The Three Amigo Bottom Indicators

The Daily Reckoning Presents: A Special Guest Essay in which the author searches for serious signs of a turnaround in the markets…


The recent market action has a lot of people scratching their heads. Of course, the cheerleaders tell us each move down is the bottom. And one day they will be right. But that does not explain the markets.

First, let’s remember a basic fundamental. For every seller in a bear market there is a buyer. Given the real problems in the economy, however, the question to those of a bearish persuasion becomes: “Why is anyone buying stocks?”

The answer is they see the potential for real profits! (Even though they have to ignore the S&P 500 selling at an unbelievable historical high P/E ratio of 29 in a bear market).

According to Bank Credit Analyst, stock market rises lead corporate earnings during a recession by an average of 11 months. On average, the S&P has risen 32% from the market’s bottom before the earnings cycle bottoms out. Note that the stock market rise does not begin after the recession is over. It begins usually at the bottom of the recession when things look the worst.

This market rise comes before things turn around and before unemployment bottoms out. It begins when it looks like there is no end to bad earnings reports. Thus the search for: The Bottom. A 32% rise in less than a year can salve a lot of bear market wounds.

Seems easy enough. Just invest when blood is running in the streets. But the trick is to figure out when things look the worst. Are we looking for ankle-deep or knee- deep blood? Things may look pretty bleak today, but there is no reason they cannot look worse tomorrow.

And that, dear reader, is what our assignment is today. We are going to explore some of the signs that happen when things are at their worst. We want to know what month in the future earnings will turn up so we can subtract 11 months and jump back in the market BEFORE the 32% rise.

In the Fed Watcher section of his website, Dr. Ed Yardeni, chief economist with Deutsche Bank Alex Brown, gives us a number of charts which show the relationship between certain factors and Fed funds rate. I take these and overlay the S&P 500 data to help us see if we can find something of market-predicting significance.

There are several items which are highly correlated with Fed fund rates. They are also highly correlated with stock market direction. And even more important, when you go back to 1990-91 and pay close attention, some of them even give us a hint at that most elusive of moments: The Bottom.

As you might expect, the direction of the Fed funds rate is closely related to GDP growth. In past recessions, the Fed funds rate only started to come down after GDP growth slowed down. But in our current economic cycle, we see Greenspan and crew cutting rates only shortly after the slowdown began. Faster than at any other recent period, but not soon enough in the opinion of many observers, including your intrepid analyst.

This is why so many analysts are bullish; they see that chart and connect the dots which show the economy and markets growing stronger next year. I think this “correlation” is tentative, at best. Betting my economic future on the effectiveness of rate cuts, let alone on the likelihood that cuts actually produce magical changes in exactly 12 months, seems questionable.

The first indicator I want to look at is the strong connections between capacity utilization, the Fed fund rate and the stock market. Interestingly, capacity utilization bottomed in early 1991 and the stock market found a bottom a few months later.

The second indicator is the NAPM Price Index (National Association of Purchasing Managers). It also bottomed in early 1991.

All the other graphs show the correlation to the Fed fund rate with factors like industrial production, G-7 industrial production, profits, earnings, commodity prices, metals, etc. While correlated with the Fed fund rate, these did not seem to anticipate a turn around in the stock market prior to the actual rise. (I should note that these are my conclusions and are NOT to be interpreted as coming from Dr. Yardeni.)

It makes sense why capacity utilization and the NAPM Index would tend to be a pre-cursor to a turnaround. Until factory production and purchasing turn around, how can we say we are at the bottom? Unemployment, earnings and such will still tend to look bad and get worse, even as the stock market and the economy rise from their graves, but something has to signal that we are at: The Bottom.

Remember my earlier point: as bad as things are, they can get worse? Until these indexes start to show some signs of life, things can get worse, and probably will. On Wednesday, the NAPM Index, after rising slightly in May, fell out of bed in June. Every month brings a decrease in capacity utilization.

But I promised one more indicator of The Bottom. And that would be junk bonds, the current nuclear waste of investments. Junk bond funds typically turn around at the bottom of a recession. Again, this is logical, as bond values are an extension of the ability of companies to make their payments. When the prospect for re-payment improves at enough companies, the bond funds themselves begin to show signs of life.

Junk bonds are currently showing no signs of life. They really are getting treated like nuclear waste. I could quote some devastating numbers about how default telecom bondholders are only getting 12 cents on the dollar and about how many hundreds of billions of dollars of telecom bonds are still waiting for the shoe to drop, but space and time suggest not.

Someday, however, you will want to invest in junk bonds, only then we will respectfully call them High Yield bonds. High Yield bond funds rose almost 80% after the last recession in 1990-91. I actually look forward to the day, as it will be a once in a cycle trade that we will get to brag about to our brothers-in-law.

But for now, the Three Amigos of capacity utilization, the NAPM Index and junk bonds tell us we are not yet at the bottom. When to get bullish? When these indicators start to turn up for two months. (Or you can be aggressive and start to increase your portfolio at the first signs of life in all three indicators simultaneously.)

You might miss a point or two in the following rise, but history says you won’t miss too much. And you could miss more than a point or two in the market fall as we wait for the economy to turn around.

Still searching for the Big Bottom…

John Mauldin,
August 3, 2001

for The Daily Reckoning

John Mauldin is an investment advisor, an authority on hedge funds, and a frequent contributor to the Daily Reckoning and the Fleet Street Letter. You can read his latest writings or subscribe to his e-letter by going to, or sending him a note at:

*** Hmmmn…wasn’t it just a week ago that we were lamenting the fact that “the only thing new in the ‘news’ these days” is the names of companies reporting bad earnings and announcing layoffs…

*** Just yesterday, in fact, we reported 31,000 people lost their jobs in one day. Wait, it only seems like yesterday. In fact, it was last Friday.

*** Over a million have gotten the ax since January first of this year. Intel reported profits for the 2nd quarter had dropped 94%…computer-related industry profits were down 66% across the board…

*** Yet, Craig Barrett, hombre numero uno at Intel, says he believes the end of the global slowdown in demand for tech products “is in sight,” and “boom!” up the stock leaps 4.5%…

*** The chip sector has been on a tear for the last seven days…jumping 3% yesterday alone…Dell was up 4%…PMC Sierra leaped up a whopping 10.5%…

*** Has Boobus Americanus lost their collective mind? (Thank you Doug Casey for that most affectionate term.)

Before we try to answer, let’s check in with our man on the scene in New York. Eric?


Eric reports from Wall Street:

– Ask most investors about the tough economic conditions hovering over the stock market and they’ll invariably say, “Earnings will recover in the second half;” Or, “The economy is bottoming;” Or, “Greenspan will cut interest rates until the market recovers.”

– And now, along comes Salomon Smith Barney equity strategist John Manley with the comforting observation that the economy and corporate profits are – at last – deteriorating at a slower rate.

– Three cheers for slow deterioration!

– Yesterday, the rose-colored glasses crowd was out in full force, proclaiming among other things that semiconductor prices had hit bottom.

– “The industry has bottomed out,” Intel’s Chief Executive Craig Barrett told reporters in Penang, Malaysia. “There will be an uptick in demand in the third and fourth quarters.”

– The Semiconductor Industry Association seconded Barrett’s optimistic outlook. “Based on the inventory reduction that has occurred in the first half of 2001 and the further reductions projected for the third quarter, we believe the industry will return to sequential growth in the fourth quarter of this year,” said George Scalise, president of SIA.

– The Philadelphia Semiconductor Index (SOX) rallied on the rosy forecasts and has now gained more than 19% over the last seven trading days.

– The Dow backtracked from a 99-point midday advance, but hung onto 41-points to finish at 10,551. The Nasdaq, meanwhile, gave back nearly half of its early session gains to finish up 19 at 2087.

– Even if the glass is suddenly half-full in the semiconductor industry, Wall Street is just beginning to feel the pain. “There is a major job recession on the Street,” writes the New York Observer’s Landon Thomas. “With at least 1,500 investment-banking jobs already gone this year, it’s going to get worse before it gets any better.”

– Dresdner Kleinwort Wasserstein’s announced recently that they will cut 1,500 banking jobs – with the knife’s sharpest edge to be felt in its New York offices.

– “No longer are just ‘under-performing’ bankers getting the ax,” Thomas continues. “These days, anyone can be let go. Indeed, the joke within Merrill now is that if you’re not working on a live deal – even if you’ve just closed a major one – you are liable to get fired.”

– How’s this for proof of a bubble in the real estate market? Coldwell Banker released a report showing that if you want a 2,200 square foot, 4-bedroom house in Oklahoma, it’ll cost you $134,275 in Tulsa…but only $134,225 in Oklahoma City. A $50 dollar divide.

– In Palo Alto, your family digs would set you back $1.1 million, while just a few hours away, in Bakersfield, that dwelling costs only $119k. Over a million dollars separates the two…

[Here’s a simple question: Does anyone really need a house in Palo Alto that badly?]

– “Wow!” is all I can say to another survey conducted for the Securities Investor Protection Corporation (SIPC) and the National Association of Investors Corporation (NAIC). The survey was designed to test “investor awareness”…and 4-out-of-5 investors failed.

– Fewer than one in five realize that there is no “insurance” for stock market losses. When asked to identify the “organization that insures you against losing money in the stock market or as the result of investment fraud,” only 16 percent knew that there is no such group.

– “We’ve been at this for 50 years now,” says the NAIC’s Robert O’Hara “and we see the same problem over and over again: new investors come in during bull markets and then don’t know what to do when things go sour later.”

– “Informed is better,” says James Grant.

Back to Addison in Paris…


*** Informed is better with respect to the perennial search for the bottom, too. “Stock market gains lead corporate earnings during a recession by an average of 11 months,” writes John Mauldin. “The cycle begins when it looks like there is no end to bad earnings reports.”

*** Mauldin’s research shows that, on average, the S&P rises 32% from the market’s bottom before the earnings cycle bottoms out. (Mauldin suggests a few potentialindications below…)

*** Here at the Daily Reckoning…well, we’re not so sure. “Talk is cheap and Wall Street gets it wholesale…” says Bill King, and we’re inclined to agree. “Until a requisite number never want to hear the words stock and market again, the bottom is not in.”