WAVETECH ENTERPRISES, LLC
By: John T. Moir
Chief Editor: John Allen
Associate Editor: Barbara Crenshaw
Position overview . . .
Last year, we encouraged readers to reduce equity positions at a number of key levels. The call in April of a top in the NASDAQ proved quite accurate. Numerous calls for DOW tops also proved timely. The successful tactic from a risk/reward perspective was unquestionably looking for selling opportunities as opposed to buying ones.
Numerous currency spreads were employed during the year which played the dollar against both European and Asian currencies. While most were intended to generate profits on their own, some were used as a means of hedging domestic trading positions. We booked profits early in the year by shorting the T-Bill market as a hedge against our cash treasury positions. This proved very successful until indicators showing a dramatically changing market allowed us a timely exit in April.
Depending on which of the five trading models are used, the cumulative gross return on management services for the year 2000 ranged from 53.3 to 92.5 percent. This represents a strong rate of return if compared to most mutual funds. These funds predominantly showed negative returns with only a few positive and a handful over 10%.
Looking forward . . .
The US economy is facing some serious headwind. Third quarter results show GDP growth slowing to 2.2%. While this is not considered anemic by historical standards, it represents an abrupt departure with recent quarterly reports. All indications show the fourth quarter is shaping up about the same.
First quarter 2001 promises to continue the deterioration as many economist forecast penciled in growth between 1% and 1.5%. Several negative factors — higher energy prices, inventory drawdowns, stock-price declines, and even the weather — will collide in the first quarter. The American consumer, who accounts for about two-thirds of GDP, is clearly limping into this new year if the recent holiday spending results are any indication.
The consensus is for GDP to accelerate slowly after the first quarter and come in around 2.5%-3% for the year. Five years ago, that would have been considered the economy’s noninflationary speed limit. Just as New Economy productivity gains have lifted that growth potential, they have also apparently lifted the lower boundary of growth that is considered too weak.
In the Old Economy, when GDP growth exceeded 2.5%, an immediate tap on the brakes was in order. Now it falls to 2.5% and we are concerned about a hard landing. It is fair to conclude that 2.2% GDP growth now is significantly softer than 2.2% 10 years ago. Economists feel that if productivity is really trending at about 3% a year (double its rate from the 1970s through mid-1990s) then companies will have to shed workers even if output grows at a similar pace.
Though economists differ on the magnitude of policy easing in the first half of the year, the various treasury instruments have already factored in a total easing of 140 basis points or 1.4%. In contrast, our expectation is for a 100 to 150 basis point easing in the first six months with the Fed possibly on hold for the remainder of the year. With the recent rate cut of 50 basis points to a new Fed Funds rate of 6.0% on January 3rd 2001, there is still further easing expected as the Fed plays “catch-up” due to the six month lag before a rate cut actually starts to effect the economy and consumer confidence levels.
With this in mind, our expectations are for the DOW to be range-bound between 11,200 and 10,000 with more opportunities available in shorting the various treasury instruments. This will effectively hedge and protect profits in cash treasury investments (T-Bills, T-Notes, T-Bonds) and defer tax obligations due upon liquidation. Further focus will be given to the individual European currencies and various spreads with Asia currencies as the US dollar continues its decline over the long-term.
In addition to the outlook provided above, we are seeing confirmation of a bear market and the entrance into the second phase, which is discussed further below:
ENTRY INTO SECOND PHASE OF PRIMARY BEAR MARKET:
In the July 2000 Newsletter, we stated that the stock market had entered the first phase of a three phase primary bear market. In that issue, we stated that the stock market had begun to top out when the NYSE had hit it’s peak in October 1997, and the advance-decline ratio topped out in April 1998. It now appears that we have entered the second (and usually the longest) of three primary psychological phases. Before this phase is exhausted in 2004-2006, we could see an unprecedented deterioration, in absolute points, to DOW 5000 or lower with relief rallies along the way.
There are already clear signs that the US economy is turning down and that the dollar could be putting in a major top. With so many dollars held abroad, a flight from the greenback would be very bad for US financial assets.
In brief summary of the three phases, the first phase or stage of the primary bear market erases the foam and froth churned up at a bull market’s top. Business conditions remain good, so the sight of many stocks declining sharply is met with public disbelief and denial. In the second stage, stocks slide in the face of visibly deteriorating business conditions and falling corporate profits. The public’s appetite for equities diminishes, finally ending in sullen anger as losses mount. In the third and “give-up” stage, good stocks are thrown away with the bad. We are not there yet and will not be there for some time.
Neither the duration nor the magnitude of a primary decline can be accurately predicted since the DOW will in all likelihood zigzag down and up before collapsing. However, our expectations are for an eight-year bear cycle, with the final low not being seen until 2005 and the waterfall decline still two or three years ahead. This projections could and will change has the technical wave pattern unfolds over time.
There is one important thing to keep in mind. Markets swing from extreme optimism to abject pessimism, from overvaluation to undervaluation. Currently, investors are basing their investment decision in the DOW and various stock funds on price or fund appreciation and not dividend yield, which is common at market periods of overvaluation and tops. Companies find little need to offer dividends when their stock is appreciating at 30% or more! At market bottoms, investors evaluate things differently with equity preservation and dividend yield becoming their primary objective. This stands to reason as In the past, the DOW has often bottomed when the dividend yield was 6% versus the 1.7% yield seen today. If history repeats, it is feasible we could see the DOW drop to 5,000 or even much lower before corporations feel the pressure to offer a yield of that size in order to entice investors to return . . . hopefully this time with a more conservative outlook!
Even when the Fed cuts interest rates during the first six months of the year by 100 to 150 basis points, we will see temporary rallies, but will then resume the primary bear market trend. The fed will make every effort to prevent the economy from going into a recession, but all they will do is extend the process. The bear will express himself no matter what happens. It’s only a question of how long it takes and how low the market falls.
The public will start to pay closer attention to the DOW when it falls once again below 10,000. However, the lows last year at 9,796 and 9,650 are very crucial levels as well.
The NASDAQ has already been clobbered and is starting to have net outflows from stock funds. Why is this important? The strength of flows into or out of mutual funds is a strong indicator of investor confidence along with the amount they are willing to borrow (margin) and invest. At a market top there is strong inflows as investors, who tend to move with a herd instinct, rush to share in the wealth. Individual investors follow a similar path by buying more on margin (borrowing) to increase their investments. During the subsequent decline the inflows start to diminish as more and more investors decide this is NOT a place to make money. Eventually they start taking money out as confidence continues to erode. At the bottom outflows are peaking as panic sets in. Currently we have just recently transitioned from inflows to outflows. We are not yet at even high outflows, much less panic ones.
Margin debt, however, tends to act a bit differently. It remains and may even grow in the initial downturn as optimists will increase their margin debt to preserve or add to their positions because they are expecting bounce back. They are still viewing drops as opportunities! Margin calls escalate as the dips get lower and lower. People are forced to choose between contributing more cash to this painful process or selling stock. They almost always choose the latter. As optimism is replaced by pessimism fewer are willing to consider borrowing to buy stock. Market bottoms are near when margin debt approaches historic lows. We are currently at all time highs of over 300 billion in margin debt!
SUGGESTED INVESTMENT PORTFOLIO BY PERCENTAGE OF ALLOCATIONS FOR YEAR 2001 THROUGH 2006:
Fifty percent in Government or bank related instruments such as Treasury bills, notes, bonds and Certificates of Deposit (CD’s). As discussed earlier, the Treasury instruments have already factored in the Feds lowering interest rates by 140 basis points (1.4%). However, even with the recent rate cut of 50 basis points to the Fed Funds rate to 6.0%, the various treasury instruments have still factored in an additional 90 basis point adjustment. Therefore, a majority of this allocation should be in either the Treasury Bills or CD’s as well as money market accounts for proper liquidity. If already positioned into these instruments, the derivatives/futures can offer a means of hedging and protecting the non tax-declared profits required upon liquidation. Hence, deferring the requirement of selling the instrument to preserve the equity value.
Thirty percent in US stock equities with an emphasis in stable utility companies, Real Estate Investment Trusts (REIT’s) and equities providing consistent above average dividend yield and a preferred price/earnings (PE) ratio at the time of purchase between 6 to 10. Please note that these two areas have already rallied significantly over the past eight months, and REIT’s were suggested at their bottom in the April 2000 newsletter. Therefore, when considering a particular stock in these areas, please select a purchase price that will represent a reasonable entry level on a pullback in the stock price. Any stocks selected should be based on dividend yield and price without the expectations of price appreciation for a conservative return. Furthermore, if uncertain of the desired price of entrance, use dollar-cost averaging to accumulate a position in the stock for a more balanced entry stock price level.
Twenty percent in the Derivatives/Futures market with an emphasis in the foreign currencies, stock indices and treasury instruments where profits can be made by either going long or short as provided in our management services. Hence, providing stability or outright profits for the entire portfolio through this bear market cycle over the next 5 to 8 years. With a projected weaker US dollar, it will become important to hedge your portfolio (including US real estate holdings) in the foreign currencies to maintain the overall value as other currencies become more valuable against the US dollar and when the remaining US stock indices proceed lower.
“THINKING OUT LOUD”:
Editorial by Chief Editor: John Allen
What happened to the “Santa Claus rally” and the “January effect?” Did they disappear along with retailer’s sales and Internet riches? Is the only prince that this “Cinderella” market can respond positively to, 5’7″ with an ungainly nose and only remnant wisps of hair? Can his waking kiss of 1/2 percent really be so stimulating?! Well, I suppose it depends on WHERE it is placed . . . Seriously though, these events (or lack thereof) all posses a commonality in that they are symptoms of a much greater malady. The malady of shaken confidence and recognition of excessive spending before the check clears.
Consider this scenario: You’ve never gotten around to saving but as luck would have it you find you have just won the NASDAQ lotto and will be receiving untold riches. You take your “significant other” out to that expensive theme restaurant you’ve prudently avoided and for good measure invite some friends to help you celebrate. Next, out goes the Honda – in comes the BMW. Oh yes, and lets get started on that sun room addition and vacation in Australia. The credit cards are all now maxed but what the heck. THIS IS THE LIFE! Then the call comes. “Mr. Jones, we regret to inform you that we confused you with another Mr. Jones in Spokane. We hope this has not caused you any inconvenience.” Think you’re spending spree might come to an abrupt halt? Even things you used to do might seem extravagant for a while.
The market has snatched over 7 TRILLION (notice the tr. NOT the b) dollars of investor’s winnings in just 8 months. Those winnings represent most investors’ liquid assets as we still maintain a negative savings rate. That money was closer to us than that of the lottery winner. It was IN our accounts! Briefly . . . The loss has changed us from “buy on the dips” optimists, to “sell on the rally” pessimists. This will not change tomorrow.
As with our lotto winner, the spending from both individuals AND corporations has receded abruptly. Financial statements have still not had time to fully disclose the damage. It now is obvious that the feds put the brakes on too gently in the beginning and ended up having to compensate by being too firm for too long at the end. Apparently they are not going to try to duplicate those errors on the way down.
NOW we understand why the Christmas rally didn’t come. What about the January effect? Normally there is strong selling of depressed stocks through Christmas due to investor attempts to register their capital losses against gains to minimize the tax burden in April. This selling normally diminishes after the 25th as institutional investors begin to position themselves in beaten down stocks for the inevitable rise in January when tax loss selling stops. So why did the ratio of sellers/buyers on Jan 2 exceed that of the previous week? It seems losses were SO steep that many sellers held back after matching up their gains and loses and carried the remaining excess losses to post in January against hoped for future gains. With the extent of losses in 2000 we will likely see more of this process. People will come back to reality and see that the1/2 point drop in the Feds rate, while helping the confidence factor, will do nothing to stem the tide of earnings warnings and missed “whisper” numbers for months to come.
These factors along with those previously covered, (Ref: “Thinking out loud” Nov 00/ copies available) should provide us with an exciting ride on a violently bucking bear. Hold on to your Greenspan and remember that while being short may not be desirable on a first date, it works wonders in a bear market!
A balanced and properly weighted investment portfolio will be absolutely essential as we proceed through this 5 to 8 year bear market cycle. Insightful diversification will greatly augment the overall portfolio appreciation while lowering potential risks. Should there be any questions regarding the information discussed within this newsletter or our management services, please e-mail or call the number provided below and we will be glad to assist with further clarification.
John T. Moir
Worldwide Investment Manager
Wavetech Enterprises, LLC
Phone: (775) 841-9400