August 2001

That Was Just A Dream

Losing My Religion...Although the financial press often describes the historical reconciliation of bubble environments as "crashes", we would suggest that they are more correctly characterized as a process.  The word crash tends to connote an event as opposed to what is more historically accurate as an unfolding of a series of events in a process of confidence destruction.  One step at a time.  Page by page.  Investor by investor.  In essence, the mirror image of the confidence building process that created the bubble environment in the first place.

The official repeal of the latest "new era" is occurring in stages.  First the failed dream of dotcom profitless prosperity being laid to rest.  Next, the faith that tech sector revenues and earnings would grow in linear, if not exponential, fashion as far as the eye could see being questioned by the reality of current P&L statements.  The hope that the cyclical nature of the real economy and financial markets had been banished in some type of quixotic triumph over the age old interplay between current rate of return and the gravitational attraction of risk capital to that return.  So much of the process of reconciliation during this cycle that has played out up until now has been on paper.  It has been suggested or inferred by the movement of stock prices.  Although corporate earnings and macro economic statistics have weakened, the dream that what had come before as being able to again be attained at some future point has seemed to remain alive and well.  Alive in well in the "bottom is in" chants of sell side Wall Street participants.  Alive and well in the dreams of an investing public reluctant to part with the paper representation of a hoped for better future lifestyle - mutual fund shares.

Trying Hard To Recreate What Had Yet To Be Created...As the process of financial, emotional and psychological bubble deflation continues, another milestone has been reached in that the recent 2Q GDP report included a very important rewrite of modern statistical economic history.  A history that was intimately intertwined with the dreams of a new age of technology driven prosperity.  A history that had been labeled by the former bull market cognoscenti as a new era.  The recent 2Q GDP report included important benchmark revisions to the GDP calculation whereby adjustments were made for methodological changes in the measurement of "equipment and software".  The revisions encompassed the period of 1998 forward.  The following chart demonstrates that the revision represents a certain deflation in the exuberance of the reporting over the last three years.        

The above chart details the quarter by quarter revisions in the official GDP calculation.  Importantly, six of eight quarterly GDP readings covering the 1999 and 2000 calendar years were revised downward.  As you know, this was the heart of the suggested new era.  The heart of the period supposedly driven by tech influenced productivity gains.  The GDP revision certainly suggests that quite possibly the influence of tech on productivity, corporate profitability, and ultimately GDP growth, was not as strong as what may have been perceived at the time.  Or, more importantly, what may have been discounted in financial asset prices at the time.  As can be seen in the chart, the most dramatic revision to GDP came in the first quarter of 2000.  Instead of GDP growth being an annualized 4.8%, the revision revealed a 2.3% rate.  This largely caused total year 2000 GDP to be revised from 5% to 4.1%.  In hindsight, it sure seems a shame that during the first quarter of 2000, with the NASDAQ at 5000, that GDP growth was being so significantly overstated, now doesn't it? 

Estimated Prophet...As one would imagine, along with macro GDP revisions came statistical corporate profitability reductions.  In what is clearly a significant message in this anecdotal evidence of the repeal of the new era is that with these revisions, after-tax profitability for non-financial corporations actually peaked in 1997 as opposed to what was previously thought of as the peak during 2000.  Even the bleak corporate earnings report of 1Q 2001 became a bit more bleak with the benchmark revisions:    

Despite the revisions described above, what has not changed with the re-benchmarking is just as important as what in fact did change.  Unchanged?  Wages and benefits, implying productivity numbers may be overstated.  Surely money supply growth during the 1998-2000 period was unchanged.  The fact that the GSE's (government sponsored enterprises) grew their balance sheets at both significant relative and absolute measures did not change.  Expansion of personal and corporate balance sheets will be exempted from any revisionist treatment.  Many of the credit-related drivers of financial asset prices remain intact from a historical standpoint, while the very economic assumptions that underpinned the absolute financial reality of those assets is being recanted in part.  The process of economic, emotional and psychological reconciliation has moved from the subjective (financial asset prices) to the objective (measurable economic reality).  The process continues, just about right on schedule.

Off To Never-Never Land?...As a final comment on the possible larger meaning of the GDP revisions to the financial markets, the rewrite of the recent past quite importantly poses a much bigger question about what lies ahead.  Are investors still expecting a return to an economic and corporate earnings environment that really never was?  Although the Street and many individual investors simply ignore the current boat anchor of corporate write-offs, those very write-offs are an admission that the earnings that preceded them were overstated.  Now the revision that accompanied the 2Q GDP report conceptually delivers the same message in a greater macro context.  If a former economic period described as a new era, and heavily influenced by historical extremes in monetary accommodation (money supply, etc.), credit expansion and capital availability (IPO, VC, etc.), could only produce what would be termed average GDP growth relative to historical experience, what can we reasonably expect ahead in terms of economic growth during this period of reconciliation?  The correct answer will make all the difference in the world to financial asset prices.
  

In last month's discussion, we briefly touched on the fact that non-linearity was the economic norm as opposed to the anomaly during prior economic downturns.  Economic growth rarely, if ever, declines in absolute linear fashion.  Likewise it rarely, if ever, recovers in exact linear fashion.  From the perspective of year over year and period over period deceleration, many economic measures of the moment already reflect recessionary experience.  The depths of much historical experience has already been plumbed.  In like manner, just because recent deceleration has been swift, it is in no way a guarantee that recovery will either be sharp or is imminent.  As unfortunate as it may be, we see far too many of the fortune tellers of the moment on Wall Street trying desperately to call an economic bottom with each temporary up tick in any monthly economic statistic.  In like manner, much of mainstream financial commentary is almost manic-depressive in nature with each passing headline of the hour.

Expect non-linearity.  It's the story of our economic past and most assuredly will be the story of our economic future.  Trying to "catch the first eighth", so to speak, in terms of economic recovery, can be an expensive exercise.  The recent economic statistics dramatically display the thought:  

And this non-linearity in near term economic trajectory is reflected in the emotions of the consumer:

As you know, there are no magic signs at the bottom.  Much like the financial markets themselves, the bottoming of a cyclical economic decline is a process.  Trying to pin point that bottom can be a costly undertaking.  Remember, based on history, economic head fakes are the norm, not the exception. 

Behind Enemy Headlines...It's certainly no mystery that the consumer is absolutely critical to the stability of the economy ahead.  Critical not only in terms of the importance of current consumer spending, but critical from the standpoint that statistics regarding employment should weigh heavily in any directional analysis or projections of future economic growth.  Although simplistic, rising job losses puts future consumer spending at risk, which can lead to declining corporate profits and more job losses.  Although we as a society are learning to harness the technological benefit of real time information, the potential self reinforcing mechanisms that can be a part of short term decision making can cut in both directions.  In the current case, the ultimate economic consequences of the speed with which layoffs have accelerated this cycle most likely remain to be seen ahead.

In light of this and our desire to try to put the non-linear pattern of economic growth described above into context, we believe the employment survey deserves short mention.  In looking for both clues to consumer strength ahead and a potential bottoming or ultimate turn in the economy, the household survey that is a component of the employment report stands out as a "must monitor" type of statistic in our minds.  Briefly, the headline or "establishment" employment number contains a number of adjustments that may be maligning its message at the moment.  Specifically, it contains a plug figure for newly created business too new to show up in the official employment census.  How do the statisticians adjust for this?  By looking at experience of 12 months ago.  In the current environment, that includes the brief experience of the former dotcom employment mushroom cloud.  You know and we know that the dotcom business formation that contributed so heavily to last year's actual experience is probably close to zero right now.  Direct from the icebox at Webvan, make that subzero.  The household survey, conversely, contains no adjustment contaminants.  Are you working or aren't you?  Yes or no.  Survey over.

Through June, the job loss discrepancy between the establishment number and the household survey results is close to 800,000 jobs.  Just have a look:

The household survey is reflecting a loss of close to 1.07 million jobs between January and June while the headline report details a loss of 270,000.  That's one big gap.  We tend to side with the message of the household survey given that Challenger, Gray and Christmas have estimated 800,000 announced layoffs this year.  Much closer to the household survey results.

We'd suggest keeping an eye on this report as we expect the household survey to be more reflective of real economic activity during this cycle.  We expect it to lead an upturn as corporations ultimately begin hiring again when they feel more confident regarding the economic outlook.  In like manner, given the plug adjustment in the headline employment number for business formations, its future message should lag the reality of an economic upturn.  Clearly the household survey is not the Holy Grail of economic indicators, but just may be "current" enough to coincide with a real economic bottom.

The Kindness Of Strangers...The last thought we will leave you with this month regarding the repeal of the new era, our own economic trajectory possibilities, and asset values in our financial markets, is that we need to be very mindful of the kindness of strangers.  Very mindful.  An important characteristic of our financial markets and economy over at least the last half decade has been the action of the foreign community in "recycling" trade dollars back into US dollar denominated financial and real assets.  Real assets in terms of corporate M&A as well as greenfield operating expansion (Honda auto plants, etc.).  Simplistically, financial assets being our stock and bond markets.  In essence, the US has become the world's largest global recycling station.  This was one minor topic that seems to have slipped the minds of the global powers that be recently in Genoa. 

The motion of global capital flowing into the vortex of the US financial markets is continuing unabated in 2001 at what is a record annualized pace:

($ Billions) 

The table above depicts the last step in the process that is the global financial recycling station operation.  As you know, our mushrooming trade deficit has made the US dollar the chief US export.  And those dollars have been recycled on a global basis back into the US financial markets.  In effect, acting to support US financial asset prices to a great extent.  Allowing the US economy to import disinflation, if not deflation.  Helping to keep domestic interest rates low (vis-à-vis the implicit price support seen in foreigners using exported US dollars to in turn purchase US fixed income assets) and allowing the US consumer to continue demanding foreign imports through the vehicle of further exporting the relatively strong dollar.  And hence, the recycling operation begins anew.  The recycling operation has become its own self reinforcing and sustaining financial eco-system, if you will, especially post the Asian crises of a number of years back. 

The exporting of the US dollar in exchange for cheap foreign goods (low inflation) and the reimportation of those dollars into US financial assets (price support) has been a key circular relationship of the up until now miracle of US prosperity.  With US imports from foreign nations starting to fall coincident with our domestic economic slowdown, and as the concurrent decline in economic health abroad accelerates as the global consumer of last resort retrenches, this recycling operation is at risk of a "drop in volume".  The potential for less dollars recycling into US financial assets is certainly a double negative.  A negative for the implicit support mechanism to US asset prices.  And, a negative in that foreign exports (US imports) will most likely be the driver of the drop in recycling volume, currency exchange rate movements aside, ultimately reinforcing the synchronous nature of the global economic downturn.

The last point of potential risk in the new era recycling operation is where foreign asset recycling participants have placed their bets:

 ($ Billions) 

The record simply speaks for itself.  Not only have foreigners willingly supported the recycling program, they have also traded up on the investment risk scale with their reinvestment activities each and every year since 1995.  We would suggest that US financial asset prices may be at risk not only from a potential drop in volume, or inflow, from the global dollar recycling program into US financial assets, but also from potential asset allocation changes at the margin.  In terms of investment risk, just how happy do you believe foreign investors in US common stocks and bonds were to find that historical GDP had been revised downward in the recent report?  After all, over the past few years they have forgone Treasury purchases in deference to purchasing tickets to the new era (common stocks and corporate bonds).  As you know, this risk is again exclusive of the exchange rate risk ever present in the current global environment. 

The kindness of strangers has been an incredible gift to the US financial markets and economy over the last half decade.  The most important question, though, is whether it will continue to be the gift that keeps on giving ahead as more and more of the signposts to the new era prove to be dead end streets.

As financial and asset bubbles burst and complete the ultimate process of confidence destruction, the financial, economic, philosophical and emotional layers of that confidence built up in original support of those bubbles seem to peel away one by one.  One dream at a time.  The irony, of course, being that just about the time the last dreamer has departed the financial field of play, it will once again truly be the time to view it as a field of dreams.