Stockscom Report for Sunday, December 3, 2000

A Bad Week, More to Come, But Not Necessarily Right Away

By recent standards it was not all that bad a week for the indexes but the deterioration continues apace. The indexes and many individual stocks are oversold enough for some kind of rally to start. Should that happen, it could go farther than you might expect as shortcovering brings in more shortcovering. Nevertheless, the major trend is DOWN and likely to continue.

There have been fairly decisive breaks in stocks like Intel and Dell and no bottom is in sight for them. Most important, however, is that so many formerly strong stocks have started to roll over or look likely to do so. Among these are General Electric, American Express and Citigroup. Even stocks like Merck, Coca-Cola and the brewers look to have reached valuations so high that further upside progress is improbable and they are vulnerable to a major setback, if not necessarily their own proprietary bear market.

Here are two significant pieces of information to add to the fundamental case for the continuing bear market.

1. Telecommunications infrastructure pioneer XO Communications announced last week that it is scaling back by $200 on its capital investment. This is most likely a harbinger of many more cutbacks that will impact suppliers like Nortel, Cisco, Ciena, Corning and JDS Uniphase, to mention just a few of the more prominent high tech bastions.

When this kind of capital investment cutting starts, it is likely to gather momentum. That is how recessions start. A company like an XOXO has difficulty raising money because of impending industry overcapacity. So it orders less and everything backs up. Layoffs lead to less consumer spending and so on, ad infinitum.

XOXO stock itself has backed up from $66 to 16 after hitting a low last week at 11.50. There is no particular reason for the decline to stop here.

2. Cash flows into stocks appear at last to be ending and have almost certainly started a trend reversal. Through October, and despite the declining market, investors put $19 billion more into equity mutual funds, according to the Investment Company Institute. During October fund managers raised cash reserves to 6 percent of assets, from a near-record low of 5.3 percent in September. In the week ended Wednesday November 29, investors invested a modest $1.4 billion in equity funds after two weeks of heavy net redemptions.

Contrary to what the mutual funds industry and the brokers say, the public will not stay the course for the long term in an entrenched bear market. It may take a long time to do so, and has done this year, but eventually investors realize that buying into a declining market is an exercise in throwing good money after bad. Mutual fund redemptions compel fund managers to sell stocks to raise the cash to meet further redemptions and their selling causes further declines in stock prices. Eventually, fund managers get the hang of it and get ahead of the redemption curve. At the eventual bear market bottom, they should have 15 percent or more of assets in cash. That of course is the exact opposite of what they ought to do, but they are subject to human emotions too.

Added to the start of serious damage to the mutual fund industry is, of course, the fact that the decline in stock prices leads to contraction of margin debt, by selling stocks.

As we have said before, a bull market feeds on itself on the upside. A bear market feeds on itself on the downside. Even when economic conditions seem to be wonderful, a bear market can of itself be the cause of a recession. Never mind what’s happening in the stock market, a business slowdown is clearly occurring now. The question is whether growth will turn negative, thereby causing what the prognosticators call a hard landing, as opposed to a soft one, when there is no more than a slowing in the pace of expansion.

After the massive expansion of the past decade, with its corresponding excess, the probabilities in our view overwhelmingly favor a hard landing. Those who don’t know what a hard recession and a correspondingly severe bear market are likely to learn over the next year or two.

In sum, there will be rallies, and possibly huge ones, but there is a very long way for stock prices still to go down. This bear market is now only just starting.

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