25 Jan 2002 No January Effect This Year?
There is an old adage on Wall Street that says, ‘as goes January, so goes the year.’ The indicator has accurately predicted the market’s direction for the full year in 48 of the past 51 years. The Vietnam War affected the results of two of the three incorrectly predicted years just as September 11th may impact this year’s results. But if the indicator has any validity at all, it doesn’t look like 2002 will provide the comeback we were hoping for.
Tom Gavin, Chief Equity Strategist of Credit Suisse First Boston and a long-term bull made some chilling, but important observations in his most recent weekly piece. The paragraphs that follow in quotes are attributed to Tom.
“We are in a deflationary boom. Despite a 2.3% decline in the deflator, nominal retail sales for the fourth quarter advanced by 5.0% versus fourth quarter 2000. By way of comparison, fourth quarter sales were essentially flat at 0.1% during the 1991 recession. For the 12-month period ending in December, the Consumer Price Index advanced at just 1.6%, less than half the previous year’s gain of 3.4%. While the drop in energy prices had a significant downward impact, the strength of medical care and housing inflation is helping to exaggerate ambient inflation given that more than half of the CPI components are falling in price. Real consumption or growth is substantially greater than nominal readings. A key dynamic is that wage growth, unlike the early 1990s, continues to exceed falling inflation which fuels strong buying patterns from consumers. The conclusion from our work is to expect ongoing bankruptcies beyond the economic rebound and more losers than winners because leverage and deflation mix poorly together.”
“[Individual stock selection] rather than pure sector or market bets will define superior portfolio performance for years to come. It will not be uncommon for some firms such as Wal-Mart to have stocks at or near 52-week highs while simultaneously once considered blue chip companies like K-Mart are heading to bankruptcy. Market P/E multiples may not change very much but the spread inside sectors between deflationary boom winners and losers will grow increasingly wider. The only sector where valuations could remain a comparatively tightly knit neighborhood would be health care, where leverage is de minimus and pricing usually exceeds inflation.“
“The classic seasonal demand for equities by individuals is not happening, which draws into question the sustainability of the recent rally. Over the past five years (1997-2001),U.S.equity mutual funds have enjoyed on average $6.8 billion of inflows during the first two weeks of January. So far in 2002, Trim Tabs estimates that the industry has absorbed outflows of $4.7 billion. Meanwhile, money market funds and bond funds continue to enjoy strong investor appetite. In fact, since September 19, AMG calculations show the industry absorbing a total net outflow of $1.7 billion. The implications are two-fold. First, investor psychology has clearly changed from buy-on-the-dips to one of caution and capital preservation. Second, if the disenchantment by individuals continues, then a lack of liquidity surely dooms the hope of a new bull market.”
“Factors other than individual’s demand for equities are also unfriendly at present. Corporate insiders have shown renewed selling activity, which hopefully is just year-end tax planning initiatives. Cash takeovers that might reduce the supply of stock are almost radio silent. Complicating the demand conditions is a huge wave of convertibles issuance, which often provides hedge funds greater capacity to short equities. The technical picture is also depicting a tired market. Trading volumes were falling as the NASDAQ Composite price was rallying, demonstrating low confidence and high skepticism. Our favorite short-term indicator is an oscillator that looks at the percentage of stocks above their respective ten-week moving averages. It recently moved above 70%, which is typically overbought territory. We last published the indicator on Sept. 24 when it neared its trough level of 11%. A review of the move over 70% based on five experiences in the last four years shows that markets need to digest recent gains, consolidate and often move sideways for some period. We find no particular reason to chase stocks at present until a sharper read on the first quarter and first half rebound in earnings can be more tangibly understood.”
But Don’t Despair
“Before getting overly concerned regarding investor indifference at present, one should realize that the current lack of love is often a cyclical affair and need not jeopardize a market recovery. The graph below shows that inflows toU.S.equity funds typically lag the economy by roughly six to nine months when viewed against the OECDG7 Leading Indicator.”
“A review of the post 1987 Crash also outlines outflows continuing for a full twelve months after market lows were reached. Stock prices had rebounded over 30% before inflows began again. Negative market returns in 1994 led to a quiet time for fund inflows in 1995 but shares ignored the lack of affection and rose nearly 35%. In other words, flows always lag the market and are not a precursor to a rally as long as the price turn is ultimately confirmed by the economic turn. Some help will also come from pension fund reallocation of cash and bonds to equities and foreign investors concerned over tougher conditions at home. At this point, a continuation of improving economic data points such as retail sales, weekly unemployment claims, home construction permits and manufacturing new orders will be critical in restoring investor psychology and restarting dollar flows to equity funds.”
“As we get closer to the end of the first quarter, we should get confirmation that the economic and earnings recovery that represent the basis of the recent rally actually exists. For the first two-thirds of 2001, the NASDAQ market trading volume moved in the same direction as its respective Composite index. Increased investor participation helped drive prices higher. Conversely, when investors stayed on the sidelines, stocks fell. The fourth quarter rally was largely price driven as volumes declined from late-September through into the New Year. The NASDAQ has shown limited sponsorship from buyers as prices advanced. The dwindling volumes suggest that confidence remains low and skepticism high. Though these volume trends bear watching, it appears to be a replay of the tentative mood of investors following the 1987 Crash suggesting more cyclical than secular dynamics.”
“The current lack of any appetite for equities or margin debt coupled with a strong preference for money market funds implies low investor expectations, which is healthy. While we remained concerned that investor psychology may have permanently changed towards equities owing to volatility and negative returns, history tells us current outflows may prove to be just a cyclical pattern. [The graph above] shows that inflows to funds closely track momentum in the economy as measured by the OECD Leading Indicator. Also, a review of the post 1987 Crash and down market of 1994 demonstrate that outflows or limited inflows can continue for at least 6 to 12 months following a stock price bottom. The S&P 500 needed to rise and sustain a 20% to 30% gain in 1988 and 1995 before money flows returned. Therefore, because flows lag not lead performance, we may not fully understand the reluctance of investors towards equities until this summer or early fall assuming we can hold onto the fourth quarter gains. Should monies late this year and next continue to flock into money market and bond funds, the prospects for an enduring demand and liquidity driven bull market will wane considerably”
So far retail sales show that consumer liquidity is not a concern. Existing home sales, just released, came in as expected, and new claims of unemployment continue to decline. The consumer will play a major role in the recovery of this economy. But business investment must improve soon to sustain consumer confidence. The initial recovery in business is expected in the coming months at companies rebuild their inventories. The inventory replenishment cycle will have a strong initial impact on the recovery of the economy, but the only consumption will sustain the recovery. Greenspan boosted markets yesterday when he said “There have been signs recently that some of the forces that have been restraining the economy over the past year are starting to diminish and that activity is beginning to firm.” His comments to the Congress yesterday were considerably more positive than his remarks inSan Franciscotwo weeks ago. On the inventory buildup he said, “With production running well below sales, the potential positive effect on income and spending of the inevitable cessation of inventory liquidation could be significant.”
With more that half of the S&P 500 companies having reported earnings we now think that the earnings recovery is further off than we earlier hoped. Our strategy continues to concentrate our holdings in those companies that generate lots of free cash and have little or no debt. But, with the likelihood of a more draw out recovery process we will include in our universe a larger number of quality ‘recession-safe’ companies that may have additional price upside in spite of their already high prices. In short, the chance that the broad averages may not show much appreciation this year has increased, but the possibility that individual companies and their stocks can outperform the indexes remains high, given the indications of a stabilizing economy.
