Equity Bulls in Denial

Adam Hamilton    May 11, 2001    4201 Words


As equity fundamentals continue to deteriorate, bubble psychology is still alive and well in the United States of America.  Amazingly, one could gather that the devastating NASDAQ debacle of 2000 never occurred by listening to the professionals’ passionate “words of wisdom” on bubblevision.  As we monitor the mainstream financial media to determine what “conventional wisdom” on Wall Street is at the moment, or at least what the financial industry wants the naive investing public to think, we continue to hear the same bullish propaganda utilized in early 2000 before the NASDAQ crash.


“Buy technology.”  “The tech recovery is here.”  “Buy and hold.”  “Investors should be in for the long haul.”  “The economy is improving.”  “The Fed will not let the markets go down.”  “Earnings will grow at double digit rates for the foreseeable future.”  Yada yada yada.  Listening to assertions such as these while at the same time carefully noting the increasingly ugly economic and equity fundamental data as it emerges, we are getting a growing feeling of cognitive dissonance similar to 2000 before and after the NASDAQ crash.


Even more surprising, however, is the intriguing fact that many equity bears, students of history, finance, and markets, are jumping on the bullish party wagon with great enthusiasm.  The bulls have an excuse to be bullish, as they are permanent optimists who do not let meddlesome realities like cashflow and valuation get in their way.  The yellow-bellied bears turned newly bullish, however, some of them prominent “contrarians”, are without excuse.   Many bears who were railing about NASDAQ valuations last spring and summer have now stated unequivocally that the bottom is in.  They acknowledge that valuations are more extreme now in some cases than last year due to plummeting earnings, yet these bears believe that the new economy has suddenly become a reality and can support these valuations.  It is disconcerting watching some equity bears execute a turn-one-eight and join the bulls in their unbridled enthusiasm for an overwhelmingly lousy US equity market.


As if the turncoat bears’ stance on the financial markets wasn’t strange enough given their past writings and interviews, some bears have even began to believe in the apparent divinity ascribed to Greenspan by the bulls.  We have seen more and more information emerge from the bearish camp that the US economy will not enter a recession, that Greenspan has worked his magic, and that the markets will rise through 2001.  These assertions may prove correct, but we really doubt it.  In light of all available historic and fundamental analysis, the odds of Greenspan being able to stop this bubble bust before it runs its course are stunningly low.


The last time we brazenly scolded our weak-spined bearish brethren for buying into the incessant cacophony of baseless bullish hype was late January 2001 in our “Bubbling Interest Rates” essay.  Please recall that in late January the NASDAQ was above 2800 and the general sentiment in the market was resoundingly bullish after Greenspan’s first emergency rate cut.  Even longtime contrarians and bears were getting all hot and bothered about the bullishness of the rate cuts, and it felt pretty lonely to be steadfastly bearish for fundamental reasons.  Here is a paragraph ripped from the end of that essay…


“We cordially invite our formerly contrarian and bearish friends back into the fold of reason and fundamentals. The equity perma-bulls are nuts, as their behavior in late 1999 and 2000 exemplified, and we understand why they are excited about a bear market rally. Yet we fail to understand why contrarians and bears, regardless of the technicals, are ignoring history and true valuation fundamentals and jumping on the popular NASDAQ bull party wagon.”


Today the equity sentiment landscape looks very similar to the exciting days of late January.  The equity bulls are falling all over themselves to aggressively and emphatically declare a hard NASDAQ bottom has been laid-in and all is well in the US equity world.  This is no big surprise.  It is disturbing, however, that many of our good professional bearish friends, who have studied market history and psychology in depth, are also calling a bear market bottom in the NASDAQ at the April 4 lows of 1637.  What are they thinking??  To these dear fallen bears we dedicate this essay, a discussion on why we believe the NASDAQ and US markets in general are nowhere near a bottom yet.


The crux of the endless debate on the future direction of the NASDAQ revolves around a simple question.  Do bubbles have consequences or not?  If bubbles DO have consequences, then we should expect similar performance after the NASDAQ bubble burst as with previous historical bubble bursts from the Tulip Mania in Holland in the 1630s to the Japanese real estate/equity mega-bubble of the late 1980s.  If bubbles do NOT have consequences, then we are confronted with the extremely far-fetched possibility that we have transcended cold, hard, historical market and economic realities.  To use a physics analogy to illustrate this, asserting that bubbles do not have consequences is comparable to claiming the universal and well-tested law of gravity is suddenly being revoked.  Such a wild assertion on the NASDAQ bubble demands overwhelming evidence from the “new-era” equity bulls today, which they have been unable to provide.


Unlike the newly minted “bullish-bears”, we retain our fundamental view that bubbles DO have consequences, and that the NASDAQ was quite possibly the most spectacular mainstream speculative bubble of the last six millennia.  We have not altered our bearish stance on the NASDAQ one iota since early 2000.  In late August 2000, when the NASDAQ was hovering around 4200, we published an essay called “To Crash or Not to Crash”.  We bucked the overwhelming bullish psychology trend of the time and stated that we believed there was an 80% probability of an extended bear market in the NASDAQ.  I remember being laughed at and ridiculed when that essay was published.  “How can you be pessimistic?”, people scoffed.  “You bears just do not understand the new economy.”  Really?


In “To Crash or Not to Crash”, we built some early graphs comparing the NASDAQ 2000 bubble to the infamous DJIA 1929 bubble.  Incredibly, the correlation in August was VERY high between the two widely separated market events.  The following graph is updated from that original essay, where it is described in more detail.  The Y-axes of this graph are both zeroed, so the NASDAQ and DJIA can be compared in absolute terms.  The only notable “twist” in the graph is the NASDAQ time series is effectively doubled horizontally.  Because of the amazing pace of global information flows today compared to 1929, we decided to try and model the impact of instant information dissemination by graphing one NASDAQ trading day next to two DJIA trading days.  The DJIA scale on the X-axis is twice as long as the NASDAQ X-axis, but otherwise the graph is as straightforward and as simple as it appears.  In this latest iteration, we threw in a graphic of a boy blowing a bubble to help our dazed and confused bullish-bear friends make the bubble connection between NASDAQ 2000 and DJIA 1929.



The break of the NASDAQ 2000 bubble thus far is amazingly similar to the 1929 calamity on Wall Street.  This may appear startling at first, but actually makes much sense when one realizes the primary factor which causes booms, bursts, and busts never changes.  It is the human heart, pure human emotion, that drives market macro over-valuation (bubble) and under-valuation (bust) cycles.  Humans lapse into unadulterated greed every few generations or so, and a monstrous speculative bubble is bred.  At the top, almost always for unknown reasons, the great herd of investors suddenly experience great fear and stampede out of equities en masse and the bubble bursts with an initial sharp panic decline.  After that, it is a long, slow, grinding bear market punctuated by exciting bear market rallies until the ultimate bear market bottom FAR below the lofty bubble top.


Remember playing with soap bubbles when you were young?  Did you ever try to put a bubble back together after it burst?  Of course not, as it is impossible!  Once a bubble bursts, that is all she wrote.  That specific bubble cannot be resurrected.  Any new bubbles have to grow elsewhere.  The word “bubble” is an incredibly good financial analogy of the boom and bust process in equity markets not only in the growing boom phase but also after the burst phase into the bust.  Once a bubble bursts, just like Humpty Dumpty in the classic nursery rhyme, all the king’s horses and all the king’s men cannot put the bubble back together again.


Now that we have established there is an undeniable and overwhelming correlation between the NASDAQ 2000 bubble and bust and the DJIA 1929 bubble and bust, we would like to fast forward to some other research we did last year.  In our “Volatility Squared” essay published in November 2000, we presented our original research that indicated that bubble bursts and the ultimate bear market bottom are both marked with “volatility tops”.  For a full explanation, please see that earlier essay, but in a nutshell a “volatility top” is a climax in intraday volatility within an equity index.  We used a 100 day moving average to smooth out the very wild raw intraday volatility data into something more presentable.  The thesis in our “Volatility Squared” essay was that historical bubbles and busts were always marked by TWO distinct volatility tops.  The first volatility top spikes up after the initial crash event and the second volatility top emerges after the ultimate bear market bottom.  The following graph is updated from “Volatility Squared”.



In the infamous 1929 DJIA bubble and bust, there are two distinct tops in the 100 day moving average of intraday volatility of the index, marked with dashed yellow circles in the graph.  The first is after the crash event and the second after the ultimate bear market bottom.  The general trends of the DJIA (blue) and the 100 day moving average intraday volatility of the DJIA (red) are noted with the light dotted trendline arrows in the respective colors.  As a bubble bust unfolds, an index plummets over time while volatility builds to a tremendous climax.


The key points to glean in this graph revolve around the yellow numbers.  After the initial volatility top, each successive “mini-top” in volatility is marked by a yellow number. 


Imagine living through the early 1930s and hearing the perpetual optimism spewing out of Wall Street.  You would have NEVER been told to sell, only that things were looking up and the stock market was doing great.  Look at each major bear market rally (in blue) and pretend you can’t see everything to the right of it on the graph.  Imagine you are living through those markets at each volatility top, and realize that Wall Street would tell you that the bottom was definitely in each time a bear market rally roared forth. 


Note that virtually every sharp sell-off of the DJIA was marked with an interim volatility top.  As markets move asymmetrically, volatility is typically much more pronounced on the downside.  Stated another way, fear is a much, much stronger emotion than greed.  Markets fall much faster than they rise.  When fear takes hold, markets plummet like a massive steel anchor cast over the side of a modern supertanker.  After each sharp bear market rally, which ALL looked promising at the time, there was a major sell-off to new lows and the volatility tops continued to climb with each successive sell-off.


It was not until the fourth and highest volatility top that a true final bottom in the DJIA had been reached.  The initial volatility top and the final “number 4” volatility top after the bottom together marked the signature “double volatility top” of major bear markets following a bubble burst.


Finally in this graph, please note the big yellow arrow.  This arrow marks the spot from the first graph of this essay where the NASDAQ is right now in our NASDAQ 2000/DJIA 1929 comparison.  If the 2000 NASDAQ bust continues to mirror the classic 1929 DJIA bust, we have a LOT more downside to go until an ultimate bottom is reached.


The next graph is also an update from “Volatility Squared”, and shows the same 100 day moving average intraday volatility for the ever-evolving NASDAQ 2000 debacle.



As we would expect from our historical research of booms and busts, the NASDAQ had an initial volatility top following the crash event.  The first volatility top is marked with the dashed yellow circle.  In a provocative sidenote, just as Wall Street still refuses to acknowledge today that March 2000 witnessed a NASDAQ crash (it is just a big “correction”, they claim), the professional Wall Street crowd in the early 1930s also refused to acknowledge the DJIA had crashed in 1929.  After the initial frantic headlines of the crash in 1929, the professional financial establishment continued to assert all was well, October 1929 was only a correction, and a major recovery was right around the corner.  Deja vu all over again.


After the initial crash event, the NASDAQ tried valiantly to rally but soon plummeted as its fundamentals were atrocious.  A spectacular bear market rally punctuated the slide in January 2001, which is easy to see on the graph, in response to Alan Greenspan’s desperate inter-meeting attempt to manipulate the US equity markets like a Russian commissar regulating the supply of cheese in the Soviet Union.  Greenspan was able to generate a phenomenal bear market rally, and even long-time bears were bullish by the end of January.  Nevertheless, the January rally soon collapsed and the NASDAQ plummeted to new lows as there was no fundamental foundation for the Greenspan rally.


The next interim bottom slammed into was the April 4 NASDAQ low of 1637.  Note that the 100 day moving average of intraday volatility had a top (marked by “1”) BEFORE the April 4 low was hit.  In all our historical research, the second volatility top occurred AFTER the market bottomed, not before.  This is partially because the 100 day moving average of intraday volatility tends to lag the underlying index as it is calculated on the previous 100 trading days’ data.  Since this initial NASDAQ interim volatility top happened before the April 4 lows, we strongly believe that there has been NO classic volatility signature that indicates the NASDAQ bottom has been reached.  The best of the NASDAQ (if you are short like us) or the worst (if you still believe the “new era” hype) is likely yet to come!


In yet another intriguing sidenote, note the level of the FIRST volatility top of this NASDAQ graph (the dashed yellow circle).  It peaked at roughly 4%.  Now scroll back up to the DJIA 1929 graph.  The initial volatility top in the DJIA was also around 4%.  The SECOND volatility top in the DJIA 1929 debacle was over 5%, however.  We believe that the final NASDAQ second volatility top marking the true bottom will also be well over 5%, adding to the evidence that April 4 was NOT the final NASDAQ bottom that so many bulls and bears are heralding it to be.


We fully expect the NASDAQ to turn south after this current wild bear market rally collapses, and higher intraday volatility tops to be made as the market dives further.  The fact that the classic double volatility top signature of a collapsing bubble has not yet been observed indicates that there is an extremely high probability that we are nowhere near the perpetually sought after yet highly elusive NASDAQ bottom.


One final note on this last graph.  There is a yellow dashed line from the April 4 NASDAQ low extending to 1998 NASDAQ lows during the Long Term Capital Management/Russian debt crisis fiasco.  In our recent essay on Greenspan’s SECOND panicked emergency inter-meeting rate cut (ironically right after Greenspan testified to the US Congress that inter-meeting rate movements were bad as they implied to the markets that there was panic at the Fed), “Emergency Rate Cut Numero Dos”, we pointed out that major secular bear markets after bubble bursts typically wipe out 10-15 years of equity gains.  As the yellow line in this graph shows, the April 4 NASDAQ low was far above even the October 1998 low.  The odds of this brutal NASDAQ bear market only wiping out a mere 18 months of gains (from October 1998 to March 2000) and then going back into hibernation are so trivial as to be laughable.  A true bear market is not so merciful as to only maul 18 months of gains.  For a startling comparison, the NASDAQ low in 1990 was 325.  If history proves to be a valid guide yet again, that level is much closer to where the true NASDAQ bottom will be than the lofty 1650 range in which the perma-bulls and the bullish-bears have foolishly placed their faith.


And there is far more evidence that the NASDAQ bottom is nowhere to be seen and the ever-wily bear is simply waiting in the woods like a wraith, a bloodlust in his cold, terrifying eyes, as he patiently watches more bulls get lulled into complacency.  The bear will strike when bullish sentiment reaches a crescendo, and the bulls will be mutilated by the sharp bear claws and the wailing and gnashing of teeth will be great on the next major leg down.


From a pure fundamentals standpoint, valuation levels in the US equity markets are absolutely atrocious.  On April 30 the market darlings of the NASDAQ 100 had a market-capitalization weighted average price earnings ratio of 55.8!  That is stupendously high and we struggle to find the necessary superlatives to adequately describe it.  Everything else being equal (no growth assumptions), this number indicates that if someone bought the NASDAQ 100, the best and biggest stocks of the NASDAQ, they would have to wait over 50 YEARS for those companies to earn back the money that they paid for the stocks on April 30!  After five and a half DECADES they would finally start to earn a return on invested capital.  Now THAT is long-term investing! 


The broader and blue-chip markets are not much better, with the S&P 500 sporting a market-cap WA P/E of 32.2 and the DJIA of 29.2 as of April 30.  The inherent lunacy in these US equity market valuations today is astounding!


Of course, the NASDAQ perma-bulls and now the yellow-bellied bullish-bears believe that the tech darlings’ growth rates compensate for these stellar valuations.  What happens, however, if earnings growth rates go negative?


Cisco Systems, the king bubble in 2000 and still at grossly bloated bubblicious levels today, is a perfect example of the rock hard reality that is going to smash these bullish fantasies.  When valued near $80 per share last March with a P/E around 150, bubblevision analysts literally fell over themselves in their zeal and enthusiasm for the future of this maker of commodity internet switches.  ALL the way down, all through 2000, the bullish analysts continued to recommend CSCO as a strong buy, effectively destroying nearly $400b of capital of American investors who TRUSTED the perpetually bullish market analysts, bubblevision, and the Wall Street establishment to protect and enhance their capital.  The dereliction of fiduciary duties in this case is very sad and potentially even criminal. 


We are aware of at least one high-profile class-action lawsuit recently filed against Cisco Systems alleging all variety of financial improprieties in managing earnings.  Knowing our litigious society, more lawsuits are bound to fly sooner or later, both at bubble stocks and those who shamelessly promoted them.


CSCO recently announced earnings, and they were appalling, actually shrinking dramatically.  Bubblevision, in a revealing display of questionable judgment, proudly displayed CSCO’s $0.03 per share “earnings” as “beating lowered expectations” of $0.02.  The paltry three pennies represented operating income, but CSCO actually LOST $0.37 per share on $2.7b in inventory writeoffs during the quarter.  Speaking of inventory writeoffs, didn’t we hear all last year that we are now in a “new era” and computers allow companies to better manage inventory and eliminate inventory mismanagement?  Hmmmm.  If CSCO’s $0.37 per share loss was actually used by Wall Street instead of the fanciful “pro forma” earnings numbers in vogue right now, CSCO has eked out dismal total profits of a whopping 15 pennies per share in the last four quarters.  At a current stock price around $19, that puts CSCO at a staggering trailing P/E of 127, for a company with SHRINKING EARNINGS!  Mega-ouch.


To be more conservative, imagine CSCO will make 3 pennies per share in each of the next four quarters as well, remaining stable in this miserable economic environment.  If the future earnings for the next year weigh in at 12 cents per share, CSCO is currently trading at a forward P/E of 158, on par with its 2000 bubble valuation!  Not surprisingly, many of the rocket scientists on Wall Street, or should we say public relations propaganda specialists, have recently upgraded CSCO alleging that the worst is behind this mega-bubble company.  We will see.


In another unreal example of the bubble psychology pervading this bear market rally, another NASDAQ darling Sun Microsystems (SUNW) recently announced it was shutting down company-wide operations for a whole week in early July.  ALL of Sun’s 38,000 employees will be forced to take vacation time or unpaid leave.  I remember my jaw dropping when I heard this announcement on April 25.  As every business owner and capitalist knows, it is BAD news when business is so horrible that a company simply closes its doors to cut costs.  It also begs the question why does Sun need 38,000 employees if it can send all of them home at once for a week with no consequences to its business!  The day of this stunning announcement, Sun was trading around $16.  In early May, it was back above $19.50 with a P/E around 38. 


With all the stocks in the universe, why bid up struggling tech darlings like Sun and Cisco that are experiencing terrible contractions in their businesses and plummeting earnings?  Is a company temporarily closing its doors because there is not enough business “good news” in this crazy financial environment?


In one final note, many disciples of the “new economy”, including Alan Greenspan if Bob Woodward (author of “Maestro”) is to be believed, have stated over and over again that information technology has led to a new era of ever-increasing productivity gains.  They believe that the “productivity miracle” supports equity valuations today that would have been considered the height of insanity during the 1980s. 


Unfortunately for the new-era acolytes, the latest productivity numbers were just released, and Q1 2001 weighed in at a stunning DECLINE of 0.1%!  The last four quarters showed productivity gains of 6.3%, 3.0%, 2.0%, and –0.1%, respectively.  A child could analyze this trend, yet the latest numbers have been ignored.  Coupled with this rapid fall in productivity growth, unit labor costs are continuing to accelerate at ever-increasing rates, up 5.2% last quarter.  This disturbing information is so utterly devastating to the intricate mythology of the new-era bulls that bubblevision and most of the mainstream financial press and analyst community have simply chosen to ignore it rather than reporting on it, praying the bad news will go away. 


The bubble psychology is alive and well in the US equity markets, there is no doubt.


We believe, for many fundamental and technical reasons, that the bear market in the US is just beginning, NOT ending as most bulls and bullish-bears assert today.  This current NASDAQ, DJIA, and S&P action looks and smells like a bear market rally, as there is no fundamental foundation for the spectacular gains since early April.  With the US economy deteriorating, earnings plummeting, and Greenspan promiscuously growing money supplies at virtually unprecedented rates to desperately attempt to reinflate the bubble, we believe that the US markets are in dire straits.  Just as in all past bubble busts and similar bear market environments, this current bear market rally will most probably turn over and die soon, taking all the major US indices to new lows on the year.


We also believe, just as we did in late January, that the yellow-bellied bullish-bears who are buying into the bullish sales-pitch are going to feel pretty silly a few months from now.  The maniacal actions of the bulls are understandable in a bear market rally, but to see some learned bears beginning to spew the new era myths along with the bulls is difficult to comprehend.  Either fundamentals, bubble/bust psychology, and financial history matter, or they don’t.  We happily cast our vote with fundamentals and rock-solid financial realities, not the same pie-in-the-sky mumblings from the same bullish camp which failed to warn its clients of the NASDAQ bubble and bust in the first place.


As in past secular bear markets, the equity bulls are in denial.  They will probably remain in their fantasy dreamworld until the ultimate bottom.  The overwhelming weight of evidence and probability suggests this current US bear market is just beginning.  History and fundamentals will not be mocked.


Adam Hamilton, CPA     May 11, 2001     Subscribe