Dynamic Market Theory
An entirely different explanation for the rally on Wall Street…
Something has changed in the stock market. That ‘something,’ of course, is the dollar amount of Federal Reserve repurchase agreements, which has dropped considerably.
There is a strong correlation between repurchase activity and the current rally in stocks: In the second week of August, the Fed’s repurchase activity totaled US$48 billion. A week later, the total is was ‘only’ US$35.25 billion. (Which means that for a mere US$83 billion, you, too, can create a 100-point rally in the Nasdaq.)
The question is: How long will this go on? How long will the Fed continue to feed the stock market’s addiction to liquidity? I think the answer is simple – 2,000 and 10,000…as in Nasdaq 2000 and Dow 10,000. Those are big, round numbers that will scream, “the economy is OK!” to the American people.
But is it OK? Or is this rally based on a false idea of value?
The traditional measures of value for investors all have to do with the actual or potential earnings of a company. What is it producing? What are its costs of production? What is its position in the marketplace? What is its competition? What is its future potential for earnings?
Dynamic Market Theory: Our View of Value
Oddly enough, few investors these days seem to care about value any more. They didn’t back in 1999 (when all they wanted was an Internet-related business plan scribbled on a cocktail napkin). And unless they’re seeing sales and earnings increases in U.S. companies where we can’t find them, they still don’t care now. But maybe you don’t have to care about value to make money. In fact, based on Taipan’s research into Dynamic Market Theory, the traditional views on value are all wrong. I’ll get to Dynamic Market Theory in just a minute, but first, let me explain our view of value.
We believe most market theories all deal with the ‘intrinsic’ value of stocks or other commodities. In other words, the notion that the value comes from within the thing. That it has value by and in itself, regardless of any associations with other things.
But we believe that, for investors, the only value of any importance is the value that someone else places on a stock or investment at any given point in time. Following this idea, there is really no such thing as a ‘bubble.’ If the price of a commodity like real estate, tulip bulbs or Internet stocks rises to hyper-value based on demand…then that is its true value at that moment in time.
You see, a ‘bubble’ is an argument about value – mostly made in retrospect, after a particular investment fad has gone bust. Investment fads that don’t go bust, conversely, are called ‘strokes of genius,’ even if the underlying speculative analysis and risks are the same for both.
Dynamic Market Theory: A Small Percentage of Shares
For example, at the market peak in early 2000, it was said that the stock market had a valuation of US$17 trillion dollars. That amount had dipped to US$8.5 trillion by October 2000. Right now, the valuation of the stock market is about US$10 trillion. But all these figures are assignments of value based only on what a small percentage of shares is trading for.
Only a tiny fraction of a given company’s shares are in trade at a given time. Take Microsoft, for example. There are almost 11 billion shares of Microsoft outstanding, but on any one day, only 25 or 30 million might change hands. If you dumped all 11 billion shares on the market at one time, the price would plummet because of the monstrous excess in supply – no matter what was going on at the company or in the stock market. So the ‘valuation’ commonly given to any or all stocks is arbitrary, not real, even if it is based on the latest sale of a few shares of the stock.
Those subscribing to a bearish view of the market like to say that around US$8.5 trillion dollars of equity valuation was ‘destroyed’ in the bear market from early 2000 to October of that year. But since valuations are assigned arbitrarily anyway, they can’t be destroyed. They change up, they change down. But they never go away. And that US$8.5 trillion wasn’t ‘created,’ but was generated by the reallocation of savings and spending money put into stocks, which pushed share prices up overall, causing the higher ‘valuation.’
And here’s another interesting little fact: In 1982, at the beginning of the last ‘bull market,’ there were only about 1,500 companies listed on the New York Stock Exchange, with roughly 40 billion shares. The market valuation was around US$1.3 trillion.
But by the year 2000 and the end of the bull market, there were over 3,000 companies listed on the New York Stock Exchange…with over 349 billion shares available. Granted, some of these were start-ups, but it’s obvious that a lot of the ‘wealth’ that was ‘created’ actually came from existing private companies going public, taking advantage of a rising market and putting shares of their company up for sale to the general public.
Dynamic Market Theory: Merely Changing Hands
These companies were already in existence, with dynamic value. It’s just that their value was now counted as part of the stock market. So in these cases, wealth wasn’t created – it merely changed hands, from a few private owners to millions of stock investors. Realistically, since stock market valuations came down, the amount of money invested in stocks also came down. Much of that money was simply reallocated to other assets…like real estate, bonds, gold, and other commodities.
Stocks are valuable to investors because their prices change, both up and down. If they didn’t change, why would investors want them? It would be easier to hold cash – it’s more liquid, and there are no transaction fees.
Now, anyone with a computer can see – in an instant – that a stock’s price has moved from US$20 to US$25. And anyone with any imagination can see that they could have made a quarter for every dollar they put down. That’s how it begins. And that’s usually about the time average investors make their first mistake.
Because, as soon as you start looking for a particular stock whose price could rise, you introduce the idea of valuation – that a stock’s price is somehow linked to the prospects of the company. But this is true only in the most general understanding of valuation.
If you watch stocks trade on options expiration days, you’ll realize that ‘valuation’ takes a back seat to the infinitely more powerful forces of money flow. The only question is, who’s going to be left holding the bag? Watch a stodgy old NYSE stock as options expiration day (the third Friday of every month) approaches. Pay particular attention to the open interest on puts and calls in the vicinity of the current stock price. Like clockwork, the greatest number of people who can be squeezed out of their money at expiration, will be. Whether that means selling down a ‘good’ stock or pumping up a ‘bad’ one!
Want to know where the S&P 500 and Nasdaq are headed? You could listen to bulls or bears or stock analysts. You could track unemployment, follow earnings trends, and pay close attention to market gurus and the financial media. But if you really want to know, you should check the “Commitment of Traders” report released every Friday by the Commodity Futures Trading Commission. This report is more valuable than all the economic or technical analysis known to man.
Dynamic Market Theory: The Money That Moves the Market
Because this report will tell you what the big money, the money that literally moves the market, is doing. And this is where you’ll get your first clue about what’s really behind value…and why we prefer to use the realities of Dynamic Market Theory.
You see, 99 times out of 100, you’ll find that the big money is doing the exact opposite of what ‘the herd’ is doing. The investors looking for steady growth, low P/E stocks in which to park their US$100,000 IRA have no idea what they’re up against. The big money, the guys with billions upon billions in buying and selling power, WILL have their way. And if that means dropping a low P/E stock even lower, then so be it.
For example: eBay currently trades at 22 times sales, has a P/E above 100 and a 50% premium to its growth rate. It is richly valued, to say the least. Eight million shares are sold short. And the open interest on options is about 2-to- 1 in favor of the puts (investors betting the stock will go down). A lot of people are betting the stock is overvalued…and expecting it to fall.
It’s not that they’re wrong. It’s that they’re asking the wrong question.
The single-most important question you need to ask is not whether it’s overvalued, but…who’s going to make money? When you know the answer to that question, you can make a fortune. That’s how the richest people in the world make their money.
Here’s what I mean: The top three institutional owners of eBay have about US$3.5 billion in the stock. Add in the next three institutional owners, and you’re talking about US$6 billion. So, will the investors who have approximately US$800 million in shorted stock ever turn a profit?
Not likely. The big boys, that is, the top institutional owners, will keep the price up until the shorts call it quits. Or they’ll run the price up and ‘squeeze’ the shorts – handing them bigger and bigger losses – until they give in. And the situation is even worse for the vast number of put options holders.
So, sometimes it pays to poke your head up out of quarterly reports and valuation models and see what’s around you. If you find yourself surrounded by a bunch of people who, like you, think they’re about to make money…well, you’re probably wrong.
Dynamic Market Theory: Money Always Wins
The stock market is a game, pure and simple. And there’s only one rule: money always wins.
In other words, a lot of that money that ‘disappeared’ from stocks (equity funds) simply moved into bond and money market funds. The money didn’t ‘disappear’ – it moved. Add to that the moves into gold and real estate, and you begin to see that – allowing for fluctuations in the ‘value’ that we love to give to the market – money tends to move around more than it ‘appears’ and ‘disappears.’
Point is, all that money didn’t just ‘vaporize,’ as the perennial bears like to claim. A lot of it simply moved. Now money is flowing back into stocks again. But beware – the market is set to fool investors and separate them from their money yet again.
But if you follow Dynamic Market Theory, you’re much better positioned to profit…no matter what happens in the stock market. It’s a new and different way of investing that takes into account volatile market conditions and the many factors stacked against the individual investor.
Many stocks exhibit certain predictable behaviors before they make a large move…that is, before the money moves into or out of them. Over time, this behavior – shown by any number of indicators – gets recognized, and everyone begins to look for those indicators and act on them. Then the significant factors evolve into something else.
To turn this action into profits, you need a set of individual ways of looking at the dynamic market action of stocks (in other words, price action) to arrive at decisions about how to invest. With these individual systems of looking at dynamic action, you can predict developments in stocks…in any market…by looking at the different indicators.
What’s become obvious is that static theories or traditional views of the markets can’t and won’t work in the long run. Because there is no one set of principles – like value investing – that will always work. Since the market is dynamic and ever-changing, following one investing principle dooms you to failure.
It may work for a short period of time, but once the market factors change, then so must your investing philosophy.
for The Daily Reckoning
October 16, 2003
P.S. If everyone looked for ‘value’ and bought ‘value’ based on certain criteria, there would be only buyers for stocks one day, and only sellers another day. Markets just don’t work like that. There have to be both buyers and sellers to maintain equilibrium in the markets.
If you’re concentrating on only one ‘sector’ or one style of investing, you’re going to fail. Money is constantly flowing from one stock to another, and from one sector to another. This dynamic action is what you must read to be successful.
Following the market’s dynamic fluctuations, my Taipan team has identified half a dozen opportunities you can take advantage of.
As publisher of Taipan, J. Christoph Amberger’s role can be compared to that of a spider in the middle of the web. He is constantly in touch with all of Taipan’s sources, contacts, and correspondents, directing their research, and identifying new and promising investment opportunities. A frequent speaker at international conferences, he is also the author of several books and scores of articles on topics including international politics and travel.
“It feels strange to be quoting [NY Times economist] Paul Krugman,” said colleague Dan Denning last night. “But his analysis is pretty good, even if his solutions are foolish.”
“There one thing I can’t help noticing,” wrote the foolish economist earlier this week. “A Third World country with America’s recent numbers – its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world – would definitely be on the watch list.”
Normally on the ‘watch list’ are Third World countries with big financial troubles. Argentina, Brazil, Indonesia, Malaysia – all have made the watch list. All have subsequently suffered banking and currency crises, or hyperinflation, or depression or some hellish combination of economic fire and brimstone.
But now, “the U.S. budget deficit is bigger relative to the economy than Argentina’s in 2000,” says Krugman, “and the U.S. trade deficit is bigger relative to the economy than Indonesia’s in 1996.
He continues: “The brokerage firm Lehman Brothers has a mathematical model known as Damocles that it calls ‘an early warning system to identify the likelihood of countries entering into financial crises.’ Developing nations are looking pretty safe these days. But applying the same model to some advanced countries ‘would set Damocles’ alarm bells ringing…most conspicuous of these threats is the United States.'”
Welcome to the pampas, dear reader.
George W. Bush may not feel like the president of a backward, Third World nation when he visits Asia this weekend. Americans do not go around barefoot, nor do they live in horrible scrap-cardboard shanties. Instead, they live in $200,000 suburban shebangs and borrow against them in order to buy $100 Nikes imported from Asia.
But selling Nikes to Americans has left the Orientals with $1.7 trillion in U.S. dollar-denominated Treasury bonds. It also leaves them with a strong desire to keep their currencies low compared to the dollar in order to keep the cash flowing their way. To this end, the Chinese are unlikely to revalue their yuan upwards in the near term…and the Japanese, with no further rates to cut, have taken to printing money (the money supply in Japan is now growing at a 21% annual rate).
The U.S. Treasury has not admitted it, but the strong dollar policy of the Clinton Administration has been replaced by a third-worldish peso policy. And Fed governors have announced their intention to drop dollar bills from helicopters if that is what it takes to weaken it.
The sluggish chocolate-making countries, too, are eager to keep their currency from rising. Close to recession, Europe can ill afford a rising currency.
And yesterday’s news brought word that Russia’s ruble had risen to a 22-month high against the dollar after Moody’s upgraded Russian bonds to investment status. The authorities were not happy, blaming the rise of the ruble on ‘speculators.’
How all this will end up, we don’t know.
Consumer prices may rise…or they may not. China can produce new widgets and gee-gaws almost as fast as the rest of the world can print and circulate paper currency. Besides, demand for widgets and gee-gaws could decline sharply when times get tough.
But while America, the Far East and Russia can print all the paper currency they want, the supply of gold is limited to what miners can pull out of the ground. It takes years to bring a new mine into operation; during the 20-year bear market in gold, few new ones were put into service. And even now, after the price of gold has risen from a low of $253 a few years ago to $373 today, miners are still reluctant to invest in new production.
And while there may be only 370 dollars ready and willing to purchase an ounce of gold today….there will almost certainly be more next year.
Our old friend Chris Wood guesses that the price of an ounce of gold will reach $3,400 before this bull market is over. That price would equal the peak at the last bull market, adjusted for nominal increases in personal income.
While we are waiting for gold to reach $3,400 an ounce, here’s Eric with more news:
Eric Fry, our man-on-the-scene in Manhattan…
– The stock market’s formulaic rally continued yesterday morning, as if following the same tired script it has been following almost every morning lately…
– Here’s the basic storyline: 1) High-profile tech stock reports “positive earnings surprise” after the close of trading; 2) High-priced tech stock then soars in after- hours trading, thereby establishing a “bullish tone” for the following day; 3) All evening on CNBC, Maria Bartiromo gushes breathlessly about high-profile tech stock’s positive earnings surprise; 4) The nation’s investors lay themselves down to sleep, comfortable in the knowledge that the bull market in stocks will resume the following morning; 5) When the following morning finally arrives, the stock market opens for business to a flood of buy orders for tech stocks…Voilà, another bullish trading day is born.
– Alas, by day’s end yesterday, the Dow was down. Intel provided a tailor-made earnings surprise Tuesday evening, by reporting a third quarter result of 25 cents a share – a couple of pennies per share better than the consensus earnings estimate. The company also offered an upbeat forecast for the fourth quarter.
– On Wednesday morning, predictably, Intel shares spiked more than 5% higher immediately after the opening bell. The rest of the stock market tagged along. But the market’s early gains faded in the afternoon, as the Dow fell 10 points to 9,803 and the Nasdaq slipped 4 points to 1,939.
– The bulls needn’t despair just yet. Last night, IBM became the latest high-profile tech stock to provide an “earnings surprise.” Actually, the earnings themselves weren’t much of a surprise, but Big Blue’s big plans for 2004 were quite surprising. The company announced that it hopes to hire 10,000 new employees next year.
– Notwithstanding the company’s optimism, IBM shares fell in after-hours trading. Which brings up an all-important question: Is a strong economic recovery already priced into the stock market? It’s true that the economy is showing signs of life. But it’s also true that stocks are not cheap. Isn’t it possible that the richly priced stock market more than adequately reflects current economic realities?
– Signs of economic recovery are almost as plentiful as signs of investor exuberance. Here in New York, the Federal Reserve’s Empire State Index of conditions at regional manufacturers jumped to 33.7 in October from September’s 18.4 in September. On Wall Street, signs of recovery include rising interest rates. Yesterday, the 10-year Treasury yield jumped back up to its early-September high of 4.38%.
– Signs of recovery are also trickling in from Main Street. “Uniform rental industry statistics showed that employment growth began picking up over the summer,” the Wall Street Journal reports. Citing a survey conducted by Michael A. Schneider, an analyst at Robert W. Baird & Co., the Journal notes, “In June, just 28% of the companies surveyed said business was improving – they were adding more rentals in their existing accounts than they were losing – while 12% said business was getting worse. [By contrast], in the September survey, 41% of the companies said they were adding more rentals than losing, while just 6% said things were getting worse.”
– It’s comforting to know that ketchup and deep-fryer grease will be splattering a few thousand more fast-food uniforms this year than last. But doesn’t the stock market’s lofty valuation reflect this bullish fact already? Doesn’t a Nasdaq Composite selling for 50 times earnings verily scream, “Recovery!”?
– Indeed, the Nasdaq not only screams recovery, but “sustainable recovery.” And that is where we beg to differ. Consider, for example, that the boost to consumer spending provided by the Bush tax rebate has already run its course. Retail sales, which boomed in August, petered out completely in September, according to the latest stats from the Commerce Department.
– Consider as well that the nation’s massive financial sector is heading into its own private recession, thanks to rising interest rates. The financial services industry was one of the very few industries to add jobs since 2000, even while the manufacturing sector was shedding 2.6 million jobs. But now, financial services jobs are starting to disappear, even as other industries begin adding a stray job or two.
– Unfortunately, even if IBM promises to hire only unemployed mortgage brokers, job losses in the financial sector could offset employment gains elsewhere in the economy. In other words, the jobless recovery may hang with us for a while longer.
– Lastly, consider that finance companies are not the only American corporations vulnerable to rising interest rates. As we have noted frequently in this column, “closet” finance companies like General Motors are also vulnerable.
– Yesterday, the giant automaker reported a profit of $425 million in the third quarter. But GM’s global automotive operations contributed only $34 million to the bottom line – down dramatically from $368 million a year ago. GM’s finance operations – especially its mortgage finance operations – carried the day, contributing essentially all of the company’s third-quarter profit.
– The richly priced stock market may be ill prepared for the trauma of rising interest rates…Watch this space.
Bill Bonner, back in Paris…
*** This is a dumb-money stock market rally. Investors are buying the worst companies at the highest prices – and making the most money!
Insiders, meanwhile, are using the opportunity to get out. In the third quarter, insiders sold $8.7 billion of their own stock, 36 times more than they bought.
*** An old friend describes the financial industry:
“It may sound harsh,” begins Marc Faber, “but the entire financial service industry is a like a huge brothel. The brokers push stocks they know nothing about, but which move and, therefore, can be turned over quickly, thus generating commissions. The analysts recommend stocks not necessarily based on sound fundamentals, but because they are showing signs of rising momentum as other analysts are also recommending them. And the fund managers are forced by the brothel’s owners to perform by buying sectors that they don’t really like but which will, as they soar, give full satisfaction to the brothel’s clients.”
Ah, there’s the difference…and the libel to all of whoredom. The brothel’s customers typically leave satisfied. Real whores give value for money. But the investment industry is just a pretender.
Another old friend, Martin Spring, explains:
“A new survey by the Vanguard Group, ‘Sources of Portfolio Performance,’ shows that professional managers are often not even able to deliver enough additional return to pay for their fees and expenses.
“They analyzed the performance in the U.S. over 40 years of 420 actively managed balanced mutual funds – those investing in both shares and bonds – finding that only 7 percent were able to add value on a consistent basis. And only by accepting a higher level of risk.
“Financial advisers often speak and write about the various kinds of risks that investors face – that markets may fall or the issuer of a security may go bankrupt. But I have never seen anyone refer to one of the biggest perils facing the individual investor – fund manager risk.”
*** On the other hand: “Dear editors and fellow readers,” begins a letter from a reader. “Am I alone with opinion that the daily e-mail needs a thorough revamp?
“While subjects are usually topical, I think it just takes too much time of your readers to pick good vs mediocre stories. Hey, the Lessons of History are great for readers to put current affairs in perspective.
“However, it’s a real waste of time to read through Bonner and mates indiscriminately bashing the stock market and pumping gold. I don’t disagree on the long-term view, but didn’t Keynes say: In the long run we’re all dead! Fact is that markets go up and down and you want to be long when up and short when they go down. People want to be rich as opposed to be right!! And we don’t need to hear the same off-message time and time again!”
Thorough revamp?! Waste of time?! Oh yeah?! We’ll have you know, we’re a versatile lot…Bonner and mates can indiscriminately pump up the stock market, too. See the essay from our friend and colleague, Taipan’s Christoph Amberger, below…