A weekly newsletter based on the fact that stock market sectors are made up of industries, that industries are made up of individual stocks, and that individual stocks in the same industries and sectors move as a group. The proven best way to profit from the stock market is to keep your funds invested in the stocks of top performing sectors/industries at all times, and the best measurement of performance of these sectors/industries is their price movement over the previous six months. Below you will find commentary of Sectors, Industries, and Stocks based on the most recent 6-month period as well as updates on the past week’s action...

November 3, 2006

Danger: Moral Hazard Ahead 

TM: If you knew the government was putting a floor under stock prices to keep them from falling very far, how much money would you put into the market?

LR: Is this a serious question?

TM: As serious as I can get.

JRR: I'd say that a lot of people would probably put in a lot more than they do now. So, what are we talking about?

TM: In 1988, after the Crash of '87, Reagan created The Working Group on Financial Markets - derisively referred to today as "The Plunge Protection Team." It's composed of Treasury people, the Fed, Wall Street types - the people who have their fingers on the pulse of the financial markets. Their job is to step in and try to control disruptive markets if and when they happen. 

LR: Oh, that group. Aren't there constant rumors about their activity whenever the market takes a dump, or something about keeping the price of gold contained?

TM: Yes. The Japanese have something similar. But theirs didn't work very well - the Nikkei Average plummeted from around 40,000 all the way down to 7,500 in 2003. They thought they knew how to keep a floor under prices.

JRR: It didn't work very well, did it?

TM: No. But what I want to bring up is its effect upon our willingness to take risks. If we come to believe somebody will bail us out, say, like a safety net under our high-wire walking, doesn't that create a moral hazard? 

JRR: It could certainly be a bad thing. The purpose of the markets is to allocate resources, not save people from themselves.

TM: But then what should we make of the "Greenspan Put?" And what about the rescue operation that was put into motion to shore up markets after Long Term Capital Management threatened the solvency of various securities firms in 1998?

JRR: They're just examples of the government stepping into the market to shore them up during times of stress. It's a role that is hotly debated all the time.

LR: I can see that keeping the markets liquid and also keeping investors' faith in the market's viability is a good thing. But where are we going with this discussion? Are you for it or against it? What's relevant here?

TM: Although it is necessary to keep the markets solvent, I worry whether this type of activity doesn't encourage reckless activity, giving people a false sense of security that encourages them to make decisions they wouldn't normally make if they had to consider all the negative ramifications of being wrong.

JRR: Well, the "Greenspan Put," as you put it, certainly enabled the markets to climb higher and higher in the face of mounting economic signs of financial distress. Now look at the real estate markets, look at..."

TM: Maybe I am arguing with myself, but I can see that it does have a positive effect to keep the financial markets stable. Who gains by market crashes? Only the short sellers, albeit they have their place in the scheme of things. Greenspan believed that nobody could preordain when a bubble grew to dangerous proportions. He saw his role as clean-up man, ready with mop and pail, but not the party pooper. 

LR: You are talking in circles. Let's go on to another subject or make sense of this. We do have the Plunge Protection Team in existence. It isn't going away. It will step in when the markets get unwieldy again as they did in 1987. And maybe 1998. And certainly after 9/11. You have mentioned many times that the burgeoning derivatives markets have enabled millions of people to get access to credit that they would have never come close to before. So that's positive. But you have also argued that the derivatives markets can make all the financial structures more dangerous. Are you now backtracking now?

TM: I guess what's disturbed me is two things that happened this week. As you know, I've been a vocal critique of the "numbers" that come out regularly from the government and other large organizations. It's just fascinating how analysts take a few thousand inputs of data and extrapolate them into a "national" figure...sometimes all the way out to three decimal places. It's ludicrous.  

JRR: So...that's the way the game is played. 

TM: Well, today the employment numbers came out as they always do on the first Friday of the month. They showed a much stronger economy than other recent reports have, and ran counter to what many analysts had interpreted as economic weakness based on those previous reports. But the real news was the revisions of past reports. They were significant. And last month we also got huge revisions. So, the question of what's really real comes up for discussion. Remember my review of The Secrets of Economic Indicators? My question is how anyone can put any credence in these reports?. As a side note, that's why we're technicians here at the Simplespread Institute. We watch what real people do with real prices, not samples taken from who-knows-where.

LR: But most of Wall Street uses those numbers to make investment decisions. You're saying something along the lines that maybe... 

TM: Exactly. The other piece of news this week was when one of the Fed governors admitted that the Fed probably erred in pushing interest rates so low and for so long as they did up until June of 2004. What he said was that they made their decisions based upon the data they had to work with. He tried to defend the Fed's actions by arguing that their decisions were the best that could be made based on what they had to work with, but now they see it was the wrong thing to do. He admitted they had bad info! Another great book - The Logic of Failure. It says that most mistakes are because the decision maker doesn't have enough information or doesn't have the right information to make the decisions.

JRR: So you're saying that what we've got today is top decision makers making wide-ranging financial decisions that affect all of us based on what you're going to contend is bad data. Right? 

TM: Right. And they admit it. How else could you interpret it? But the rub comes when the government is committed to supporting prices that were elevated due to faulty data. That could bring down the whole edifice. Remember Bernanke said a few months ago that he and his group were "data dependent?" Well, what if that data is faulty? What if bad data pushes prices upward, then we do a "The-Emperor-Has-No-Clothes" double-take and see that there's no there there. You know, like one of those old cartoons where the Roadrunner goes shooting off the cliff only to look down and see that there's nothing underneath him...as he spins his heels in the air?

LR: Your problem, then, is what do the government officials do? Bring in the Plunge Protection Team, or let prices adjust to reality. Is that it?

TM: It's a problem, isn't it? And I didn't just make it up. It came to the forefront this week.

LR: Since technicians trade off investors who do trade off fundamentals...you're worried that all information, both technical and fundamental may be in question?

TM: You're reading my mind.

JRR: And your solution is...?

TM: I don't have one. Remember, the definition of a "panic" is when whoever is supposed to be in control...loses that control, and all hell breaks loose. As long as things are working correctly, everybody's okay. But in the back of my mind is that situation when a moral hazard has pushed stock and bond prices up so far on the basis of everybody believing they won't, can't, come down...then when a dose of reality hits and everybody heads for the door...and the Plunge Team tries to step in....

LR: And the whole thing implodes. Now, your true colors are out. You're bearish, aren't you? You're just like the rest of the Cassandras, waiting for Armageddon. If it can happen...it will happen. 100% probability. 

TM: No. All I'm saying is that it does nobody any good to build your house upon an unstable foundation - especially if that foundation is made of questionable data. And if the Fed admits they're questioning their own data, then I think they ought to rethink their commitments to putting a floor under the market for the sake of the health of the market, itself. Herein lies the moral hazard. They should make public their concerns about what's going on so they don't have to be called in to rescue a sinking ship. Do you disagree?

JRR: You'll get no argument on that point. But if the data is questionable, can't it be questionable in a good way as well as the bad way you're anticipating? Data is underestimated as well as being overestimated.

TM: Sure. That's the other side of the coin. And that's how we've gotten up this high to where we are now. Okay, I guess I have talked myself into a circle. I'll admit it. We're back to where we started.

LR: Okay, so we got some interesting points of view with that. Let's move on to doing the weekly review. Here we have real prices that we can get our teeth into.

FOR THE WEEK...12,000 and sputtering
                                                               

LR: Well, your worries about a narrowing rally last few weeks finally showed up. Weakness, but not much emotion. 

TM: Right. It was a rather slow-moving selloff, wasn't it?.

JRR: We barely closed under 12,000. By, uh, what was it? 14 Points?

TM: The bulls say it's healthy for the market to take a rest. We were up something like 13% since the middle of July. That's a good year, you know.

LR: But few things have changed with our sector leaders. It's still mostly the bear market hedges. 

TM: Right. And the question remains of whether the stocks of the healthcare complex, Telecommunications, and Computer Software & Services without Hardware and Electronics are strong enough to take the market higher? I certainly don't put much hope in the likes of Tobacco or Food & Beverage or Insurance.

JRR: Usually bear market hedges don't take the market higher. They just perform admirably while the rest of the market goes to pieces.

TM: True. But it's been a weird summer and fall. A lot will be riding on Tuesday's outcome, I expect. I hate to think that our markets are held hostage to the Beltway, but it looks like it is simply marking time until it learns who will be making the rules for the next few years.

LR: It seems to me like the market would prefer gridlock. It could be worse than a split Congress and a checkmated president.

JRR: Yes, I've heard the same thing more than a few times recently.

TM: Well, Tobacco, at #1, keeps on keeping on, regardless of whether every court in the country has their sights on the smokers' bankrolls.

LR: And Utilities and their dividends hold strong at the #2 spot.

JRR: Talking about dividends, Real Estate, at #3, could get a nasty surprise on Tuesday if a changeover in power doesn't extend the dividend tax relief. That's what happened in Canada this week. They repealed some favorable tax treatments and the affected stocks took a beating.

TM: Media is holding in there at #4. This makes 12 straight weeks in the Top Ten. For whatever reason, TV and CATV are rebounding strongly.

LR: Our old favorite, the health complex, with Drugs at #5, is finally making a strong showing this year, isn't it?

TM: I still don't know what to make of Computer Software & Services at #6. There are some pretty good looking stocks shaping up in that sector. But with Computer Hardware and Electronics doing such a poor job, it's hard to get excited about this lone wolf. Keep your eyes open for opportunities here. 

LR: The #7 position goes to Consumer Non-Durables. Rather dull stocks doing a good job of keeping up with the market.

JRR: Telecommunications occupies the #8 spot. The sector is up 18% for the year. Here, we have a mixture of large, mature companies and small, innovative companies, fighting it out for leadership in this highly competitive area. There are plenty of interesting stocks when the time is right.

LR: Can you believe Health Services? Finally made it into the Top Ten at #9. And when you combine it with Drugs, this is one, powerful investment area. Dozens of stocks with options traded on them.

TM: That leaves the Dow Jones Industrial Average to round out the Top Ten in the #10 spot. It has been a very regular stair-step pattern upward since July. Support rests several hundred points below current levels. 

JRR: It may have support, but you aren't convinced this is a new bull market, are you? 

TM: I'd be as happy as anyone else to see Dow 36,000, or 40,000, or 100,000. The way our strategy is set up is that we automatically go with the flow. The market tells us where to invest. But after 3 1/2 years of almost straight up price movement, I do get a little nervous. Tracking the money flows into the market you see some very strong numbers. Also, foreigners are piling in. And investors are overwhelmingly bullish. However, none of this is bullish, historically speaking. So, no, I'm not convinced. But I won't fight it. We've have had a very good year with the Metals, Drugs, Energy, Telecommunications, and other strong areas. We can't complain. I just want to remember that as Mark Twain said, November is one of the 12 dangerous months to own stocks. And we're in November. And we're in election time too. So, be careful.

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