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WEDNESDAY a.m.
July 9, 2003




Speculative Fever
by David Nichols

According to the "wisdom" of the market, the economic recovery is going to be led by the likes of Ask Jeeves (ASKJ), a former Internet penny stock now shooting for the stratosphere. (Important note: I'm NOT recommending this stock!)



Let's consider some facts on Jeeves. The company has managed to get itself in a position to generate about $1.7 million per quarter in net income from operations, and they've now done that 2 quarters in a row. That's considered pretty good, I guess, for an Internet stock. And for all of this marvelous cash-flow generating potential, the market is now rewarding Jeeves with a $700 million+ market cap.

It's the bubble all over again. The Fed's liquidity push is once again sending excess money supply straight into speculative Nasdaq stocks. It's amazing that the Fed, from its lofty central-planner perch, actually thinks it can control which areas of our immensely complex economy it can "re-flate." They think they can re-flate things equally. That's absurd. Their liquidity pump just inflates asset classes that are easily inflated. The real economy isn't seeing a dime of all this liquidity, and there's no evidence that all this monetary growth is going into investments that can fire up real economic growth.

At the current price of $17, ASKJ is sporting a P/E ratio on true cash-flow generating potential this year somewhere around, oh, 700 to 1. And there are hundreds of similar cases. I'm only picking on ASKJ because I came across the chart.

It's almost impossible to think that such an "echo bubble" could form so soon after the collapse of the big one. I certainly didn't think it was possible. But here we are. If you're kicking yourself for not shorting Internet stocks back when valuations were so obviously ridiculous, well, you're going to get another chance.

And this is what's bothering me so much about the course the Fed has put us on. The Fed is trying to bail out the speculators at the expense of the savers. There was a heart-breaking story in the Wall Street Journal a few days ago about the serious hard times that have befallen retirees on fixed incomes, who never speculated on anything their whole lives. The Fed has punished them brutally, in an effort to bail out and encourage wild speculation of all kinds. The trouble is the speculators can't be bailed out, so everybody is going to end up hurt. And in the process, there is going to be a serious Fed crisis, as confidence in this institution evaporates.

But that's tomorrow's problem. Right now it's all about the here and now. I know at this point I sound like a "young fogey" and a curmudgeon, just like the doubters sounded in February and March 2000. But we will 100%, definitely, without-a-doubt see all of these current speculative gains completely annihilated, just like they were that time.

One looming problem for all this Fed-supported craziness is the bond markets. Even though the Fed wants to cut rates to the bone and keep them there, the market doesn't have to cooperate. Interest rates have been jumping up of their own accord. If the market itself chokes off the flow of easy credit, then the whole speculative house of cards comes crashing down. That's why the Fed has been making noises that they're willing to wade into the open market to buy bonds, and keep rates low. They know it takes more and more money to keep bubbles moving forward. Higher rates cut off the bubble flow.



Strangely, the VIX has been living in a very tight, narrow range over the last months. Since volatility is anti-persistent, meaning it swings back and forth from low to high, this congestion is a major aberration.



Sentiment guru and contributing analyst Jason Goepfert of SentimenTrader went back and looked at how often the VIX behaves like this. Here are his comments:

"Over the past two months, the VIX has been stuck in under a 5-point range. During the history of this indicator, such a small range over such a sustained period is quite unusual, as less than 5% of the days have shown such a small range over the prior 42 days. Since volatility is supposed to be mean-reverting, meaning periods of low volatility precede periods of high volatility and vice-versa, I thought it would be instructive to see what usually happened over the NEXT 42 days. For those days that showed the smallest range in the VIX over the previous 42 days (the bottom 5%), the next 42 days showed a higher average range more than 85% of the time. For those days that showed the largest range in the VIX over the prior 42 days (the top 5%), the next 42 days showed a higher average range only 1.5% of the time. So, it does appear that periods of low volatility are followed by periods of higher volatility.

If we look at the VIX's range over the past two months as a percentage of the VIX itself, then our current situation becomes even more interesting. Viewed in that vein, the current situation has been the least volatile in history, except for one other period -- mid-July 1997. During that time, the VIX was also stuck in a very tight range heading into the summer months, with a slightly smaller range than the current one. The result was a small rally before the market declined into August and September. The market eventually recovered during the latter half of September and October before the crash in October of that year. Interestingly, the next least volatile period was early June 1989. The result of that was a market decline throughout June, then a recovery during the rest of the summer -- then a mini-crash in October of THAT year as well. It would be ridiculous to leap to the conclusion, based on these precedents, that we will decline for a month or so, recover, then crash in October. But I do think it's reasonable to expect an increase in volatility over the coming months -- and as we all know, an increase in volatility (as measured by the VIX), is normally associated with declining markets, not rising ones. "

So the odds are extremely high that the VIX is going to take off to the upside, with the markets pulling back. But right now the good price action and surplus liquidity is stoking up the speculative fever, keeping the markets moving forward.

Interestingly, a few weeks ago we had a similar "fantasy Monday", where traders went gonzo for the Empire State Manufacturing Index -- which is just a sentiment survey, it turns out -- and that marked the top. This Monday was a similar exhaustive rise on very little hard information -- again, some sentiment surveys were the catalyst -- and Tuesday was unable to make more headway.

The market may indeed by able to make it back to our bear market re-test level of SPX 1021, but to get much beyond that is going to take some real, hard evidence of a booming recovery. That's going to be a tall order. It's much more likely that the levels we are seeing now are going to mark the top for many years, just as the 21,000 level in the Nikkei has marked the top of that bear market for years. More on that tomorrow.