Terminal Descent

Adam Hamilton    July 21, 2000    3230 Words


Trouble in the air is very rare.  It is hitting the ground that causes it.  — Amelia Earhart, 20 Hrs 40 Mins, 1928.


As all pilots know, flying through the air is exhilarating.  Who, as a child, did not spread their arms and run as fast as they could in the hopes they would cast asunder the bonds of gravity and soar with the eagles?  Just like flying, investing in equities can be incredibly exciting and rewarding when everything is going well.  Also like flying, however, the stock market situation can deteriorate incredibly rapidly.  An anonymous quote from the WWII era warns, “Aviation in itself is not inherently dangerous.  But to an even greater degree than the sea, it is terribly unforgiving of any carelessness, incapacity or neglect.”


Of all the many varieties of flying humans enjoy, the most exciting, both to participate in and to watch, has to be precision aerobatic flying.  Aerobatics pilots have to be in phenomenal physical shape, as they consistently pull G-forces that even exceed those which military jet fighter pilots are exposed to.  Aerobatics pilots also have to be very intelligent and have an uncanny sense of three-dimensional spatial awareness.  In some maneuvers, performed at dizzying speeds, even an error of a few feet can be instantly fatal for the pilot.  A good friend of mine, an aerobatics pilot, recently compared one aspect of precision flying to stock market investing, in an analogy I found absolutely irresistible.


One of the most difficult skills for fledgling aerobatics pilots to learn is sustained inverted flight.  When one is flying right side up, control of the airplane is intuitive, and almost instinctual.  In order to gain altitude, all the pilot has to do is pull back on the control stick.  In order to descend, the stick is pushed forward.  The beautiful blue sky and brilliant sun shine above, and the verdant green earth unfolds below, like a magical kingdom in a fairy tale.  Once the pilot rolls 180 degrees, however, and points the belly of the airplane to the heavens, the situation becomes drastically different.  As creatures that can’t fly un-aided, humans are naturally comfortable with the ground below them.  Inverted, an aerobatics pilot sees the massive planet suspended in the air above, and there is a sensation of nothing under the plane, on the sky side.  The force of gravity pulls the pilot up (down towards the earth) out of his seat and he hangs in his five-point harness.  The normal intuition of flying, if heeded while inverted, will almost certainly prove lethal.  If the pilot senses trouble, his immediate reaction is to “pull up”, to pull back on the stick.  In normal flight, this will take the airplane further away from the unforgiving terra firma, buying the pilot time to address whatever troubling occurrence arose.  In inverted flight, however, if the pilot instinctively pulls back on the stick, he will end up decorating some farmer’s field with aluminum fragments.  The aerobatics pilot must learn to fight his intuition, to fight the disorientation from being inverted, and use his brain to do exactly the opposite of the control inputs he would use while flying in a normal, upright attitude. 


My friend wisely pointed out that investing in the stock market is similar.  In a bull market, certain strategies can greatly reward an investor.  In a bear market, which is analogous to inverted flight, these same strategies are lethal.  “Buy the dips!”, for instance, is the mantra that has been emanating from Wall Street with a virtually religious fervor in the past six years.  In a period of continually rising prices, this strategy has yielded great profits to those who adhered to it.  In a classic bear market, however, each “dip” is continually exceeded by a series of ever-lower dips.  Just as using conventional flight strategies while flying inverted is lethal to a precision aerobatics pilot, using bull market investment strategies will prove absolutely fatal in a bear market.


Is a bear market in US equities approaching?  In this essay we will examine three additional leading indicators that appear to be telegraphing warnings that all is not well in the US equity markets, including the CFTC Commitments of Traders report released July 17th, the NYSE advance/decline line, and a few of the negative earnings surprise meltdowns we have seen in the first few weeks of the second half of 2000.


Every couple weeks, the United States Commodities Futures Trading Commission releases its Commitments of Traders (CoT) report.  The report is available free of charge at www.cftc.gov/dea/cot.html.  It summarizes the open interest positions of traders in over 50 different futures and options contracts, including everything from cocoa to unleaded gasoline.  Even more revealing than the open interest numbers, however, is the fact the CoT report breaks down open interest in various futures and options contracts in several ways.  First, all contracts are broken down into commercial open interest and non-commercial open interest.  Commercial open interest, according to the CFTC, involves traders entering into futures and options contracts as a hedge against price changes in a commodity that is essential to their business interests.  The non-commercial open interest consists of traders who are purely speculating on the price of a commodity, with no intent to take delivery of whatever the contract represents.  They are playing the game in the hopes of a speculative profit.  The CoT breaks down both commercial and non-commercial open interest into long and short positions.  From a speculation perspective, those traders who are long contracts are bullish on future price movements of the underlying commodity, and those traders who are short contracts are bearish on future prospects of the underlying commodity.  The latest CoT released this week continued to show a very provocative divergence between commercial and non-commercial bets on the future direction of the NASDAQ 100 and S&P 500.



The four pie graphs above show the CFTC CoT open interest data for the July 17 CoT report.  The left two pie graphs represent long and short open interest percentages in NASDAQ 100 futures and options, and the right two graphs outline the S&P 500 futures and options positions.  The top two graphs represent commercial bearish (red) and bullish (green) positions, and the bottom two graphs represent non-commercial open interest sentiment.  The graphs show an incredible divergence between commercial hedgers and non-commercial speculators in their predictions of future price movements of the NASDAQ 100 and S&P 500.  In the NASDAQ 100 futures and options, a whopping 72% of the non-commercial speculators believe the index is going higher.  The majority of the commercial traders, however, have a negative outlook on the future of the NASDAQ 100 index.  Only 47% of commercial traders are long the contract.  A similar divergence exists in the S&P 500 contracts, with 60% of non-commercials being bullish on the index and only 46% of the commercials having a positive outlook.  Commercial traders are the big guns of the derivatives world, play to win, and are much more likely to have important information on impending price movements than amateur traders.  Derivatives (futures and options) trading, unlike equity investing, is a dangerous zero sum game.  Each contract has two parties.  In order to make money trading derivatives, the counterparty to a trader’s contract must lose the same amount of money the trader wins.  The non-commercial camp, which is very bullish on the NASDAQ 100 and S&P 500, most likely consists of more amateur and small traders.  The commercial interests, on the other hand, are usually consummate professional trading organizations, and their continuing existence depends on not being on the wrong side of many trades.  As a leading indicator, it may portend troubling developments ahead in these two very important equity indices if the commercial traders are correct in their bearish assumptions.  What do the sharks know that the little fish are oblivious to?  What is coming down the pike to shake the US equity markets?


The above graphs don’t tell the whole story of the recent CoT report.  In the S&P 500 contracts, commercial interests hold more than 93% of the outstanding contracts.  In the NASDAQ 100 derivatives, the commercial interests hold over 63% of the outstanding contracts.  There are about 13x more S&P 500 contracts outstanding than NASDAQ 100 contracts.  Commercial interests have a huge pile of money riding on these bets on the future direction of the indices, and the probability they are wrong is small.  It has been said if one is playing a game of poker, and doesn’t know who the patsy is, chances are they are it.  The incredible divergence between commercial and non-commercial expectations of future index directions does not bode well for small bullish speculators or the near term future for the S&P 500 and NASDAQ 100 indices.  Is the airplane that is the US equities markets going inverted?


The NYSE Advance/Decline line is also casting forth bearish vibes.  Every day, some stocks go up and some stocks go down.  In any given day, the stocks moving up are the advancing issues, and the stocks moving down are the declining issues.  By subtracting declining issues from advancing issues, the net advance decline line is determined.  In general, in any stock market rally, the more stocks that go up in the rally the stronger the foundation for the rally is considered to be.  Here is a look at the daily close of the S&P 500 stock index graphed against the 100 trading day moving average of the net NYSE advance/decline line.



Although the net A/D line has been improving in 2000, the long-term picture is still very bearish for the S&P 500.  From January 1995 until May 1998, the net A/D line had an average of 71, meaning, on average, each day 71 more stocks would trade higher than the number of stocks trading lower.  In May of 1998, however, the A/D line began a brutal drop, and it has struggled to recover ever since, only briefly piercing breaking even three times since then.  The average net A/D plummeted to –111, indicating 111 more individual companies were dropping in price each day on the NYSE than were rising.  Although not all the S&P 500 stocks trade on the NYSE, the S&P 500 is probably one of the best overall stock indexes, as it represents the 500 biggest and best companies in the United States.  Although the S&P continued to rally dramatically since May of 1998, the deterioration of the A/D line indicates the foundation for the rally may be rotten.  As fewer and fewer NYSE listed companies’ stocks have participated in the S&P rally, more and more money has been concentrated in a few companies, driving their valuations to unsustainably high levels.  Like the ancient proverb of building a house on rock versus building on shifting sand, the huge S&P 500 rally is built on a sandy and unstable foundation.  A stock market index rally rides on the backs of its individual company constituents.  The fewer stocks carrying the index rally, the less likely it is to survive.  Some of the stocks bearing the index, for example, will fall in price for any variety of reasons, including earnings surprises, fundamental business changes, and general investor psychology.  The fewer stocks participating in the rally, the less cannon fodder there is to absorb the flaming arrows of shifting investor sentiment.  Without a firm A/D foundation, only a relatively small number of stocks become of crucial importance for the whole S&P 500 index.  Investor money pours into the stocks, and their valuations become very high and unsustainable over all but the very short term.  If any material bad news occurs for any of the high-flyers, and investors begin to dump that stock, the probability rapidly rises that the whole index will crater.  In May 1998, the S&P 500 was sitting near 1100.  Since then, it has gained a very impressive 36%.  With the foundation of the rally being inherently weak, however, a retracement of the S&P 500 to that 1100 level would not be surprising.  The 500 best companies in America losing over 25% of their value on average to make this retracement is an extremely bearish prospect.  The abysmal net NYSE A/D coupled with many other leading indicators indicate we may be entering inverted flight and flirting with a merciless bear market.


Another classic leading indicator of impending trouble is negative earnings surprises.  Ultimately, all investments are only worth the future cashflows they can provide to investors.  If there is a broad-based decline of earnings or earnings prospects, the investor expectations of future cashflows diminishes rapidly.  The decline in these expectations can lead to share liquidation, which can be quite dramatic.  After all, if earnings and expected cashflows for an investment drop, the investment should be priced lower to reflect these revised expectations.  Bubblevision has been reveling in earnings season the past few weeks, but they have been downplaying some negative earnings surprises that turned into disasters for investors caught in those companies’ stocks.  The following table shows some gut-wrenching SINGLE DAY losses of stocks that have missed market expectations of earnings…



The carnage is palpable!  For contrarians who think gold stock investing has been rough this year, imagine waking up one day and finding 40% to 60% of your capital has vaporized instantly.  Interestingly, most of these drops occurred in after hours trading, BEFORE the NASDAQ and NYSE opened for business.  Big institutions put on a fire sale of the stocks early in the morning, and almost all of the losses occurred prior to the normal market opening.  For small investors owning these companies, they were most likely trapped in these black holes as the big guys pulled out.  Even if small investors were prudent enough to place stop losses on these stocks, chances are the protective stops were never triggered.  If the majority of the losses occurred in the pre-NYSE and NASDAQ opening extended trading sessions, stops with most brokers would have missed the drop.  By the time 0930 rolled around and stop losses could potentially be triggered, it was usually way too late… 


The right column of the table indicates the price earnings ratio at the END of the trading day, AFTER the loss occurred.  Five of these companies were losing money.  Of the seven that are making money, ALL were still dramatically overvalued after the negative earnings surprise.  In order to have a valuation in line with historical stock market averages, these companies would need to see P/E’s in the 13 to 14 range, indicating they have a lot further to fall if sustainable valuations are to be seen.  One day hits of this magnitude are very abnormal, and tend to cluster around market tops when valuations breach historical extremes.  Although these companies are smaller than the market darlings, they are an incredibly bearish leading indicator of things to come.  Technology investors and speculators are notoriously fickle, and most are in the game to make a quick buck, not for the long-term ownership of companies.  In the near future, what happens to NASDAQ mega-caps Cisco (P/E of 193), Intel (P/E of 62), Microsoft (P/E of 44), Qualcomm (P/E of 81), Dell (P/E of 83), and Oracle (P/E of 37) when investors realize they may not be able to live up to the stellar earnings expectations assigned to them?  If a solid company like Computer Associates (in table above) can lose 43% of its value in a single day, so can the six NASDAQ mega-caps, which make up a phenomenal 30% of the value of the NASDAQ 100.  Interestingly, Microsoft and Intel both BEAT street expectations of earnings this week.  Did they rally?  The day after the earnings for last quarter were announced, Microsoft lost almost 7% of its value and Intel was given a 3.5% haircut.  What will happen if these mega-caps miss expectations next quarter?  The results of these early negative earnings surprises are sobering warnings of very tough sailing ahead for the US equity markets.  50% losses in a single day should be VERY rare, not happening virtually every trading day.  These few initial earnings related stock meltdowns are warning shots fired across the bow of folks speculating in overvalued equities.  They are yet another indication that we are entering a bear market and transitioning to highly risky inverted flight…


Remember those “B” grade barbarian movies?  The good peasant people, working in the fields outside their idyllic villages, would one day set down their hoes and scythes almost in unison.  They would stand tall, raise their hands to their brows, and carefully scan the horizon for trouble.  They couldn’t see the barbarian hordes descending on their village, but somehow they just knew something wicked was bearing down on them like a juggernaut.  There is an incredible amount of anxiety in the global markets today.  Like the peasants in the movies, individual investors and speculators are beginning to sense some great non-linearity approaching.  As more and more warning flags are thrown up relative to a myriad of different perspectives on the current state of the equity markets, it is harder and harder for enthusiasts to be bullish.  The CoT report, NYSE A/D line, and recent negative earnings surprise meltdowns are merely the tip of the iceberg of occurrences causing the prudent to pause and ponder.


The evidence continues to mount that the US markets are on the verge of transitioning from intuitive normal flight to dangerous inverted flight.  If this is the case, equity investing strategies that worked incredibly well since 1995 will become gaping pits of doom, with a gluttonous and insatiable appetite for investor capital.  So how does one survive and profit in the coming years if the high probability of an imminent bear market proves correct?  Although bear markets can be played on the short side, that can be pretty risky unless one is a very sophisticated trader, as bear market sucker rallies are among the most powerful and violent rallies stock markets witness.  Fortunately, there is a simple answer that has protected countless people through all manner of financial debacles all throughout history.  Gold.


Gold, the metal of legend which virtually all ancient and modern empires have coveted, is currently at 20+ year lows and fundamentally poised for a massive up move.  Gold traditionally shines its brightest when the merciless bear is mauling financial assets.  EVERYONE who believes valuation matters, believes markets are cyclical, wants to protect and enhance their wealth, and is patiently scanning the horizon should have gold in their investment portfolio.  A possible 60 year equity market Kondratieff cycle top coinciding exactly with a 20 year low on the golden timeless asset is a once in a lifetime investment opportunity.  Historically, all investments ultimately regress to their mean values.  Equities are far, far above their mean valuation, indicating an impending drop.  Gold is far, far below its mean valuation, indicating an impending rally.  Now is the time to take advantage of the golden chariot to ride through any coming financial/geopolitical storms in style.


The bear market is coming.  US equity markets are or will soon be flying inverted.  And to add to the excitement, a fog bank lies ahead.  Will your portfolio (and future) be in a paper airplane or a golden fortress when the terminal descent begins?


The prudent see the danger and take refuge, but the simple keep going and suffer for it. – Proverbs 22:3 and 27:12


Adam Hamilton, CPA     July 21, 2000