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July 12, 2004
Beware The Flat Stock Market

The yarn spun in early 2003 was that the inevitable post-Iraq stock market rebound in America would quickly blossom into a full-blown economic recovery. Forget for the moment that most of Wall Street expected a similar stock market/economic recovery in 2002 and 2001 -- in 2003 the story tellers were right. 

With few exceptions 2004 has gone according to the most optimistic of forecasts. To be sure, the US economy is growing, jobs are being created, deflation fears have been purged, and alternative engines of global growth have emerged (i.e. China, Japan). Wonderful!

But alas, there is one notable exception to the upbeat script: stocks are flat on the year.

Stock prices all about liquidity, not destiny

Keep in mind that the ‘good news’ has not been confined to American economy. Rather, earnings came in 7.9% above expectations in 1Q04 and earnings are expected to be significantly stronger than expected in 2Q04 (on Jan 1, 04 2Q04 earnings were expected to come in +14.9% while today the estimates are pushing 20%).  Moreover, according to First Call analyst currently expect earnings to be stronger in 3Q04 and 4Q04 than they did on Jan 1, 04. 

Suffice it to say, what efficient market theories overlook is that stocks are more than the sum of good and bad news. For an embellished example, if all American companies decided to double their outstanding share bases tomorrow via stock issuance, the markets would plunge – not necessarily because the investor’s take on the economy and earnings, but because the capital needed to purchase this massive issuance would likely not arrive until lower prices prevailed (i.e. until less capital was needed to absorb the stock sales). 

With this in mind, corporate stock issuance is up this year, short selling is up, dividends have taken the place of some repurchase plans, and corporate insiders have been selling.  What is more, and although hard statistics from ICI do not yet confirm it, there is reason to believe that fund managers are carrying more cash today than to begin the year as they await lower prices.  In short, all of these things must be taken into when considering stock market liquidity. Unlike the economic/earnings trends, these liquidity items help explain why stocks are flat on the year even though equity mutual funds have attracted massive amount of capital inflows.

The Potentially Really Bad News Is Stock Prices

Greenspan recently raised interest rates for the first time in more than four years, a plethora of key tech stocks are warning on earnings, and a handful of economic reports – including payrolls, factory orders and ISM services index – have recently arrived weaker than expected.  For these reasons and many others – including oil, debt, and overvaluation - stocks could be in trouble going forward.

No disagreement here.  However, there is another key reason why US stocks could be in serious trouble that is often overlooked: stock prices have stopped rallying.  Despite the warning ‘past performance does not represent future results’, as stocks stall so to does the incentive for sidelined investors to rush into the markets.

Mind The Momentum

Although used in an inexact manner, the word ‘momentum’ is often used to describe why upward or downward trends un the markets are embellished. And while a complete lack of market momentum – as seen today - is not necessarily a bad omen for stocks, the realization is that when upward momentum ceases investors should be given pause.  Quite frankly, that stocks have failed to rally in the face of good news suggests that a poor future liquidity trend is in development.

With this in mind, probably one of the most appropriate comparisons to 2004 is 2000. In reference to the economy and earnings nothing went gravely wrong in 2000, and yet stock prices declined on the year.  The most commonly used explanation for 2000 was that the ‘tech/internet bubble burst’. The more accurate summation is that maniacal momentum to the upside paused, and when it did liquidity ran dry.

Incidentally, what is also notable about the year 2000 is that the Fed raised interest rates (May 2000), but was forced to start cutting rates in January 2001 (from 6.50% to 1%). The Fed raised interest in June 2004…but no similar window of stimulus to that of 2001-2003 can be opened today should stock prices run into liquidity nightmare.

Conclusion

Nearly half of the $250+ billion in new equity mutual fund money that has entered the market since June 2003 is currently profitless. In other words, there is a lot of capital in the markets still waiting for gains. Stronger fundamentals may easily permit this money to sit in a holding pattern, but the speculation that weaker stock prices (stronger fundamentals or not) could spark a sell off is omnipresent.  Quite frankly, rising stock prices – as foolish as it may sound – are one of the best indicators of strong future mutual fund flows.  Similarly, declining stock prices suggest fund flow weakness.

Getting back to Wall Street story telling, it is worth remembering that in 2003 another Bush tax cut scheme was passed and the Fed cut interest rates for the 13th time in a row.  Despite these pote