Signs Say the End May Be Near, Market Says Otherwise

The nettlesome thing about Friday's big rally was the holiday-shortened session didn't allow time for the final-hour selloff so commonplace of late. This morning's action confirmed what cynics said would have happened had Friday's session been a full one.

As trading desks returned to full staff, stocks swooned early Monday thanks to allegations of accounting chicanery at Merck (MRK), which says it was in compliance with GAAP, weak earnings by Alcoa (AA) and a profit warning from Allegheny Energy (AYE). Additionally, there was a re-examination of Friday's lackluster employment report and the realization that the day's gains were built on a tenuous foundation.

Those factors -- and the fact we're in a bear market -- were more than enough to offset positive developments such as the (thankfully) event-free holiday weekend and news of a Warren Buffett-led $500 million investment in Level 3 Communications (LVLT), which was recently up 41.9%.

As of 2:24 p.m. EDT, the Dow Jones Industrial Average was down 0.9% to 9294.22 after having traded as low as 9245.27. The S&P 500 was off 0.9% to 979.84 vs. its early low of 974.32 and the Nasdaq Composite was down 1.62% to 1424.88 after trading as low as 1414.88.

The market's early losses notwithstanding, talk of "bottoms" remains prevalent.

"We might be getting close to a bottom for the market," Thomas McManus, equity portfolio strategist at Banc of America Securities, commented this morning, citing persistent mutual fund redemptions, improving valuation for equities vs. fixed-income, and recent rises in the put/call ratio and CBOE Market Volatility Index. Of late, the put/call ratio was 1.02 and the VIX was up 3% to 31.10 after trading as high as 35.35 last Wednesday.

Additionally, sentiment surveys are "all indicating that the complacency evident a few months ago has shifted to concern," McManus wrote. Indeed, bullishness fell to between 18% and 26.6% last week in surveys conducted by MarketVane, Consensus Inc. and the American Association of Individual Investors. However, bulls actually rose to 44% from 42.4% in the latest Investor's Intelligence poll.

As reported Friday, McManus is one of many prior bears who have recently turned more optimistic. Still, he's no wide-eyed bull, and maintains a defensive recommended equity allocation of just 55%. Additionally, the strategist reiterated a belief today that "economic growth will remain somewhat less robust than commonly held, and that stock prices remain vulnerable to downward estimate revisions -- revisions that seem almost inevitable."

Searching, Searching

Still, the hunt for a near-term rally continues, and many observers cite similar factors as those detailed by McManus.

AMG Data Services reported that equity funds suffered net redemptions of $4 billion for the four days ended July 2. Separately, TrimTabs.com estimated today that equity funds had outflows of $13.8 billion for the five days ended Wednesday, the most since the week ended Sept. 25.

TrimTabs.com estimated June outflows for equity funds will total $20.9 billion, while AMG Data puts the estimate at $11.8 billion, The Wall Street Journal reported.

Meanwhile, Paul Merriman, who operates a mutual fund timing service (www.fundadvice.com), reportedly generated a sell signal of his recommended 25% equity position late last week, and now recommends 100% cash.

Historically, this is the stuff bottoms are made of, as retail investors have a tendency to buy big at market tops and sell out at the bottom. (Sorry, but it's true.)

Trim Tabs' Charles Biderman included individual investors "bailing out" of funds among his reasons why "the prelude to a bottom is happening." Others included a shift in corporate activity to buying vs. selling shares despite the recent spate of offerings (there have been over $2.2 billion of buyback announcements per week for the past five weeks, led by Pfizer (PFE)) and the VIX approaching the mid-30s late last week. (On a related note, Jim Bianco of Bianco Research suggested the mid-30s is relatively high for the VIX if you exclude "crisis events" such as Sept. 11 and Long Term Capital Management's implosion in 1998.)

"The key to the market over the short term is the amount of rebalancing that occurs this month," Biderman wrote, referring to the amount of "rebalancing" by pension funds into equities from bonds.

During the third quarter of 2001, 10-year Treasury yields fell 15% while the S&P 500 dropped a similar amount -- from 1224 to 1040. Pension & Investments, a biweekly newspaper which covers the money management industry, estimated that during October 2001 pension funds sold $90 billion in bonds to buy $90 billion in stocks.

Many market participants are expecting a similar movement into equities this quarter as 10-year Treasury yields dropped 10% to 4.82% from 5.33% in the second quarter while the S&P dropped 14% (1147 to 990).

I've been doing some preliminary reporting on a story about this potential rebalancing. While many pension funds have become "overweight" bonds and "underweight" equities relative to a preferred 70/30 stocks/bonds mix, many don't make reallocation decisions until well after the end of the quarter. For example, a spokesman at California Public Employees' Retirement System, the nation's largest public pension fund with assets totaling $151.4 billion as of March 31, said they have an allocation meeting in August and won't make major allocation decisions until then.

"We believe a lot of plan sponsors will find themselves overweight fixed-income and will slowly move into equities, but we also think they're likely to do it over the course of the summer to minimize market impact," said Diane Garnick, global equity strategist at State Street Global Advisors, which is the top servicer of U.S. pension funds. "It's not like they say 'let's just move the money.'"

Of course, some equity players are anticipating that movement, another potential bottom-making event, and may be looking to buy in anticipation.

The problem is that "stock prices can plunge very sharply over the period of time while the bottom is being made," as Trim Tabs' Biderman wrote, and as the past few weeks and Monday's early action demonstrate.

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