THE SOVEREIGN ADVISOR
Prepared by Sovereign Asset Management
Summary
--Over the past year, both the Dow and S&P 500 have struggled.
--NASDAQ investors have either given back most of their gains, or actually lost money over the last 2 months.
--Interest rates must either stabilize or fall before this bull market will resume.
Downturn Almost Over?
(May 12, 2000) With the S&P 500 and Dow in a year long trading range, the NASDAQ having crashed over the past 2 months, and the broad market having fallen for over 2 years, it is time to review where we have been and where we are going. The fabulous gains investors have experienced since 1995 were the result of two things: 1) surging liquidity, and 2) falling interest rates. Once interest rates began to rise in October of 1998, as I had forecast, the broad market began to fall and the massive amount of liquidity which was being pumped into the economy because of Y2K found its way into a select few stocks instead of the economy as intended. The result of which was a speculative bubble in tech stocks which has now been popped. As a result, what we have seen over the past year is the development of a market top in all of the major indices. From what was once a "buy at any price, it can't miss" attitude of just 6 weeks ago has now turned into a market where the psychology is changing to "we need to pay attention to the valuations," as higher interest rates and inflation return and P/E ratios contract. With no leadership and no momentum, the market is now free to drift until the Fed gives the all clear that inflation is under control, the economy has slowed, and stocks are reasonably valued. So over the past two years, the broad market (the majority of stocks) has fallen, with the Dow and S&P 500 over the past year having returned (-5.75%) and +1.40%, respectively, while at the same time the NASDAQ at one point skyrocketed over 100% only to crash and fall by over -37% in 5 weeks, resulting in a fabulous one-year return of +38.44%. However, you only got this return if you bought at the bottom before the rally started. Since most investors did not buy at the bottom, but near the market top, they actually lost money. This is evidenced by the peak in money flows into the market coinciding with the NASDAQ top (i.e., investors bought at the top and held through the crash, giving back most of their gains, or actually losing money). So what we have seen over the past year is a poor market expect for a handful of select stocks which because of their market capitalization carried the indices to their highs.
What can we expect going forward? It appears that the majority of this downturn (approximately two thirds) in the market is over, which means that even though we may be near the end, it can continue to perform poorly over the next several months. In order for the bull market to resume, we need to see the following occur: 1) The Fed to stop raising interest rates. The bond market as well as interest rate sensitive stocks should begin to rally. Before the last interest rate increase which will be the first signal that the investment environment is turning more positive; 2) The Fed needs to once again add money into the system; and 3) The leadership stocks need to stabilize and lead a broad-based rally on heavy volume.
The only way the Fed is going to stop raising rates is if the economy slows to their target growth rate of 2-1/2% to 3%, inflation (especially wage inflation) stays below 3%, and the stock market begins to trade at more reasonable valuation levels. On this last point the Fed should begin to feel more at ease with the market as a great deal of the excesses have been tempered. However, it will take time to slow the economy and especially control inflation as it has now been entrenched in the system. There is a light at the end of the tunnel, but it will still be extremely rocky getting there. What concerns me most? If inflation proves to be a bigger threat than anyone realizes, which means the Fed will be forced to raise rates to a greater degree than the market and the economy can handle. The key is to remain flexible and not get too entrenched in any one bullish or bearish scenario.
Indicators
Monetary Indicators
Bearish--There is now a 70% chance based upon the Fed funds futures market that the Fed will raise interest rates by 50 basis points (one half point) at their May 16th meeting. The only way this can be construed as bullish is if the market interprets it as the Fed's last move of the year. If market players are inclined to think this way, then the market should begin to rally soon. My indicators continue to point to further rate hikes after the May meeting which means further market weakness.
Bond Indicators
Low Neutral--The bond market has once again sold off. If you are a trader, you should take profits, as a long-term position holder, you should not make any additional purchases just as I recommended in my last advisory. The bond market will tell us when the Fed is finished raising rates, until then hold off on any new positions.
Momentum Indicators
Neutral--The end of a market downturn normally occurs once the market leaders begin to falter. We have begun to experience this as over the past several weeks the NASDAQ leaders have fallen from their highs: Intel -27.00%; Cisco Systems -28.67%; and Microsoft -44.87%. The advance/decline line has been trying to put in a bottom which means the broad market is trying to stabilize and rally. A broad-based rally will be needed to finally get a new bull move started. Again, this is not in the cards until the Fed stops raising rates and liquidity enters the system.
Inflation Indicators
Moderately Bearish--Inflation is now most definitely on the radar screen as we are seeing costs rise and productivity fall. The employment cost index was up 1.4% in the first quarter, which was the highest level since 1989, while productivity fell from 5.8% in the fourth quarter to 2.4% in the first. The economy needs productivity growth at 6.5% to offset the effects of higher inflation and money supply growth. Since it is unlikely that we will see this happen, we can expect interest rates to rise (as bond prices fall), which will hurt the stock market.
Market Notes
The Fed rarely changes interest rates near the time of a presidential election. This means that the Fed must be aggressive in raising rates over the near term. As I have said repeatedly, this is a negative for stocks and bonds. However, as we come closer to election time, the Fed should have completed its job of slowing the economy, inflation, and the stock market. This will present a great buying opportunity within the next several months. Investors should prepare by building cash positions to take advantage of stocks at bargain prices.
Trading Rules
2) Be Intolerant Of Losing Positions
Many investors like to sell their winning positions and keep their losing ones with the hope that they will turn around to be later sold once they reach break even. The result--a portfolio of losers. This is the opposite of what you want. Keep your winners and sell your losers.
Portfolio Strategy
When the Fed raises interest rates on May 16th, the stock market will respond in one of two ways: 1) With a quarter point increase, the market will fall as it will be perceived that the Fed is behind the inflation curve (as they have been for a year); 2) A half point increase will see a rally, the extent and degree of which will be dictated by whether market players believe that it is the last rate hike for the year. If we see a broad-based, sustained rally, it will be worth adding onto our positions. I am expecting more of a sucker's rally as the Fed will not accomplish its goal of slowing the economy with one more rate hike, meaning we will see more rate hikes down the road. A sucker's rally is an opportunity to lighten positions if one has not done so already.
Model Portfolio: Balanced portfolio is now 53% stocks; 12% bonds; and 35% cash. Equity portfolio remains at 55% stocks; and 45% cash.
May 12, 2000 Donald L. Sazdanoff Sovereign Asset Management 2628 Trotters Way, Columbus, Ohio 419-884-8309
Hosted by:
CONSENSUS, INC. AND INVESTORS
CO-OP
1737 McGee
Kansas City, MO 64108
(816) 471-3862
editor@consensus-inc.com