the next Japan: big market run and economic boom, collapse, and then decade-long recession and deflation. The response (us included): no, we are doing the right things with the Fed belatedly but aggressively cutting interest rates and a tax cut already enacted, both historically proven methods of pulling out of a recession and preventing further stagnation. Japan on the other hand did not move rapidly to cut rates and the government refused to cut taxes so citizens and business could decide where best to spend the money. Instead it tried massive government spending to spend its way out. As history shows, government does not put the money in the right places; it is not efficient at dispersing funds to the sectors of the economy that will use it to grow. Of course, this spending plan did not work, so Japan cut interest rates again and again and again. It is now down to effectively 0% interest rate levels, but still it is in an 11-year plus recession with deflation rampant. Deflation is the loss in value of assets, e.g., homes, buildings cars, etc. Everything you own loses value. The key: NO ONE wants to invest in anything because it will only lose value. It is a very, very difficult cycle to break as Japan's ongoing woes demonstrate.

Well, after looking as if we were going to take the right steps and even pass additional stimulus, now we have a shift ongoing as politics is overtaking the will to do what is right for everyone. Four months of stock market gains and Japan is forgotten. What do we mean? The stimulus package has stalled, ostensibly because one side wants most stimulus to be government spending while the other wants to include tax cuts. Japan has shown the way not to do it: there should be little government spending and a lot more tax cutting: when taxes are cut, money is invested because you get more back on your investment. Otherwise there is no reason to spend in a recession (you are going to lose on your investment), and the money stays locked up. In any event, nothing is getting done because when a 'compromise' was not coming where 100% of the spending demands were met, talk of a stimulus package went away. After all, they reasoned, we are going to get a recovery anyway. Greenspan's speech Friday sharply said 'that ain't necessarily so,' and the market picked up on it. Bet our leaders do not.

What else? Talk of delaying or rescinding the already passed tax cuts. Delaying tax cuts is the same as no tax cuts; indeed, it is a tax hike. Remember the civil rights slogan: justice delayed is justice denied? If you are going to get a tax cut maybe later, you will wait to make any spending decisions until things are certain. The effect: no investment and thus no recovery (or a very weak one) while waiting to see if you get your tax cut. And believe me, if there is recovery those same people advocating the suspending of the tax cuts will then say it is not necessary to have a tax cut.

If we continue to proceed down this road, we need to keep looking for the road markers that are written in Japanese. This is exactly what killed Japan and Greenspan gave us an honest warning on Friday. Again, no one seems to be getting the message that was really delivered: the bond market needs to back off and the recovery is not a sure bet. Those that assume recovery is coming simply because we always bounce back will be shocked. We, however, will pay the biggest price.

Producer prices down, but gold and the dollar are moving in strange directions.

Producer prices were reported down in December for the third straight month and 1.9% year over year. That is the biggest drop in 15 years. There is no inflation; talk of deflation surfaced again Friday.

Gold has been moving up lately. Indeed all commodities have been improving. That is normal when there is an expected recovery. Last week commodities flat lined on the Fed talk of a potentially weak or non-existent recovery. Gold continued to climb. Gold traditionally serves two purposes: a hedge against inflation, or a safe bet in times of uncertainty. Now there have been climbing interest rates on the concern of future economic recovery. Perhaps gold is rising on that basis, the hedge against inflation idea. But there is no sign of inflation at all yet, not enough to get any serious move in gold. It may be another false start by gold, but without any inflation this has the look of a fear move as opposed to an inflation hedge.

The dollar index is setting up a potential head and shoulders pattern over the past three months. When the U.S. was heading into recession the dollar weakened and there was the threat that money would be taken out of the U.S. and placed elsewhere. The rest of the world when down, and it turned out there was no better place to put your money, so we avoided a major problem. Stocks were still hurt by this prospect, however. The dollar has not rolled over by any means, and the rest of the world is still struggling as well (though South Korea is already looking better). Thus we will keep an eye on the dollar.

Still positive signs out there near term: the 'boat show indicator.'

Every year at this time we discuss the Houston boat show as one of our leading indicators. The past two years it was showing us problems ahead. Last year was particularly telling as the major market, the small to mid-range boats, was way down. This year was a different story. The 10-day show ends Sunday, but as of Friday the eleventh, boat sales were running on par with the best year ever for some of the dealers. Similar to the autos in October and November, boat manufacturers were offering some strong incentives to move boats, and that was helping. Again, however, it shows the consumer is ready to buy if he or she believes there is a deal there. Last year the consumer was not budging regardless of any show discounts.

The Economic Cycle Research Institute's leading indicators rose yet again last week, up to 102.7 from 117.4, its highest reading since early August. That is important because it shows leading indicators back over where the were prior to 9-11. It is also important because the index factors in stock market gains, and the fact that the market was flat to down last week indicates that other areas are improving.

Housing market and some retailers may be tapped out for now.

Last week many homebuilders reported strong, strong sales, but their stocks fell on heavy volume. LOW, the discount building supply chain, crashed through its 50 day MVA Friday on heavy volume. We believe this is showing us that the home building run is long in the tooth. A move down in long term rates in the short run may spur one more refinancing rally for those that waited a bit too long to refinance and rates jumped up in November, but that may be it until the economy is really moving once more. So many houses were bought and refinanced, now there has to be some economic rallying (more jobs) to draw the next major round of buyers in.

Retailers are showing some similar signs. The holiday season was better than expected, but the stocks were showing this already. Look at BBY and others: even with a supposed poor holiday season approaching, they did very, very well. They were forecasting the economic recovery just as they usually do: they were out and running up ahead of the pack. They have fully priced in the holiday season, and now there is a bit of economic uncertainty interjected. Until it is clearer that the economy is still moving higher, these look to be under some near term pressure. Not all, but many of the stocks that have run far are looking toppy, making low volume highs or second tops.

THE MARKET

The Fed chairman tried to speak the truth, and investors could not handle it. The Dow was down all five session while the S&P and Nasdaq could not muster much better. Up until Wednesday's reversal they were setting up rather well for a move higher. They did not collapse and volume remained light, but the Dow and S&P are heading for tests of the 50 day MVA. The indexes have suffered periodic distribution throughout the move up, Wednesday's action, while disappointing, was not alarming. What really counts now is what happens when the indexes hit the next support levels. There is more uncertainty about the economic future now, and the market is trying to price it in right now. So far no series of distribution, but we are seeing some sectors that look ready to sell after long runs during this time of some uncertainty. There appears to be a leadership change coming with retailers and homebuilders ready to give some ground, but this does not mean that the rally is over. Regional banks were leaders last spring and then turned over. Then certain healthcare such as ESRX and ADVP that were leading imploded. Each time new leaders have filled in.

Secondary indicators: Volatility and the put/call ratio are sentiment indicators. They are thus contrary indicators (typically moving inversely with the market) and are most useful at extreme levels. They take a back seat to price and volume, but they can give us a heads up or a caution flag so to speak ahead of time. That is why we keep an eye on them.

VIX: 23.98; +0.85. No real movement at all on the selling last week. Volatility is getting stagnant, not moving up on selling. When it gets sluggish like this, not a good signal. Price/volume action is still decent, so watching closely.

VXN: 48.37; -0.29. Volatility dropped on a down session and was up on a slightly higher close Thursday. As with the S&P, volatility is becoming compacted near the summer 2001 levels when the markets were in the dumps. We are keeping a close watch on volume and the action of leaders such as the semiconductors.

Put/Call Ratio (CBOE): 0.68; +0.10. Right back up on the selling on all of the indexes as the ratio continues to show plenty are ready to bet the downside on any selling. We have noted it before, but this indicator has held up well, showing no complacency, through the rally.

Nasdaq

After trying to break over the December high on Wednesday, the index meandered on low volume. Friday was a significant point loss, but the index is still holding well above support. That does not mean a lot if volume selling re-emerges this week, but we note that many big names are not selling on high volume.

Stats: -24.78 points (-1.2%) to close at 2022.46.
Volume: 1.625 million shares (-7.7%). Well below average volume as the index sold once again on lower volume. This is what we want to see if there is selling, though the selling from a price standpoint increased to more uncomfortable levels.

Up volume: 422 million
Down volume: 1.1171 billion. Selling volume shot up, easily outdistancing buyers. Still, they were not the majority compared to the last week of action as the overall volume was down.

A/D and Hi/Lo: Decliners jumped ahead 1.4 to 1 (advancers led fractionally Thursday).

New highs: 103 (-3)
New lows: 18 (+2)

The Chart: http://www.investmenthouse.com/cd/$compq.html

Back below the December tops, testing down to the 10 day MVA (2024) on the close. It is still holding above the 18 day MVA (2005.90) and 2000, a level of some moderate support. After that there is not a whole lot until the conjunction of the 50 and 200 day MVA at 1938 and 1931, respectively. That level is also right in line with the November tops ranging from 1934 to 1941. So, there is a lot of support there if it is reached. The Nasdaq has somewhat double topped on the pattern, but it rallied to the recent high on strong volume and has backed off on lower volume other than Wednesday. That rally that was ready to the upside was not ready when it tried Wednesday, and now there is some uncertainty in the economic picture as investors were reminded on Friday by the Fed. It has yet to sell off on rising volume, and that maintains the current trend. We will have to watch how that uncertainty is resolved this week by watching the volume. Again, action similar to last week's occurred in November and the index bounced ahead to a nice gain. Things have changed a bit since then from the economic viewpoint.

End Part 1 of 2

world stock market
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