AEGEAN CAPITAL GROUP INC.
STOCK MARKET REPORT

 Publisher: AegeanCapital  Group, Inc.,    Report#25,    9-22-2001,  10:30pm PST ,  Page 1of 14

What Now?

 In our weekly update for 4-6-01 -five months ago- we said:

 "...In addition, we are increasingly worried about the escalating violence in the Middle East. Over the past few months we have repeatedly  stated -see daily updates- our deep concern over the situation. MAKE NO MISTAKE, the continuous violence -if goes unchecked,-will ultimately impact our financial markets, directly, or, indirectly. Investors must understand, that there is a war taking place in the Middle East, and in the eyes of many Arabs, we ARE already a part of it. It does not matter whether the escalating violence results in a wider conflict in the area, or, Islamic  extremists bring the conflict to our shores, either way , we will still be drawn into it with grave consequences. The violence in the Middle East, is the biggest and wildest card of all. Investors beware! ..." (see Weekly Updates Q2-2001)

In our wildest imagination, we could not have predicted the exact horrific event. However, all the signs were pointing to an escalation of the hostilities with the U.S. being one of the targets. Look at the table below, it chronicles the terrorist attacks against the U.S. over the past 18 years.

Notice that we had just as many terrorist attacks the last four years, as we had the previous ten! Clearly things have been heating up. In addition, the last year we have seen an unprecedented increase in violence between Israelis and Palestinians, which usually raises not only  the level of hatred from Islamic extremists towards the U.S., but also  their desire to do something in return. So, finally they did, now what?

This is a financial publication, so we will not make any attempt to address the political, and military ramifications, however we will attempt to shed some light on the financial ramifications. In this vein we would like to remind our readers of the following a) in our last newsletter dated 8-19-01 we stated the following with regards to U.S. equities:

"... if the upcoming news, confirm that the economy -and corporate profits- are getting worse, instead of better, then we would expect for the "floor" to cave in, and NASDAQ to head somewhere between 1100 and 1000, and the SP500 somewhere between 880 and 950."

And in our weekly report for 9-7-01 (four days before the attack on the WTC) we posted the following charts, and said the following with regards to the Japanese and German Stock Markets:

As of the close of the market on 9-21-01, the DAX Index closed at 3787, and the NIKKEI closed at 9555! The reason we are bringing these up is not to congratulate ourselves, but to make a very important point: The markets both domestically and abroad had been weakening for several weeks before the horrific events of 9-11-01. The signs of the weakness were abundant, and could be seen by anyone except the myopic "experts" who appear on the mainstream media. Industrial production had fallen for 11 consecutive months, unemployment was on the rise, hours worked had fallen, foreclosures and bankruptcies were up, consumer confidence had been falling, housing had started to roll over, with R.E. agents reporting rising inventory, but no buyers. The attack on the WTC, simply made it undisputable that indeed there will not be a second half recovery, in the economy, or,in  corporate profits, and the markets did what they would have done anyway, but they did it  in a more accelerated fashion. The question in everybody's mind is whether markets -at current levels- have discounted all possible negative outcomes, that may result from the recent events. 

At the moment we believe that it is way too early to draw any conclusions, given the lack of clear evidence. Assuming that there are no more attacks on U.S. soil, "conventional wisdom" holds that the economy will rebound sharply due to monetary and fiscal stimulus. However, almost everybody will agree, that "conventional wisdom" has been one of the casualties of the bear market of the past 18 months! We believe that in the short to intermediate term  the fall out of the attack on the WTC will be far more negative than advocates of "conventional wisdom" are advocating. Furthermore we need to consider the following: Stock prices will continue to be impacted from what happened as long as, investors do not have a clear indication of the outcome of this war. It should be noted that the markets started to rally after the Battle of Midway, and in recent years, after the bombing of Iraq commenced. In both instances the markets saw -in black and white-that ultimately the US was going to prevail. At the moment we hope that we will prevail, history and righteousness are on our side, but no evidence yet to confirm the hope! Thus, the market has no solid reasons to recover for. Moreover, the U.S. equities will continue to experience outflows from European investors for the foreseeable future for the following reasons:

In the late 90s the US offered the following:
1. Appreciating Financial assets
2. Appreciating Currency
3. Strong Economy
4. Political stability
5. Predictability
6. Productive employment of resources
7. Confidence in the institutions of the country to maintain the "status quo"

The above reasons combined made the US a superior place to invest, an environment in which investors achieved returns above the historical average while the underlying risk was below the historical average. So, if you were sitting in a pile of money in Rome, Athens, Madrid, Munich, etc. it was a no brainer where to put your money: The U.S. Consequently billions upon billions came into the  market from European investors in the second half of the decade. 

All that started to change the last 12 months.
1. Financial are no longer appreciating.
2. The currency has started to lose value as well. (The result of this combined phenomenon is that foreigners holding US assets, are losing money from TWO sources, if the equities markets fall by 10%, and the US dollar falls by another 10%, the total loss to the foreigner is 20%)
3. The economy is no longer the envy of the world. It is now clear that the  bubble has burst. Every honest professional -who's not in denial- knows  that it takes time for post bubble economies to recover. So at the best, we were expecting a slow recovery. All that changed with the attack of the WTC. It is now becoming clear that the consequences will have a severe economic  impact. More over, because this a situation that nobody really knows how
it can unfold, nobody is willing to make a bet -with his clients' money-  that nothing else will happen. If no more terrorist attacks took place then pretty much everybody agrees that the liquidity, and fiscal stimulus injected into the system, are more than sufficient to get us going again. However, what happens if there is another attack, let's say in L.A., or Miami? If you are a money mgr. from Germany, how do you explain to your clients your decision not to reduce your exposure to US equities given  the circumstances? Any prudent, risk-averse manager, must anticipate the worse, and position the portfolio accordingly. In fact, because you have
a "fiduciary" type of relationship with your clients, you are contractually obligated to do so! So, you are not going to wait until the next attack and the next 2000 points decline in the Dow, to reduce your exposure, prudence tells you to do it NOW (you can always come back).

4. At the moment there is unity across the political spectrum. However, we are getting into something that is unknown and may take years. Europeans, believe that Americans do not have the stomach for another  Vietnam , of much larger scale and involvement. Neither, do they have the stomach for civilian casualties. Thus, a prolonged fight will result in divisions, and political instability. Is it certain to happen? Of course not, but again, as a money manager. -responsible  for other people's money- you do not wait until it happens, to reduce your exposure, you do it now, and you wait to see how things turn out.

5. Stability, produces predictability. Since, stability is threatened so is predictability. You can no longer predict returns based on quantitative studies, because outcomes are influenced by exogenous events, that are un-predictable, and un-quantifiable. For example, how do you quantify risk in owning Disney stock, if you have to take in consideration that Disneyland and Disney World may be the next targets? What are the odds of Disneyland being the next target? we do not know, but if you're responsible for somebody else's money, and you hold Disney in the portfolio, then you'll sell some, to reduce your exposure, just in case !
6. Productive employment of resources produces superior returns. War re-deploys capital from productive investments to non productive investments, thus depressing  the long term returns on investment. For example, we are spending 17b to rescue the airlines. We are spending 17b -and rightfully so- just to put them back where they were 10 days ago! In other words, 17b later, and we are back where we were 10 days ago. That is the  impact of war. So, from a "macro" point of view, if indeed the US gets involved in a long protracted war, the aggregate returns on the economy -and those of the stock market- must be adjusted down. So, as a money mgr. you need to re-adjust your exposure to US equities.

7. Last and perhaps more important than anything else, is the loss of confidence in the US and
its ability to use its vast resources to protect itself from catastrophes like the one we just experienced. Terrorists were able to highjack four planes on the same day, and fly them into three of them  into N.Y. and Washington. What does that tell foreign investors about the agencies that are in charge of preventing these things from happening? There has been a monumental lapse of intelligence, yet nobody is asking tough questions in the spirit of national unity. However, Europeans do not have to display such unity, so, they can ask questions like this: what was the FBI and the CIA doing? If they were unable to prevent this, why should we be confident that they can prevent another attack? So, because of loss of confidence in America's internal defenses, no one wants to wait until the next attack to reduce their exposure to US equities, they are doing it now, and asking questions later (PLEASE NOTE, THAT -AS YOU KNOW WE WERE 93% IN CASH AT THE TIME OF THE ATTACK, AND IN NO NEED TO SELL- 90% OF OUR CLIENTS ARE EUROPEANS, SO WE KNOW FIRSTHAND THE SENTIMENT DESCRIBED ABOVE TO BE TRUE AND ACCURATE)

It should be noted that Europeans are holding 1.7 trillion in U.S. financial assets, if those assets were reduced just by 20% -which a reasonable expectation- that will translate into an outflow of 340 billion dollars, which is nothing to sneeze about! 

All that will change the moment the US can demonstrate to the world that once again we will prevail, thus restoring confidence in our systems and institutions. We believe that U.S. intelligence underestimated terrorists and they committed a major blunder that resulted in the loss of thousands of innocent lives. We also believe "pundits" are now underestimating the fall out of this horrific event and any "war" resulting from it. However, even more strongly we believe that underestimating the US and its resolve, will be the biggest blunder of all. Ultimately we will prevail, however until the markets see solid evidence of this, they will continue to suffer, both from the economic impact and  uncertainty.   Do not be surprised to see the "elusive bottom" come at around 7000 for the Dow, 755 for the SP500 and below 1100 for NASDAQ.

Now let's take a look at the technical condition of the equity markets.

NEXT PAGE

DISCLAIMER

All rights reserved. Any reproduction of the text, graphs, tables, or analysis, in their entirety or in part, without the written consent of AegeanCapital Group  and  of the author, is strictly prohibited. Analysis is derived from data believed to be accurate and in accordance to the investment methodology of the firm as outlined in our “methodology” section of our webpage. It should not be assumed that such analysis, past or future, will be profitable or will equal past performance or guarantee in any way future performance or trends. Information is provided to assist subscribers in formulating their own understanding of market dynamics and no statements therein should be construed as recommending any specific course of action outside of our firm’s trading in our own account. All trading and investment decisions are the sole responsibility of the reader. The firm, the editor (in  their accounts) from time to time they may have open positions in the markets  covered.  Also, please see our “Disclaimer ” in our web page.