Sugar Plums

“It’s beginning to look a lot like Christmas…”

Author Unknown (at least by me)

“Following a social movement,” came the announcement. “Service is interrupted on the #9 line.”

“Social movement” in France means a strike. Like so many things in public life, the words tell you exactly the opposite of the thing they are supposed to describe. Stopping the subways, by those paid to operate them, may be more correctly called an “antisocial” movement.

Forced up out of the metro, I arose on the corner of the Champs Elysees and Avenue Montaigne. Both were lit up brightly, decorated for the holiday season. What a marvelous time of the year! But it is also a difficult time of the year for many people, the social scientists and feeling meddlers tell us. People build up such high expectations for Christmas, that they are often disappointed – and even depressed – by the real thing.

It is still early in the year to be writing about Christmas. But I do so not to spread holiday cheer, but holiday gloom. For whenever expectations become exaggerated – like a bum upon finding an unlocked liquor store – the outcome is rarely as beneficent as anticipated.

Investors are getting ready for Christmas. “Wall Street continues to believe that the current environment represents the best time to buy equities in the last 16 years. We find it incredible that even the prospect of war can’t dampen their bullishness,” says Richard Bernstein, chief quantitative strategist at Merrill Lynch.

The big bottom of their dreams has come and gone – they believe. Visions of sugar plums dance in their heads. Sadly, the more the candies twist and boogie in their minds, the less likely that investors will get what they want from Santa.

Anticipation, it turns out, is a fairly reliable predictor. The more people expect a given outcome from the market…the less likely they are to get it.

This is especially true when applied to professionals. So regularly do Wall Street strategists get it wrong that you can practically set your watch by them. When they are extremely bearish, stocks rise. When they are extremely bullish, stocks fall.

Merrill Lynch is so sure of this phenomenon that they have developed what they call a “Sell Side Indicator” out of it. Audrey Kaplan, quoted in the International Herald Tribune over the weekend, calls it “the most reliable quantitative market-timing barometer.”

“We have found that Wall Street’s consensus equity allocation has historically been a reliable contrary indicator,” Ms. Kaplan explained. “In other words, it has historically been a bullish signal when Wall Street was extremely bearish, and vice versa.”

The Sell Side Indicator tells us what percent of your portfolio Wall Street’s brokerage houses are recommending that you put into the stock market. Since 1985, the number has varied from a low of about 47% in 1989 to a high of 71% today. Until recently, the indicator had never been greater than 62%. In December of 1996, when Alan Greenspan warned of “irrational exuberance” among investors, they were actually calm and reasonable. Wall Street pros were recommending only about 50% exposure to stocks. But while stocks fell, beginning in the spring of 2000, Wall Street became more and more bullish. In fact, it has never been more sure that stocks are the place to be.

Other surveys tell the same story. Investors polled at the end of August, notes Barton Biggs of Morgan Stanley, found remarkably high expectations. “You couldn’t ask for a much grimmer period,” said Biggs. Household wealth had already fallen by $875 billion in 2000 and another $532 billion in the first half of 2001. But investors were upbeat – the average one expected an 18% return on equities next year. Only 2% thought they would lose money on stocks and 82 percent expected to end the year richer than they began it.

Investors were far from capitulation in late August. If anything, they are even farther from it today. The American Association of Individual Investors also surveys its members to get a reading of sentiment. At the very peak of the stock market bubble – in December ’99, bullish sentiments had spread to 60% of the members. A 60% reading is rare. But, again, as stocks went down, bullishness went up. Last week, 69% of respondents were bullish – while only 20% were bearish.

How could investors be so wrong, so often?

“In the short run, the stock market is a voting machine. In the long run, it is a weighing machine,” said Ben Graham. In the short run, investors vote for whatever outcome they want and/or expect. If they believe the future will bring good news…and that Alan Greenspan can avoid a recession…they will pay more for a stock – because they look forward to compounded growth in earnings over a long time. Or, if they are fearful, they worry that they may have to sell the stock next year… or that earnings may go down in the future rather than up.

But whether they are extremely bullish, or extremely bearish, their “votes” tip the scales in the opposite direction. When investors are bullish, more and more money is invested in a given stream of earnings (a company…an industry…or even an entire economy only produces so much profit)…leaving a smaller and smaller return on investment for each investor. As long as confidence in the future is building, prices rise. But eventually, when the anticipation of future profits – and bullishness – reaches its zenith, prices give way. Smart investors notice that earnings will not be sufficient to keep up with the stock prices. Stock prices fall, until they are at last bargains again…and then, the stupid investors sell.

There are no exceptions to this pattern. Over the long haul, the market weighs out the real return on an investment and brings it into line with the rest of the economy. If stocks have gotten too high…they are driven down. If they have gotten too low…a new bull market begins.

Over the long run, the stock market cannot stray too far from the underlying economy. Investors are paying for earnings, after all, and earnings go up or down along with everything else.

“The stock market does not grow faster than the economy,” writes John Mauldin. “If it goes too high or too low, it always comes back to trend.” When investors have become unusually confident, they are pulled back down to the trend…when they have become unusually fearful, they are pulled up by rising stock prices. The more investors anticipate either outcome…the further they have to get back to the trend.

At the bottom, they have an opportunity to buy stocks for the right reason – because they are bargains. Later, when stocks approach a top, they can buy them for the wrong reason…because Wall Street and other investors tell them to do so.

“Stock prices fluctuate dramatically,” Mauldin observes. “There have been 7 secular bear markets and 7 secular bull markets since 1802. These are periods of at least 8 and up to 20 years where stocks are either generally rising or falling over the entire period. There are, of course, bear market rallies and bull market corrections, but the long-term trend is still either up or down.”

Up and down…down and up.

Mr. Market is never satisfied. He never sits still. Thank God we have the professionals to tell us what direction he is not going to take.

Your correspondent,

With his eye on the pros…and visions of sugar plums dancing the can-can in his head…

Bill Bonner
December 4, 2001

Patriots fixed their plastic bayonets and charged last month, sacrificing their financial integrity in a hopeless and lamebrained cause. As Eric reports below, consumer spending rose while spending power declined. Mortgage delinquencies rose to 4.87%, but that didn’t stop people from buying. “U.S. goes cheap car crazy,” said the BBC of Americans’ car buying last month.

Consumers are voting with their pocketbooks – for a new boom. Too bad it doesn’t work that way.

“Economy shrinks at fastest rate for a decade,” says the Financial Times. And not just the U.S. economy. “Gloom Deepens in UK Economy,” too, says the BBC. And “Euro-zone manufacturing shrinks for 8th straight month,” reports the Financial Times.

Unemployment in France rose for the 7th month in a row, adds Le Monde.

Consumers can vote all they want – it won’t change the seasons or make water run uphill. Democracy is a bit of a fraud, in the market as well as in politics. But that is another subject.

Eric, what’s shaking on Wall Street?


Eric Fry in New York…

– Okay, now it’s official, American consumers have gone mad! Personal spending surged in October, despite the fact that after-tax personal incomes FELL. Alan Greenspan must be very proud of what his rate-cutting extravaganza hath wrought.

– The Commerce Department reported Monday that personal spending soared 2.9% in October – the largest monthly jump since the data series began in 1959. Meanwhile, personal incomes were stagnant in October for the second straight month – the worst showing in more than seven years. It gets worse…Americans’ incomes after taxes actually fell.

– “The 1.7 percent decline in after-tax incomes and the record increase in spending meant that Americans’ personal savings rate dipped to a record low of 0.2 percent in October,” the New York Post reports. “The fact that incomes remained frozen in both September and October raises concerns about the future course of the economy.” That’s putting it mildly!

– Skyrocketing spending, despite falling incomes and dwindling savings, does not look like the stuff of enduring economic vitality.

– Are we becoming a nation of reckless spendthrifts? Has Enron become the new financial model for businesses and individuals alike?

– Enron’s $53 billion bankruptcy filing is exceptionally large, but it is hardly exceptional. Enron has plenty of company in bankruptcy court.

– A record 230 public companies with more than $182 billion in assets have already filed for bankruptcy this year, according to Last year, only 176 companies with a total of $95 billion in assets filed for bankruptcy.

– “As the number of bankruptcy filings by public companies surges to a record,” the New York Times reports, “companies are increasingly being forced to liquidate instead of reorganizing as viable businesses…The liquidation rate is far higher than a decade ago, the last time there was a surge in bankruptcy filings.” One assumes that many members of the Bankruptcy Class of 2001 were never “viable businesses” in the first place.

– Henry Miller, vice chairman of Dresdner Kleinwort Wasserstein, tells the Times “A lot of companies have melting ice cubes for assets, and there’s not a serious prospect of restructuring on a stand-alone basis.”

– Recklessly engineered finances seem to be the order of the day. Remember that in 1999, Enron agreed to pay a staggering $100 million over 30 years for the right to name the Houston Astro’s new ballpark “Enron Field.” Probably, most of the 4,000 newly unemployed Enron employees could have found better uses for that cash.

– Then again…maybe not. Aren’t a lot of folks busy buying overpriced U.S. stocks? If you’re going to invest in money-losing companies, why not pay money to name a stadium after yourself?

– Yesterday, the buyers took it easy on Wall Street. The Dow lost 87 points to 9,764, while the Nasdaq shed 26 points to 1,905.

– The shares of J.P. Morgan Chase (JPM) were a conspicuous loser, falling 3% to $36.55. JPM is among the more prominent of Enron’s creditors. “According to the U.S. bankruptcy court filing in New York, JPM is on the hook for about $2 billion in unsecured loans to Enron,” reports. “The Texas-based energy company turned out to be all hat and no cattle.” (

– also points out that JPM may soon have a new headache to worry about: Argentina. The country imposed stringent capital controls over the weekend in a desperate attempt to avert a default or currency devaluation. As of September 30, JPM’s exposure to Argentina totaled $900 million. What will become of this nearly $1 billion liability is anyone’s guess. “Other interesting tidbits: JPM’s consumer credit card exposure has increased 32%, from $403 million (Sept. 30, 2000) to $534 million (Sept. 30, 2001), with average annual net charge-offs growing from 4.99% to 5.64% over the same period.” There’s that heavily indebted Mr. Consumer again!

– Public Service Announcement: Starting today, Cisco will be hosting its gala “Worldwide Analyst 2001 Conference” from Santa Clara, California – in the heart of the Silicon Valley. No doubt, we can expect to hear a lot of feel-good blather about “demand stabilizing” and about an “improving long-term outlook.” The current quarter will be awful, of course…and so will next quarter…and maybe the one after. But you can be sure that, a few quarters out, things will start looking okay…

– Don’t they always?


Back in Gay Pareee…

*** The financial media is beginning to catch on to the threat of deflation – at least enough to be able to dismiss it.

*** “Almost anywhere you go this holiday shopping season, you see the sale signs,” says a report from the Seattle Times. “From The Bon March? to J.C. Penney, from small boutiques to stalls at the Pike Place Market, prices are down.”

*** But while “most economists say the United States likely will avoid another deflationary spiral like the one that crushed the economy in the 1930s,” reports the Oregonian, “…they’re not ruling out the possibility that the nation could be gripped by at least a short period of mild deflation in the wake of the Sept. 11 terrorist attacks.”

*** Why not a long period of severe deflation? Who knows! Who would have thought that the Fed would cut interest rates 10 times with no improvement in the economic situation? And who would have imagined that the World Trade Center towers would be demolished by terrorists?

*** Almost every news story or opinion we read here at the Daily Reckoning is positive…confident…upbeat… Whether it is the economy, the stock market, or the war in Afghanistan – everything is going to turn out well, and soon. This is the best time to buy stocks in 10 years, says one investment guru, because the stock market will soar as our success in Afghanistan is completed.

*** We don’t know what the future will bring, dear reader, but investors and consumers are voting for success. If only it worked that way! Instead, when investments are priced for success, investors pay a heavy price for failure. And the Law of Perverse Outcomes practically guarantees that some degree of failure is what we will see. Where? When? How? More below…

And stay tuned…