A State of Denial

05/13/2005 12:00 am EST


John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger has a unique ability to explains complex technical factors within the context of long-term, common sense fundamentals. Here, the analyst well-known for his "Bollinger Bands" looks at stocks, bonds, and commodities within the framework of corrections.

"We hear the term ‘correction’ in relation to the financial markets all the time. ‘The markets corrected today.’ ‘It was a technical correction.’ ‘We expect a correction of 5% to 7%.’ ‘The stock market was ripe for a correction.’ ‘The correction came out of nowhere.’ After years of hearing the term used and abused, I can't help but wonder whether if it has any meaning left at all. Let’s look at corrections and their lore and assess their role in practice. The original idea of a correction was that it was a minor move in the opposite direction of an encompassing trend. Perhaps an example serves best to illustrate.

"We'll use the S&P 500 and focus on the bull market that ran from 1982 to 1998. There were five important corrections as the index soared ten fold; they occurred in 1984, 1987, 1990, 1994, and 1997. Each of these was quite different in character, length and depth. 1984 was characterized by a massive sell-off of speculative tech stocks. 1987 featured rapid destruction brought on by a meltdown of an ill-conceived portfolio insurance scheme. 1990 was known as the portfolio blowout and consisted of a single quarter of intense institutional selling. 1994 was a drawn-out, sideways affair characterized by massive internal rotation. 1997 was a quick ‘come too far, too fast’ pullback. These corrections were frightening affairs that profoundly affected investors. Indeed, to suggest that the crash of '87 was a correction will serve to some as final proof that I am unhinged, but so it was.

"Corrections are supposed to be relatively short affairs that occur when the market has gone too far, too fast and belief is high. The idea is that they shake out the weak players and set the stage for the next major trend. The important thing is to understand the purpose of the correction - correcting excesses - and be flexible about the correction itself, analyzing what it is, not what you think it should be. As we saw in the '82-'98 bull market, corrections come in many stripes, but they all serve the same purpose: clean-up from the prior leg and prepare for the next leg. The current correction started in early March and has run 9.0% for the S&P 500, 8.6% for the MidCap S&P 400 and 10.7% for the SmallCap S&P 600. In our view that is about normal, 10% or so for the important indexes and a month or more seems like a garden-variety short-term correction.

"If you step back a bit, you'll see a longer-term 13% correction in the NASDAQ Composite that began at the turn of the year, now in its fourth month. As we go to press we see a well-formed short-term W bottom in place amidst deeply oversold conditions. Methinks this is the end of the correction or at least a good trading opportunity. We seem to be a bit out of phase with the seasonal patterns as this correction is running several weeks late. The good news in that there are very strong seasonal patterns directly in front of us that should carry into late summer. We are now a bit more than a quarter of the way into the pattern.

"Meanwhile, I have long warned about an outbreak in inflation, indeed they will recall past assertions that inflation was already a problem, just not visible yet. When the March inflation report came out it was a whopper, up 0.6% for March with a core rate up 0.4%. Of course, inflation's apologists soiled themselves trying to explain it away, but the facts are the facts; inflation for the first quarter roared at an annualized rate of 4.3%. At that rate, your purchasing power is cut in half every 17 years. So far, we have been living with accelerating inflation and few seem to care, but there will come a time when they will care and care a lot. In our view the event that will cause them to pay attention will be when energy prices stop rising and inflation keeps right on going. In other words, when investors realize that energy was just a cover for burgeoning systematic inflation, the proverbial fan will get a shellacking.

"Why should we care? Investors must understand what a mighty destructor of value inflation is. While in unadjusted terms the S&P 500 is above its 1998 peak, in adjusted terms it is below that level. This comparison is particularly interesting, as this was a time in which deflation, not inflation, was the threat that people worried about. With the stock market going nowhere for seven years now, and inflation roaring, investors are being eaten alive. The yield on the S&P 500 is 1.5% and inflation is ripping along at 4.3%. That means that the real value of a portfolio decreases by 2.8% per year. Ouch! So the next time you hear some mutual fund salesman tell you that buy-and-hold is the way to Nirvana, run 'em out of town on a rail."

"These days it seems like all the respect that Rodney Dangerfield couldn't get is going to bonds. It appears that everybody is seeking solace in Treasuries with the greedy bidding for junk. With inflation running at a 4.3% annualized rate in the first quarter it is simply impossible to believe that the 10-year Treasury is trading to yield 4.2%. If I had to characterize the bond market, it could be done with a single word, hysterical. Yes, I know there are many reasons to bid Treasuries and many bidders to bid them, but who buys a bond to yield less than inflation? Bonds have been characterized elsewhere as certificates of guaranteed confiscation, but usually there is some room for hope. Today they are bought on the prayer that inflation will wane and in the face of a negative current real yield.

"Everyone seems to think that the rally in energy is over and that lower prices lie just ahead. This seems like a combination of optimism and denial. This is especially clear when consulting the long-term charts where price strength seems quite persistent across all sectors. We had thought that the equilibrium price for crude was $45 or so, but in light of recent trading the equilibrium may be as high as $50. Is this a permanent state of affairs? Possibly not. Economic weakness could take prices lower, as could an increase in supply. But an increase in supply is going to be hard to come by and economic strength ought to be sufficient to sustain demand. In any case, the charts support firm prices, with weakness being rare and quickly overcome. If we are correct in this analysis, then the current pullback (dare we use the correction word again?) in the energy stocks has to be seen as a buying opportunity.

"From our discussion of corrections, recall that they create opportunities within the context of a primary trend. The oil stocks have done very well indeed and may really have run out of potential for a while, but the oil service stocks are just getting going. Normally we don't like laggard groups, but in this case we expect a game of catch up to be played. Commodity prices made a peak in mid-March and have pulled back about 6% since. This, as you might have come to suspect, we regard as a correction. The pullback was accomplished with some help from energy, but it was more widespread than that. We gather that the big question on everyone's minds regarding commodities is whether Chinese demand will continue. Our answer is yes.

"Denial seems to be the operative mode for the financial markets these days. It can be seen in the dollar where free fall for the buck is the belief, but not the reality. It can be seen in the bond market where bonds are being bought as fast as humanly possible despite looming inflation. It can be seen in the mortgage market where variable rate mortgages are still in style despite steadily rising indices. It can be seen in the stock market where stocks are still bought avidly in light of seven years of no return. It can be seen in the commodity markets where few have the courage to embrace the idea of higher commodity prices despite the fact of higher commodity prices. And it can be seen in the energy market where opportunities are going begging in anticipation of lower prices. We wonder if this isn't a 100-year storm in the making. Consider what it might be like if all these illusions were unwound at once. We don't expect a disaster, but it never hurts to keep an eye on the weather."


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