Past Long Term
CHILDREN OF GOLDILOCKS
Awakening from our two season long
writing siesta, we suddenly knew how Rip Van Winkle must have felt, for it
was a different world that greeted us upon our first tepid steps out of
Tulips headquarters into our little town on the Hudson.
Gone were the children of Goldilocks,
dashed to bits were dreams of silicon pots of gold at the end of every
rainbow, our fearless hero the Pre-Emptive Crusader had long since put
down his rate hike baton, and the acrid smell of dot death permeated the
holiday season air.
It seems that history did repeat itself
during our snooze, and as in countless other new eras when exuberance
ruled with an iron grip on the hearts and minds of its followers, the last
in the door suffered the worst carnage.
The wounds suffered by those late to the
party will cast an evil spell upon the fortunes of the land, turning
springtime dreams of endless prosperity into winter time hopes for
recovery, but those winter time thoughts of better days ahead are likely
to be dashed as the bloodshed continues, as the pendulum continues its
age-old tradition of swinging further to the other side than even the most
pessimistic expected, the children of Goldilocks wearing tattered rags when
the dust has settled.
SILICON DEATH ALLEY
Stepping through the rubble created by
an inability to separate reality from dreams, fact from fiction,
salesman's pitch from viability, we sense that even with the ranks thinned
and faces long, the march into the abyss of Silicon Death Alley is not at
its end, a bottomless pit waiting to swallow the dollars of those who feel
the worst has passed.
The ranks of the extinct will continue
to swell in the months ahead, making anything dot com a nightmare for
investors who stayed the course, hanging on in the belief that after a 90%
fall the only possible way was up for their beaten down shares, forgetting
that even at pennies on the dollar the possibility of a 100% loss of
In the land of dot death, the pyramid
scheme to end all pyramid schemes has been thrown into reverse with a
vengeance, dragging down all in its wake as the soldiers fall one by one,
forcing even the fittest to do daily battle to survive.
In the land of dot death, the carnage
has been great, the mightiest of superstocks have been beaten to a bloody
pulp, but even at these levels there is likely to be further to fall as
the death of the minnows slows the growth rate of the industry Goliath's
to a crawl.
Perhaps a glimpse inside the numbers emanating
from the finely tuned machine of Tulips headquarters is needed to
illustrate the aftershocks that are yet to come. Traffic to our humble
abode is booming, with 521% more bodies cramming through the door this
November than last, and December's figures running 35% above those of
November, but advertising revenues are running flat with last
November--a tale that is being repeated throughout the land.
With these facts in hand, we would avoid
those who remain heavily dependant on advertising, for the odds of a safe
trip home for these hapless souls is more dim than bright. Community
web site operators a la iVillage and theglobe.com, teen portals a la
snowball.com and delia*s (nee iTurf), and numerous content sites have the
odds stacked against them in the year ahead.
The goliath's who relied heavily on the
second tier will see their growth stunted, the outfitters (or software
makers as some of you may call them) will also see their outlook dim.
NEW YEAR'S DOGS
While Y2K is rapidly turning into the
year of dot death, Y2001 is likely to be remembered as the year of the
aftershock, with the stocks of brokerage firms and real estate companies
thrown in the 50%-off bin before the dust settles, the turn of the two
industries from boom to bust appearing as it always does: suddenly and
hero is this weeks pariah, last weeks forgotten man is this weeks
hero, new is out, old is in, sector rotation is the flavor of the day, but
momentum remains king in the land of guaranteed golden dreams.
The stock markets frenzied two day
game of sector rotation, the backwards push from the heretofore exalted
new economy stocks into the forgotten downtrodden denizens of the old
economy, took a breather on Friday. The NASDAQ Composite continued the
recovery that it began Thursday afternoon, gaining 80.74 on the day and
ending its two-day spell below its 21-day moving average to close at
4798.13. The Dow Industrials took the opposite road. The index never
recovered after it ran headlong into the twin obstacles of resistance at
10750 and its 55-day moving average, reversing mid-morning to end the day
down 35.37 at 10595.23.
The key question going into next week
will be whether today marked the end of the old economys brief tenure
in the leadership chair, or merely a brief pause in a sustainable rally.
The briefly battered but never panicked
parabolic superstars: the tech stocks, Internets, and biotechs, may regain
a bit of their former luster as the quarter winds to a close. The publics
love affair with the over hyped technology sector remains intact despite
this weeks carnage. The latest figures from AMG Data Services show that
the lions share of fund inflows continued to find their way to the
technology and aggressive growth sectors in the week ended March 15th,
with technology funds picking up $2.4 billion and aggressive growth funds
adding $2.6 billion.
These inflows are likely to continue
into mid-April, providing a temporary safety net for the overextended
darlings of young and old.
The tech sector will also receive a
boost from our old friend: the window dressing portfolio manager. While we
are looking for value in the likes of Goodyear, Sears, J.C. Penney and
their ilk, the average retail investor is unlikely to be impressed by this
downtrodden trio, preferring instead the overpriced delusions of grandeur
that a portfolio laden with the likes of Ariba, eBay, Sun Microsystems,
and Cisco offers. The average portfolio manager will oblige the media
driven wishes of investors in his funds, giving the tech sector a late
As we have said before, we expect the
tech sector rally to continue until mid-April when seasonal factors will
begin to work against the sector, making this weeks bloodbath seem like
childs play as the summer begins.
With the tech sectors parabolic rise
nearing the climax of the blowoff top it began late last Fall, are we
rushing to place our bets on this weeks leaders, the revitalized rust
belt cyclicals, consumer goods makers, and brokerages?
The answer: a resounding No.
Three familiar (and perhaps not so
familiar) names argue against diving headlong into the suddenly reborn old
economy stocks: Alan Greenspan, Procter & Gamble, and H.B. Fuller.
Soap maker Procter & Gamble and
chemicals maker H.B. Fuller issued separate earnings warnings earlier this
monthwarnings with a common thread: rising raw materials costs and the
strength of the dollar against the Euro. We expect to see many more
companies fall short of expectations in the coming weeks as this quarters
twin rise in oil prices and the dollar wreaks havoc on the bottom lines of
many old economy stocks and companies with a heavy exposure to Europe.
We have been saying for many months that
the bubbling undercurrent of inflationary pressures building below the
surface would leave many companies with two options, neither of which is
good news for investors: companies faced with rising raw materials prices
would be forced to either pass along price increases to the consumer or
they would be forced to eat the added costs, with profit margins taking a
hit. At this point, it appears many companies have been forced to choose
the latter option. . The key question becomes how long will companies be
able to absorb the effects of rising intermediate and crude goods prices
before they are forced to pass the increases onto their customers.
Margin pressures caused by rising raw
materials costs are likely to continue into at least the second quarter,
and possibly beyond. Thursdays release of the February PPI numbers
showed an acceleration in inflationary pressures in intermediate goods and
crude goods, with intermediate goods rising a stronger than expected 0.8%
for the month and crude goods jumping 4.7%. The 0.8% gain in intermediate
goods prices was the largest increase since a 1.1% gain in January 1995.
Intermediate goods prices are up 5.3% over the past yeara fact that
will not go unnoticed by the Fed at Tuesdays meeting
.which brings us to name number three
on our list: Alan Greenspan. The stock market has already braced itself
for an increase in interest rates at Tuesdays FOMC meeting and has
battened down the hatches for a further increase in May. This weeks
economic data: from the unrelenting pace of consumer demand growth in the
face of rising interest rates as shown by the latest retail sales numbers
to signs of inflationary pressures accelerating in the pipeline, indicates
that the Feds tightening cycle will stretch far into the summeran
event which the stock market is unprepared for, and an event which
indicates that now is not the time for a sustainable rally by the beaten
down stocks of the old economy.
loves a bargain, and everyone loves the only game in townthe game where
the risk/reward ratio is perceived by the faithful to be 100 parts reward
and 0 parts risk, the game where the players view the path ahead as paved
with gold and believe participation is the only requirement for future
success, the game where those late to the party are the biggest fans, the
game where charlatans in search of a fast investment banking buck cloak
themselves in an air of respectability and charm the unsuspecting with
glowing research reports based more on fantasy than fact, the game which
has replaced baseball as the national pastime.
In days of yore, in a long lost time when
participants still contemplated the relationship of market valuation
levels to historical norms and in a forgotten era when brokerage house
"buy" ratings were based on an analysis of the underlying
fundamentals rather than on an analysis of the investment banking dollars
to be gained, market participants knew that there were no guarantees, no
easy ticket to the promised land of the good life. They played the game
with a knowledge that can only be gained by experience, knowing that
parabolic climbs were most often followed by blood curdling declines,
knowing that nothing lasts forever, understanding that there are times
when gravity will win out and will prevent the ball from bouncing back to
the lofty levels it once so easily attained.
Today, in the golden era of bits and bytes, of
digital dreams , of overnight paper billionaires, the lessons of the past
are often overlooked, the laws of gravity held in contempt, the
participants lulled into complacency by their ride on a rising tide, the
boastful confusing trading skill with the fortuitous luck of entering the
game on a sunny day. Today, when the going gets tough and gravity exerts
its pull on the bouncing ball, the tough and not so tough get going
their nearest phone or computer terminal to bark out buy orders to their
broker, confident in their belief that Annie was right, "The sun will
(always) come out tomorrow".
The unwavering faith of current day participants
that "what goes up, will always go up", when combined with the
age-old tendency of the inexperienced to disregard the commonplace warning
"past performance is no guarantee of future performance" has
magnified the divergence between the performance of the narrow strata of
brokerage "analyst" pushed crowd pleasers and the
underperforming broader market. In recent weeks, when the going has gotten
tough and the buy on the dip faithful have dutifully and mechanically
arrived to save the day, their buying has been concentrated not in the
markets true bargains but rather in the markets most overvalued
sectors, namely technology, Internet, and biotech-- pushing these sectors
further into the uncharted waters of record valuation levels.
Neither the gravitation towards the most highly
"touted" stocks nor the leaving of historical valuation methods
by the wayside are surprising, for they are events which routinely occur
when widespread knowledge of the longevity and strength of a trend inspire
mass public participation, creating a mass frenzy of buying which
culminates in a blow-off top similar to that seen in technology stocks
After an initial parabolic upward thrust,
blow-off tops will often culminate in a period of widely volatile
distribution as money passes from weak hands to strong hands, from the
experienced to the inexperienced late-arrivers who have been lured to the
"game" by the scent of easy money.
The markets current phase of distribution is
likely to continue until Tax Day, April 15th, as strong inflows
continue to provide a cushion that counters the waves of selling by
The numerous cracks that have begun to appear in
the market: from the breakdown of 2/3 of the Dow Industrials (the past two
days cyclical dead cat bounce notwithstanding) to the freefall of the
Transports, from the breakdown of Internet leaders AOL and Yahoo to the
signs of a top in many tech leaders, suggests that the road after April 15th
will take a turn for the worsethat perhaps the chorus line singing
"The sun will (always) come out tomorrow" would be well advised
to bring an umbrella.
holiday season: a time for rejoicing and merriment, a time for giving, a
time when millions momentarily forget the grind of the workweek and spend
carefree days with friends and family, a time when young and old gather, a
time when all feel an enhanced need to belong...
...and perhaps it is only this need to
belong, to feel part of the festivities, to share in the holiday
spirit, to give something back, that can account for Tuesday's less than
sagacious Fed peace offering of a symmetric directive to the assembled
euphoric tribes of the speculative bubble.
Granted the wording of the Fed's
statement hinted of rate hikes yet to come, but to a stock market which
has grown myopic and has developed a tendency to focus on one word, idea,
or bit of data, at the expense of the larger picture, the words "no
change in bias" are a license to soar skyward unfettered from the
chains of the wall of worry.
While the boost of confidence provided
by the Fed's officially neutral stance will help avert short term
market turbulence in the runup to Y2K, we have to question the wisdom of a
short sighted policy that in its desire to avoid short term pain is
helping to set the stage for the financial markets to suffer through a far
greater degree of pain down the road.
By not seeking to halt the further
development of the market's current state of frenzied euphoria,
Greenspan & Co have fallen far behind the curve--not the inflation
curve, but the curve of avoiding the unstoppable market meltdown that
inevitably is bred when euphoria is allowed to run unchecked.
The Fed's booster shot to complacency
will make their job that much harder in the new year. The Fed's
careful handholding of the markets has made its three rate hikes this year
for naught. With 30-year yields approaching 6.5% and no sign of an
ebbing of demand in sight, the Fed will be forced to abandon the days of
quarter point hikes and deliver harsher medicine--and there is no
guarantee that one dose of 50 basis points will do the trick.
The Fed's unwillingness to act to
prevent the further growth of a dangerously speculative environment has
set the stage for the pendulum to ultimately swing much further to the
downside than it otherwise would have needed to, and in the process, the
Fed has lost the window of opportunity that it had to bring the economy in
for a soft landing.
By allowing euphoria to grow to levels
not seen since the last time that the mass public's imagination was
captured by a technology-spawned New Era, a time when radio rather than
Internet was the buzzword, the Fed has set in motion the necessary
ingredients for a hard landing--a hard landing that could have global
warm November days are a study in contrasts in our little town on the
Hudson. In the center of the village, workers transforming the town
into a winter wonderland decorate the holiday tree in Rockefeller
Center as tourists in summery shorts and t-shirts stop to gawk. At
the southern tip of the town, where the deep canyons of power cascade down
to the Battery, the Tulips are in full bloom and the Bears have retreated
into deep hibernation.
The second blossoming of the Tulips
should come as no surprise because the mood in our town recently has been eerily
reminiscent of the carefree days of last Spring, that time when the days
were spent frolicking in the sun without a care in the world, that time
when Fed induced interest rate jitters had yet to cast a black cloud over
When the summertime jitters finally
departed earlier this month, it was no surprise that all soon reverted to
how it had been before their appearance--no surprise because throughout
the summer of discontent the word capitulation never entered the
Without capitulation, without a
widespread sense of fear, there was nowhere to go but up when the last
shackle of uncertainty was lifted--nowhere to go but back to the crowd
pleasing favorites of Spring.
Thus, it should have come as no surprise
that the crowds soon returned to the land where the promises of analysts
are great but the potential delivery of meaningful profits is
barren: the Internet stocks. For those with a little knowledge
of the market's past, and for those who have been through a major top or
two, this return to the most speculative of the bunch also should have
come as no surprise because this is where the crowd most often congregates
during those times when it seems nothing can go wrong, those times when
sentiment skyrockets and all clamber to get aboard a streaking train of
seemingly limitless profits to be made, those times that go down in the
history books as a blowoff top.
Despite today's selloff by the major
averages, we don't think the end of the trajectory has been reached
yet--there is still a long line of people rushing to throw their money at
the crowd pleasing wonder stocks of the day. Thus, we think there is
most likely one last gasp left in this parabolic juggernaut before the
building list of negatives bubbling beneath the surface force a retreat
from la-la land--a retreat that could very well start with the release of
the November employment numbers.
With the phrase "this time it's
different" once again returning to the tip of every pundit's
tongue and with the boldest of learned camera hungry gurus now seeing
NASDAQ 4300 just over the horizon, now is perhaps the time to stop and
reflect, because "this time it's the same".
The scenes of frenzied crowds in an
accelerating rush to participate, of commentators unanimously proclaiming
the all clear sign, of novice traders growing careless as a runaway trend
gives them false hope in their abilities as traders, the chants of
"It's a New Era, this time it's different", the mass exodus of
the bearish into hibernation, the air thick with complacency--we've seen
them all before, collectively they're known as the end of a major trend.
This time around, market history is
holding true to course. Extreme levels of complacency have instilled
a sense of permanence, a sense that nothing can go wrong, a blindness to
all that conflicts, a complete unawareness of signs of trouble brewing--a
state of market psychology we affectionately refer to around here as the
Blinded Superman Syndrome.
The greatest enemy of those afflicted
with the Blinded Superman Syndrome is, of course, the continued pressure
of the crowd as mass opinion feeds on itself, creating a blindness to any potential
potholes in the road ahead.
As Winter approaches, and sentiment
retraces the path of the Spring, there is a growing list of potentially
trend reversing factors building momentum just beneath the surface: from a
still strong economy and ever tighter labor market to surging oil prices
and rising intermediate goods products prices, from rising bond yields and
a rebound in consumer confidence to increasingly narrow breadth and an
advance/decline line that is rapidly sinking back towards its lows.
Perhaps the greatest threat to the
market going forward is the tech stocks themselves, where extreme levels
of bullishness have left the market with no room to maneuver in the event
the wildest of expectations are not met.
With the valuation levels of many
leading NASDAQ stocks now discounting all expected earnings growth into
the early years of the next century, it should be remembered that the
technology sector's ability to make it through this quarter without
suffering the effects of a Y2K related slowdown is still very much up in
The October Durable Goods report showed
a 15.3% plunge in orders for electronic equipment, the largest decline in
2 1/2 years. Shipments of electronic goods fell 1.1%, their third
straight decline. While one month's durable goods report does not
make a trend, the NASDAQ's recent runup has left it in an extremely
vulnerable position in the event that October's slowdown in orders
continues into the quarter's last two months.
Tread lightly when Spring Tulips blossom
in late November.
life in the Fear Free Zone, a place where Goldilocks has just been
installed as Ruler for Life, a place where the time is and always will be
the New Era, a place where the economic textbooks have been rewritten to
justify the prevailing mood, and a place where banishment is the
punishment doled out to those who dare to use the V(aluations) word.
Welcome to the latest chapter in the
decade's longest running show, The Great Bull Market of the '90's, a
chapter which opened as expected with the FOMC raising rates by 25 basis
points and moving to a neutral bias, with the added twist of a 25 basis
point hike in the discount rate thrown in for good measure.
Welcome to a world where complacency has
gone off the top end of the scale, where the wall of worry has evaporated,
and where all of the good news is already discounted. In short, welcome to
a world where, in the short term, momentum and crowd euphoria are strong
enough to carry stocks to new absurdities of valuation, but where, in the
longer term, the cheers are likely to be replaced by the ominous hissing
sound of air escaping from a bubble as euphoria runs headlong into the
The Fed did as expected, and the stock
market answered with the expected, a powerful rally borne of relief and
complacency that carried the S&P 500 and NASDAQ Composite to new
records. For the NASDAQ, it was but one of a string of recent new
highs, for the S&P 500, it was the first new record in nearly 5
months. The Dow Industrials, while failing to participate in the
day's round of record setting closing highs, did manage to break above
resistance at 10860, setting the stage for it too to reach for the heavens
in the not too distant future.
The current euphoric state of investors
could very well set off a broad based short-term rally that carries the
market well past its old highs, but the future is unlikely to be nearly as
bright for the effervescent U.S. equity market.
Although an equity market valued at more
than 1.6 times GDP is more than a concern, valuation levels will not be
the pin that pricks the bubble. While we would have no qualms in
placing a bet that the current stratospheric P/E ratios of market darlings
Applied Materials (60.6), Cisco Systems (136.2), General Electric (43.6),
Home Depot (55.4), Lucent Technologies (70.4), Microsoft (61.4), and Sun
Microsystems (99.7), will be significantly lower and perhaps cut in half a
year from now, these valuation levels will not be the downfall of
No, rather euphoria is likely to die
because of a certain incompatibility that has developed in the
marketplace: an incompatibility between the current belief that the
Fed's job is done, and soaring stock prices and falling bond yields.
The Fed's job can not be considered to be complete until the economic
imbalances that prompted its first rate hike have eased.
Perhaps the key phrase from the FOMC's
policy announcement to keep in mind going forward is "the expansion of activity continues in excess of the economy's growth potential". Although the market is celebrating what it believes to be the end of the current rate hike cycle, further rate hikes can not be ruled out as long as the current conditions of unsustainable above capacity growth and labor market tightness continue.
With the wealth effect still very much
alive and closely correlated to the direction of stock prices and to a
lesser degree interest rates, as the recent rises in consumer
sentiment and mortgage applications that occurred simultaneously with a
sharp stock market rally and a steep drop in long term interest rates
shows, it is unlikely that a scenario of "no more rate hikes"
will be able to coexist with a continuation of the recent rallies in the
stock and bond markets.
In order for the prevailing wisdom that
"3 did the trick" to translate into reality, it will be
necessary for consumer demand to ease, a scenario which will likely only
occur if the wealth effect is thrown into reverse: i.e. a rise in bond
yields and a fall in stock prices puts a strong enough damper on consumer
confidence that the consumer is forced to think twice before pulling out
In order for a drop in consumer
confidence to erase the possibility of further rate hikes, the drop in
domestic consumer demand must be of a large enough magnitude that it
negates the growth spurring effects of accelerating global economic
growth. Not until the net demand for goods and services eases from
its current blistering pace and translates into a lower demand for new
workers will the danger of wage pressures developing be erased, and as
long as the threat of an acceleration in wage pressures remains, the
potential for further rate hikes will exist.
While the Fed has made its last rate
hike of the year, it has more than likely not made its last rate hike of
the current cycle. After the Fed takes a momentary respite in
deference to potential Y2K related problems, we expect further rate hikes
to follow next year--a scenario which is not at all discounted by the
Welcome to life in the Fear Free Zone, a
place where danger is lurking around the bend.
springs eternal, especially when it has a 12 year track record of
profitably rewarding the faithful. Although hope is eternal, the medium in
which it is embraced by, and conveyed to, an eagerly awaiting populace is
not, rather it changes with the passing of time. In every era there
is a new guiding light, a beacon that calms and provides sustenance,
drawing the crowd in, giving them the faith to press forward despite
mounting risks, to overcome their fears, to climb to yet higher heights,
to set new records.
Once upon a time, in an era far removed
but yet very similar to today, in a time when today's average portfolio
manager was knee high and spent his days dreaming of the video arcade
rather than stocks and bonds, in a time when the bulk of the money
invested in today's market had yet to enter, in a time before technology
had rewritten the rules of market history, the public found a new source
of hope, a new bulletproof method of mitigating risk, a sure fire way to
always win and never lose.
This new practice helped build
confidence, instilling in citizens near and far the belief that the good
times would always come, that the only thing to fear was not being in the
market, that the risk of suffering unforeseen career ending losses was a
thing of the past. The time
was the summer of 1987, and Portfolio Insurance was king of the hill.
The days of Portfolio Insurance's reign
proved to be numbered however as subsequent events caused the public to
move on, to seek a new method that would provide them with the necessary
hope needed to climb new peaks and would at the same time quell the
debilitating fear of risk.
The search for a new method proved to be
a short one, and the successor to Portfolio Insurance has enjoyed a long
and profitable tenure. Since the dark days of October 1987, Buying
on the Dips has become the public's guiding light, providing investors
with an increasing sense of confidence and at the same time diminishing
their fear of catastrophic loss, providing them with the same sense of
comfort that Portfolio Insurance once gave to their predecessors.
the stock market's recent decline and five months of interest rate
uncertainty, this faith in Buying on the Dips remains as strong as ever,
and confidence in the ability of the market to replicate the
above-historical trend success of the past 5 years remains strong, with
many investors clinging to the belief that "you can't lose money by
investing in the stock market, it always goes up".
sitting patiently on the sidelines for two days, a restlessness began to
stir in many investors on Thursday, a desire to participate. Better
than expected results from Apple and Altera caused the initial spark, a
healthy report from Boeing, declines in Oil and the CRB (and yes, in
coffee prices) and a better than expected headline Retail Sales figure
fanned the flames of hope. After the Dow Industrials bounced off the
September lows, reversing their morning decline, the urge to participate
grew irresistible, and the talk grew louder that a bottom was in place.
many investors, it was time to execute their time tested strategy, it was
time to Buy on the Dip, a feeling that only grew stronger after Sun
Microsystems released better than expected earnings after the bell.
But was it really time to buy on the
Leaving aside for the moment Alan
Greenspan's post-close chatter of tulip mania and asset bubbles, talk
which has pushed the S&P futures to a double digit loss, but talk
which we have heard before to no effect, there was little to like in
It was one of those days that instills a
false sense of confidence, one of those days when newscasters across the
country are heard to say, "the Dow reversed sharp early losses to end
the day solidly on the plus side", one of those days where the
performance of the major averages masks a continued deterioration of the
As has become par for the course, the
underlying technical picture was anything but healthy, with decliners
leaders advancers 18 to 11, new lows swamping new highs 27 to 367, and the
Dow Transports and the S&P 500 losing ground even as the Dow
Industrials and NASDAQ perked up....and then there was the bond market.
The bond market remained on full
inflation alert, with yields on 30-year treasuries pushing up to 6.31%, a
level which essentially mutes any prospects of the stock market embarking
on a sustainable 'next leg up'.
bond market woes, as well as the continued market-jarring saber-rattling
of the Fed, can be placed squarely at the foot of the unrelenting strength
of consumer demand. A closer look at yesterday's release of retail
sales paints a far different picture than the headline figure would
suggest. Core Retail Sales shot up at 0.6% during September, twice the expected
increase, as consumers remained undaunted by rising interest rates.
is the inability of two Fed rate hikes to curb the growth of consumer
spending that spells further trouble for the U.S. stock and bond markets.
the release of today's PPI numbers has the potential to spark powerful
bond and stock market rallies if the numbers come in better than
expected, any such rally is likely to enjoy a limited stay before
the jitters once again return to dampen spirits.
consumer demand eases from its torrid pace, the threat of inflationary
bottlenecks emerging will remain, and uncertainty will dominate the
markets, with the prospects of further rate hikes by the Fed looming.
consumer spending remains undeterred in the face of surging interest
rates, further action will be needed to tame its growth. In order
for consumer demand to ease, consumer confidence will have to drop from
its near record levels, a drop which will only be brought about by one, or
a combination of, three events: rising unemployment, a severe stock market
selloff and a contraction of still near record P/E ratios, or sharply
higher interest rates.
is unlikely to rise, nor is labor market tightness likely to ease, before
consumer spending drops off, and so the fear of job loss can be ruled out
as a factor that will cause consumer spending to dip. The burden
thus rests on the stock market, and/or interest rates, to slow
The path to the
end of the market's 5-month battle with uncertainty, and the path to the
end of the current Fed rate hike cycle, will likely not be in sight until
market conditions deteriorate much further. The above trend
portfolio gains of equity investors in recent years have helped to ease the
impact of this year's rise in interest rates, and thus a rise in long bond
yields to 7% is not out of the question, for it could take rates this high
before the consumer begins to feel the impact.
order for a stock market decline to impact consumer spending, any decline
will have to be deep and sustained-- a short-lived, sharp v-shaped bottom
like last October's will not do the trick of slowing demand.
answer our earlier question, now is definitely not the time to be Buying
on the Dips
|The de facto devaluation of the
Brazilian Real should have come as no surprise to observers of the recent ineffectiveness
of IMF policy implementation. Likewise, the resulting sharp sell off in the U.S. stock
market came as no surprise to participants who were looking for any excuse to take profits
after the market's 3-month 2000 plus point rally. Similarly, students of market psychology
were not surprised by the sound of eternally bullish money managers producing such
soundbytes for the ratings hungry financial press as "We expect the market to sell
off for a few days in reaction to Brazil before beginning a new move up, but ultimately
Brazil will have little effect on the U.S. The U.S. economy is strong and the
consumer is driving its growth." What may come as a surprise to many, however,
is that ultimately those who think Brazil will have little effect on the U.S. economy are
right. These analysts are right not in their simplistic reasoning that "Brazil
is a fundamental nonevent", but rather they are right in the sense that in
comparison to the other problems facing the American economy, Brazil is a minor blip on
the radar screen.
Granted, a further deterioration of the situation in Brazil, or an outright collapse,
would have devastating effects on Latin American economies and heavily exposed major U.S.
money center banks. It would also have a serious effect on economic growth in the
U.S. The damage that a Brazilian collapse poses are small, however, in comparison to
the underlying systematic damage that has already been done to the U.S. economy by a
combination of unsupervised thrill-seeking amateurs, irresponsible policy makers, and
shortsighted executives who have unwittingly built the greatest economic pyramid scheme
since the late 1920's.
The Fed's expansive monetary policy during the
last 5 years, and the resulting flow of dollars flooding into U.S. equity markets, have
driven equity markets above the high end of their historical valuation range extremes .
As the liquidity driven bull market has gathered steam, the public, sensing a sure
fire money maker, has stampeded into its midst. The resulting inflows of individual
investor's money have served to drive the market ever higher. With each surge in
equity prices the individual has grown more confident that investing in the stock market
is the path to riches. Emboldened by the rise in their portfolio values, the
consumer has gone on a spending spree thus pumping more money into the economy which
ultimately finds its way back to the stock market. The combination of an overly
expansive monetary policy, a rising stock market, and increased consumer spending
have created a self feeding economic boom that relies on one hand to feed the other.
It is the economic equivalent of a ponzi scheme, in which each person who joins the
party adds more cash to the game thus creating the illusion of a growing, healthy economy.
Like a pyramid scheme, the "recession proof,new economy" relies on the
entrance of new participants to sustain its growth. This artificially created
expansion has instilled in the public a false sense that "this time it is
different", "recessions are a thing of the past".
With each 1000 point rise in the Dow, the ranks of
individual investors participating in the stock market have increased. In scenes
reminiscent of the height of stock market fever in mid 1990's Singapore and Malaysia,
shopkeepers and hairdressers now bark out orders to their brokers from cell phones.
"Playing" the stock market has replaced baseball as the public's sport of
choice. Internet based stock picking contests have helped create a carnival
atmosphere about the market. The contest winners boast of their stock picking
prowess in the 1990's equivalents of the 1920's speakeasy: the chat rooms and message
boards of Silicon Investor and Yahoo Finance. The confidence of the individual has
grown with each upward leap in asset values. Every doorman and cab driver in New
York is now an expert stock picker. Fundamentals and lessons from the past no
longer matter to this new breed of investor who believes that 20% annual gains are a given
and an internet stock is the ticket to wealth.
Analysts, market gurus, and newsletter writers
have also become believers. The percentage of advisors who are bullish is at its
highest since January 1992 (Just before the last biotech bubble burst). Analysts have
tossed aside the valuation measures of the past. A new type of analysis has been
invented to fit the new economy. Actual earnings are no longer a concern. Celebrity
analysts recommend stocks with market caps of $12 billion and sales of $45 million as
screaming buys to their legion of followers who dutifully bid the price up. Internet
gurus, knowing a good long term investment when they see one, recommend stocks like
Broadcast.Com because it is now a value at $150 (never mind that in the 2 prior days it
had risen from the mid 80's to $270 before falling back, or that it has no earnings).
Money managers are heard to exclaim, "The type of excitement that we saw in
the internet stocks in December has spilled over to the rest of the market. This is
bullish for the market." Yes, excitement is the order of the day. We're told
that a new technological revolution is at hand that demands new valuation measures.
We're told that market history no longer matters. Unfortunately, we've seen this
saga played out many times before. It's called a bubble, and history does repeat in
the stock market.
In a bubble, it is the individual investor who is
the last to arrive and the last to leave. Sadly, the individual investor's inexperience
with past market history and the flip side of a bull market often leaves him unprepared
for the inevitable end of the bubble and the market's return to historical valuation
norms. In previous market bubbles the psychology of the individual investor has
mirrored that displayed by today's chat room cowboy. The current gung ho, "I've
found the secret to market riches" attitude exhibited by many inexperienced investors
is similar to that shown by many beginning futures traders who start out their
trading career with a string of wins and think, "This is easy. I'm guaranteed 40%
returns." Unfortunately these are the same individuals who dominate the ranks of the
80% of traders who leave the futures trading field by the end of their first year.
Just as overconfidence and excitement are an anathema to a long term career as a futures
trader, they are the fatal flaws of an individual investor at a market top. With
nearly 40% of U.S. households invested in the stock market, and with a large percentage of
them exhibiting excessive enthusiasm and believing that 20% returns are the norm,
the outlook is anything but rosy when the current bubble bursts and reality sets in.
The belief that this time it's different has been
played out during each previous market bubble. The discarding of past valuation
models in favor of new models that are developed to accommodate the excessive
valuation levels of a new high growth industry is nothing new. The 1920's radio
stock craze, the late 1960's computer industry bubble, the early 1980's PC bubble, and the
biotech stock bubble were all accompanied by a belief that a breakthrough technology
justified new valuation methods. The belief that a new technology would change
the world is not unique to the internet, neither are the valuation excesses and the
justifications given for them, or the buying frenzies to get in on the next sure thing.
The fate of investor's who jumped on an internet bandwagon that has
already reached manic levels while disregarding history will not be unique either.
A sudden bursting of today's stock market
bubble would have disastrous consequences for the U.S. economy. The underlying
economy continues to weaken, with pricing power nonexistent, over capacity rampant, labor
costs rising, and corporate operating earnings in decline. The economy, which has
relied on consumer spending to generate growth and create the illusion of a healthy
economy, would be thrown into a tailspin if the consumer were suddenly forced to cut
back (or if the consumer were forced to stop spending more than he makes). With the
S&P500 trading 50% above historical norms, any break in the illusion of endless
economic growth could be disastrous for the heavily invested investor on Main Street.
If the U.S. hopes to avoid the fate of 1990's Japan (or of a similar technology
driven bubble era: the 1920's), steps must be taken now to ensure that the air is let out
of the bubble slowly.
An effort must be made to take some of the froth
out of the market. We commend the efforts recently taken by Merrill Lynch and
several other brokerage firms to rein in their customers' internet feeding frenzy, but
much more needs to be done. Many market gurus, members of the financial press,
newsletter writers, and (dare we say) internet stock analysts need to pick up a book on
market history before continuing to advise their faithful followers to make the same
mistakes that have doomed others during past market bubbles.
Perhaps the biggest effort of all must come from
the Federal Reserve. The Fed must not wait until after the fact to address a
problem, as it did when it cut rates in late 1998. The dangerous over use of
derivatives and inadequate risk management practices employed by many firms were widely
known and ignored for several years before the Fed acted when ultimately faced with
disaster. The Greenspan Fed has helped to inflate the bubble, and it must take
steps now to slowly let the air out of it before it explodes. Merely voicing concern
over the extended valuations of the market is not enough to stop the bubble from
expanding. The public's feeding frenzy (not to mention its ingrained belief in
eternal 20% annual gains) has reached a level where words of warning are no longer heard
over the voices saying, "It's a sure thing. Valuations don't matter. No price is too
high." The Fed must act now by either raising margin requirements or bumping up
interest rates a 1/4% point. Acting now would produce an initial sharp correction,
but it would ensure the future health of the market. If the Fed fails to act the
U.S. will be doomed to repeat history, in this case the history of 1990's Japan.