Shattered Expectations

Adam Hamilton    October 13, 2000    4009 Words

 

“Pray for the peace of Jerusalem.  They shall prosper that love thee.”  -  the ancient Israeli King David, in the Tenakh, ca 1000 BC

 

Few would dispute that the Temple Mount in Jerusalem is one of the most important 45 acres on the planet earth.  From a secular perspective, there is no reason Jerusalem and its contested Temple Mount should be so valuable to so many people around the world.  Jerusalem is not on a major trade route, it has no harbor, and is not a great center of commerce or wealth.  Yet, all the nations of the world look at Jerusalem and shudder, as final status negotiations between the Palestinian Authority and Israel failed over the incredibly contentious issue of Jerusalem.  All over the western world, people felt let down as violence erupted throughout Israel in an escalating maelstrom, with Palestinian militias engaging Israeli soldiers throughout the small nation.  The expectations of peace, which welled so great in so many people around the world, were shattered as Israeli soldiers were lynched by a Palestinian mob and Israeli Cobra gunships fired rocket salvoes into PA controlled areas of Israel in retaliation.

 

Unfortunately, the western media and politicians largely ignored the ancient roots of the conflict.  Jerusalem is held sacred by tens of millions of Jews and hundreds of millions of Muslims around the world.  The high expectations of peace were highly dependent on a millennium long conflict being forgotten by both sides.

 

To the Jews, the Temple Mount in Jerusalem is the most important piece of real estate on earth.  Some Jewish mystics believe the God of Abraham, Isaac, and Jacob stood on the huge foundation stone of the Temple Mount when he created the world.  The great Jewish patriarch Abraham almost sacrificed his beloved son on Mount Moriah, a vastly important event in the history of Judaism.  Mount Moriah, of course, is the very spot known as the Temple Mount today, in the heart of Jerusalem.  Two great Jewish temples of antiquity were built on this site, and all Jewish males were required to come to the Temple Mount three times each year, for the great feasts of Passover, Weeks, and Tabernacles.  The first temple was built by King Solomon around 950 BC, and was destroyed by the Babylonians when Nebuchadnezzar sacked Jerusalem in 586 BC.  Rebuilding of a second temple on the Temple Mount in Jerusalem began in 520 BC by Zerubbabel.  The second temple was expanded substantially in 38 BC by Herod, the Roman appointee governor of Israel.  The second temple stood until 70 AD, when the 5th, 10th, 12th, and 15th Roman legions led by Titus Vespasian invaded and razed Jerusalem to put down a Jewish revolt against Roman imperial authority.  Jerusalem is mentioned by name 667 times in the Jewish holy scriptures, the Tenakh, and alluded to innumerable other times by other names, including the City of David.  Without Jerusalem and the Temple Mount, the beating heart of Judaism is ripped out of its chest.

 

Following the Roman destruction of Jerusalem, the Temple Mount lay fallow for 70 years.  In 141 AD, the Romans led by Antoninius Pius built a Roman temple on the site known as Aelia Capitolina, in direct response to another Jewish revolt to regain the Temple Mount led by Bar Kochba.  In 312 AD, the Roman Emperor Constantine had his famous vision of the cross in the sky, ostensibly converted to Christianity, and officially established Christianity as the state religion of Rome.  The Roman temples, including Aelia Capitolina, were converted into Christian churches.

 

In 570 AD, a man was born who would forever change the course of history and have a vast impact on the world.  The Prophet Mohammed was from a powerful trading family from the city of Mecca, in what is now western Saudi Arabia.  As he was nearing the latter days of his incredibly interesting life, Mohammed wrote the Koran, the holy book of Islam.  The word “Islam” means submission to the will of Allah, and Mohammed laid down the foundation for the faith.  Mohammed’s teachings would form the nucleus of the fastest growing religion ever seen on earth.  Although the Koran does not mention Jerusalem by name, in the seventeenth sura the famous night journey (al-Mi’raj) of Mohammed is referenced.  The Prophet was awoken from his sleep by the great Archangel Gabriel.  The Angel had brought a mighty horse for Mohammed to ride, Burak.  Gabriel led Mohammed and Burak through the night air to Mount Sinai, where Moses had received the Law, to Bethlehem, where Jesus Christ had been born, and then to the “remote mosque”, which the majority of Muslim scholars believe is a reference to the foundation stone of the Temple Mount in Jerusalem.  From the remote mosque, Mohammed ascended into heaven, met many of the Biblical patriarchs, and was shown the glory of heaven by the Archangel Gabriel.  As the modern Islamic world firmly believes the Temple Mount is the launching point of the ascension of Mohammed, Jerusalem is the third most important holy site in the Islamic faith, right behind Mecca and Medina.

 

In 637, soon after Mohammed’s death in 632, Muslims captured Jerusalem.  The Dome of the Rock was built to commemorate Mohammed’s ascension.  The Dome is the architecturally beautiful building with the golden cupola so prominent in all the pictures of Jerusalem we see today.  The mosque is of vast importance to hundreds of millions of Muslims around the globe.  In 715 a companion mosque was built immediately south of the Dome of the Rock on the Temple Mount, the Al Aqsa mosque.  In 1099, the European crusaders captured Jerusalem.  In 1187, one of the greatest warriors who ever lived, the great Saladin, routed the crusaders and Islam once again gained hegemony over Jerusalem and the Temple Mount.  In 1517, the Turks captured the Holy City which then became part of the Ottoman Empire.  Following the defeat of the Ottoman Empire in WW1, British general Allenby captured Jerusalem in 1917.  In 1922 the League of Nations ratified the British Mandate on Palestine, allocating land East of the Jordan River to the Palestinian Arabs, in a state to be called Transjordan (simply Jordan today).  Land west of the Jordan River was given to the Jews.  In 1947, the United Nations proposed partitioning Israel in Resolution 181, with the West Bank, Gaza Strip, and most of northern Israel going to the Arabs, and the rest to the Jews.  The Jews agreed to the partition, but the Arabs declared it unacceptable.  In May 1948, Israel declared its nationhood and Egypt, Syria, Lebanon, Jordan, and Iraq immediately declared war on Israel.  Jordan captured the eastern half of Jerusalem in the war, including the Temple Mount, but Israel survived the hostile onslaught.  In June 1967, Egypt, Syria, Iraq, and Jordan again invaded Israel, and were once again routed.  Israel recaptured Jerusalem and the Temple Mount before the short war ended.  In a conciliatory move, Israel allowed the Waqf, the Muslim High Council, to retain administration of the Temple Mount.  It has been under direct Islamic control in the center of Jewish Jerusalem ever since.

 

This brief and superficial history helps give a sense of perspective to the current conflict over Jerusalem.  Tens of millions of Jews and hundreds of millions of Muslims around the world believe Jerusalem is an uncompromisable component of their faith.  The conflict is primarily a holy war, not a political issue easily negotiated.  High western expectations were shattered when the peace process fell apart in recent weeks, but any peace plan that fails to account for and address the history of the Temple Mount is bound to fail.  The battle for the Temple Mount is an ancient struggle between the two great faiths of Judaism and Islam.  Quick fixes and clever political maneuvering will not solve the contentious issue.  Very few people who understand the history of the Jerusalem believed the current talks between Israel and the Palestinian Authority would result in the resolution of this powder keg.  History is CRUCIAL for the proper perspective on current events…

 

In the current US equity market environment, expectations are also very high.  Unfortunately, like the frantic negotiations to resolve the age old struggle for Jerusalem, these expectations for US markets are not grounded in history.  Even after the recent drubbing of the US equity indices, investor sentiment still remains extremely bullish, and no major capitulation selling has yet been seen.  In reality, the bulls utterly disregard history in order to form their stellar expectations of future performance.  If all of market history will prove not to be obsolete, the US equity markets are STILL vastly overvalued, and the bear is just beginning to stretch his legs after a long hibernation.  In this essay, we will take a brief look at the US equity markets and examine the validity of general bullish investor expectations of the near future direction of the US equity markets.

 

Friday the 13th ended a wild week in the NASDAQ, S&P 500, and the DJIA.  Although a few folks began to get nervous on Thursday the 12th, after a nearly 400 point drop in the DJIA and two tough weeks of negative NASDAQ closes, the modicum of negative sentiment soon vaporized into the ether.  All the US indices were up dramatically the day after terrorists cowardly attacked a US Aegis destroyer, Israel and the PA erupted into renewed violence, oil spiked to $36 per barrel, and even the old yellow dog clawed up $6.  The NASDAQ led the charge of the renewed stampede of the bulls, galloping to within a few basis points of being the highest percentage gain ever in a single trading day, almost 8%.  Watching bubblevision Friday afternoon was like watching a late night infomercial.  Everyone was all smiles, proudly asserting that a bottom in the NASDAQ absolutely HAD been reached, and the bull was back.  It was like listening to used car salesmen.  Once again all was well in US equity land, and everyone could live happily ever after and enjoy their weekend.  Bullish sentiment was rampant, and expectations for the near future of US equity markets were very high.  Do the bulls have anything to cheer about?  Let’s take a slightly broader perspective and look at the US markets for all of year 2000… 

 

 

Do these graphs look like bull markets?  While Friday’s action was certainly a nice little bounce for the bulls, the relative immateriality of it becomes quite obvious when looking at the graphs above.  All three major US indices are off materially from their 2000 openings, with the mighty NASDAQ leading the losers, still off a dismal 20% AFTER Friday’s fireworks.  The NASDAQ, S&P 500, and the DJIA are all trading in relatively narrow and precipitously sloping downward channels, and none of the indices even jumped up to the halfway mark in the short-term trend channels (bounded by straight lines on the graphs above), let alone breached them on the upside.  The NASDAQ looks more and more like a bear market with every additional day added to its chart, and the S&P 500 and DJIA have largely been flat on the year, trading in restricted ranges.  The bubblevision claim of a bottom is particularly goofy, as true market bottoms are marked by extremely negative sentiment, very heavy volume, and massive capitulation selling.  We have seen none of these phenomena yet.  With the benefit of a little broader perspective, the bulls’ claims of a resurgent bull market in US equities is a much tougher sell…

 

Interestingly, one of the areas that bullish Wall Street analysts are most exciting about is earnings releases in the coming few weeks.  The same analysts that were crowing from the rooftops about NASDAQ 6000 in early March are now telling investors that all is clear, the big earnings hits are past, and we are looking at much smoother sailing now that the market has “bottomed”.  They have even had the audacity to claim that earnings are generally very positive, with little to worry about in the realm of a potential slowdown in sales in the third and fourth quarters of the year.  We have been tracking negative earnings surprises carefully, and the results have NOT been encouraging for the perma-bulls.

 

Before we look at the numbers, it is important to understand how CRITICAL expectations are.  In the global consulting arena, for instance, success and failure is measured solely by initial expectations set.  If client expectations for a project are exceeded, the consultants are heroes and ride out on white horses.  If client expectations for a project are not met, the project is a failure and the consultants limp out with their tails between their legs.  Even if the exact same work is performed in either case, success or failure is ultimately measured by the work performed in light of initial client expectations set.  This is also a very useful truism in real life.  Here is an empirical test you can do at home…  Some day, tell your spouse you will be home from work at 8:00 PM for dinner, but arrive home at 6:30.  With expectations set at 8:00, the 6:30 arrival is a big victory, as it exceeds expectations.  On another day, tell your spouse you will be home from work at 5:00, but actually arrive home at 6:30.  In most cases, you will be in BIG trouble.  The actual 6:30 arrival time is constant between both examples, but the original EXPECTATIONS determine whether one is a hero or a goat.  In the equity markets, analysts and companies set expectations for earnings each quarter.  The actual earnings numbers are not that important, but where they land relative to expectations is HUGELY important, especially in a skittish market.  Here are a few examples of SINGLE DAY losses suffered by companies in the first two weeks of Q3 that did NOT meet analyst expectations with Q3 earnings…

 

 

Ominously, we recorded well over 50 negative earnings surprises resulting in greater than 25% losses in market value in a single trading day.  The chart above shows a fairly representative sample.  The losses on average for negative earnings surprises were HUGE, and they did not discriminate against any tier of companies.  Companies with ludicrous valuations, trading at more than 100x earnings were hit hard if they missed expectations, which is an expected outcome.  Companies with zero earnings, even hip market darlings like Marimba and Razorfish, were pummeled hard on missed earnings numbers.  UNEXPECTED, however, was the fact that companies trading at or below fair value were also eviscerated on negative earnings surprises.  Imax, for instance, in the chart above, was trading near a normal 13.5x earnings multiple yet it lost 70% of its value in a single day.  How would you like to wake up, check our portfolio, and see 70% of your investment in a particular stock, one that was not overvalued, had been nuked?  NOT a happy portent of things to come.  This is not a sign of a healthy equity market.  Very large companies were also rocked when they missed their numbers.  Lucent announced a negative earnings surprise for the THIRD time this year, and the stock was given yet another 20%+ haircut in one hour of after hours trading.  It is currently trading at a fraction of its 52-week high.  Home Depot, a prestigious blue-chip Dow 30 component since November 1999, lost 20%+ of its value on a negative earnings surprise.  The list of important companies getting whacked on lowered expectations is long, and includes major names.  Every successive quarter in 2000, we have seen more and more earnings warnings, and more and more severe punishment for these negative earnings surprises.  The number of companies missing expectations is continuing to grow, providing an early warning of broad and systemic problems with the United States economy.  If spending and sales are slowing, the outrageous multiples of many very important companies, like General Electric (46.7x) and Cisco Systems (155.7x), the two biggest companies in the world, are definitely unsustainable.  If the mega-caps, God forbid, announce they are lowering expectations in coming quarters, the resulting carnage in the important US equity indices will become very ugly very fast.  Increasing negative earnings surprises do not bode well for the near future of the US equity markets.  Ignore the incessant bubblevision hype and carefully watch the profits…

 

On an allied front, and even more disturbing than the ever increasing high profile earnings misses, there have been some companies that have met, exceeded, or dramatically exceeded earnings expectations, and even they have been sold off dramatically.  Large drops in price on POSITIVE earnings surprises are seldom seen in healthy bull markets.  In a bull market, people want to buy anything, and they pounce on a company that exceeds expectations with buy orders.  In a bear market, however, folks are looking for ANY excuse to sell, and we have seen a lot of stellar results lead to major selling of the reporting company.  Micron, for instance, beat the street estimates by a wide margin, but was sold off dramatically the following day.  Yahoo, arguably the last of the dot com companies that had not yet cratered in value (now that Priceline has been shot and is bleeding to death and the venerable Amazon has yet to make a single penny) exceeded analyst expectations by a penny, almost 8%.  Ominously, the institutions begin to batter it immediately, and the stock was sold off severely.  Yahoo lost 21% in one day on a POSITIVE earnings surprise, closing at $65, a 52-week low.  The wounded high flyer’s 52 week high was $250.  On the bright side, however, the P/E of Yahoo dropped to a mere 200x, now only slightly more fancifully valued than the king of the NASDAQ, Cisco.  With investors looking for any reason to sell, and selling on excellent news for specific high-profile companies, something fundamental is very wrong in the US equity markets.

 

Another popular refrain that has been heard ALL YEAR reverberating from Wall Street is the following…  “because this is an election year, stocks will go higher.”  “Stocks never go down in an election year.”  We ran the numbers to see if there was any truth in this high Wall Street expectation, using the S&P 500, which tracks the 500 best companies in the United States.  Average election year returns were computed each month for election years 1960, 1964, 1968, 1972, 1976, 1980, 1984, 1988, 1992, and 1996.  The results were averaged together to make a composite S&P expected election year return graph.  The yellow line below represents the average composite S&P 500 return for election years from 1960 to 1996, and the blue line represents 1980 to 1996…

 

 

Interestingly, beginning in May, the S&P 500 historically has a strong upward bias in an election year.  This trend is apparent all the way back to 1960, and the positive bias becomes even stronger from 1980 to 1996.  The 2000 S&P 500 monthly closes (red line) are graphed next to the expected election year returns above.  Historically, the precedent does show election years have better than average annual returns.  With 2000 graphed next to expectations, however, it is very obvious that 2000 is NOT a normal election year.  The 2000 S&P closes are all over the chart, and the October 13th close is a whopping 12% below the expected S&P level from a historical perspective.  The expectation gap is ENORMOUS.  The bulls were right at the beginning of the year in assuming markets typically go higher in election years, but 2000 has NOT been a typical year.  Although the US markets could rally into the election, it is highly unlikely due to the myriad of incredibly negative fundamentals weighing on equities.  These include sales and earnings slowdowns, rampant equity overvaluation, the overvalued dollar that will begin to fall at some point, rising monetary inflation, the mushrooming trade deficit, raging commodity prices, and many other hostile environmental factors for equities.  Even if the markets were able to somehow rally to the election, they would have to make up a virtually insurmountable amount of ground to achieve quasi-normal election year results.  The election year expectations of the bulls have been shattered, and all the king’s horses and all the king’s men won’t be able to put humpty dumpty back together again…

 

Finally, as with the endless conflict over the Temple Mount and Jerusalem, it is much easier to understand the current market situation with the benefit of a historical perspective.  We continue to be amazed at how well the NASDAQ is currently tracking the DJIA of 1929 to 1933.  We have used this graph before, and apologize for gratuitously using it yet again here.  With newly updated data, however, it is definitely worth a gander as it puts the massive 8% leap in the NASDAQ on Friday the 13th into proper perspective.  To approximate the faster flow of information and the faster market moves today, one NASDAQ trading day is graphed next to two historical DJIA trading days…  

 

 

No one would argue, with the benefit of 20/20 hindsight, that the blue DJIA line is a snapshot of a bull market!  Notice the almost terrace like sequence of drops in the Dow after the infamous 1929 crash.  There was typically a steep decline, then an interim “bottom” was reached.  After the interim bottom, a rally would rapidly retrace about a third of the previous decline, and then the rally would collapse and drop to new lows.  Big rallies in bear markets are not uncommon, and bear markets actually sport some of the most violent and quickest rallies ever seen in equity markets.  Since the NASDAQ is still trading at incredibly unsustainable valuations, we believe there is a very high probability that this current rally will soon collapse, and the grinding downward bear trend will continue.  The correlation between the recent NASDAQ and the DJIA 1929 debacle continues to be eerily precise…

 

Like the age old struggle for the Temple Mount and Jerusalem, the US equity markets are much better understood with the crucial foundational perspective of history.  Equity overvaluation results as greedy investors bid stocks to stratospheric levels, and then equity undervaluation follows as scared investors sell and stocks collapse to less than half their true value on a cashflow basis.  This cycle of asset valuation extremes is almost as old as Jerusalem itself, and it has existed in every age and every culture where trading and commerce have flourished.  Every asset boom in history was followed by an asset bust of similar magnitude.  The Wall Street bulls finally are willing to admit that the dot com craze WAS a bubble (this ex post facto admission sure does not help all the folks who lost boatloads of capital in these flaky investments by following this dangerous advice).  They are right.  It was a bubble.  Those same bulls are currently telling the American people that all is well, the correction from the bubble is finished, and it is time to resume the drunken speculative orgy in the US stock markets.  They are wrong.  Just as they lacked the insight and courage to call a spade a spade in March, their myopic view of markets is preventing them from seeing that the bubble has spread to the rest of the equity markets.  History will not be mocked.  The US equity bubble WILL pop.  Actions have consequences that reverberate throughout history, and unprecedented equity overvaluation will be followed by unprecedented equity undervaluation as sure as winter follows summer.

 

The seething crucible of the endless struggle for Jerusalem has shattered the expectations of western diplomats who naively believed they could sit around a table, have a beer, ignore thousands of years of history, and unilaterally create and imperially impose an artificial Pax Americana on the region.  US investors will soon have their expectations of endless prosperity and gains in equity valuations shattered as well.  Sooner or later, they will realize that the brave new investing world they envisioned is much more dark and dangerous than anything they could have ever imagined.

 

Adam Hamilton, CPA     October 13, 2000