In the first week of trading for the Year 2000, we saw a 10 percent correction in the NASDAQ and 5 percent in the DOW before a partial recovery on Friday after the December Unemployment number was released. As I have mentioned to some of you, I was looking for a top of these indexes on January 6th, but, the 7th may have completed the bear market rally and actual top. However, with the inflows of cash that may start on Monday, January 10th, the actual top may occur between January 18th and 21st 2000, instead. The upside is very limited to between 3 to 5 percent.
In the year 2000, I am looking for a high level of volatility with a wide trading range in the NASDAQ of between 4,000 and 2,950 and in the DOW of between 12,000 and 9,000. With limited upside potential and the strong possibility of a major top being placed in January 2000. Those of you holding individual stocks or stock mutual funds for the long haul, may have difficulty generating a positive return for the year due to the following reasons:
1. Expenses & Spreads: All mutual funds charge various fees for their services, which include the commissions associated with buying and selling the different stocks. As published in Barron’s, a financial publication, about 8 months ago, the break-even for the different types of funds can vary between 8 to 17 percent. A small-cap fund is between 14 to 17 percent, mid-cap fund is between 11 to 14 percent, and a big-cap fund is between 8 to 11 percent. Most of the break-even expense is associated with the spread between the “bid” and the “ask” when a stock is bought or sold.
For example, if a fund manager wants to buy XYZ stock and the bid is 100 and the ask (the offer) is 100 3/4, the fund manager will try to buy the stock at less than 100 3/4, like at 100 1/4, and place the stock in the fund at 100 3/4. The difference of 1/2 per share goes into the fund company’s pocket and this is perfectly legal. This is why there are brokerage houses out there willing to do stock trades for $8.00 per 1,000 or 5,000 shares. They make huge profits on the spread especially with market orders. If the fund manager simply placed the stock in at their purchase price, mutual fund breakeven’s would drop by 75 percent. Since small-cap stock are not traded as frequently and have a small open interest in the number of shares publicly traded (float), they typically have a larger spread, hence higher break-even.
This spread expense is not noticed with an upward trending market, but when the stock market goes into a trading range or a major decline, this spread increases the loss level for the mutual fund.
2. Price/Breadth Divergence: Currently, this divergence has lasted 19 months, which is longer than previous divergence’s that occurred before the 1929 and 1974 major stock market corrections.
3. Complacency: There are analysts who are fixated on the Internet and high-tech stocks, while little is being said about the meaning of a steady decline in the great majority of stocks. Three-quarters of the stocks on the NYSE and the NASDAQ continue to decline from peaks set last year. Also, investors have become complacent because there has not been a meaningful decline over the past 18 years, and markets have snapped back quickly from these minor pullbacks. The assumption that the past trend will persist is a dangerous one of complacency.
4. Corporate Investors are extremely bearish: One of the best indicators of a market direction is the action of corporate investors/insiders, which has become very bearish. Corporations have been telling their shareholders a story of far more optimism than their own actions and what they have been telling the tax collector. Federal corporate tax receipts for 1999 were actually lower in 1999 than in 1998. As an example, Michael Dell, CEO for Dell Computers, sold 4 million shares of his personally held stock on December 20th 1999 for $190 million dollars.
5. Interest Rates: Even though the stock market soared last year, interest rates have risen significantly all around the world with the 30-year Treasury bond rising by over 30 percent to a current level of 6.55 percent. With money supply growth at historic level (18 percent) and wages rising at an annualized rate of 3.7 percent, the Fed’s will have to continue raising interest rates in an attempt to slow the economy down.
6. Margin Loans: Investors have dramatically increased their leverage to maximize their stock returns by borrowing against their stock holding to acquire additional stock. It is also certain, even though not easily measured, that investors have borrowed large sums against their home and credit cards for stock purchases.
7. Mutual Fund cash reserves: Currently, most mutual funds have drawn down their cash levels to all-time lows trying to compete with other funds by acquiring as much stock for the various funds as possible. Unfortunately, everyone owns the same group of large-capitalization technology stocks. Investors are behaving like “sheep on margin”. The American public has committed the greatest percentage of its assets to the most expensive stock market in history.
8. Federal Reserve Dependency: Currently, investors feel that the FED will come to their rescue like they did with Long-Term Capital Management(LTCM), and intervene by raising interest rate aggressively, if necessary, to prevent inflation from getting out of hand, and causing a major stock market decline.
With the above items outlined, and the “buy on the next dip” mentality so fully ingrained in investors minds, trying to prevent all but a sudden steep market decline increases the probability of a threatening and violent end to this bull market.
Such a change in prosperity with a sharp selloff of the stock market would effect the economy due the high level of consumer investment. With the stock market losing it’s favorable position, real estate prices would fall, the demand for dollars would shrink, which would force the US to pay higher interest rates to attract foreign capital and cover our ever rising trade deficit.
Higher interest rates and the decline of the US stock market would weaken the economy and further depress the market. In essence, the whole positive cycle that we have experienced since the early 90’s would be completely reversed. Of course, with the dependency on the Federal Reserve, consumers will expect them to intervene. The Fed’s have periodically expressed their concerns about market valuations, but have been forced to politically reverse their position and refer to the stock market condition as a “new paradigm.” Each change of positions has brought forth further robust moves upward in the NASDAQ and an IPO market that appears to be on steroids.
If the FED decides to become serious without political intervention, they should send a message to investors by raising margin requirements and interest rates immediately with a clear warning that more increases will come in the near future if the high level of “unreasonable expectations” persist. The FED should realize that it is more acceptable to incur a small amount of pain now and reinforce a “proper level of risk” then go through a major change in economy for several years to come.
However, if the Fed’s continue to only due what is politically acceptable, we could see a massive blowoff top in the NASDAQ, NYSE, and DOW with a subsequent collapse that could severely damage this nation for many years to come. Obviously, this is not the desires scenario, but it is important to be aware of possible future turn of events.
With the economic conditions outlined above, there are and will be preferred opportunities to capture profits or hedge your current stock portfolio in the futures/derivatives markets by shorting the S&P 500 and NASDAQ 100, shorting the US dollar against the European currencies and trading the bond market as it goes from inflation concern to becoming a safety instrument with good liquidity.
Should you have any questions, please feel free to send me an e-mail at JOHNTMOIR@aol.com or call me at (775) 841-9400, and I will be glad to further clarify any of the information discussed.
John T. Moir