Bulls Win this Round (with Help from the Labor Department)

Wow, what a week  one of the wilder roller coasters we can remember - certainly enough to make one dizzy. After what looked to be a rather hospitable environment for us bears, a favorable report from the Department of Labor incites another round of panic buying and a virtual stock market meltup. When all was said and done, today erased much of the weeks earlier declines. For the week, the Dow lost 12 points. The S&P500 gained 1%, while the Transports, Utilities, and Morgan Stanley Consumer indices were unchanged. The Morgan Stanley Cyclical index dropped about 1%. The small cap Russell 2000 rose about 1%. Throughout the technology sector, a spectacular and historic speculative run actually turned up a notch this week. For the week, the NASDAQ100 and the Morgan Stanley High Tech indices each gained 4%, both closing today at record highs. This increases year-to-date gains for these averages to 37% and 43%. The Semiconductors surged another 7% this week, increasing 1999 gains to 60%. The Street.com Internet index rose 4%, as its year-to-date gain jumped to 47%. The NASDAQ telecommunication index added 1% this week and now sports a 28% 1999 gain. Despite big gains today, the financial stocks ended the week in the red. Both the S&P500 Bank and Bloomberg Wall Street indices dropped about 1% for the week.

Truly war-like conditions exist throughout the "trenches" of the financial markets. And in this context, the monthly employment report has certainly become a key battleground for the stock market. Not, however, because of its importance as an economic indicator. After all, it has not been very reliable. In fact, over the past few months we have had several "weaker than expected" reports from the Labor Department, each leading to major bond and stock market "relief" rallies. Yet, these weaker reports have proved woefully inaccurate indicators of what has been persistently stronger than expected economic performance. Despite todays data, labor markets are exceptionally taut and wage pressures are the strongest in quite some time. So why does the stock market pay such close attention to, and respond so ferociously to, the monthly non-farm payroll data?

Well, investors understandably fret this monthly release, particularly in the credit markets. Several times over the past few years surprisingly robust employment data has led to major bond market declines that also hammered stocks. And, clearly, todays employment numbers took on even more critical importance with credit markets in the midst of a tough and potentially severe bear market. This week, bonds had been trading quite poorly and yesterday bond yields moved to key technical levels. The December bond futures contract again touched contract high yields of 6.8%, while 10-year swap spreads traded to 12-year highs. So, todays report was key, holding the potential to push the credit markets "over the edge," with strong job creation or wage gains potentially sparking an ugly rout for bonds and, hence, the stock market. Moreover, with the dollar continuing to trade pathetically, a bad report could have sparked a truly seminal day for US financial markets. No doubt about it, todays number was "big". As such, the markets needed a favorable number from the Labor Department and, sure enough, they got it. But did the data justify a gain in the Dow of 235 points, the largest point gain ever for NASDAQ, a 4% gain for the NASDAQ100 and the S&P Bank indices, a 5% gain for the Semiconductors, and a 6% gain for The Street.com Internet index?

Well, we have a hunch that todays stellar stock market performance had much more to do with market dynamics than it did with actual economic fundamentals. As such, we dont think todays data shed any new light whatsoever on economic developments. However, recognizing that it was a crucial report in a most unsettled environment, we believe there was considerable hedging ahead of todays data. Institutions, investors, and speculators, alike, appear to have taken short positions and purchased put options for market insurance. But with the release of this non-threatening data this insurance was moot. Actually, "moot" does not adequately address the realities of the situation. What really happened was that as soon as the favorable data was released, it was apparent that many of these derivative hedges and speculations would then be unwound. Around big economic numbers like this mornings, particularly during periods of general financial turbulence, derivatives really come to "rule the world." And, importantly, derivative players become King of the markets!

Todays derivative-related event was also exacerbated by the fact that next week is holiday-shortened, hence only nine trading sessions remain until September option expirations (and only eight days for many index options). This is not much time for holders of put options. So, with the release of the favorable data it became immediately clear that the market was safe (for now), and the mad panic began. This meant that put writers, having shorted stocks and futures to hedge option exposure, would move to the buy-side quickly and aggressively to mitigate losses. This incited heavy buying at the open, with prices gapping higher. And, importantly, those that had shorted stocks and futures for hedging or speculating would also be forced to cover at sharply higher prices, fueling even stronger gains and more pain on the bear camp. Here we saw another episode of derivatives adding great fuel to a self-feeding market move. Today, it was on the upside. And, of course, when the bulls see that the bears are caught, they cant help but to add a bit to the "squeeze." It really is amazing how the market has this ability to "put the screws" to those found on the wrong side of a trade. After gapping open, stocks only gained more ground as some pretty strong punishment was dished out to those that had bet against the bull market. And into the close, it was much the old "full court press." Admittedly, it was a job well done by the bulls and we will concede this round, but only this round.

It is one thing for the market to gap higher and force the unwinding of bearish bets and something quite different to have a stable and healthy marketplace conducive to a sustainable bull market. In this regard, what we have currently is a particularly unstable and unsound stock market and financial system. And nothing that occurred today changes this. In fact, we see such market action as further confirmation of decidedly unhealthy underpinnings. This is not just unrelenting bearish banter; the behavior of the credit markets for the past six months and the recent performance of the dollar much support this view. And, actually, the stock market environment continues to demonstrate all the classic characteristics of a major market cycle top: wild volatility, lack of breadth, and declining volume, all indicating faltering liquidity. The technicians refer to such action as distribution that, by the way, precedes the inevitable bear market liquidation. Such periods, however, tend to go on for longer than one would expect. And now that we are living through the experience, we do have a much better appreciation for the extraordinary nature of both psychology and market dynamics behind previous momentous market tops. Certainly, recent stock market action and the general environment demonstrate many eerily similar parallels to what we have read of market behavior during historic market tops, particularly the US market in the summer of 1929 and Tokyo in the autumn of 1989.

One thing that stands out clearly: at major inflection points things always go nuts for a period, with particularly tumultuous trading conditions. In hindsight, it does seem like investors were provided great opportunities to get out of past manias before the onset of the inevitable collapse. In fact, in hindsight it often appeared obvious that the environment was deteriorating and that the market was ringing the bell loud and clear. When we first studied material describing that fateful summer in 1929, we were simply stupefied that investors did not see the "handwriting on the wall." "How could everyone have missed it", we would repeat over and over. It appeared "crystal clear", again in hindsight, of course. Amazingly, however, the vast majority of investors chose to ignore the many signs of impending trouble, choosing to hang on in what had become a virtual crusade of speculation. But thats exactly what manias are all about. Interestingly, we can now see why these tops are so powerfully seductive; there are days just like today that keep investors and speculators intent on continuing to play the game. How can one not continue to play when major indices are gaining 4% to 6%, in a single day? With such money to be made, lets play! Well, all we can say is that todays market was much like the loud bells and sirens and the clatter of coins that casinos use to keep the gamblers depositing their coins in the slot machines. Admittedly, it is extremely effective.

Going forward, however, we see no way around continued unsettled financial markets and fully expect more chaotic trading in the stock market. It is difficult and often frustrating but it is also, at the same time, scripted right from the textbook of how manias end. Importantly, despite todays strong advance, the credit markets and the dollar had another losing week. The dollar was weak, almost across the board, with more than 1% losses against most major currencies. Bond yields rose all along the curve, with spreads rising sharply this week. Today, despite a huge rally in the stock market and significant recovery in the credit markets, the key 10-year swap spread barely budged. It ended the day at 107, five basis points wider than last Friday. This is actually not too surprising. While stocks and bonds can take the employment data and enjoy a big day of fun and games, this report does nothing to alter true underlying fundamentals. The economy is much too strong, there have developed increasing inflationary biases and economic imbalances, and our credit system is today acutely vulnerable to an impending flood of paper coming to market. Our financial system is fragile, and todays wild ride higher in the stock market only adds to its vulnerability.

The bottom line remains that a big problem continues to develop in our financial system, one that will not be rectified anytime soon. The problems are very much structural. We continue to work diligently to position the fund to profit from the developing situation but at the same time strive to control risk. A day like today, with stocks gapping higher on a critical news-related event, is clearly the most difficult for us to deal with. No doubt about it, it is quite a challenging environment. We are disappointed with the way the week ended in the stock market, but we are certainly anything but discouraged with the way fundamentals are developing. As painful as today was, it does create tremendous opportunities.

David Tice

prudentbear.com

-- andy (2000EOD@prodigy.net), September 05, 1999

Answers

As I keep thinking, if this keeps us even the poorest should borrow off their credit cards at 22%, invest in the market and get 40-45%, and live like kings forever.

"Amazing" and "unbelievable" are the two words I hear most often. But people seem to think we (U.S.) have found the key to perpetual wealth and will soon invent the genetic "fountain of youth" so as to live happily ever after (to bad about those dumb starving people).

-- Jon Johnson (narnia4@usa.net), September 05, 1999.

Jon - I think a much larger percentage of people than is generally realised are doing just that - maxing out their cards, maxing out their margin limits, even borrowing on their houses at 125% of the equity, living on the edge care of the banks - they know that if they lose it all they can simply declare bankruptcy and walk away from the consequences...

hey, the goon squad on msnbc etc. every day are projecting a dow at 40,000...

unbelievable...

-- andy (2000EOD@prodigy.net), September 05, 1999.

It's an addiction like gambling- no different than buying oodles of lottery tickets each week, cause if you skip a week- that might be the week your "number" would have hit big, etc, etc. It's gonna come down- and lots of people are gonna lose big- they're just scared if they pull out "too soon"- they might lose that next big market uptick- and look dumb around the water cooler and all- greed has its price- i feel no pity. I got out of the market several years ago- thought it was overvalued back then and made no sense- couldn't afford to lose my principal- regrets? None- I sleep like a baby at night.

-- farmer (hillsidefarm@drbs.net), September 05, 1999.

Andy-

N.Y.TIMES-Sunday-today

DOW-36,000 ?

-- David Butts (dciinc@aol.com), September 05, 1999.

This so eerily like the summer and fall of 1929 it's chilling!

-- Gordon (gpconnolly@aol.com), September 05, 1999.

This is certainly government sanctioned gambling, only with much higher stakes than piddly lottery money. So many believing that this is nothing like betting on the ponies, why it's (almost) foolproof. Thinking they understand what others do not. Should we feel bad for them when the house of cards collapses? No. They had the opportunity to educate themselves. Arrogance does have a price.

-- Gia (laureltree7@hotmail.com), September 05, 1999.

Someone wrote a book on stock market investing a couple years ago and started it off with a statement something like this: "When we play the horses, that's gambling. When we play poker, that's entertainment. When we play the stock market, that's business. See the difference?":-)

-- Gordon (gpconnolly@aol.com), September 05, 1999.

Back in the 80's there used to be an index called the odd-lot, that kept track of purchases and sales of less than 100 share lots. What it basically said that the little guys buying less than 100 shares were the last ones in (coming in at the top of the trend) and the last ones to sell (indicating a market bottom). Not sure if they even keep track of this anymore, since most use mutual funds today.

What it basically meant is that it's time to sell when the stupid people (or people who don't know what they are doing) make money in the market. I certainly know a few of these types today.

Saw the same thing in real estate in the late 80's. Folks buying and flipping houses and making $10-25,000 in a couple of months. Most got stuck holding the bag, and lost it all when prices flatten and went down some.

Anyone else see any of these signs today?

-- Bill (tinfoil@deserthat.com), September 06, 1999.