Back in April 2000, I wrote an analysis of what drives the stock market up and down. One of the conclusions of the piece was that the stock market is a fragile thing – small movements of funds in and out of the market are magnified into huge changes in the market’s total values. The other conclusion is that the market’s direction is the composite of all the money that is moving in and out of the market, and that dissecting the various sources of funds into the market will give us insights about where the market is going.
Follow The Retirement Funds
One of the things that became apparent after the violent crash of the Nasdaq market last spring is that, despite the violent nature of the crash, it essentially would not go below an imaginary line. That imaginary line, which I have called the Basic Trend Line, happens to be the extension of Nasdaq’s previous trajectory before its magnificent rise.
This behavior of adherence to a basic trend line does not just exist in the Nasdaq. If you look at the chart of the S&P 500 Index during the last several years, you’ll also see that the famous index also hovers above an imaginary line, except for a brief interruption in the fall of 1998. 
The basic trend lines in the Nasdaq and the S&P 500 basically represents a stable source of continuous new investments into the market, most likely the retirement savings of the population. Most of us set up the retirement savings as a once-a-month automatic deposit into some mutual funds (and a lot of this goes into S&P index funds), and don’t mess with it except under very unusual circumstances.
I have not been able to find a number that sums up all the various different kinds of retirement savings, but I do have anecdotal data. Most of my former employers provide 401(k) retirement accounts into which employees can contribute up to 14% of annual salary. Some of the companies also provide matching contributions, bringing the total to up to 20% of salary. This amount is comparable to the effective income tax rate of most workers. (Other types of company retirement plans are probably of similar value.) It means that the retirement savings could be in the same order of magnitude as the federal government’s budget, which currently stands around 1 trillion dollars a year.
The Hovering Speculators
Let’s distinguish between two components of the market: the steadily rising basic trend line(s) representing the steady infusion of retirement savings money, and the part that causes the market to fluctuate and hover above the basic trend line, representing speculative money.
The S&P 500 index has come back to visit the basic trend line in each October of past 3 years. In 1998, it dropped significantly below the trendline – as we may recall, that was during the Asian currency crisis and when Russia defaulted on its national debts and an international economic crisis was looming. That was about the only time when the retirement money was fleeing the market during the last few years.
In 1997, 1998, and 1999, the S&P 500 Index came back to visit the basic trend line only once each year, and each time around October. However, the index has visited the basic trend line 4 times so far this year: in February, April, May, and again August. We can perhaps safely expect another return visit this coming October.
There will always be a certain amount of speculative money hovering above the market. But for Nasdaq at least, the glorious days of last spring’s speculation is essentially over. Back in march, the speculation money causes the Nasdaq to depart 2000 points (nearly 70%) from its basic trend, now it’s only 400 points or 12% above the trend line.
The speculation money is always quick to flee the market, but it also doesn’t want to stay out of the market for long. If the market sticks to the basic trend line during the coming correction, we can expect some of the speculators to come back afterward, perhaps fueling another late year rally.
There is a vast reserve of potential speculators: the $1.5 trillion of savings in low interest U.S. bank accounts. Giving a large enough amount of hype, some of this money would be lured into market speculation. That was probably what happened to Nasdaq last spring.
Riding the Tide That Lifts All Boats
Supposed we ignore all the speculators, and invest only with the basic trend. What kind of return might we expect?
For the last 3 years, the S&P 500 Index’s basic trend line has risen about 200 points a year. Since the basic trend line currently projects at around 1450, it gives us a potential return of about 14% a year. For Nasdaq, the basic trend line increases by about 650 points a year and current projects at about 3650 points, or 18% annually.
This means that, even if we take away all the speculation money, we can still expect to earn about 14% on S&P, or 18% in Nasdaq just by riding on the retirement funds. Or put it another way: if you enter the market when it drops back to the basic trend line, a year later, even if all the speculation money is not there, you can still expect to make that much money.
Instead of just riding the tide, you may be able to do a little better by surfing the waves a bit, especially during the current turbulent market: For example, if you enter the S&P Index funds during the 4 times that it touches the basic trend lines this year and then departed during its subsequent peaks, you would have made 60% since last October (This is only the theoretical possibility. Timing the market is usually harder than it seems since the benefit of hindsight is not there.)
During the last several months, when speculation money dominates, certain segments of the market have been decidedly bearish since last April. But now that the speculation money has subsided, what is the mid-long term prospect of the market?
I have visited upon the Dow Jones Industrial Average’s charts a couple of times during the last few months and saw a couple of reversal signals there. Coupled with Nasdaq’s reversal, I have forecasted a long-term general market reversal. Now we should perhaps incorporate the theories from this article into the forecast.
I wish to de-emphasize the Dow Jones average for a couple of reasons: its narrow representation of the market (only 30 stocks), and its significant reconfiguration early this year (the addition of Microsoft, Intel, and Home Depot) has called into question the continuity of its charts.
The Nasdaq and S&P 500, representing the technological and the general markets respectively, will be our favored barometers. One nice feature of these two indexes is that they allow us to distinguish between speculation money and steady investments. If we subtract the basic trend line from these two indexes, we can see that the speculation portion has been decidedly bearish: in addition to Nasdaq’s actions, the S&P 500’s speculation has dropped back to the base line 4 times so far this year already, whereas in previous years none would have happened until October.
Ignoring the speculation portion of the market, so far there has been no exodus of retirement funds since the Asian currency crisis. So this portion of the market is neutral or even slightly bullish.
So watch the Nasdaq and S&P 500’s charts closely. If either of these charts should drop below the basic trend line and doesn’t quickly bounce above it, then the long-term bear market has arrived. We can expect the retirement money exodus to begin once there’s a perceived down turn in the economy. Another possibility is that, after the speculation money is gone and doesn’t come back for a while, the retirement money will get nervous and begin to exit too.
But the long-term prospect of the market remains bearish. The market has simply risen too much during the last 10 years: even from a basic trend line standpoint, the S&P has risen 70% during the last 3 years. It’s hard to imagine the natural cycle of the market to not set in sooner rather than later. But at this point, that bearishness has not spread from speculation money to retirement money just yet.
The S&P 500’s basic trend line has been rising 200 points a year. Since the index stands at about 1500, you’d think that S&P 500 was at zero 7.5 years ago. But that is of course not the case. There has been a redirection of retirement funds into the stock market during the last several years. (Another possibility is that the basic trend line is really a composite of retirement funds and some other recently arose source of stable investments.) This trend would be reversed as the economic slows down and baby boomers approaches retirement age. The first baby boomers are now 55 years old and financial advisors typically tell us to move money from stocks to bonds 10 years before retirement.
None of this new analysis changes my original assessment that the financial markets are pyramid schemes that depend on the continuous recruitment of new money to keep going up.
I have increasingly come to view the financial markets as the center of wealth redistribution rather than wealth creation. The sometimes appearance of wealth creation in the market is, like I have pointed out, actually an accounting gimmick and conspiratorial recruitment tool of the markets.
So, if the retirees have put X trillion dollars into the market, that will perhaps be the amount they are likely to get out (if the market’s recruitment prospect doesn’t change). The only difference is that, some will take out more than they put in, others who act late will take out less.
09/10/2000
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