War Rally Failing
This week was a fascinating multi-pronged anniversary in the equity markets. Exactly one year ago the war rally in US equities launched when Washington, DC began its operation to annex Iraq by bombing Baghdad on live television.
The war rally turned out to be one of the most extraordinary equity rallies witnessed in decades. Its magnitude and duration were unprecedented in many ways, especially when considering the blisteringly high valuations from which it erupted out of the blue a year ago this week.
The war rally proved especially vexing to contrarians, as many including I lost big bets on the short side last year when the rally powered relentlessly higher in brazen defiance of many proud and usually rock-solid sentiment indicators. Extreme greed not witnessed since the terminal months of the Great Bubble of the late 1990s fueled the powerful rally while sentiment indicators screamed to stay short the entire way up.
While we on the contrarian and bear side were gutted and filleted like fish by the war rally, the bulls rejoiced, and rightfully so. They are always happy to point out that the war rally was really technically a cyclical bull. And they boldly made the claim that the Great Bear of the early 2000s was rendered extinct by the war rally, even though general stocks never traded below 20x earnings or above 2% in dividend yields last March, traditional long-term topping, not bottoming levels.
Battered and bruised, we contrarians had no choice but to grudgingly accept the surreal and unnatural war rally, carefully biding our time and waiting for the popular euphoria to fade, as it always does. Even today a year later we still see rampantly overvalued markets trading near historical bubble extremes in P/E and dividend-yield terms, drenched in naked greed.
For some, particularly perma-bulls, twelve months of war rallying or cyclical bullying is enough to convince them that we are sojourning through a brave New Era where valuations are irrelevant, where buying any stock at any price at any time for any reason is always a bargain. We contrarians sure don’t buy this happy rationalization though!
This week marked a second, and far more important, anniversary as well. Four years ago, the US stock markets blasted to nosebleed bubble extremes in valuations never before witnessed in US history, even in 1929. Four years ago this week the bulls, just like today, happily argued that valuations were meaningless since a brave New Era was upon us. Who needs those dusty old laws of market history anyway when the markets are soaring, right?
And four years ago this week, history finally caught up with the bulls with a vengeance and mercilessly started crushing them like bugs for their irrational exuberance. The New Era of unlimited eternal gains of the late 1990s proved to be as mythical and silly as all the other New Era promises in the centuries past. Turns out that valuations really did matter after all! Today, we are facing a similar reckoning in the unbelievable war rally of the past year.
The spectacular war rally of 2003 once again defied rational valuations, blasting into stellar greed extremes never before witnessed in modern history, including in 1999 and early 2000, according to some elite sentiment indicators. As such, we contrarians could not rely on valuation or even sentiment to help us discern when the bullish stampede was running out of steam. These limitations left us to consider the war rally in purely technical price terms. Bring in the charts!
Finally on this anniversary week the long-cryptic charts have at last spoken, and not even the perma-bulls can argue with these startling developments. The mighty war rally is failing! All of the elite US indices are entering accelerating technical decay curves on weak internals and increasing selling pressure. The implications of the potential end of the war rally for speculators and investors are quite profound.
Our charts this week delve into this increasingly obvious technical peril in the general US stock markets. They compare the war-rally-to-date gains in the NASDAQ, NASDAQ 100, S&P 500, and Dow 30. As I will discuss below, the speculative premium inherent in the US markets is fading fast, suggesting that popular greed has hit the wall and a sentimental sea change is well underway.
In this first chart of the entire war rally, the technical decay in the past couple weeks is very evident with the plunging rally-to-date gains lines. Note the shrinking gap between the hyper-speculative tech-stock indices and the far more conservative blue-chip indices. Popular speculative fervor is fading fast as the war rally rolls over and fails.
[Blockierte Grafik: http://www.lemetropolecafe.com/img2004/Zeal031204A.gif]
With NASDAQ war-rally gains approaching 70% and blue-chip gains near 45%, there is no disputing the majesty and power of the US stock markets in the past year. Whether you were on the right or wrong side of this particular market movement as a speculator, this rally was certainly spectacular by any standard.
One of the war rally’s distinguishing characteristics that intrigued me the most was the large divergence between the far more speculative technology indices and the less risky blue-chip indices. As you can see above, the tech indices led the war rally’s charge higher for the entire year. As the war rally grew more mature, the NASDAQ complex even accelerated farther ahead of the traditional headline indices as speculative fervor surged into the latest interim tops witnessed in January.
This development is rendered very clearly on the graph. I call the gap between the NASDAQ indices and the S&P 500 and Dow 30 the “speculative premium”, as this gap showcases the very large differences in war-rally returns between purely speculative tech stocks and more traditional blue-chip investments. While none of the major indices shown above was ever absolutely inexpensive in recent years by any means, the valuation numbers help illustrate their different fundamental natures.
Early last March prior to the war rally, the NASDAQ 100 was trading at 32.6x earnings and yielding a laughable 0.2% in dividends, which are both far in excess of traditional bubble-top levels, not long-term bottoming zones. Meanwhile the S&P 500 was trading at 20.6x earnings and yielding almost 2.0% in dividends. While this is very highly valued historically, it was still relatively cheap at the time compared to the NASDAQ mania valuations.
So with the NASDAQ 100 trading at 60% higher valuations and yielding only 1/10th the dividend levels of the blue-chip S&P 500 right before the war rally launched last year, it is fair to call the NASDAQ the highly speculative play and the S&P 500 the far more conservative option, at least in this context. If you were a speculator last March betting with the war rally odds are that you gravitated towards tech stocks, while investors looked to more traditional and safer blue chips in the S&P 500.
As you remember, the largest general-market news issue early last year prior to Washington’s annexation of Iraq was the discussion on the reduction in dividend double taxation. Historically a very large portion of the stock market’s entire long-term return comes from dividends, so an easing of the onerous and immoral double taxation on dividends ought to be bullish for the stock market. Indeed, traditional Wall Street bulls were virtually unanimous in believing that solid dividend-paying stocks would be the best performers of 2003.
Thus, in the first couple months of 2003 prior to the birth of the mighty war rally, the popular bullish bet to take was that blue-chip dividend-paying stocks would outperform the more speculative overvalued sectors like technology. The long-overdue dividend tax cuts were expected to unleash a surge in dividend increases and popular interest in dividend-paying companies, especially in Greenspan’s negative real-rate environment hostile to traditional capital formation.
The war rally utterly defied these dividend predictions, with the most speculative companies paying little or no dividends witnessing the highest performance! All throughout 2003 I heard Wall Street strategists commenting on this and scratching their heads. It seemed like the least attractive companies in fundamental terms were reaping the biggest gains in the war rally, with the dividend-paying blue chips lagging far behind. Naturally the least fundamentally attractive sector was the still hyper-overvalued technology realm.
As the chart above shows, the speculative premium between the technology indices and the blue-chip indices grew throughout most of the war rally, ultimately growing quite wide. At the apparent top in late January, the NASDAQ was up 69.4% while the S&P 500 was “only” up 44.3%. The most speculative stocks had outperformed the usual blue-chip stable by well over half again as much!
So what you wonder? Here is the kicker! At real long-term secular bottoms, such as the ones that mark the ends of major bear markets, the backbone of the popular speculation psyche has been totally shattered. The bear has done such thorough work that much of an entire generation vows to never again gamble in the stock markets. The only survivors are the long-term value players, the very contrarians who would want to buy the lower-valued and higher-dividend-yielding stocks.
The war rally, however, was not led by the value players looking for historically sound returns. The very same slack-jawed starry-eyed New-Era maniacs who fed the NASDAQ bubble of the late 1990s led the war-rally charge northward as well! The war rally was fueled by tech speculators buying the most-overvalued tech stocks with the most meager earnings and effectively zero dividends. Blue-chip investing lagged far behind the war-rally tech mania.
With technology speculators still multiplying like rabbits even after the brutal October 2002 and March 2003 interim lows, the Great Bear never really finished its gruesome work. After historical bubbles the bubble-leading sector never leads the next real secular bull market forward. There are always new leaders not tainted by the previous bubble excesses that light the way out of the ashes of a supercycle bust.
If tech speculators had enough collective power to dominate the war rally, then it really looks like a temporary echo bubble and not a new sustainable bull market. A sustainable new bull market would not be led higher by the old usual-suspect tech-mania stocks, but by long-term value players chasing the best blue-chip stocks on fundamental grounds.
Now whether you agree with me or not that the Great Bear’s work was never finished without a real historically undervalued bust is not relevant for my thesis this week. This war-rally-to-date gains chart shows, undisputedly, that tech speculators led the war rally. As long as the speculative premium was growing, the war rally had to be taken seriously. But in recent weeks, the speculative premium has started to shrink dramatically.
If tech speculators led the war-rally charge northwards, casting their capital into the most overvalued and dividend-poor major stocks in the United States today, what does it mean when these very tech speculators grow tired, nervous, or overextended? As you can see above, in the past six weeks or so the speculative premium between the tech indices and blue-chips has shrunken rather dramatically. The tech specs who led this rally are abandoning ship!
Initially the war rally seemed to take the ill news of the desertion of its leaders rather well. From the NASDAQ top of late January until only a couple weeks ago, the S&P 500 and Dow 30 held strong near their rally-to-date highs. The tech stocks were contracting rapidly and hemorrhaging a large chunk of their gains, but the blue chips were rather stoically holding the line. Just this week, however, marking the anniversary of the war rally, the blue chips have ominously started to crack as well.
The speculative premium between the NASDAQ and S&P 500 has plummeted from 25.1% in late January at its zenith to a much smaller 14.1% today, and this contraction shows no signs of abating. Is there any chance that the war rally can continue its march higher when its leaders championing its cause for the past year are selling out?
Zooming in a bit, we can really see the interaction between the rapidly shrinking speculative premium and the newly failing blue chips. The war rally’s one-year anniversary was marked this week with all four of the major US stock indices cracking below their short-term support lines to the downside. The evidence of widespread technical price decay that we contrarians have long sought is finally showing up on the radar.
[Blockierte Grafik: http://www.lemetropolecafe.com/img2004/Zeal031204B.gif]
For the entire war rally, corporate insiders in almost all sectors sold their stock aggressively, suggesting they did not believe it was sustainable over the long-term. For a whole year though there was enough new capital pouring into the US markets, especially in technology, to absorb this increasing deluge of insider selling.
By the end of January however, the tides of circumstance had shifted as the tech speculators started getting nervous over their nearly 70% war-rally gains. The tech specs finally joined the insiders in selling and the NASDAQ complex started falling. Since January 26th, the technology sector has given back over a fifth of its entire gains achieved during the war rally!
For most of the last six weeks, the blue-chip indices generally shrugged off the ominous portents of speculator desertion in tech-land. The S&P 500 closed at 1155 on January 26th when techs topped, it closed at 1158 on February 11th, it closed at 1157 on February 17th, it closed at 1156 on March 1st, and if closed at 1157 just last Friday on March 5th. The S&P 500 valiantly turned the other cheek as the war-rally leading-edge vanguard of New-Era tech speculators locked in their profits and walked away.
Interestingly the even more blue-chip Dow 30 was not quite as resilient though. While the S&P 500 traded sideways since the tech top, the Dow 30 managed one marginal new rally-to-date high near 10738 on February 11th. Since then it has slowly drifted lower, almost imperceptibly at times, until this week.
On Tuesday the psychologically crucial NASDAQ 2000 level failed as support, sending a great collective shudder of fear through the tech speculators who had led the entire war rally. This sparked farther late-day selling on Wednesday as the understanding of the implications of this development spread through Wall Street like wildfire.
The day that these charts were created, Wednesday March 10th, all of the major US stock indices graphed above broke through their short-term support heading lower. Even the resilient blue-chips hemorrhaged more than a tenth of their entire war-rally-to-date gains in only a few short days!
These ominous technical breakdowns highlight the serious trouble the war rally is in. Without its tech leaders, odds are that it cannot continue powering higher. With the psychologically immense NASDAQ 2000 level failing as support and the rapidly shrinking speculative premium of the war rally betraying increasing technology selling, this weakness is almost certain to feed on itself.
Initially the bulls will say no big deal, that this is just a necessary healthy bull-market correction. And perhaps they will be proven right! But it is crucial to realize that valuations remain at historic bubble extremes, suggesting that the Great Bear has not yet finished its grisly work and is due to make a stunning encore appearance.
As the tech portion of the war rally topped in late January, the NASDAQ 100 was trading at an unbelievable 45.5x earnings and only yielding a laughable 0.2% in dividends! Meanwhile the blue-chip S&P 500 was trading in official bubble territory as well, at 28.4x earnings and yielding only 1.6% in dividends! When hyper-overvalued markets are coupled with accelerating technical decay and fleeing speculators, it is certainly possible and even probable that something much more dangerous than an ordinary correction is approaching.
The technology sector has great influence, direct and indirect, outside of the NASDAQ as well. Most of the elite tech darlings of the NASDAQ 100 are also included in the S&P 500 component companies. And the two largest and most important NASDAQ companies, Microsoft and Intel, are also included in the Dow 30. In addition to commanding over a quarter of the NASDAQ 100’s entire market capitalization, these two companies are the second and sixth largest components of the elite Dow 30 industrials as well.
The elite tech darlings are still incestuously and hopelessly intertwined in all of the major stock indices following the Great Bubble of the late 1990s, and the collateral damage across the entire US market landscape from a technology failure of the war rally could be extensive.
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On this pivotal week of important market anniversaries, the bulls are happily focusing on the one-year mark for their cyclical bull market in US equities. The contrarians, on the other hand, still see this war rally as an unsustainable anomaly and look back to the hard lessons from the Great Bubble tops so far above current index levels that were achieved four years ago this week.
The primary lesson of the Great Bubble was that valuation matters. The bulls still brazenly ignore this hard lesson, while the contrarians can never forget it.
As the war rally continues to deteriorate and fail, perhaps we will all soon know for sure whether valuations still really matter or not. Whether the abandonment of tech speculators of their mini-mania leads to a healthy correction or a brutal Great Bear downleg remains to be seen, but either way the war rally is failing.
Adam Hamilton, CPA
March 12, 2004
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