Stockscom Report for Sunday April 15, 2001

Publisher: Colin Alexander (613-745-5593) Editor: Ken Wilson (450-691-4617)

Subscriptions and Administration: Pierre Fichaud (1 866 487-9711)

 

Stocks up, bonds down--for this week, but not a trend reversal

Strong likelihood of a bear market rally in stocks

Oils and oil service companies look better than ever

 

Market Synopsis

 

Our interpretation of recent market action, and particularly last week, is that stocks have experienced a substantial rally, but one with dimensions that are routine and which do nothing to suggest the end of the major downtrend, let alone to suggest the start of a new bull market. The other side of the coin is that the downdraft in bonds is also substantial, and possibly enough to suggest caution.

 

During the bull market, those of us who were aware of the unprecedented high valuations in the stock market were concerned that every downdraft in stocks might be the start of a bear market. Of course, it didn’t happen for a very long time. The upward zigzag in the indexes continued inexorably higher. That was, until the eventual top, and the start of a downward zigzag. During the bull market, you had to keep the faith in the technicals, which kept the bull market designation in force.

 

After so much downward correction in many stocks, and particularly in high tech, there is a temptation to revert to the previously successful methodology of buying the dips. The logical corollary of this thinking is that the bigger the dip, the better the buying opportunity. Put into practice, this means that money sitting on the sidelines, often in the hands of pension fund managers, is poured into stocks. It is human nature to want to buy great stocks at or near the bottom, when they seem to offer much better value than before.

 

The problem with this approach is that it fails to consider either history or the technical implications of a bear market. Let’s say it again: A bull market designation derives from a series of upward zigzags on the monthly chart and a bear market comprises the opposite, a downward zigzag on the monthly chart. Although you can be certain that one apparent low will put in the bottom of the market, you can do no more than guess which one it will be until after the event, when a new upward zigzag starts.

 

From a long-term historical perspective, it is extremely unlikely that the bear market has run its course, or that it is even close to doing so. It’s possible that it has done so, but the probabilities are very heavily weighted against this being the case. Yes, of course, the NASDAQ has come off by two thirds from its high. Nevertheless, it is still immensely high by all normal valuation criteria even for high tech stocks, and more so when you consider that price/earnings multiples are based on earnings still near the peak of the cycle. Consider that you could buy Intel in 1990 for some 10 times earnings. How then can the stock now be worth 19 times earnings, which probably don’t even exist? Certainly, conditions in the chip business are about as bad as anyone has ever known and normally that’s a signal to buy the stocks. But there's still the possibility that worse problems are camouflaged and consequently their stock prices are simply nearer the bottom than the top they left behind last year.

 

It is our strongly held view that the current downturn in stocks will be accompanied by a mild recession at a minimum and, more to the point, a much more serious profits recession than most people are currently expecting. Memories of an ever-expanding economy and the ever-rising stock market are still quite fresh in the minds of ordinary investors. Even now there is still no serious fear, let alone the kind of loathing for stocks that is associated with bear market bottoms.

 

Telecom Commentary

 

At a gathering this weekend in Kanata, home of major Nortel operations, the view prevails that this is one powerful company which must prosper in the long term. Until recently, the same could have been said about Lucent and their major customer British Telecom, for example. The fact is that Nortel has been cash-flow negative for well over a year. With perhaps a billion dollars in the kitty, Nortel is actually in serious danger of duplicating Lucent's fall and running out of money. Sales booked by lending the purchase cost AND the cost of setup, configuration, etc. to your customers can go only so far before you run out of money to pay for the production of the goods sold on credit.

 

In due course, the impact of cash pressures on the likes of Cisco and Nortel, which of course are the strong companies in high tech, must lead to layoffs and contraction in expenditures that feed on themselves. Then this impact flows through to retailing, banking, real estate and so on, leading uncontrollably to a continuing vicious downward spiral in stocks. That’s what makes a business contraction.

 

Historical Perspective

 

We think you can largely disregard the action of NASDAQ stocks as a barometer for the general market. (In fact, despite the massive tumble that we've witnessed in the NASDAQ, the upward trendline, beginning in 1995 for this market, was only breached in February of 2001). Regardless of the smaller sampling of stocks, the action of the Dow Jones Industrials is probably more indicative of the overall strength or weakness in the economy. Here we find ourselves looking at the possibilities for the current bear market by looking at some historical precedents, and not just the extent of the decline and the duration of the bear market beginning in 1929:

 

Top                              Bottom                         Duration                       %Decline

 

Oct. 1919        119      Aug. 1921        67        22 months                    44%

Aug. 1929        380      Jun. 1932         42        34                                89

July 1937         185      Mar 1938         98        8                                  47

Nov. 1972       1018    Dec 1974         616      26                                40

 

Bear Market to date

Jan 2000          11,750 Mar 2001         9106    14                                23

 

Looking at the above sample of bear markets, we believe that the current one has done nowhere near enough in either time or price to prove the argument that a mere 23 percent decline is enough to cleanse the excesses of the greatest bull market in history. On the contrary, we believe in the general concept that market reactions tend to have a relationship to the preceding major bull or bear market. Our best guess is that the Dow will decline to at least 7400 (a decline of 37%), and that the major downtrend is unlikely to end until the third or fourth quarter of 2002. Then there will be the opportunity of a lifetime to buy stocks.

 

Recommended Actions

 

Despite our outwardly bearish sentiment, we continue to search for potential purchases. Given that in a general bear market 90% of all stock prices decline, the challenge is admittedly difficult. However, we still see a few stocks where the reward to risk justifies continuing ownership, mostly among the energy and energy service stocks. Oil and natural gas do not look as if they are likely to go down substantially, although there is a strong probability that their highs last winter will not be exceeded by much, if at all. The main reason for holding them, is that downside risk is comparably much smaller. Moreover, the addition of a strong dividend increases the likelihood of never seeing a loss procured. The pipelines are especially preferable as a balance against the volatility of world prices for energy.

 

We continue our Fed Watch with the expectation of a rate cut sometime before the next Fed meeting in May. On Tuesday, we will see the publication of consumer price inflation figures, housing starts and industrial production numbers, which could steer the market into a new direction or prolong the rally. Naturally, extending the current rally a notch further would seriously endanger our portfolio of equities held short.

 

Regardless of the market action, we see continuation of the considerable deterioration of the economy due to a glut in the inventory cycle and the end to the capital investment boom. A rate cut of 0.5% will do little to correct this weakness and will not change the downward trend of the markets. The excesses of the past few years will be worked out of the system through the actions of the same forces that worked out previous excesses - lower production, layoffs, bankruptcies, etc. and not through the use of new technological gadgets. 

 

New Buy Recommendations:

None.

New Short Sales

None.

 

Stock Positions to Sell/Exit:

 

None

 

List of Current Stock Recommendations:

Action Ratings. The following is the legend for designating immediate action
for our stock recommendations. The first is B, meaning the stock is timely
to buy but the case for doing so right here is not overwhelming. Either the
stock may have gotten ahead of itself and may be vulnerable to a retracement or
else the stock has been performing disappointingly but may simply be
regrouping. B+ and B++ indicate stocks for which there is a technical case
to buy now, with plusses adding weight according to how many there are, up
to a maximum of two. Stocks rated H are ones to hold, awaiting confirmation
to buy more or to sell. SELL, of course, means what it says. It seldom pays
to override this designation. In the case of stocks held short, the rating is S where positions should be retained. S+ and S++ indicate stocks for which there is a technical case to add to the positions with plusses adding weight similar to long positions. The maximum number of plus signs is 2.

Stocks marked # are eligible for Canadian RSP funds. Otherwise there is a
20pc restriction on foreign stocks held in these accounts.

Date of Entry	Name	Symbol	Entry Price	Current Price	Action Rating
02/01/01	Acm Government Income Fund	ACG	8.07	7.94	H
02/01/01	Acm Government Opportunity Fund	AOF	7.99	8.00	H
12/18/00	Alberta Energy Co.	AOG #	42.63	45.60	B
12/18/00	Kinder Morgan	KMP	50.00	64.09	B++
12/18/00	Occidental Petroleum	OXY	21.88	26.11	B+
02/01/01	Pioneer Interest Shares	MUO	11.95	11.45	H
12/18/00	Precision Drilling	PDS #	33.19	39.29	B+
12/18/00	Trans Canada Pipelines	TRP #	11.19	11.45	B
12/18/00	Ultramar Diamond Shamrock	UDS	28.38	39.63	B+
02/12/01	US Treasury 20 Year Bonds	USH	104.21	104.21	B

·        Rolled from the March contract and price adjusted

Short Sales

Date of entry	Name	Symbol	Entry Price	Current Price	Action Rating
03/21/01	Amazon.com	AMZN	10.38	14.67	S
03/21/01	Citigroup	C	44.31	47.30	S
12/18/00	Coca-Cola	KO	54.00	44.57	S
03/21/01	Juniper Networks	JNPR	53.00	50.38	S
03/21/01	McDonalds	MCD	25.60	26.89	S

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