Annex Bulletin - 98-29 ("Small Caps Sinking First")

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Wall Street Gloom - Main Street Boon?

A Wall Street gloom could mean a Main Street boon. Until now, money has been flowing mostly out of the Small Caps and into the Blue Chips, i.e., still circulating inside the casino. But when the Blue Chip stocks also tumble, the lucky sellers will have to invest their money somewhere else. Government securities or savings accounts is one relatively "safe" option. If a portion of that money finds its way into the economy, however, rather than being transferred to another world casino, or is spent on economic perversions, such as stock buybacks, Main Street may yet get a welcome boost. As that old saying goes, "one man's loss is another man's gain."

PHOENIX - The raging bull of Wall Street is just that - bull. For a majority of the stocks traded on the New York Stock Exchange, the bear market has already arrived. It's only the bluest of the Blue Chip companies with the largest market capitalization that are creating an illusion of prosperity. Yet even the Dow Jones Industrials Average (DJIA), the index of 30 such enterprises, is down 4.5% since the 1998 high (reached in mid-July), according to the July 30 Wall Street Journal report.

As with any general rule, there are exceptions. The IBM stock, for example, has been setting new all time highs - $134 on July 30, then $138 on July 31, even as the DJIA tumbled nearly over 140 points the same day. And the Big Blue did all that despite its dismal second quarter financial report (see Annex Bulletins 98-27, 7/21/98, and 98-28, 7/30/98).

But while this case shows that you can buy Wall Street's approval and create an illusion of prosperity if you repurchase enough shares ($20 billion-plus in IBM's case), the picture for most other stocks isn't nearly as rosy.

The Standard & Poor 500 index, which reflects wider market trends, is down 5.1% from its 1998 high. Nasdaq composite, yet a broader indicator, is down 6.6%. And Russell 2000, an index of smaller stocks is down 13.2% since its April high, and down 2.5% for the year.

In other words, while the Blue Chips peaked in mid-July, the Small Caps had reached their pinnacle three months earlier. As with a sinking ship, water fills first the lower compartments, before rising up to the higher ones, and capsizing the whole structure.

Beyond the stockmarket indexes, the bear is looming even more prominently, especially for companies with the smallest capitalization. The July 30 WSJ report also showed that the stock with the largest capitalization - greater than $20 billion - were off by 11.7% from their 52 week high. But the smallest of the Small Caps - with capitalization of less than $250 million - were down 43.3%. And 51% of the Nasdaq stocks are down 30% or more since their 52-week highs.

"The smaller a stock, the more of a bear market," one investment banker told the WSJ.

A disaster in the making? Not quite. Despite the raging bull of Wall Street, less than 20% of Americans had stock portfolios, according to the 1995 NYSE Fact Book. And while that percentage has certainly increased since 1995 (due to the prolonged bull market; some estimates put the stock ownership now at one-third of the population), still a vast majority of Americans couldn't care less about which way the Wall Street indices point (that they should care is another story, as their lives are affected by Wall Street whether or not they play the market).

Furthermore, we estimate that only 3% of Americans own about three-quarters of the stock portfolios. And since the stockmarket wealth is concentrated in so few hands, the heart palpitations which occur with every swing of a Wall Street index are limited to relatively few hearts. (Those who believe that Wall Street is being run by heartless tycoons may question even that notion ).

As the IBM example has proven, Wall Street has become almost totally decoupled from the nation's economic activities. Like a gambling casino, it is largely driven by investment cashflows, not profits or losses of the companies it trades.

But while some worrisome trends at the Wall Street casino may not worry too much the non-gambling public, another report just in from the U.S. Commerce Department should. The second quarter's Gross Domestic Product's (GDP) growth plunged to only 1.4% from a blistering 5.5% pace in the first quarter.

And even the 1.4% rate may be understating the economic slowdown. The Commerce Department was assuming that inventories grew faster and that the trade deficit narrowed in June. When these estimates become known facts in a month or two, there chances are the 1.4% GDP growth will be revised sharply - downward. Which prompted one analyst to say to the Investors Business Daily (Aug. 3) "it sounds like they didn't want a negative number." In other words, a recession.

One factor which has boosted the GDP in the second quarter was a strong computer sector's performance. Consumers' purchases of computers soared by 45% in the second quarter, after a 68% pace in the first. Excluding computers, the GDP growth would have been only 1%.

A strong housing market also aided the growth. But the GM strike and a soaring trade deficit were the drag on the GDP growth. So even without the "fast track" legislation (which would have given the President more power to negotiate trade deals), the one element of the U.S. economy that is already on a fast track skid is our trade deficit.

Reflecting the trickle-down effect of the Asian crisis, the U.S. trade deficit soared in the second quarter to an annualized $253 billion, up from $199 billion in the first, and up from $192 billion in 1996.

Well, the predicted economic deterioration which was expected to take place over a year-plus period has evidently been compacted into a mere six months, as the second quarter exports plunged 8% while imports jumped 12%.

These figures put a very different spin on President Clinton's recent trip to China, a country which has now surpassed even the highly industrialized Japan in terms of the bilateral U.S. trade deficit, according to the President's own February 10, 1998 "Economic Report on Trade."

While Clinton's rhetoric in China made it seem as if he were promoting the U.S. exports to that market, the economic statistics prove that this U.S. President has been actually helping export the U.S. jobs. For, the $253 billion trade deficit could translate into a "great sucking sound" of about 2.5 million American jobs vanishing.

In reality, Clinton's trip was primarily intended to protect the $158 billion Big Business had invested in China during the 1990-1996 period. Which means that China got one-third of all investments multinational companies had made in the developing world during that period. And it also shows who Clinton really works for.

Meanwhile, back at the ranch, the Chicago purchasing managers' index for July provided additional food for worrisome thoughts. Business inventories rose more than 11 points in July - the biggest increase in more than a year. And that's despite the fact that the prices index dropped to a seven-year low.

Let's summarize: the stockmarket is emitting signs of weakness; the economy is showing signs of slowing down. Yet consumer spending is soaring (up 5.8% in the second quarter; up 6.1% in the first). And why not, given the bullish headlines the government officials have been feeding the gullible public.

But prudent investors and consumers will discern from these indicators signs of potential trouble for the second half of 1998 and beyond. And will begin to lower their risks before either the stockmarket or the economy does it for them.

Can you afford not to know such things if you're a global competitor? If you agree, call us as (602) 824-8111.