There is going to be a terrible break in the Wall Street Wall a rhetorical wall that remains optimistic in the face of a tech bloodbath, a wall that still thinks the bull market is alive and well. This break will be in the 30 most treasured companies in America the companies that represent the Dow Jones Industrial Average. It will mark the dawn of a horrific U.S. recession, and the true beginning, despite the rumblings since March, of the real bear market. "...the unique technical condition of this stock market is reflected in investors' desires to continue to hold equities by selling one stock and buying another, rather than selling and raising cash. This seems the key technical difference between this stock market decline and others in our history." Frank Cappiello CBS, December 14, 2000 Stock market fever, despite the ravaging of technology stocks, is alive and well. Investors who were in tech funds in late October felt the sting as fund managers closed their books for the year by selling tech and buying everything thought to be a 'value'. The Dow, which hit a low of 9654.64 on October 18 now stands at over 10,600 it had previously hit 10915.40 on December 13 capping off its fastest 1,000+ point advance in history. As Mr. Cappiello correctly points out, investors have handled the tech slide by changing their focus, not their choice of instrument (equities). History offers an incomplete guide to both the present and the future. The markets today are functioning differently if you had said in January that the Nasdaq would drop 50% while the Dow would rally, you probably would have drawn strange looks. Better yet, if you had said in January that Microsoft would lose 50% while utility stocks would in some cases double in share price, well, you would have been locked up. The point is, beneath the surface the markets are not operating according to traditional bullish or bearish standards. To begin with, the Dow as a whole remains overvalued by all historical standards. Part of the reason why an average trailing price to earnings ratio of 27 on the Dow (take 15-20 as the historical norm) is possible is because of the current rotational trend, but another reason has to do with the perception of earnings. Expanding upon this notion, it is essential to compare the Dow's future to that of the demise on the Nasdaq, the once fearless bull market leader. In beginning such a comparison one need surmise the action since October: What has hit the Nasdaq recently is a wave of earnings warnings from the biggest and brightest, including Microsoft, Intel, and DELL. It is widely believed that Federal Reserve interest rate hikes coupled with high-energy prices has created the current tech debacle, but this is somewhat misleading. What happened to tech companies prior to their drops was that market momentum made share prices unrealistically high. So high, in fact, that literally anything could have triggered the fall. Let's be honest, telecommunication debt did not appear out of thin air the money was lent freely and institutions ignored the possible repercussions of risky loans. Priceline.com did not suddenly stop reporting fabulous revenue gains investors woke up one morning and noticed a cash stricken multi-billion dollar company projecting losses many years into the future and sold their shares. The same holds true with any of the PC related techs PC sales are not infinite inside of a mature market. Higher Megahertz speeds simply cannot stimulate market demand beyond a given point, and Y2K revenue comparisons will be difficult to match we all knew this, but up until now no one seemed to care. So, in this manner investors in tech-land have followed the historical norm: they bought what was hot and sold it like wildfire when perception changed. However, not only did they sell the losing company's shares, but anything related inside of the technology sector Which brings us to the Dow, the catcher's mitt that caught a great deal of the capital swelling out of bruised techs. The same scenario which has unfolded in tech stocks will soon come to pass in the Dow, because the principles are much the same. The majority of comprising the Dow have earnings estimates in place which are as ridiculous as the tech estimates were just a few short months ago, and valuations are likewise not a concern. To illustrate a simple example, look at General Electric. GE has 5-year earnings growth estimates in place of 15.4%. GE did not even grow by this amount during the last 5 years, which were 5 of the strongest in the history of the United States. Additionally, analysts continue to raise estimates on GE even as the economy slows and GDP estimates get revised lower (chart below). Is this an accident waiting to happen? If so, what will investors blame it on? Will they blame it on the recession, and not the perfectly priced earnings perceptions? The Recession Ahh, yes, the 'R' word. It has come to everyone's attention, rather abruptly, that the word 'recession' may mean something after all. If indeed we are headed for an economic recession in 2001 the main cause will be the byproducts of investor lunacy. The circumstances referenced beyond this are merely diversions, or scapegoats, to the actual facts. Fact: the Fed began hiking interest rates back in June 1999 and investors claimed the first three were conciliatory of three cuts in 1998. Fact: The fed continued hiking in 2000 and investors continued buying stocks on the adage that tech stocks were immune to any business cycle or recessionary developments. Fact: throughout oils' rise investors claimed the new 'service based' economy was less dependant upon crude and that the markets would remain largely unaffected. Final Fact: investors were wrong and over $2.5 trillion in paper has been deleted from existence on the Nasdaq alone. Did rate hikes hinder lending policies to a great extent as credit spreads widened? Up until recently, no. Did predictable spikes in energy costs take more poof out of consumers pockets than the drop in the Nasdaq did? No. All that has changed for the markets is investor attitudes towards specific stocks, and this is why 'safe' areas of the marketplace have benefited. People fear what they have been told to fear (tech) and they have bought what they have been told to buy (defensive stocks). To coincide with this perceptual evolution doubts over economic strength have emerged, just like they emerged after every previous historical mania died. To sum up why a recession may come to pass: no longer is lending, spending, and investing done with reckless abandonment. Clearly the Fed is getting ready to cut sometime in 2001 if economic weakness persists. As a result, how stock prices react to the Federal Reserve Board's actions will play an important role in impacting consumer confidence. Many foresee a repeat of 1998 the Fed starts cutting and equities start bubbling. But the likely alternative to another 'Fed cutting rally' is that stocks prices will continue to slide, and continue to reflect corporate earnings rather than 'new paradigm' thinking. If this is the case, the Dow is getting ready for a severe drop and the recession could ultimately be solidified by the blue chip debacle. Dow Valuations GE's largest revenue and earnings contributor (of its eight segments) is General Capital. In fact, GC's revenues alone matches the other seven segments combined: "People may be unaware, for example, that their department store credit card is likely to be issued by GE Capital, or that their mortgage insurance is underwritten by the firm. Many airplanes they fly in are owned by GE Capital and leased to the airlines; GE Capital also owns and leases oil tankers, locomotives, trucks and personal and fleet automobiles." GE Capital One would assume that an economic slowdown would impact the earnings prowess of GC. Add to this assumption the fact that GC has invested over $10 billion in Japan over the last 2 years, and one could conclude that GE looks more like an investment bank than anything else. It may seem nonsensical to harp upon GE the largest and probably the most solidified company in the world. But when are the markets about companies? Is not stock prices the game, and is GE's price not high? A similar outlook can be garnered from the likes of Coke, Wal-Mart, and McDonalds. Great companies, but the stocks are priced for a perfectly soft landing. In fact, one of the only Dow components suffering a major downturn in earnings estimates since mid-June is General Motors (nearly 3% off on its 5 year estimates). Not exactly what you would expect from a market heading towards a possible recession.
The Dow has the same qualities as the Nasdaq did prior to October: unattainable targets and lofty valuations fueled by market momentum. Even as Home Depot and Proctor and Gamble have warned of earnings shortfalls and suffered a crunch, that crunch was more readily patched up. An odd and perplexing situation that can only be explained by current rotational devices in the markets. An odd occurrence, which began in late October, and has not subsided yet. Take notice of the October striations and you will be one step closer to understanding why the Dow is destined to follow the hits which have struck tech this year. The earnings estimates in place on the Dow will not be met, and the funds which have spiraled capital into the Dow will be left hanging as redemptions multiply over the near term, and momentum reverses course. It is an awful thing to realize, but the Dow will be the primary causal agent leading us into the next recession. The Fed may soon cut interest rates, but earnings cannot rebound overnight. Remember, 5,000 on the Nasdaq was a party, but 10,000 was a once in a lifetime festival of lights. The Dow Jones Industrial Average is the most exposed major grouping of stocks on the planet to a recessionary environment, and the fallout is just around the corner. |