Let the Mafia Speak, Main Street Loves the Dons

Yesterday’s 80 point drop on the Dow aside, The Fleet Street Letter’s Lynn Carpenter takes a stab at explaining why some of the late-great-bubble’s biggest stocks led the fall rally.

Two months ago they were all crooks. Today they’re gods. It might surprise a man or woman of common sense, but not a historian, that the brokers are still fixing the market. And this time, you can’t blame the perps. Like drug dealers and prostitutes, the analysts hang out where the buyers are.

Wall Street will never be innocent until Main Street stops buying what it has to sell. It’s a culture thing.

Culture – as opposed to official policy – springs from below, and nothing the officials at the top can say or do will ever change that phenomenon. The heavy hand of official policy has never won the game against culture.

Consider England. Almost a thousand years ago, a pack of Frenchmen invaded Jolly Old England. Well, it wasn’t quite the France of today, but William the Conqueror and his minions were Normans, and that’s as good as French. Soon after setting up a new government and installing their own people in every duchy, barony, abbey and major office, the Normans insulted the native Anglo Saxons further by outlawing their tongue. What they didn’t write in Latin, they spoke in French. English became the language of the underclass…and a degraded and forbidden one at that.

And that’s why you who read these words must now contend with one very badly botched and oddly spelled language. Forbidding English only drove the words into hiding long enough to mongrelize it. The Germanic nature of the language remained so powerful that it never went away.

In the end, it changed the French spoken in England until it was no longer French at all. It was English again, with a French vocabulary sitting on top. Today we have a language with 75% of its words coming from Latin or French origin and all the structure coming from Germanic origin. We might use two French-born words, such as “royal” and “mess,” but it will always be a royal mess in the Anglo fashion, not a mess royal in the French style.

The French should have learned better from the Romans who tried to overrun the local culture a few centuries before them. The Romans brought the church and Christianity with them. Sure enough, the English bowed, crossed themselves and built churches. And then the English (and their fellow Germans) turned Rome’s new Middle Eastern-Southern European derivation into a sturdy Germanic tradition complete with holly wreaths, ivy, Christmas trees, wassail bowls, Yule logs, Easter eggs and Halloween ghoulies and ghosties. All the favorite pagan festivals lived on.

And that’s why brokers still rule the investment world. No matter how many journalists converge to expose crooked analysts and shady investment banks…no matter how many Congressmen spout outrage…no matter how many new laws the SEC enforces…the culture at ground level is ever the same. People still look to experts for guidance, and despite all they know, they still consider Wall Street the home of investment knowledge.

You want proof? Look no farther than the 100 best- performing mid and large-cap stocks of the past 13 weeks. The list wanders everywhere. Some of the stocks on it are bargain-bin finds; some are still at high P/Es. Some are even tech stocks, which were supposed to be dead meat, as well as healthcare and adult education stocks, which have been recent sweethearts. The stocks in the top 100 have very little in common with each other-except what analysts and institutions think. And what analysts think about how well they confirm what they thought.

The most consistent feature among these top 100 stocks is a 5% or better earnings share surprise in the previous quarter or two. The stocks that made analysts look righter than right soared compared to those that merely came close or disappointed. Analysts love to be confirmed. And why not? I feel pretty good when I’m right myself. Don’t you? But I would find it very odd if all my neighbors took great joy of it.

Yet, when it comes to investing, our neighbors are buying what the analysts rated well…and they are buying even more after the analysts have presented them with examples of stocks that beat their estimates.

Now, how does this fit into a world where everyone has supposedly learned to distrust Wall Street? Not well at all.

In fact, the day after I completed my analysis of what was moving stocks lately, the Sunday New York Times landed on the front steps. I read what Mark Hulbert had to say. Hulbert, too, was curious about the analysts and their doings. He pointed out that in 2000-2001, the 10% of stocks with the lowest (worst) analyst ratings did best in the markets. I’ve seen this claim in writing many times over the past few years. Just do what the analysts say not to do has become a popular theme. And a wrong one…

As it turns out, 2000 and 2001 were strange years. From 1986 through 1999, the stocks the analysts rated highest also did best in the market.

And that is what is happening again.

Instead of being wary of Wall Street, investors are leaning on its wisdom more than ever. Not only did the stocks with the best earnings surprises do best in the past quarter, the stocks that had the most analysts covering them were superheroes, too. On average, each of these top 100 stocks had at least 10 analysts covering them. Some had more than 20! Only six of them had three or fewer analysts peeking and prodding…and advertising…their business. Unrated stocks didn’t even make a showing.

As for ratings, they do count in the short run. You may have heard that the stocks with Strong Buy ratings do worse than those with lower ratings. So the bottom fishers say, but they’re wrong. If you give stocks a 1 to 5 rating, with 1 standing for “back up the truck” and 5 standing for “sell it yesterday,” you can see a pattern of docile investors following their cues almost perfectly. The analysts had a clean “buy” to “strong buy” (ratings of 1 to 2) opinion on the best performers. Only two of the stocks on the top 100 list verged into the “sell” or “hold” territory with average ratings of 3 or more.

This isn’t bad news. In fact, it’s pretty good news. The smart investor doesn’t spend too much time worrying about how the world ought to work. People ought not listen to 95% of Wall Street analysts. But they do, and that moves the market. And that’s what you should understand when you go with the analysts or against them. So be it. At least once you understand who’s marked the cards, you can cheat along!

The truth about what analysts think is this: In the long run, analysts are as unimportant as ever. None of the world’s best investors listens to the analysts…they are their own analysts. The real investor, the person who does hard analysis and plans to hold for two years or longer, will probably beat most analysts to their top finds.

What’s more, he or she can usually hang through periods when analysts downgrade their holdings. They know it’s a game and the analysts will come back round again.

But in the short run, which is speculation, analysts are still the gods of Wall Street…and you need them on your side. Earnings surprises and strong buy ratings are still very good indicators that a stock might move higher in the next weeks or even a few months. There is one caution here, and only one…when the analysts suddenly change their opinion, your stock is likely to move the wrong way on you very quickly. You must be prepared to move out of the position just as quickly. Act fast enough, and you may even have time to consider playing the stock on the downside.

Just think of the extra profits as a gift from the gods.


Lynn Carpenter,
for The Daily Reckoning
October 23, 2002

Editor’s note: The Fleet Street Letter’s US editor Lynn Carpenter will tell you: “I’m not easily convinced by anybody about anything.” And maybe that’s the secret behind her success outside Wall Street. Beyond the Fleet Street Letter, Lynn’s trading service, The Contrarian Speculator, has helped investors earn profits in everything from oil and steel to emerging technologies, defense stocks, Swiss annuities and commodities.

What are these guys smokin’?

On October 9th…the same day that the Nasdaq ‘surprised’ us all with a 5-year low…Glen Hubbard, chairman of the president’s council of economic advisors, published an article in the Financial Times attempting to put investors at ease…and bolster confidence in the ever- impressive US economy. For your entertainment, of course, The Daily Reckoning digests Hubbard’s piece here. But also, perhaps, to caution you about the quality of ‘advice’ your president is getting.

First, Mr. Hubbard characterizes “the problem” economy in this way: “The end of a stock market bubble causes consumer spending and business investment to collapse. The subsequent fall in aggregate demand puts downward pressure on prices. Once deflation begins, the real burden of debt increases, so borrowers must cut their spending to pay off the real value of their debts and the cycle continues.

“The new twist in the modern retelling of this story is the link between the fall in the stock market and the rise in housing values since 1997. Some have argued that the inevitable decline in consumption has been delayed by consumers refinancing their mortgages, extracting equity so that consumption levels are maintained, for a time. But the day of reckoning will eventually arrive, consumption will fall and the deflationary spiral will begin.”

Not bad…we couldn’t have said it better ourselves, actually. But then Mr. Hubbard takes leaves of his senses entirely.

“…Analysis of the productivity data,” says Mr. Hubbard, and we try to hold ourselves back from groaning…when will this productivity chimera fade? we wonder aloud to nobody, “…over the past six quarters confirms some of the best news that economists have delivered in a generation – the acceleration in productivity growth that began in 1995 continues unabated. Thanks to this, today’s consumers can look forward to real incomes that grow much more quickly than they have during the past 30 years – a good omen for current consumption.”

If I recall correctly…oh, yes, it was only yesterday…we reported here in the Daily Reckoning that companies in the real world – productivity gains or no – are planning some rather drastic cost-cutting measures in 2002: including among other things hiring freezes, salary caps and doing away with bonus structures. Somehow, that doesn’t sound like “real incomes that grow much more quickly”…but we could be wrong.

Mr. Hubbard goes on to report “disposable personal income – the amount of current income that consumers can spend – has held up much better over the current business cycle than in previous recessions.” Could that be because we haven’t really felt the pinch yet? The real impact of the “negative wealth effect” has only just begun to be felt, as Eric suggested last week. Many of the real losses people have experienced from the ‘crash’ of stocks have come over the last 12 months.

And you’ll love this next bit…what is the reason given for disposable incomes remaining high? Why, it’s the panacea du jour – the “refi boom”!…star of yesterday’s Daily Reckoning. “Fears that the U.S. housing market is in the midst of a bubble are unwarranted,” says Hubbard. “Behind any bubble is the hope that an investor can purchase an asset for one price and sell it quickly for a higher price. This is hard to achieve with houses, because of the high transaction costs in housing markets. And without a rapid and nationwide decline in housing wealth, it is hard to see how deflation can occur.”


Besides, the argument goes, falling prices aren’t always bad. “Just ask your local car salesman,” (sic!) says Hubbard. “The surge in car sales brought about by zero percent financing offers should add from ? to 1 full percentage point to gross domestic product growth in the third quarter.” The obvious question: “how are car companies going to grow profits with zero percent financing?” is left unanswered. But then, for a guy who can’t even be bothered to fill in the question marks in his own article, well…I can see how that would be a tough one to tackle.

Perhaps, Mr. Hubbard’s post was not designed to provide advice for the president at all, but something a little more…um…strategic. I can just see the man, dispatched by the Bush Administration, snickering away while he types his piece for the FT: “Productivity, Housing…and Zero Percent Financing…heh, heh…yeah, that ought to keep ’em spending. When’s my next tee time?”

“The stock market decline will not cause consumption expenditure to collapse,” Hubbard summarizes. “House price inflation may well moderate in the next few years but there is no housing bubble about to be pricked. Refinancing has helped maintain consumption growth but has not propped it up. And the economic fundamentals are sound.”

Well, we here at the Daily Reckoning still have a few questions about debt levels. But for the time being, in our own patriotic way, we’re willing to go along for the ride. We’ll certainly see what happens anyway, won’t we?

Eric, what’s the word from the Street?


Eric Fry in New York City…

– The stock market bulls took a well-deserved breather yesterday, as the Dow dipped 88 points to 8,450 and the Nasdaq eased 17 points to 1,293. Gold responded to the modest weakness on Wall Street by gaining $2.10 to $313.60 an ounce.

– But there was no such respite for weary bond investors. The 10-year Treasury note slumped yet again, falling for the eighth day out of the last nine and pushing its yield up to 4.26%. Clearly, buying bonds is no longer the fashion. Stocks are back in style.

– Notwithstanding yesterday’s “correction,” stocks have been on quite a tear lately. This, despite the fact that the US economy is a 90-pound weakling and everyone knows it – even the New York Sports Club next door to my office at 30 Wall. The club is promoting its latest membership offer with posters that read: “What’s in Worse Shape? The Economy?…Your Body?…Even if Wall Street has a bad day, you don’t have to. Join Today.”

– It’s true, the economy is so “out of shape” that stocks ought to be falling and bonds ought to be rising. But that’s not happening.

– “So what’s wrong with this picture?” wonders Pierre Belec of Reuters. “The stock market soars. But the headlines scream: ‘Lucent to cut 10,000 jobs’, ‘Consumer confidence sinks to a nine-year low’, ‘Retail sales post steepest drop since November 2001’, ‘GM’s loss widens’.

– “The simple truth is this,” Belec warns, “Don’t expect a fairy-tale ending to this horrific bear market.”

– For starters, American consumers appear to be exhausted. They’ve been carrying our massive economy around on their shoulders, all by themselves. How could they NOT be fatigued? Retail sales in September posted their biggest drop since late last year and consumer confidence dipped in October for the fifth consecutive month. “The University of Michigan’s index of consumer sentiment tumbled to a nine-year low in early October,” Belec notes. “The largest number of respondents in the survey’s 50-year history said their wealth shriveled over the past year – double the number of those who agonized about their losses after October 1987’s market crash.” Shriveling wealth is not the stuff of robust economic growth.

– Meanwhile, as the flurry of disastrous earnings reports out of the tech sector makes painfully clear, most businesses have curtailed their free-spending ways. “During the bubble,” writes Andrew Kashdan of Apogee Research, “the corporate sector wasn’t shy about capital expenditure and worried little about the cash flow needed to pay for it. Now, of course, companies are digging out from under a pile of IT equipment, Henry Miller chairs and logo-emblazoned mouse pads…[and] capital expenditures have been sharply reduced.”

– As consumers and corporations both retrench, manufacturers are feeling the pinch. The Philadelphia Fed’s October Business Outlook Survey plummeted to minus 13.1 in September from plus 2.3 in August. We’re not exactly sure what these survey results are measuring. But anything that plummets from plus 2.3 to minus 13.1 can’t be good.

– If you add up all these grim economic data points, the sum would not seem to equal “huge stock market rally.” Then again, the stock market has never been particularly literal. It is, instead, figurative to the point of being irrational. The market is given both to extreme flights of fancy and to episodes of inconsolable depression.

– “In the long run, the market is rational,” observes Newsweek’s Allan Sloan. “In the short run, the market is…the market.” In other words, in the short run, “market” is just another word for “irrational.”

– “When I look at the stock market these days,” says Sloan, “I can’t help but think of what we used to say about the weather when I worked in Detroit during the 1970s: ‘Wait five minutes, it will change’.” For example, says Sloan, “By Oct. 9, the market had hit its lowest point in five years. The NASDAQ, 1950 when the year began, had plummeted past the Magna Charta level (1215, if you’ve forgotten your history) and was heading for the Battle of Hastings (1066). With despair in the air, the market turned yet again, producing its best four-day percentage gain since 1933.” And the market has continued to soar.

– “[But] it’s silly to spend a whole lot of time figuring out what stocks’ daily gyrations presage for the economy,” Sloan concludes. “So I’m going to imitate the weatherman…I will boldly say that there’s a 51 percent chance the bear market is over. And a good chance that it’s not. If it works for the Weather Channel, it works for me.”

– Here at the Daily Reckoning, we forecast neither the weather nor the stock market’s direction. But we do peer out the window every morning before getting dressed. One thing we know; if it’s raining outside, carrying an umbrella is a good idea…It’s a simple philosophy, but you can’t imagine how many times it has kept us from getting wet!


Back in Paris…

*** The office was all agog this morning. Horrors of horrors – nobody could get their e-mails! Then Dan Denning, who has recently joined us as a permanent adjunct to the Paris office, explained the problem. There was an “attack” on the Internet last night. We were informed that despite popular belief, there are really only 13 hubs in the world through which all Internet activity is routed…7 of them were shut down by some cyber-punk or punks. According to Dan, whom I’m sure is referencing a reliable source, the Internet can still function with as many as 6 hubs functioning properly…

Imagine the blow to “productivity” if the eighth one was taken out, too…

*** Meanwhile, Bill sends word from Germany: “We’re staying at the Petersberg hotel, on the top of one of the 7 hills near Bonn, overlooking the Rhine. This is the place where Clinton stayed when he came to Germany. It is also the place where the various factions came to hash out the future of Afghanistan after the Taliban had been dispersed.

“It is a great, deluxe hotel…used often for important meetings, because the place is easily secured. There is only one road up the mountain, winding around so much your editor felt he might upchuck every time he took a taxi.

“‘Leonid Breshnev was new Mercedes when he was a guest here,’ explained our German host. ‘But as he was driving down the mountain, he lost control of it and wrecked it on one of the hairpin turns.’ “It was here, too, that Neville Chamberlain stayed when he came to Germany following Hitler’s invasion of Czechoslovakia.

” ‘Hitler paced around and became irritated,’ continued our friend. ‘He didn’t like to be kept waiting, and Chamberlain made him wait. But Chamberlain came down from the mountain and they talked. Hitler told Chamberlain what he wanted to hear. And then, Chamberlain went back to London and announced that there would be ‘peace in our time.’ He was, of course, wrong about that.’

“WWII was a disaster for the Germans. More than half a century later, they are still haunted by it. Our host had just come back from a visit to Auschwitz. It bothered him.

” ‘I don’t understand it,’ he said at dinner. ‘Before the war, we Germans were well-educated, cultured…we had art, music…it was a decent, polite society…what happened…? I saw the camps. You know, I went with my family. I tried to explain it to my children….but I didn’t know what to say…’.” More to come…

Addison Wiggin,
The Daily Reckoning