Tides of Fortune

"There is a tide in the affairs of men,

Which, taken at the flood, leads on to fortune:

Omitted, all the voyage of their life

Is bound in shallows and in miseries.

On such a full sea are we now afloat,

And we must take the current when it serves,

Or lose our ventures."

JULIUS CAESAR,

William Shakespeare

"We’re still in the early part of Stage 2 [of a bear market]," says Dow theorist Richard Russell, interviewed in this week’s Barron’s.

There are three stages to a bear market, according to Dow Theory as elaborated by Robert Rhea:

"A primary bear market is the long downward movement interrupted by important rallies. It is caused by various economic ills and does not terminate until stock prices have thoroughly discounted the worst that is apt to occur. There are three principal phases of a bear market. The first represents the abandonment of the hopes upon which stocks were purchased at inflated prices. The second reflects selling due to decreased business and earnings. The third is caused by distress selling of sound securities, regardless of their values, by those who must find a cash market for at least a portion of their assets."

I keep an eye on Dow Theory because it attempts to tell us the essential thing: are stocks moving up or down?

‘A rising tide raises all boats,’ goes the expression.

"It isn’t the waves that make you or break you in this business" explains Russell, "it’s the great ocean tide of the market.

I cannot recall the numbers, but Mark Hulbert’s two decades of research confirmed that the allocation decision was much more important to investors than individual stock selection. If an investor had been fully invested in stocks throughout the ’80s and ’90s, his portfolio would probably have risen about 1,000%. If, instead, he had followed the advice of certain strategists and remained in gold during the entire period, his coins and bars would be worth about 75% less today than they were in 1980.

Technology, the Federal Reserve, and tax policy may influence the market from time to time, temporarily damming up the supply of credit or flooding the market with cash. In this way, an expansion may be extended or retarded beyond its natural limits. But sooner or later the tides of greed and fear cannot be held back.

We watch the tides here at the Daily Reckoning. We look for things that seem particularly loony, especially foolish, or tellingly exaggerated. Ordinary behavior tells us nothing; it is only at the extremes that we gain an advantage. Dow Theory tries to do the same thing, but with more precision.

Richard Russell has been studying the market, through the lens of Dow Theory, since 1958. "The long-term track record of this technician is impressive at major turning points," writes Barron’s Peter Du Bois. "He nailed the exact bottom in December 1974, and has been rather prescient ever since."

But market timing fell from favor during the long bull market of ’82-2000. Investors came to believe that all they had to do was "buy and hold for the long run." Stocks may go down in the short-term, investors told themselves, but there is no long term risk.

Now that the Nasdaq has fallen 68% in 12 months, however, investors are taking a renewed interest in what the market might do next. Russell says the subscriptions to his Dow Theory Letters are pouring in.

People want to know when to jump back into the market.

Neither Russell nor your humble editor have much faith in being able to predict where the market is going. The secret to successful investing – a lesson learned at great expense in both time and money – is that, rather than attempt to foresee the future, you are better off trying to figure out the essential rules…and then sticking with them.

Russell’s rules:

Don’t take big losses. "When in doubt, get out," he says. It is very difficult to recover from big losses – both financially and psychologically.

Understand the power of compounding. Get rich, little by little over time, without taking big risks.

"Learn some history," Russell advises. "Learn what overpriced stocks look like. Learn about bull and bear markets."

Ignore Wall Street gurus. They are "amateurs," Russell believes, who "only care about your money."

"Value is the key to Dow Theory," Russell explains. "Even though popular indexes have fallen sharply over the past year, stocks are still very expensive by historical standards.

"Studies have shown a relationship between current price/earnings ratios and dividend yields and the likely future performance of equities. With the P/E for the S&P Index now at a lofty 23 and dividends below 2%, stocks aren’t priced to even match the return on T-bills over the next 10 years.

"I believe we’ve entered a period that will play out like 1966-74, with a series of mini-bull and mini- bear swings. Over this span, the market on balance will go nowhere for years, then collapse in the third or ‘give-up’ stage. The final phase hasn’t arrived yet, and likely won’t for some time. In other words, we’re nowhere near the bottom of this bear market."

How low will the market go?

"At other major bear-market bottoms," Russell continues, "the Industrials have tended to sell at 10 times earnings and yield 6%." Yields have dropped as low as 10% – in 1932. But the other bottoms of the 20th century – 1949, 1974, 1982 – have been graced with P/Es of about 6%. In order to get 6% dividends out of Wall Street’s current earnings, the Dow would have to fall below 4,000.

There is no guarantee current earnings will hold up for very long. Earnings tend to fall in a recession – which would force the Dow down even lower in order to reach the 6% yield. Russell thinks the Dow could drop as low as 2500 before finally bottoming out.

When the Dow falls to 2,500, with a dividend yield of 6%, it will be time to buy stocks. But not because we think we know that a bottom has been reached and stocks will head up. Instead, we will buy stocks because they will be very cheap.

Your correspondent, watching the tides…

Bill Bonner
Paris, France
April 17, 2001

*** The Big Rally may not be dead, but it had a little trouble getting back to work after the long Easter weekend.

*** The Dow climbed only 31 points. And the Nasdaq fell 51 points.

*** "The stock market had always been closed on Good Friday," observes investment advisor Richard G. Leader, "until one day, business was so good, with the Dow Jones averages setting successive all time highs, that the Solons of Wall Street decreed that the market would remain open. That year was 1929, and trading has not occured on a Good Friday since."

*** Leader, who remains skeptical despite last week’s impressive action, quotes George Santayana: "Skepticism, like chastity, should not be relinquished too readily."

*** Douglas Cliggott, J.P. Morgan Securities Inc.’s chief investment strategist, remains the firm’s chief investment skeptic. "Much optimism still remains in large-cap tech stock prices,” he said. "The growth rates these stocks would need to justify their prices are somewhere between very optimistic and ridiculously optimistic."

*** One of the stocks Mr. Cliggot may have had in mind is Cisco. The company warned last night that its sales are down 30% and that it will lay off 8,500 workers. What’s more, the company will write off $2.5 billion in excess inventory.

*** Another might be Juniper Networks – a competitor, making even more of the routers and other devices of which Cisco has too many. Earnings are expected to more than double this year. But the stock has fallen from 244 to 50. Good company maybe. But still a bad price. Even after an 80% collapse, it’s still selling at 50 times earnings.

*** Intel is expected to make 15 cents a share versus 36 cents last year. "Dividends have never been a problem for tech investors," says John Myers. "They loved the way profits were plowed into research and development that in turn spurred more growth and outlandishly high stock prices. Slowing economic growth? No problem. Inflation rising? Again no problem. But an earnings crunch? Big problem. Without earnings there isn’t growth and without growth there is nothing special about technology."

*** 68% of Wall Street strategists are bullish – the highest level ever recorded. Most seem convinced that "the worst is behind us." Or, "the bad news is all out." They think they’ve seen the bottom and are urging clients to get back into the market at "bargain" prices.

*** "Never in my memory (which goes back 50 years) have I seen such crass ignorance, arrogance and stupidity coming from Wall Street’s so-called gurus," says Richard Russell. More from Russell below…

*** Bonds sold off again on Tuesday. Is the bond market trying to tell us something? Inflation ahead? Or, is the dollar on its way down?

*** Three dollar per gallon gasoline is looking increasingly possible this summer, according to International Strategy & Investment. The lumber price is also bouncing off of five-year lows.

*** The ‘dollar bubble’ continued yesterday. The euro was forced below 89 cents. But gold rose $3.20.

*** Grantsinvestor.com’s Andy Kashdan writes, "Yes, the dollar is strong. Yes, it has side-stepped numerous pitfalls. No, we are not persuaded of its invincibility. King Dollar still reigns – for now. Despite a yawning current account deficit, a slowing economy, the plunging stock market and lower interest rates, the sturdy greenback has managed to keep its sure-footedness. But even the nimble ballet master Rudolf Nureyev stumbled on the way to the light switch once in a while."

*** "The bottom line for the dollar," says David Tice, "is that ‘credit excesses’ have essentially allowed the currency to benefit from the bubble economy. In just 10 quarters the current account deficit has ballooned from 2 1/2% of GDP to 4 1/2%. The U.S. may have been a safe haven in the past, but there will come a time when the dollar eventually breaks – and our foreign brethren will be reluctant to send their hard-earned savings to the U.S."

*** Debt, debt, debt. U.S. non-financial corporate debt has reached 46% of GDP – its highest level ever. Consumer installment debt is up to 21.7% of disposable income – which might also be the highest level ever. The average household has a credit card balance of $5,800 – an amount that would take 30 years to pay off if you made only the minimum payments. Debt counselors say they see clients with as much as $60,000 in credit card debt.

*** And the International Herald Tribune warns that the big telecom players alone are almost $700 billion in debt. Analysts believe they may default on as much as $100 billion worth of junk bonds.

*** Belts are being tightened all over the world. "Consumers are finally beginning to feel the pain," says a Bloomberg headline. "The Economy has actually begun losing jobs…and household wealth has fallen dramatically," the article explains.

*** "Across the world, consumer sentiment is flagging," explains the Financial Times.

*** "The disappearance of $5 trillion in equity value has to impact someone at some time," writes Kevin Klombies. "The financial sector makes money in many ways but if the combination of reduction of fees for assets under management, reduced commissions, curtailment of activity and reduced margin value – hence loans – were to cost this industry a percentage…the hit would come close to $50 billion"

*** Even the big banks are thinning out their soup a bit. A memo circulating at Credit Suisse First Boston warns employees not to spend over $10,000 when going out to dinner to celebrate a deal.

*** And stockbrokers are feeling their own version of misery now that stocks are selling less quickly than they used to. Lee Munson, a former broker with Bear Stearns, explained his $350,000 annual earnings to a reporter with the NY Observer: "There was only one thing you could do other than being drug dealer to make that much money: selling stock."

*** Drugs, sex and stocks have always been high margin businesses. But Yahoo announced that it was not getting into hardcore porn after all.

*** Morgan Stanley downgrades the REIT sector due to "mounting anecdotal evidence." An example: Jim Sullivan of Greenstreet Advisors says, "The thing that’s really spooked us is the big blue chip tech companies who were out looking for space and are now canceling those requirements – announcing layoffs for the first time."

*** A recent study entitled "Boys will be Boys," published in the Quarterly Journal of Economics by Terrance Odean, found that when it comes to day trading, the weaker sex excels. Based on a study of 35,000 accounts at a discount brokerage firm between 1991 and 1997, Odean found that the women in his study earned a risk-adjusted return and 1.4 percent greater than the men. Single women produced even better results, outperforming single men by 2.3 percent.

*** Day-trading facilitator Ameritrade announced a fresh slew of layoffs and a reduced advertising budget.

*** Some families seem to have more than their share of misery. I have mentioned Madame de Thierry to you, dear reader. The poor woman was widowed before she was 40 – with six small children and a huge farm (in debt) to run.

One of the children was so severely brain damaged that she could neither speak, nor see, nor move. "A vegetable" said her brother. But the girl lived for 15 years in that condition. The family cannot help but remember her today – as Madame de Thierry’s granddaughter is interred at the Lathus cemetery. The baby was born with severe problems and died 8 days later.