MASTERING
THE TRADE
ORIGINAL, INTERACTIVE SEMINAR ON TRADING USING
TECHNICAL ANALYSIS 

 SEC FILINGS

Once again, a remarkable transformation has occurred in our little town on the Hudson over the past   six weeks.  Our local weatherman has changed the forecast, and denizens of our village have been whipped into a frenzy trying to take advantage of the more favorable outlook.  The dark storm clouds of August and September are just a lingering memory.   The sun once again shines eternally bright on the street.  All around us, every house has hired an interior designer to redo the motif in colors that complement the new mood.  Even the youngsters have been caught up in the new mood.  High school students who once devoted their web space to pictures of Ferrari sports cars and musical groups have now turned their thought to developing stock market web sites.  The smallest children are busy writing to Santa Claus, who is equally busy replying, "Yes Virginia, there is a Bull Market".

It seems that the gloom and despair that resulted from the squalls of late summer was only a localized event.  On Main Street the average citizen never lost faith in the PermaBull.  During the U.S. market's  mid-July to early October tumble, the individual investor kept his eye focused on "being in it for the long term" and "buying on the dips".   This belief in the eternal nature of bull markets helped to stabilize the averages during their darkest hours.  It was the pros who were  feverishly selling stocks and shedding their bullish skins during the market's dive.  The very same pros and experts  whose "long term market outlook" changes with the direction of each day's market close ( thus providing an endless supply of sound bytes to the sensationalistic financial television networks).  Sentiment among investment advisors and newsletter writers has now come full circle.  Bullish sentiment among investment advisors has risen to its highest level in almost seven years. There is renewed talk of a "new paradigm", of a recession proof economy, of an unstoppable bull market.   The short lived realization that the U.S. operates as part of a still ailing global economy (and not in isolation from it) has been all but forgotten by many market participants.  Market players now feel the need to take part in the rally at any price because they are afraid of missing out on the start of a new bull market.   Thoughts about mundane little details like valuation levels and earnings have been cast aside in the rush to jump on the bull market express.  Internet stocks have been bid up 160% since October's lows as analysts issue buy ratings based on such astute analytical reasoning as "It's one of the few profitable internet companies therefore it's definitely a buy."  Unfortunately for the followers of the American PermaBull,  and unless several hundred year of financial market history are about to be rewritten, the current levels of bullish sentiment are not congruous  with sentiment patterns normally seen at the onset of bull markets.  Rather, the current degree of bullishness is historically consistent with those levels that in the past have been foreboders of the end of an upward run in equities.  

The extreme levels of bullish sentiment now held by many market participants has resulted in large part from a myopic view of recent Federal Reserve rate cuts.  The current consensus is that the rate cuts will act as a stimulant to an economy that is showing signs of underlying weakness. What has been overlooked is that the three rate cuts have actually resulted in an almost 1/2 percentage point gain in 30 year treasury rates.  Mortgage rates have increased since the onset of Fed rate cutting.  The jump in long bond yields could actually reduce economic activity in the coming months.  The main beneficiaries of the recent cuts in the fed funds rate and the discount rate will be the financial institutions whose inept wholesale dispensing of loans to fundamentally unstable emerging markets and large exposure to derivatives precipitated the crisis in the first place.  The Fed's emergency midday mid October rate cut should have come as no surprise to market participants since it occurred just before many derivatives were due to expire.  Many investors are still unaware of the severity of the crisis that occurred in mid October. According to the latest available government figures, the U.S. banking system had over $26 trillion in derivatives exposure.  The Fed's rate cut was thus a calculated effort to save financial institutions from facing the consequences of their poorly planned risk management policies. 

Derivative exposure aside and if one looks beyond the isolationist barriers through which many Americans choose to view the world, the recent success rates of  a policy of  rate cutting and rapidly increasing the money supply has been anything but a success.  The Japanese have been employing such a policy for much of the 1990's to no avail.  The Japanese economy is in the depths of a severe recession (some would say depression) and its stock market has made no headway this decade.  The Japanese economy is still burdened by overcapacity and the resulting lack of profit growth. 

Like the Japanese market and many of the world's economies, the U.S. economy is burdened by overcapacity.  The results have been a lack of corporate pricing power, narrowing profit margins, and slowing earnings growth.  The Fed's 3/4% cut in the Fed Funds rate will do little to ease the global overcapacity problem and the resultant deflationary forces that have made themselves felt this year.  The effects of the rate cuts will not be felt in fourth quarter profits which will show a continuation of this year's deterioration in earnings growth.  The market has been soaring on the coat tail's of the Fed's moves, and we suspect it will be faced with a severe reality check when earnings warning season rolls around next month.  The market's underlying earnings fundamentals have deteriorated since July's highs and the current extreme overvaluation of many stocks leaves little room for disappointments.

With the major averages approaching their old highs and likely to  set new highs on the back of the current overwhelming bullish sentiment led upward spike, the risk is now much higher than it was in July.   Sentiment has shifted dangerously to a bullish extreme, and the underlying fundamentals are considerably weaker than they were at the last peak.  While there is a very real chance the market's current momentum will carry it past its old highs, the stakes are much higher this time around.  This is a rally to be played by traders only, it is not a long term buying opportunity for the buy and hold investor.  There is a very real chance that sentiment, and the U.S. market, will take a sudden shift to the downside when fourth quarter earnings figures force investors to face the facts of a dangerously overextended market with deteriorating earnings. 

Yesterday’s sharp decline accompanied by heavy volume, and the ability of the SP 500 and NASDAQ to hold above key support levels set the stage for a short term rally. We expect Goldman’s reigning market guru to provide the impetus for this rally with a pep talk to her followers. Unfortunately for the Dow 10,000 crowd, these soothing pep talks have less affect with each additional 100 point loss in the Dow. Any rally will be limited by overhead resistance in the 8500 to 8600 range. We then expect the decline to resume with renewed force as political uncertainties and   the start of earnings warning season give the market a further downward prod.

The conditions are not in place for a final market bottom. While mutual fund managers have begun to show the first signs of panic, the average investor is still too complacent. Until the investors who first entered the market this decade stop believing that 20% annual returns are the norm and recessions have been abolished, we will not see a bottom. Bear markets do not end with complacency. They end when fear is the prevailing mood and the last bull has declared himself a bear.

A complacent investor isn’t the market’s main problem however. Declining earnings are the major concern. Analysts have yet to fully adjust estimates downward to reflect current fundamentals. It isn’t the Russian economy that has us worried, it is the sharp slowdown that we expect in Western Europe later this year that has us concerned. Rising European earnings have helped American multinationals offset declines in their Asian operations. With this prop removed, we believe earnings will fall short of expectations in the 3^rd and 4^th quarters. Stock valuations of large cap companies still do not reflect the lower earnings growth that we expect.

Despite their recent declines, the Nifty Fifty stocks are still overvalued. Paying over 40 times earnings for a company with slowing growth like Coca Cola is not our idea of a value play. We expect the P/E ratios of the large caps to shrink as growth slows. A market bottom will not be in place until the decline in the large cap household names catches up to the declines already experienced by the rest of the market.

We still look for the Dow to find a final bottom in the 6984-7204 range. However, if the small ‘buy and hold’ investor panics and starts redeeming his mutual funds, then all bets are off as to the market’s final bottom.

Offshore, we expect the declines in Western European markets to far exceed that experienced in the U.S. Slowing economies and lower export growth will lead to a rerating of share valuations. We are looking for the FTSE to decline to 4500 and the DAX to sink to 4000 in the coming months. We would avoid any new long positions in the U.S., U.K., Germany, and France until a bottom is reached. This is not a time to buy on the dips.

    The fundamental outlook continues to deteriorate in the U.S. and U.K. markets. The British economy is plagued by high interest rates and the manufacturing sector has entered a recession. The U.S. economy is slowing, earnings growth is anemic, and interest rates have bottomed. Earnings estimates will come down in the months ahead as they are adjusted downward for the slower growth scenario that lies ahead. Share prices continue to be based on the 'new economy' argument that has been pushed upon investors, rather than upon any  fundamental justifications.

    A top is in place. Foreign investors, a mainstay of the bull market, have been spooked by political instability in the Oval Office. This year's overhyped internet mania shows signs of abating and the sector has fallen sharply since its early July bubble high. The big cap favorites of investment clubs in America have finally joined the rest of the market in a downward spiral. Procter & Gamble's earnings warning sounded the death knoll for the overvalued new 'nifty fifty's' status as the last refuges of safety. We expect the overvalued big cap consumer stocks' PE ratios to deflate faster than the rest of the market does. We would  avoid the overvalued large cap name brands. We would also avoid long positions in the banking and brokerage sectors. Both sectors peaked before the Dow and are in sharp retreat. Rising interest rates and declining mutual fund inflows in the coming months will cause the banking and brokerage sectors to undergo savage bear markets.

    The market's technical picture continues to deteriorate. The utilities have entered a downtrend. The  transportation average is in a bear market, having declined 20% from its highs. The ratio of new highs to new lows is at its worst since 1994. The advance/decline line continues to accelerate to the downside. A double top is in place in the Dow Jones Industrials.  Today's 300 point plunge (largely caused by  Prudential's market guru turning bearish)   broke key support levels at 8675-8800 and 8560-8600. We look for the next downside support level to be the 200 day moving average at 1042 on the SP500. A break through this key support level would signal the end of the current bull market. The Dow will find strong support in the 7889-8171 level. Any further worsening on the economic, political, or earnings fronts will cause the Dow to accelerate its fall. Our final downside target for the Dow Jones Industrials is in the 6984-7204 range.

    We see little value in Western Europe. Markets have come too far too fast this year. The Spanish market is overvalued by any measure and is showing signs of making a double top.The recent repeated setting of new highs in France and Germany has put these markets at unsustainable valuation levels.   Asia related effects will be felt on the profit margins of exporters in these countries. We expect these markets to experience 10-15% corrections once Asia's full force is felt. Italy is another story. The Italian market experienced a great bull run in anticipation of EMU. Now that EMU is here, the Italian economy has begun to return to its old self. Economic growth has all but disappeared. We expect the Italian markets to give back most of this year's gains over the coming 12 months.  In the U.K., the Footsie has made another foray over the 6000 level. Expect this to be its last upward trip over this century mark for a while. Signs of an economic slowdown abound in the British economy. The earnings of exporters are coming under severe pressure as a slowing domestic economy, an overvalued Pound, and heightened export competition from Asia take their toll on profit margins. The U.K. economy is in danger of slipping into a period of stagflation, and we expect this to be felt in the FTSE.  The FTSE could experience a 20-25% bear market if stagflation rears its head. Despite the overvaluations in Europe, it is in America where we see the greatest danger.

    We regard the latest speculative bout of frenzy for internet stocks in the U.S., and the announcement of Goldman Sachs' I.P.O. as the final sign of a top in the American markets. A constant talking up of the bullish case for Wall Street's outlook by celebrity market gurus has led  mom and pop average investor to have an unrealistic belief that the bull market is eternal. We believe that these poor souls are soon going to be in for an unwelcome experience as the supports of the 16 year old bull market show signs of giving way.

    The recent U.S. bull market has been led higher by a strong bond market, a rising dollar, and growing corporate earnings. We believe that all 3  of these legs of the bull run up are in danger. The dollar has probably seen its highs. It was driven up over the past year by a robust economy and a flight to safety from the turmoil in Asia. We expect a slowing U.S. economy and a lessening of the Asian flu to lead to a fall in the dollar over the next year.  The bond market's rally to historically low yields was led in large part by a panic driven run to safety by foreign investors. As the situation in Asia stabilizes and the U.S. economy slows foreign investors will begin to repatriate the money they have placed in the safe harbor of the treasury bond market. The recent bullishness towards the bond market by investment advisors is a cause for concern. Recent polls of advisor sentiment by Consensus and Market Vane show bullishness at the 75-80% level. Sentiment extremes of this level are almost always signs of a top. We believe that the highs have been seen in the U.S. bond market.

    It is the corporate earnings picture that gives us the greatest concern however. The over inflated, never before seen, valuation levels of the American market leave no room for a slowing earnings picture. The nifty 50 and large cap stocks are trading at historically high ratios of price/sales, price/book, and price/earnings. The Asian crisis will continue to increasingly make its mark felt on the profit margins of companies. The earnings woes of the tech sector are just a harbinger of the profit slowdown yet to be felt by corporate America. We expect low priced Asian imports, and a diminished demand for American products in Asia, to lead to a decline in profit margins  and lower selling prices for both globally exposed and domestically orientated U.S. firms. Cheap Asian imports will lower the ability of domestic companies to raise average selling prices in a saturated U.S. market. We do not feel that the severity of the earnings slowdown has been recognized by analysts who have only accounted for a 3rd quarter slowdown in their estimates. The earnings slowdown will last past the third quarter. When analysts begin to take this into account and lower their estimates the over priced stock market will be hit hard. Corporate insiders have already realized the dismal outlook for earnings growth and have been net sellers of stock. The ratio of selling to buying by corporate directors has risen to its highest level of this decade.

    Technically the market is displaying signs of an impending top. The advance/decline line has continued to show severe negative divergences during the past month's rally. Daily RSI has been registering divergences. Weekly MACD has turned down.  Failed double tops are forming in the Dow Jones Industrials and the S&P Utilities.  The recent decline in the Market Volatility index sets the stage for a period of turbulence ahead.  We expect the technical situation to continue to deteriorate for the bulls as earnings are rerated.

    We would continue to be short the overvalued U.S. market. The parallels between the new economy/new era mentality surrounding the American market and the similar sentiment that existed in Asia early last year just before the Asian meltdown are too great to ignore. We expect the American bubble to be punctured in the coming months by the triple whammy of disappointing earnings growth, a falling dollar, and a falling bond market. History has a way of repeating itself, and this time it's not different.