3 Things You Need to Know Right Now

January 26, 2003

The Imagination General Electric Co. is jettisoning its "We bring good things to life" slogan after nearly a quarter century for a new campaign that emphasizes the innovative spirit that Thomas Edison started at GE more than a century ago.

Although the new $100 million advertising campaign, "Imagination at work," is meant to tout GE's reputation for innovation at all its businesses, from the NBC television network to its appliances, medical equipment and financial services, it is an example of what our economy has become. Instead of being based on producing products and selling them, our economy has been transformed into one of "services" and paper pushing all based upon credit and debt. It is fit that General Electric, a DOW 30 company that always beats estimates by a penny, has chosen this slogan, because a portion of its earnings are based on future pension earnings, which are totally made up.

The whole system is based on imagination. Investors created a stock market bubble by imagining a "new economy" that meant a continues cycle of prosperity. They were encouraged to do so by "economists" such as Lawrence Kudlow and government officials such as Lawrence Rubin and Alan Greenspan. Now they have been caught holding the bag and their minds are being hit by darker visions.

They are getting downright gloomy. According to a TME/CNN poll last week 56% of Americans believe that the country is in deep and serious trouble. Only 27% believe that the economy will get better in 12 months.

Last week the University of Michigan also released its preliminary January consumer sentiment index. The Index fell to its lowest level since October, down to 83.7 from 86.7 in December, which makes a 9 year low. This January survey comes after what has been the worst Christmas retailing season in 30 years and is further confirmation that the consumer is buckling down in the face of massive credit card debt and layoffs. 101,000 workers lost their jobs in December as industrial production fell.

Companies are also lowering their earnings and revenue estimates for this year, while simultaneously trying to provoke you into buying their stock with tricks and gimmicks. Two weeks ago, after trying to hype its stock with a stock split and microscopic dividend, Microsoft lowered its earnings projections for the rest of the year. The stock has fallen over 10% since then.

On Friday the CEO for BroadCom resigned. During the conference call, in which Broadcom also reported fourth-quarter earnings, he said that the December quarter marked the point where he can say with confidence that Broadcom "successfully navigated the worst downturn and emerged in good financial health."

Broadcom "just delivered the strongest quarter it had in recent years," said

the executive. For the quarter ended Dec. 31, the chip maker reported a net loss of $1.76 billion, or $6.40 a share, compared with a loss of $329.6 million, or $1.27 in the year-earlier period.

The CEO said he resigned to spend time with his family. Broadcom and Microsoft are just two examples of many of how companies try to hype themselves, while announcing disastrous news.

For the past two years companies have been predicting big second half recoveries while their stocks have fallen. A lot of companies, such as Intel are doing this all over again, but many are honestly saying that there won't be a recovery in 2003. As Reuters reports:

"After two years of hoping in vain for a recovery, which many said was only six months away, companies are now writing off all of 2003 and focusing on 2004 for any improvements in their markets."

"Two weeks into the new year, key European and U.S. companies have toned down their hopes for economic bloom. Slow consumer spending, a possible war in Iraq and the resulting high oil prices could further dampen business activity."

"In the past week, airlines, technology and chemicals companies, banks and retailers have all said they are hesitant to predict the upturn for this year, opting for caution after misreading their markets during the past two years. "

"The chief executive of telecoms equipment giant Cisco, John Chambers, started off the miscalculation season in January 2001, when he said he was confident the downturn could be over in six months even though his clients' businesses had hit a brick wall."

"Chambers wasn't alone with his turnaround prediction in early 2001. A second-half recovery became a mantra in the cramped corridors of the conference at the Swiss ski resort. "

"Now, however, few CEOs express such bold dreams." "The technology sector remains particularly weak after it was badly bruised in the last two years as companies -- telecoms firms in particular -- spent less on computers, software and IT services after the Internet bubble burst in 2000."

"U.S. chip behemoth Intel sees little improvement in its markets for the first six months, and cut its 2003 investment budget to below $3.9 billion from $4.7 billion. "

"Dutch chip equipment maker ASML said on Thursday a recovery in the battered sector, in its worst downturn ever, could happen in the second half, but the company declined to give a forecast and showed a thin order backlog entering 2003. "

"The same day, U.S. computer maker Sun Microsystems failed to reiterate a November target of turning a profit by the end of its fiscal year in June, blaming a murky economy. " "France's Alcatel's Chief Executive Serge Tchuruk this week forecast another down year in the telecoms equipment market after a 50 percent fall over the last two years. "

"Software makers see no recovery either. "

The Investor Remains Desperately Bullish

Despite all of the gloom and doom, a funny thing is happening. Investors continue to remain optimistic about the stock market. At the start of every year analysts give their projections on where they think the stock market will go, and incredibly their average prediction for this year is for greater stock gains then they have forecast in a decade.

At the same time investor surveys, such as Investor's Intelligence, show a great number of bulls than bears. In fact the divergence in the number is the type seen at stock market peaks.

What is going on?

People are still holding on to their stocks and mutual funds and refuse to sell them and cut their losses. They continue to hold on in desperation and hope. They listen to any commentator who says the market will go up because they want to believe them. They listen to their brokers mouth sales slogans such as holding on to the long run and dollar cost averaging down. It doesn't matter if the commentator has well reasoned thinking or is just a total crackpot. What matters is that he says what people want to hear.

The radio show I posted above brings all of these themes into clarity and that is why I posted it at the start of this message and believe it is well worth you to listen to it. It is one thing to read me talk about the typical investor, but it helps to hear a living example too. The host of the show makes the point that someone who owns mutual funds is not investing. Investing is saving your money and putting it in safe assets that will give you as close to a guaranteed return as possible. Putting your money into a mutual fund is speculating because you are betting that the stock market will go up and make you money overtime. There is no guarantee that will happen and history says that it takes years for a market to recover from a secular bear market of this magnitude and decades to make new highs. People who tried dollar cost averaging into "investment trusts" in the 1930's and "mutual funds" in the 1970's got totally wiped out. People doing it now are total fools. They are the fools of their brokers and advisors who are making a commission every time they put more of their retirement money into the sinking ship. When the mutual fund speculator loses money someone is making money on the other end. That person is often the insider who uses the buying orders from mutual funds to unload their shares. The bear market and mutual fund industry has created one of the greatest transfers of wealth in history - the Main Street investor has bought every share that has been sold in the past 3 years by the Wall Street and Silicon Valley insiders and remained bullish the whole time. Don't let your advisor fool you. You did not lose money in the stock market. You gave it to someone on the other side of your trade. The problem is that bear markets do not end until all of the potential sellers are out of the market. Bear markets are a liquidation and they don't end until the liquidation is over. The fact that everyone is still bullish and still holding means that stocks are going to continue to drop. This is one of the most dangerous moments I've seen in the stock market in 5 years.

I read dozens of commentaries a day on the market and at the moment almost everyone believes that the current dip in stock prices is going to end up being a buying opportunity. Almost everyone believes that the Iraq war will create a huge stock market rally and new bull market just like the one in 1991 did.

They think that a setback now is just because of short term temporary worries about Iraq. The current consenus is best typified by James Cramer, the CNBC talking head is who prone to bursts of Prozac induced fits of hysteria:

"You know you have to buy the end of the world. If you are not sticking bids in here, I think you are making a grave mistake. The market's going to be heavy into Iraq, but you have to pick your spots, and one of them has to be the ugliness of a cold Friday ahead of the United Nations report and the president's State of the Union address. "

"I, for one, have been saying that the BKX would take out the 750 level because that group has been acting so terribly. Here we are at 747 and I feel the downside to that index is limited from here. Twenty points down would be a stretch for it. "

"You have to buy that group when you can, not when you have to. "

Cramer has called every dip of the past 3 years a buying opportunity and blamed every dip on a short term negative event. Last year he said that the market was falling because of Enron and WCOM and that when they were cleared up there would be a new bull market. Two years ago he said that Alan Greenspan's interest rate cuts would create a new bull market. Now he is saying that the Iraq war will do the trick.

The truth is that this bear market is larger than Eron, WCOM, Alan Greenspan, or Saddam Hussein. It is a bear market created by the massive debts and overcapacity created by the 1990's stock market and debt bubble. Like all recessions and bear markets of the past it will come to an end in only one way - when the cycle of liquidation comes to an end.

That means that we are in for a trend of falling stock prices, a falling US dollar, and rising gold prices. Events such as the Iraq war may have a short term effect on all of these trends, but they will not stop them from coming to completion.

THREE THINGS YOU MUST KNOW NOW

There are three things you must know now.

1) The stock market has not bottomed - first of all we have not seen the levels of bearishness that come at the end of bear markets. After the end of every bear market in history, the first major rally has always been met with skepticism and doubt. This last one was once again accepted as the bottom. If it had really bottomed then the number of bears in the Investor's Intelligence survey would have outnumbered the bulls throughout most of the rally. Instead the number of bulls jumped at the fastest rate in three years right after the October rally began.

A second thing you need to consider is an important study by technician Paul Desmond. You can read his article here:
http://www.mta.org/pdf/2002DowAward.pdf -

Desmond went back over 70 years of market history to search for volume and price patterns that marked the end of bear markets. He found that the final down leg of every bear market had what he calls 90-90 days. These are days in which 90% of the stocks in the market fell and 90% of the volume on that day was to the downside. Once the down leg ends and the market takes an up turn and that rally has had a least one 90-90 day to the upside.

According to Desmond, "important market bottoms are preceded by, and result from, important market declines. And important market declines, are for the most part, a study in the extremes of human emotion. The intensity of their emotions can be statistically measured through their purchases and sales. To clarify, as prices initially begin to weaken, investor psychology slowly shifts from complacency to concern, resulting in increased selling and an acceleration of the decline. As prices drop more quickly, and the news becomes more and more negative, the psychology shifts from concern to fear. Sooner or later fear turns to panic, driving prices sharply lower, as investors strive to get out of the market in a panic. It is this panic stage that drives prices down to extreme discounts - often well below book values - that is needed to set the stage for a new bull market."

Desmond uses 90-90 days as a sign of panic activity in the market. It isn't enough that the market just drops, but that it drops with intensity. 90-90 down days come "when downside volume equals 90 percent or more of the sum of upside volume plus downside volume, and points lost equal 90 percent or more of the sum of points gained and points lost."

Such days come during the final down leg that ends to form a bear market bottom. They are then confirmed with an up leg that has 90-90 days to the upside. It is important that the bottom is confirmed with at least one 90-90 up day afterwards, as a confirmation that real buying is taking place.

Incredibly there was not a single 90-90 down day during the September 2001 decline or in all of 2002 This suggests that the bear market has not yet made its lows.

2)A New Down Leg is Just Beginning

Last week's action confirms that the stock market is just beginning a new bear market decline. You need to protect yourself. Now is a good time to sell any mutual funds that you hold or get rid of the once hot tech stocks that might sill be in your portfolio.

If you want to make money during this decline then you need to short sell the rallies. I like to use rallies to increase my short position and pyramid my account. However, the most important thing the average investor needs to do is to save himself. The decline will last much longer and be much worse than anyone thinks. The bear market has proven that over and over again.

3)You Need to Be Psychologically Prepared for the Decline As this market decline plays out there will be short term rallies. Although most of these rallies will last only one or two days there could be one or two that last a week or more. Such rallies will bring out all of the bottom callers on TV. Any rally that comes during the Iraq war will be heralded as the beginning of a bull market. The truth is that the decline won't end until there is a brutal selling climax and all of the people on TV start to sweat and throw in the towel. There will be terror and capitulation at the end of this decline, not hope and joy over a supposed bottom.

You need to remember this. Print the paragraph above and tape it to your refrigerator or computer monitor. If you don't then you will become a gullabull who sees a one day rally and goes long thinking that the market has bottomed because everyone says it has only to get wiped out a week later. To have the right mind frame to survive this bear market decline - or to even profit from it - you will need to ignore the bottom callers and believe in what is real. You have to have faith in history - which has proven that declines end in panic - and not fall for the bull market slogans that you will hear over the course of the next several months everyime the market is green.

You will have to have the ability to see the market go up big one day and not think it is the bottom. You have to be more concerned with protecting your money than you are speculating on a bottom.

You have to hold your wits while you will be encircled by a crowd of lunatics.

You have one choice. Will you take control of your money or listen to the dictates of CNBC and hand your money over to someone else so that you can speculate on a share of stock? Remember, when the market is green and everyone is buying someone is still selling. There is a good time to buy - just remember what you need to know to be able to know when that is and when it is too risky to try.

The View From Overseas

Unlike American investors who are holding in hope and desperation to their mutual fund and stocks, foreign investors have been net sellers of US stocks and dollars for the past year. In fact there are growing signs that this is only the start of a trend that could last for years.

This week the dollar index fell below 100 and closed at a one year low. On Thursday, the Russian central bank deputy chairman, Legy Vyugin, announced that his bank would reduce its share of dollars in its foreign exchange reserves and raise its portion of other currencies and gold. According to the AP:

"Indeed, Vyugin articulated what has become an increasingly important consideration for global bond fund managers: that dollar denominated fixed-income instruments offer unattractively low returns compared with many other global sovereigns."

"For about the past year, Asian central banks "have been talking about their concern that the U.S. dollar proportion of their reserves was far too large," says Paresh Upadhyaya, a currency analyst with Putnam Investments in Boston, which has some $67 billion of fixed-income funds under management."

"The Russian central bank's dig at an already fragile- looking dollar may encourage more central banks and major institutional investors to accelerate their shift out of Treasurys and other U.S. bonds and into European, Australian, New Zealand, Canadian and other government bonds. "

The Davos Economic Forum, which attracts elites from all of the world, is taking place this weekend. Unlike past forums, the mood is one of worry and despire. The founder of the Forum, kicked it off Friday with a speech in which he said that "never in the events 33-year history has the world been so fragile, complex, and dangerous."

Colin Powell is scheduled to speak at the forum today. Stephen Roach, the head economist of Morgan Stanley, wrote these comments about the event:

"The security is so tight, you don't even notice. Only the Swiss could pull it off. Traffic flow -- both vehicles and people -- is so tightly controlled by fences and barriers, that entrée and exit from the World Economic Forum in Davos funnels through the perfect security check. After a one-year hiatus in New York, the WEF has come back home. And the hope and healing of a year ago have given way to the grim realities of a world in trouble. "

"Like all such groups, the Davos crowd -- largely businessmen, academics, and policy makers but also a sprinkling of government officials, religious leaders, and artists -- is swayed by the moment. With geopolitical tensions mounting and fragile economic underpinnings unmasked, the renewed selling pressure in global equity markets was the coup de grace. Adding insult to injury is the growing dispute between America and two of her most important allies -- France and Germany -- over the looming battle in Iraq. Remember that this is first and foremost a European crowd. And the mood in Europe is as bleak as I've ever seen it. That's the deep sense of malaise that greets you when enter the halls of the Congress Center in central Davos. "

"Yet the debate is still intense. Three key macro issues immediately surfaced -- deflation, the dollar, and China. With respect to deflation, there were few that took my warnings seriously. "Japan is one thing, but America is a different animal altogether," was the common refrain. Yet from the start, I have felt that the Japan comparison was misplaced -- that you don't have to follow the Japanese script to tumble into deflation. America, in my view, has three of its own deflationary forces to contend with: First, it entered recession in early 2001 at a very low inflation rate (2.4% y-o-y in 1Q01 as measured by the GDP price index); inasmuch as recessions are cyclical deflationary shocks, it stands to reason that the inflation rate would move lower as it has (+0.8% in 3Q02). Second, there are the legacy effects of the bubble -- especially the excess capacity that continues to overhang markets for goods and services; relative to the post-bubble compression of aggregate demand, this excess supply puts downward pressures on the global price level. Third are the impacts of globalization -- not just the "China story" in tradable goods but also the new price competition emerging in "non-tradable" services. "

"The case for a weak dollar was better understood. The Davos crowd bought the logic that massive external imbalances are simply not sustainable. There was little concern that America would be unable to fund a likely $600 billion-plus current-account deficit in 2004. There was strong conviction, however, that the financing would have to occur on terms more favorable to the foreign providers of capital. A currency concession was at the top ofthat list. But the downside of the dollar was thought to be limited. After all, currencies are relative prices, and the alternatives to dollar-denominated assets are not thought to be all that alluring. An even stronger euro was widely viewed as an especially bitter pill for Europe to swallow. Lacking in self-sustaining domestic demand, currency-induced pressures on external demand would be even more problematic for the region's growth outlook. With its monetary and fiscal policies leaning the wrong way, there are certainly no bulls on Europe to be found this year in Davos. "

"Like the rest of the world, Davos has finally discovered China. This year, there are three separate sessions on China, and the Chinese are well represented elsewhere in the program. China is the hope of Davos. A weakened global economy needs a new push, and China was offered up as the strongest potential candidate. Never mind that China only accounts for about 4% of world GDP. As Zhu Min of the Bank of China pointed out, China accounted for 15% of the growth of world GDP in 2002 and close to 60% of world export growth. Add to that Andy Xie's estimate that China is now accounting for as much as one-third of global capital formation and the case starts to sound compelling. But I cautioned that there's more to a growth engine than impetus on the supply side of the equation. China continues to lag in delivering domestic demand to the global economy, especially private consumption. That day will inevitably come. But until it does, it's entirely premature to anoint China as the world's new growth engine, in my view. I tried to put it succinctly in my message to Davos: In a US-centric world, a sputtering US economy is a recipe for an engineless global economy. In other words, it may well be that the world economy is doomed to a period of subpar growth -- at least until the US picks up again or until the world uncovers a legitimate new source of growth. "

"My bearish message hasn't met much resistance in Davos -- although most don't take it quite as far as I do. This somber crowd has little to cheer about. And it's not just economics and markets. The glitzy parties are out this year. Even in post-September 11 New York, there were plenty of those. Tight security is a grim reminder of the undercurrent of geopolitical tensions that now seem to be boiling over. The growing split between Europe and America brings up old wounds and reveals how different the concept of war is to each continent. The perception is that America always seems to fight the "just war" in some distant land, while Europe has painful memories of devastating conflict on its own soil. Colin Powell is coming to Davos this weekend in an effort to bridge the gap. It will be a tough sell. "

"The question I've been asked the most in these early days of Davos pertains to the impact of the looming geopolitical shock. Most of the Americans here speak optimistically of the "clean war" and the promise of lower oil prices to come -- just the thing a growth-starved world economy needs. The non-Americans worry that all wars are "dirty" and that the aftershocks of a US-led occupation in Iraq could set the stage for heightened instability in the Middle East. None of us, of course, knows the answers to these profound questions. But what I do know is a simple truth of macro: Initial conditions matter. If a rapidly growing economy is hit with a shock, there is plenty of vigor to ward off the blow. If a weak or slowly growing economy is hit with the same shock, it lacks that cushion. The industrial world came to a virtual standstill as 2002 drew to a close. A shock in this context is the last thing a struggling world economy needs. Maybe that's what the Davos daze is all about -- they see it coming."

As I said earlier: at the moment the US stock market is in the most dangerous situation I have seen in years. The problem is that investors are in a state of extreme bullishness at the same time that the market is just starting a new extended decline. Another round of investors are going to get wiped out.

Mike Swanson
tradermike@timingwallstreet.com

http://www.lemetropolecafe.com/