October 27, 2008 – To identify the primary trend of the stock market, I like to follow the trading pattern of the so-called ‘bellwethers ‘, key stocks that are important to the overall market because of their high capitalization, huge shareholder base and/or other reasons. Long-term readers of these letters know that I like to use General Electric in particular as the key bellwether for the entire stock market. It is in effect the king of the bellwethers.
I have highlighted GE’s performance and price chart at several key points over the past several years. Here ‘s what I said for example in Letter No. 291 published on September 10th, 2001, shortly before Jack Welch ‘s retirement: “ There was a puff-piece in The Wall Street Journal on September 5th about Jack Welch’s retirement, and the chart of GE ‘s stock price on page B10 stunned me. There ‘s no doubt that he accomplished a lot for GE during this tenure, but GE is forming a classic textbook head and shoulders pattern, with the neckline right around $40 .”
We all know what happened the next day. When the NYSE re-opened in the aftermath of 9-11, GE quickly fell through $40, a move that completed the head & shoulders pattern so clearly visible on the accompanying chart.
Then in Letter 302 published on April 1st, 2002, I provided a more detailed explanation on my outlook for GE that remains relevant today. “I ‘m a firm believer that the market knows all. And right now, given that chart pattern in GE, the market is saying that the immediate future for GE does not look good. I think their problem area will prove to be GE Capital.
When most people think of GE, they envision refrigerators and aircraft engines. But the industrial components of GE are only about one-fourth of the business. The rest is GE Capital, and GE’s financial businesses.
In essence, three-fourths of GE is one big hedge fund, borrowing short and lending long, the classic pattern by which financial firms get into trouble. As if that weren ‘t worrying enough, many Wall Street analysts are now learning that GE is also loaded up with derivatives and SPE ‘s, the ‘special purpose entities ‘ that were Enron ‘s undoing.
GE denies any improper accounting, and its latest 10-K has been considerably expanded with new disclosures in an attempt to put the minds of Wall Street analysts at ease. But the big question is now being asked. Is GE ‘s clockwork-like growth in earnings at least partially the result of accounting gimmicks?
That question remains unanswered, but so far, GE has been getting the benefit of the doubt. But the above chart [as of April 1, 2002] indicates that people are going to be less willing to pay a big multiple for GE’s earnings, regardless of whether or not the accounting for those earnings is solid.
GE is the largest corporate issuer of commercial paper on the planet. There is some $130 billion of it, which is a staggering 9% of all the commercial paper outstanding today. Of this amount, GE Capital owes $100 billion. Plus it also has $31 billion of existing long-term debt maturing this year .
Commercial paper is essentially payable on demand, so most companies have bank lines to fall back on should the notoriously fickle commercial paper market tighten. The problem is that GE Capital only has $34 billion of back-up credit lines, $66 billion less than the amount of its outstanding commercial paper.
What happens if GE Capital’s access to the commercial paper market dries up like it has for so many other companies in the post-Enron environment? “
Those words now appear prescient, and we know now that the Federal Reserve is buying commercial paper to backstop GE while it also backstops the banks, insurance companies, and money market funds. But returning to the point at hand, when I wrote the above it was clear to me that the prospects for GE – and by extension the entire stock market given GE ‘s status as the key bellwether – had by then deteriorated significantly. To emphasize the importance of this point, I then added in Letter No. 302 the following:
“I ‘d like to make one last point about GE, which was one of the darlings of the 90 ‘s bull market. There are also other names that fit this description of past favorites. Enron had been most everyone ‘s darling before it crashed, but attention has shifted to other darlings like Tyco. Can it be too long before attention shifts to GE as well?
It has been my experience that it is the nature of bear markets to smash the darlings of the previous bull market. Also, the bear market usually only ends when the biggest icon has fallen, and there is no doubt that GE is the biggest icon of them all. Could it fall in this bear market? Is it possible that GE could trade in the single-digits before this bear market is over?
Of course, when it comes to markets, anything is possible. Only time will tell what happens to GE, but the above chart [as of April 1, 2002] is not very pretty. This chart is saying clearly that GE is a company whose outlook raises serious questions. Therefore, take the prudent course and stay away from this stock.“
I then focused on GE again in Letter 370 published on September 19th, 2005.” The warning signs are there for everyone to see, including the PPT [The so-called Plunge Protection Team, which is the nickname of the President ‘s Working Group on Financial Markets that has been rumored for several years to be buying stocks to prevent a stock market collapse, obviously unsuccessfully I might add], but the PPT cannot stop the message from this chart [of GE]. That message is to stay away from financial stocks, like the banks, Fannie Mae and GE. Yes, I consider GE to be a financial stock. Having moved far beyond its origin in manufacturing, three-fourths of GE is now in effect one big hedge fund, borrowing short and lending long, which is the classic pattern by which financial firms get into trouble. The above chart [as of September 19, 2005] is saying that GE is facing some perilous times ahead.”
I concluded with the following:” The longer the stock market defies gravity, the harder it will fall when it finally heads back to reality .”
Reality has finally struck home over the past several months. After one last hurrah in which GE in 2007 retraced all the way back to the neckline of the head & shoulders pattern at $40, GE has fallen sharply, closing Friday at $17.83. Will it hit single digits like I speculated years ago?
It is of course possible, given the worsening liquidity crisis and the pervasive, ongoing de-leveraging. But regardless, the message remains the same. Stay away from the stocks of financial companies and banks. This bear market has not drawn its last breath.