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The stock market is stumbling toward its destiny like a drunk on a dark street. It pauses occasionally to get its bearings by leaning against a lamppost, only to lurch forward and then collapse in a heap before moving on.
It appears to need a cup of coffee, a slap in the face, a shot of adrenaline or a kick in the pants. But what it may need first is both a chance to sleep off its hangover and a promise that another slug of booze may be just around the corner.
Much of what's wrong with equities today is a growing sense among investors that the excesses of the pre-millennial technology-construction boom have been repeated in the past two years with the post-millennial residential and commercial construction boom.
responded to the 2000-02 bear market by flooding the U.S. financial system with cheap money that was used to finance real-estate development at an unprecedented pace in the belief that it would jump-start a wide range of retail sales. It did, but it also set off a ferocious increase in dreaded inflation. So now money is being withdrawn from the system at an even faster pace by monetary officials who are uneasy with the monster they've created.
Drying Out the System
When the Fed takes away the punch bowl, the impact is predictable. A contraction in money, implemented by the Federal Reserve largely by raising interbank interest rates, has not yet affected home prices, but it has negatively affected all types of economic expansion and construction. And now it has begun to suck the life out of the stock market.
According to ISI Group data, growth in money zero maturity (MZM) -- the broadest definition of money flowing through the veins of the U.S. monetary system -- has declined sharply over the past three months, hitting a new year-over-year low of just 2.1% at the end of last week. Since 1960, annualized MZM growth has averaged more than triple that level, at 7%. And the bad news is that prior shutdowns in MZM growth of that magnitude have been associated with the starts of recessions, according to ISI economists.
Deprived of the inebriated confidence provided by cheap money, companies are expressing a diminished desire to buy stuff and grow, as evidenced by the nasty turndown in the New York state manufacturing index published last week. And fretful consumers likewise are expressing diminished interest in spending, as evidenced in the slowdown in retail sales in March. Moreover, they actually have fewer resources to deploy. In past years, tax refunds have grown substantially year over year -- in the double-digit range -- and yet they declined in recent weeks at a -3.4% annualized pace.
Since most of these checks are used for immediate spending, let's connect the dots from refund weakness to retail weakness. We've gone from the government putting something like $20 billion in tax refunds weekly in people's hands in past Aprils to $10 billion per week this year.
A Strange Brew
Put slower money growth, lower refunds and lower confidence in a pot together with weak earnings forecasts from the automakers and investigations of improprieties among the big insurance companies, and you have a recipe for the sort of toxic shock that has paralyzed the market the past few weeks.
So what can reverse the current level of fear and loathing? It's not just lower energy prices, as you can see from the market's lack of reaction as crude oil prices have declined almost $10 in the past two weeks.
Oddly enough, possibly the best thing that can happen to the stock market right now is an acceleration in economic weakness that dries up consumer demand, body-slams the commodities market and boosts joblessness. Weaker economic data combined with lower inflationary pressure from raw materials and wages would almost certainly compel the Federal Reserve governors to stop their campaign to raise interest rates. That would lead in turn to a big upward move for equities.
This isn't as crazy as it may sound. In recent meetings, as well as in public speeches, Fed governors have repeatedly stated that they wish to return interest rates to a "neutral" level, which has commonly been considered around 4% for a rate called federal funds. That's a level considered to be neither stimulative nor a hindrance to economic growth, and it would equate to something like 6.75% for a 30-year mortgage.
Yet that notion of neutrality is only in effect with industrial raw materials, such as oil and natural gas, at much lower levels. With crude oil prices in a band of $40 to $55, economist Ed Hyman of ISI Group estimates the "new neutral" rate could be as low as 3.25%, or the level that rates might hit after a June meeting of the Fed.
Hair of the Dog
If the Fed were to stop raising rates due to weaker economic and inflation data, even if it were considered at the time merely as a pause, Hyman believes it would give investors a sense that there is a new range for interest rates. The rally in equities that would ensue would also create a new bottom of a 10% to 15% range for the stock market, and that would also be a positive.
Of course, there are more reasons for optimism than just the possibility of a new round of bourbon from the Fed. Paul Desmond at Lowry's Reports, whom I have quoted for half a decade on timing matters, says that the nearly 100-year record of data that his firm studies suggests that the current market shows very few of the classic signs of the start of a bear market.
He continues to insist that the current decline merely amounts to a normal pause and will be seen in coming months as a great buying opportunity. His primary point is that every other major top in the market -- including 1929, the mid-1970s, 1987, 1994 and 2000 -- was preceded by six to 21 months of deterioration in the
New York Stock Exchange
advance-decline line. In contrast, market breadth, as measured by the NYSE advance-decline line, was at a new high as recently as six weeks ago, almost exactly at the same time as the market was making a three-year high. He points out that this kind of action is characteristic of a short-term correction, not an important top.
Desmond, who has been admirably free of bullish or bearish bias and follows a rigorous quantitative approach, suggests that the current weakness is the sort that would normally end with an emotional washout decline known as a "90% downside day," in which 90% of NYSE volume is to the downside, and 90% of stocks fall. "Thus what appears to be the start of a bear market to some investors might be the start of the next leg of the bull market," he said in a note to institutional clients on Friday.
Former Doubters Join Bull Party
Also moving fully to the bullish camp of late is former bear Robert Drach. Two weeks ago, I reported that he had moved 75% of his clients' funds into the market and was awaiting a further "splat" before adding the rest. Following last week's action, he has now pushed all of his chips in, and with a record of closing positions over the past 30 years with more than 95% wins, that's a decision worth noting. He said he believes the trade could last four to five months.
And finally, even some hard-edged fixed-income guys are weighing in on the bulls' behalf. The very capable CreditSights analyst Arnie Berman notes that technology companies that have expressed doubt over the near future don't represent a worrisome new trend so much as "transient seasonal" inclinations. He points out that corporate technology buyers never spend 25% of their budget in the first quarter, guarding against contingencies later in the year -- and particularly so during times of uncertainty. But he believes that companies will find that they cannot afford to continue to be underinvested in productivity tools, so he's looking for a rebound in capital expenditures -- particularly in software -- in the second half of this year, and particularly in 2006.
Further, as a veteran observer, he notes that "malaise, widespread investor disinterest and conviction that technology stocks lack catalysts are positive contrarian indicators." With so much negativity out there, he sees the potential for upside surprises three months from now -- and the potential for the market to sniff that out much sooner.
Berman's top picks are
Check Point Software Technologies
, and he particularly recommends that investors take advantage of weakness in
The market is telling Drach, Desmond, Hyman and Berman that they are dead wrong. But these guys are disciplined and have pretty good track records. Very often, it doesn't pay to fight the tape. But if you've got an appetite for risk and want to lean three sheets to the wind with them, then it may be time to bet on a rebound. After all, if it were easy to buy at times like this, it wouldn't pay off so well.
At the time of publication, Markman was long Microsoft and Cisco.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at firstname.lastname@example.org; put COMMENT in the subject line.