The year 2003 is history and, in the US, the market battle is now beginning again. For the month of January, we will have to struggle with summaries of what happened during the last year and predictions of how the major indices will perform in 2004. Neither times gone by nor anticipation will make us a great deal of money, but they make for great marketing tools for journalists and investment bankers. There are two things to watch out for as 2004 unfolds: the folks most likely to predict are those that have been singing the same market song for the past five or even 10 years. The extreme bears will predict the end of the world, while the extreme bulls will continue to predict major gains with nothing that could impact the short-term and long-term positive sentiment.
In addition, if you listened to the business news during the first week of January, the common theme seemed to be continued economic growth and a new bull market. The charming sound of agreement among the analysts and journalists is a warning sign that things might not be that easy going forward. The crowd is rarely correct. It hasn’t been effortless to understand the price action in the past 12 months, and with the macro crosscurrents unfolding daily, there has never been a time when so many balls are in the air.
Rather than look at everything at once, and rather than trying to choose whether to be a bull or a bear, let’s break the market into two important trading metrics and see where we stand:
Fundamentals: if we buy stocks at these levels, we are buying stocks at a time when the S&P is selling at around 30 times earnings while yielding dividends of around 1.7% before taxes. Historically speaking, we have lofty valuations particularly in the technology area. It’s noteworthy that analyst estimates on the earnings of individual companies were continually lowered to levels that would eventually be met. The degradation in the market fundamentals could not continue forever. That we already knew. Currently, we have continued layoffs, most recently at Eastman Kodak and Kraft. Companies with a nice tie-in to the consumer (thanks to the tax cuts) did better than most companies in the third quarter. Companies that benefited from the inventory build showed better numbers. In addition, cyclical companies benefited greatly from the rally in commodities. So yes, the tax cut helped; the rise in the stock market helped; lower rates and the refinancing boom helped; and the dollar decline helped. But there are no real signs of an improvement in end demand, excess capacity is still at high levels, and big companies like Microsoft and General Electric are struggling to grow. It’s hard to imagine a new bull market taking off with these levels of fundamentals.
Technicalities: short term traders will tell you that rather than become paralyzed by the bulls’ and bears’ sophisticated macro arguments, the easiest thing to do is to simply pay close attention to the price action that is in front of us. Rather than try to forecast what might happen next year or next month, enjoy the blessings of the current trend but be prepared to act quickly if it bends. The only problem from a technical perspective is that the indices are far above their 200-day moving averages. This means that a lot of the good news emerging (GDP up 8.2% for the third quarter) has already been discounted by the rallying indices. In other words, the stock market has simply gone very far and very fast on the upside, therefore, it may need a rest. But we are still in a major and clearly defined upward trend, and upside momentum is running high.
The business of rectifying the damage from the mania is unfinished and the excesses could take years to unwind. But this does not mean that the rally will be over soon. I’m aware that the market can do anything. John Maynard Keynes wrote: “The market can stay irrational longer than you can stay solvent.” We are in this irrational type of market. Billions and billions of dollars, euros, and yen are being tossed out in this global attempt by the central banks to keep the good times rolling. Due to these central bank actions, the dollar has seen one of its biggest drops in the last 20 years. Debt levels are the highest they have ever been, with the debt-to-GDP ratio now about 350% (in the US). One of the largest collapses in the history of the bond market recently occurred. The US budget and trade deficits are just astounding. But equities are still rallying. When you put a summation sign in front of all the above, the risk/reward equation in equities is still completely out of whack (especially for long term investors). On the other hand, if you are a nimble trader, you probably can enjoy the current positive technicals of the market and stay with the trend for now.
Ziad Abou Jamra is the head of the trading desk at FIDUS GROUP SG
