This report is now mostly a compilation of articles that have previously appeared in the Crosscurrents newsletter.  Our paid subscription stock market newsletter has only two rationales for its existence; powerful commentary and unique perspectives that cannot be found anywhere else. 

Typically, at his time of the year, we would detail our analysis of stock market seasonality in this feature, but the April 23rd issue of Crosscurrents covered the subject in far too much depth, including five charts, for the limited space we have available on this page.  We will be happy to provide readers with a copy of the issue upon request. 

If there is a single salient truth about the U.S. stock market, it is that 2007 is a record setting year from almost every aspect.  While there are a few rare exceptions that place either 1929 or 2000 in the spotlight instead, our overall impression is that the mania for stocks appears to be at least as emphatic now as it has ever been.  We have repeatedly illustrated margin debt extremes and the historically low mutual fund cash-to-assets ratio as evidence, but the best picture of the continuing mania for stocks remains the sheer volume of trading.  Not only is the volume of trading at a historic high, the velocity of transactions have exceeded the previous highs with such ease that one's only choice is the assumption that a veritable mania is still in progress, and in fact, never really ended.  Apparently, the collapse and bear market that endured from March 2000 to March 2003 was only a corrective phase to the greatest stock market mania of all time.

We make the distinction of a "corrective phase" rather than a bear market due to the observable fact that we cannot find one instance of back-to-back stock manias in the past.  Perhaps the semantics and definitions do not work for some, but nevertheless, we find it extremely difficult to dispute that the mania never really ended.  Even at the nadir in 2002, Dollar Trading Volume was still at a level that equated to a 18.3% rate of growth in velocity from 1995, when we posit the mania actually commenced.  This seven year path would have been extraordinary sans the final manic peak and subsequent collapse!

If there is only one salient truth about the stock market today, it is that the mania remains largely unrecognized by professionals and the public, who blithely continue without concern, taking larger risks with greater exposures than ever before, while denying investments in favor of trading, per se.

We define Speculative Fervor as the one-year differential in DTV compared with the level of GDP.  A market that trades an additional $2 trillion while GDP rises by 3% is more speculative than a market that trades an additional $1 trillion while GDP rises the same 3%.  Although Speculative Fervor has not reached the levels registered in 1999 and 2000, this indicator has remained at "Roaring Twenties" levels for four full years.  It is easy to posit that recent high levels have reinforced the notion that stocks can do no wrong, hence the game is still played to the hilt.  We believe it is imperative to note that Speculative Fervor remained between +15% to -10% for a stretch of 64 years (!!!) from 1933 to 1996, equating to the historic norm.  A return to these levels will result in a huge dénouement for traders and investors.  In our view, this outcome is inevitable.  We do not expect an identical collapse such as occurred from 2000 to 2003, but an initial shock followed by a consistent and steady disenchantment with the inability of stocks to recover over the long term. 

Justin Lahart's February 26th WSJ article, which can be viewed at http://tinyurl.com/335jrf, pinned down one extremely important reason for a disconnect between price and valuations quite aptly as the journalist posited, "Investors are trading so quickly they may not see the risks in the market for the speed."  The accompanying chart really tells the story, showing that as of mid-2006, the average holding period for stocks was only half of what it was five years ago.  Although the holding period has lengthened a bit in the last year, the trend is clearly to shorter holding periods.  Lahart's article goes on to cite that even in 1999, a time when the day trading mania was rife, the average holding period was a year.  Worse yet, the last time the holding period was as brief as it was a few months ago was in 1929.  Whoops.  Why is this occurring?  There are the obvious reasons such as the proliferation of derivatives, like options, the phenomenal growth in Exchange Traded Funds and hedge funds, but all of the reasons point to only one consequence.  Investment has been dis-incentived in favor of trading.  In an environment where performance is now measured on a monthly basis for hedge funds down to a daily basis for programs, the fundamental analysis of individual corporate prospects has become far too time consuming and far too expensive.  Thus, companies are now less likely to be priced on their individual prospects and are more likely to be priced upon their relationship to one another, to an index, or to a sector.

The end result is that to a large degree, individual issues suffer gross pricing inefficiencies.  The process spreads to entire sectors, entire indexes and finally, the entire stock market suffers pricing inefficiency.  We can only reiterate that the present market fails and scores a D or worse on every valuation measure history has proved valid in the past.  Explaining the lack of volatility, Lahart correctly deduces, "It may be that the combined effect of all the sophisticated trading strategies in place today have put the stock market into a state of dynamic tension, where all the tugging and pulling effectively cancels each other out, muffling price movements."  Lahart finally concludes, "stop loss" strategies may have eventually have an outsized influence with the potential to "overwhelm the market."  We cannot argue with that logic.  Since there is apparently no long term horizon for investors anymore, why would anyone hold when the trend finally, as it eventually must, turns down?

When we turn the perspective to Exchange Traded Funds, holding periods become almost laughable for their lack of duration.  The five ETFs pictured below were the five most heavily traded domestic ETFs last year.  The Dow Diamonds were the tamest but still managed to turn over more than 26 times during the year, an average holding period of 9.6 days.  The vaunted Spyders were turned over 40.8 times, or every 6.2 days.  And the phenomenally popular QQQQs turned over 54.2 times, or every 4.6 days.  An average holding period of less than one week!

We’ll say it again, since it bears repeating: investment has been dis-incentived in favor of trading.  Under the circumstances that prevail in the U.S. market today, there is every reason to believe that value is no longer a consideration in how a stock is priced.  At last report, there are at least 8000 hedge funds trading more than $1.5 trillion in stocks, while 4800 mutual funds manage $6 trillion.  Competition and performance amongst hedge funds is far more intensive than for mutual funds.  The financial industry fought very diligently for years to convince investors that the long term would bury all mistakes, that the buy-and-hold philosophy was the road to riches.  However, all that has now changed.  Despite the advice of Wall Street to buy-and-hold, any rationale for confidence in the long term has completely evaporated as turnover has risen. 

Record new highs in the Russell indexes, record new highs in the New York Exchange Composite, record new highs in the Dow Industrials.  Stunning.  Truly, a record setting market.  But you cannot get from there to here in a vacuum.  Other records have been set and must be duly noted. 

On April 26th, the Investment Company Institute (ICI) released statistics for equity mutual funds and Exchange Traded Funds (ETFs) for the month of March.  More eye openers.  The cash-to-assets ratio of mutual funds dropped to an all-time record low of 3.7%.  Assets in ETFs and the total of ETFs both rose to new record highs.  In this issue, we intend to examine what these new records portend.  While the impact over the short term may be beneficial for prices, we maintain the longer term impact is likely to be disastrous.

Many months ago, we forecast a high probability that the relative cash levels of mutual funds would continue to fall as portfolio managers attempted to compete with the rapid growth of ETFs.  By definition, ETFs are virtually all stock and zero cash.  In an environment of rising prices, such as the current cycle measured from the lows of October 2002, any entity with a significant sum of low yielding cash reserves will tend to appreciate at a slower rate than stock prices in general.  Thus, the temptation for most fund managers to spend down cash reserves has been impossible to ignore.  It is, in fact, a matter of survival.  Funds that cannot keep pace lose investors and just as importantly for the fund managers, the fund managers lose their jobs.  Worse yet, since relative performance determines success, portfolio managers are inclined to take more risks than in the past.  Simply matching the gains in one of the major indexes will not do.  If out performance requires a selection of riskier stocks or strategies, so be it.

The cash-to-assets ratio has actually been skiing down a steep hill since the beginning of the January 1991 bull market, roughly the same time that index funds really began to make their presence felt.  Like ETFs, index funds are all stock and zero cash.  Relative cash levels have continued to decline as active managers hold less cash in order to compete with index funds and ETFs.  However, as our featured chart clearly illustrates, extreme levels appear as clarion calls of impending and major market turns.  The most significant reason your Editor turned bullish in the early days of January 1991 (see Reuters interview, http://www.cross-currents.net/marketcalls.htm) was "substantial amounts of cash."  We mentioned the opposite extreme in our February 28, 2000 issue (see page 3, http://www.cross-currents.net/cc022800.pdf,  warning: poor quality .pdf file), the same issue we predicted a Nasdaq crash by mid-April.  Months ago, we cautioned that even though relative cash levels had achieved extremes, they were likely to fall still further before the bull market concluded.  Data for the month of April will not be released for another two weeks and it is entirely conceivable that the pictured extremes will be even more pronounced.  We know that the S&P 500 surged higher by 6% in April.  It appears likely that cash was spent at the same rate as in March, possibly more rapidly.  If so, the cash-to-assets ratio will have fallen to perhaps as low as 3.5%, by far the lowest in history.

This was the level we first forecasted might end the bull’s run.  Despite the momentum of recent weeks that promises to deliver still higher prices, the most obvious take away is that the lower the relative level of cash, the less firepower is available.  That said, the potential for a reversal is still impeded by absolute cash levels of close to $226 billion, the twelfth highest on record, thus our bear leanings are tempered somewhat. 

Moreover, we must add the continuing push into ETFs as a substantial factor aiding net demand.  As we see below, growth in ETF assets and the number of ETFs has not diminished; quite the opposite.  If anything, the pace has quickened dramatically and threatens to go parabolic.  In the first three months of the year, the number of ETFs soared from 357 to 454, an increase of 27%!  The seven-year growth rate of 45.4% is possibly the most amazing phenomenon this writer has ever seen in four decades of observing the markets.  Given the tax advantages of owning ETFs over mutual funds, given the lower overall management fee structure and ease of trading, it appears this impetus still has legs.

The competition is forcing funds into a corner.  In our view, one of the most important stories of the year surfaced on February 21st in the WSJ, with Eleanor Laise explaining how "Mutual Funds Adopt Hedge-Fund Tactics."  The article's subtitle tells you all you need to know, "To Bolster Returns, Firms Seek Approval to Pursue Short Selling And Other Higher-Risk Strategies."  Just what Americans' pension money needs, exposure to additional risk.  The article is a must read (see http://tinyurl.com/kxyud).  Stock mutual funds now comprise over $6 trillion in assets, roughly one-third of total market capitalization.  Despite the fact that hedge funds have outperformed traditional mutual funds over the last five years, transactions using borrowed money, short selling and the use of derivative instruments are inherently riskier and cannot possibly be suitable for the majority of investors, who do not have the experience nor sophistication required to comprehend these sea changes, particularly since they are relying on professional expertise.  As we have seen all too often in the last decade, professionals are capable of making errors in judgment on the grandest of scales and in our view, errors will proliferate at a higher rate and could conceivably lead to a cataclysmic outcome as the competition for assets forces the adoption of riskier strategies. 

More and more, we are convinced the U.S. stock market has metamorphosed into a monstrous beast, incapable of valuing corporate common stock fairly and unable to act prudently in the interests of investors.  Our best guess is that $40 billion in net inflows for April and May have been coupled with a very modest spend down of available cash, resulting in a current cash-to-assets ratio of 3.4%, a full half percentage point lower than in January 1973, the beginning of the second worst bear market in history.

Anyone studying our next chart of the Dow's progress dating back to 1897 would be hard pressed to find any problem with the notion that stocks are bound to return in the approximate neighborhood of 5% per annum, ex-dividends.  One would require blinders to miss the fact that our line remained below the 5% level for more than 65 years, from October 1930 to January 1996.  Equally obvious, the 5% average appears due solely to the enormous gains of the Roaring Twenties and the current mania, only two brief periods in the 110 year history of our chart.  Thus, we posit that a fair level for today's Dow is 9093, the 5% regression line dating from 1897 and 32.3% lower than today.  The good news is that the regression line rises over time, in this case, roughly 8.5 points per week, so that our posited "fair" value rises over time as well.  As of today, the Dow Industrials remain far, far above the regression line but one glance at the chart should be sufficient to convince even the most bullish observer that another trip to the regression line should be possible, even probable, at some point. 

Can't happen?  The historical average annual gain, which is now actually above 5%, has been buttressed by the outsized returns of the mania, now going on a dozen years at 11.74%.  Consider the following; from 1907 to 1995, when we believe the mania for stocks first began to take shape, Annualized returns for the Dow were a mere 4.37%. It can happen.

Since our best target for the eventual and secondary secular bear market low target for the secular bear market is the 5% regression line, it is clear that our target is actually rising modestly week after week.  That level, as seen above, is now Dow 9093, which approximates to SPX 1021 & Nasdaq 1743.  It is conceivable that as much as another decade might elapse before a new secular bull market is capable of taking all of the major averages above the peaks achieved in 2000.  While the Dow recently traded at a record new high, the SPX failed to achieve a new high and Nasdaq remains trapped at little more than half its all time high. 

Our prior 2007 high targets have been exceeded but with our consideration that risk is extreme and the present unfavorable seasonal effects, we can only posit modest upside progress - if any - from here, before the expected correction unfolds into the autumn. 

I hope you have enjoyed your visit and please return again.  If you know anyone who might be interested in seeing what we have to offer, we'd be happy to have them visit as well!

Alan M. Newman, June 11, 2007

All information on this website is prepared from data obtained from sources believed reliable, but not guaranteed by us, and is not considered to be all inclusive.  Any stocks, sectors or indexes mentioned on this page are not to be construed as buy, sell, hold or short recommendations.  This report is for informational and entertainment purposes only.  Persons affiliated with Crosscurrents Publications, LLC may be long or short the securities or related options or other derivative securities mentioned in this report.  Our perspectives are subject to change without notice.  We assume no responsibility or liability for the information contained in this report.  No investment or trading advice whatsoever is implied by our commentary, coverage or charts.