December 2001

Tangled Up In Blue 

Colors...The gang rivalry on the Street these days is clearly identifiable by the colors favored by two disparate factions.  At best, the gangland coexistence can be characterized as volatile.  Volatility often punctuated and defined through the occurrences of drive-by monetary policy.  Gun bursts of unexpected financial liquidity ring out on an all too frequent basis.  Reinforcing short term change in the actions and perceptions of those on the Street.  The truth as seen by one faction is sky blue.  A vision of an economy and financial market where blue skies are breaking through the clouds and rain that have provided the backdrop for financial asset price movement of the past 18 months.  The rival faction sees the economy and financial markets colored in a deeper shade of blue as economic nightfall is far from over.  Far too early to anticipate the approach of dawn.  For the moment, Street gangs are tangled up in blue.  

Making A List And Checking It Twice...Now that the recession we all knew was apparent is official, according to the folks at the NBER (National Bureau of Economic Research), calling the timing of the conclusion has become the new pastime of many a Street strategist.  In this country's postwar history, "normal" recessions have averaged 11 months in duration.  The shortest being six months and the longest being sixteen.  Since the NBER crowd has officially ordained March of 2001 as the inception of the recession, history suggests that an official beginning of economic recovery lies somewhere between now and the early second quarter of 2002.  We would suggest that the key word in coming to your own conclusions regarding the length of a blue economy be "normalcy".  Can we have a normal recession following what has been a prolonged period of "abnormal" activity?  

"Abnormal" not necessarily connoting bad or evil, but rather trying to infer a sense of balance.  What has been abnormal about the period of economic growth and reflective financial market activity has been length of the prior expansion.  Valuation levels reached by the financial asset markets at the peak and even those of the moment.  The extent of credit expansion during the prior cycle and still continuing today.  The stimulative activity of Fed monetary policy during the last eleven months (many interest rate levels at 30 and 40 year lows) in trying to act as a counterbalance to the process of economic and financial reconciliation.  Corporate accounting methodology that has stretched the boundaries of realistic presentation, especially over the last decade.  These, and many more we have not listed, were and are extraordinary events.  Abnormalities within the context of at least postwar financial and economic history.  Can we really move from an abnormal environment to one more characterized by historical normalcy with simplistic ease?  Can we return balance to an economic and financial environment that has stretched the definition of balance over the last decade at least?  The question remains unanswered, but the "blue sky" gang on the Street is not waiting around for confirmation.  

Once In A Blue Moon?...There is no question that financial markets are anticipatory animals.  Searching desperately amidst the anecdotes of today for the realities of our tomorrows.  The fact is that the anecdotes of today do not lend themselves too kindly to blue sky thinking or assignment of blue sky valuations to financial assets at the moment.  The blue sky crowd is running on faith in bidding up stock prices.  Faith that a turn in corporate profits and the macro economy as a whole lies dead ahead.

Headlines of the moment have provided anecdotes for blue sky thinking.  But, only if one stops right there.  At the headline.  Behind the headlines, the blue moon has not set quite yet.  Recent retail sales numbers were nothing short of a sight to behold.  A 7.1% headline increase for October was the largest one month gain since 1951.  Auto sales recorded their largest one month gain in history:

Their largest one month gain on the back of 0% financing offers.  An "abnormal" action on the part of auto manufacturers.  An action that most likely drew forward future demand into the current period(s).  An action suggesting that corporate executives are betting that future demand will be soft as witnessed by their need to desperately capture sales now.  

Without auto sales in the equation, October retail sales grew 1% following an abysmal September performance given the realities of that month.  It simply would have been hard to comp poorly against September.  Our choice of vantage point is rate of change:

Eliminating the year over year virtual zero reading of September, October year over year rate of retail sales change is about as low as anything seen since the early 1990's.  Moreover, retail discounting in advance of the important Christmas selling season has been tremendous.  Discounting may help positively influence sales over the remainder of December, but it is certainly not doing much for the bottom line of retail corporate America.  Likewise the implicit cost in 0% auto financing does not exactly suggest vibrancy in the bottom line characteristics of auto manufacturers ahead.  Is the blue sky crowd possibly mixing up the meaning of sales versus profits?

Consumption ahead is a key to any economic rebound.  Consensus thinkers had expected a positive move in consumer confidence recently based on a decline in jobless claims (up until last week) and the nice retail sales headlines.  Unfortunately, it is consumers themselves that are responsible for the factual information beneath the headlines of reports such as retail sales.  

Likewise, facts within the consumer confidence report help to understand the state of mind of the American consumer.  The consumer confidence survey does poll folks on how they feel about the here and now as well as their expectations for the future.  It's almost a natural to be upbeat about the future and that is exactly what has been found in the report for at least the last half year.  But the blue sky hopes for tomorrow coincide with the deeper blue answers to here and now questions in the survey.  In the recent report, plans to buy a new car fell appreciably to 6.5%, the lowest number in five years.  Plans to purchase a new home fell to the lowest number in 11 months.  Is it such that those motivated to buy a new car based on 0% auto financing and those hoping to buy a new home based on now prior multi-decade low mortgage rates have already done so?  If so, this certainly is not going to help blue sky expectations of tomorrow materialize.  And neither is the following alternative reflection of consumer confidence:

In years past, it just so happens that there has been a high degree of directional correlation between action of the stock market indices in 4Q and corresponding annualized 4Q retail sales.  It's a simplistic relationship, but one that may be more meaningful this year than not.  So far, 4Q stock market performance rivals the two best years of the last six.  Second only to 1998 and 1999.  Unlike then, current experience is now one of lessening paper loss for the buy and hold investors of today as opposed to the impressive, and continuing, paper gains of yesteryear.  Will the stock market again be the inspirational mechanism it has in the past?  Or are we facing something much different?  The answer lies just 30 days away.
  

Blue sky investors are certainly happy with 4Q market results so far, but will consumers feel the same way?  For the sake of blue sky investors, they better. 

Showing Their True Colors...On the corporate side of the equation, corporate chieftains have also chosen blue as their favorite color of the moment.  

Certainly the September terror attacks did little to uplift CEO spirits, but we have the feeling that was not the whole story.  As you know, corporate CEO's (and their close associates) have been weighing in all year with their pink slip voting ballots.  The blue sky folks were recently pointing to a four week drop in jobless claims post the highs registered after the Sept. 11 incidents as proof that the worst had been seen in labor market conditions.  But, this recent week's report was a spoiler to that declining trend as claims rebounded well above the all-hallowed expectations number.  More importantly, the continuing unemployment claims number may have been the real story.  The people who continue to be out of work.  Reflective of a tough environment in which to become re-employed.  The continuing claims number was the largest single increase in 27 years and brings the running total to a level not seen since late 1982.  Thanksgiving period seasonal adjustments may have an influence here, so we'll await upcoming reports to pass final judgment.  Nonetheless, this is not the type of report suggesting sunny skies for employable consumers ahead.

In addition to pink slip mania, corporate insiders continue to exhibit the ultimate call in insider trading, or maybe we should label this lack of trading:

In many respects, the above is a vote of confidence.  A vote on what insiders see as future business conditions.  Undoubtedly, the maintenance of profitability is front and center in the minds of corporations at the moment.  As it should be given the fact that year over year deterioration in corporate earnings is one of the most extreme on record.  Miles away from what would be considered normal or routine.  Quite decidedly abnormal.  The recent GDP revision late last week is prima facie evidence of the dilemma corporations face at the moment.  The 3Q GDP report was revised from (0.4)% to (1.1)% due almost solely to inventories.  Corporate inventories have dropped like a rock this year, but have not been able to outpace the decline in sales.  The inventory to sales ratio has simply trended higher all year.  The inventory situation is currently such that a pickup in demand would change the environment markedly.  It would cause the I/S ratio to improve, production to pick up, utilization to improve, etc.  But it is the very lack of demand that is the catch-22 of the moment.

The administration has stepped in to attempt to jump start a turn.  The durable goods orders released a few days back simply document this:

The first installment of the $200 billion Joint Strike Fighter program allowed defense capital goods to record a 206% month over month increase and a corresponding 233% rise in aircraft orders.  As opposed to being up 12.8%, ex-defense, durable goods increased 5.6%.  Ex-defense, orders in September fell almost twice that amount.  Year over year, non-defense orders are still down 25% and orders ex-transportation are down 16%.  Once again, a case where the headline alone was largely misleading.  Nothing goes down forever, but evidence of a sustainable turn is still nowhere to be found.  

Lastly, anecdotal evidence of improvement in corporate profitability is still seriously lacking.  A fact the blue sky bunch expect to see improved forthwith.  The blue sky'ers are simply loathe to miss "the turn".  In fact so much so that they are willing to pay exorbitant valuations to claim their ringside seats.  Looking under the headlines is again essential in individual investment choices as corporate profitability remains under pressure.  Home Depot  recently displayed earnings up 20% in the year over year 3Q, but under the hood, the engine is showing signs of fatigue:

Key measures of profitability and efficiency down across the board.  As we understand the recent strategy communiqué, HD plans to slow store growth and continue to focus on cost cutting in terms of improving profitability ahead.  This has a good chance of showing results...for a while.  Stealing a page from his former boss's playbook at GE, the new HD CEO is playing the cost cutting card.  Unlike the folks at GE, he has no massive internal financial services business from which to "manage earnings" over time.  Does it make sense to pay a premium multiple for a company that is telling you it plans to grow more slowly?  We don't necessarily mean to pick on Home Depot.  The theme applies across many sectors of the economy.

In a recent burst of honesty, Jim Morgan of AMAT confided the following during the recently reported quarterly loss.  "We have arrived at the moment of truth for the world's chip industry.  Money for capital investment is cheaper now than it has been since the chip was invented."  Bulls eye.  Right to the heart of the matter.  And yet investors are currently paying 80+x's estimated 2002 earnings for the privilege of being there at the turn in AMAT's business.  Just for perspective and drill, we have taken AMAT's high price for each calendar year since 1990 and run the yearly high P/E ratio against that year's earnings.  
  

                          *Based on Nov. '01 closing price plus 2002 analysts estimates.

Is this what blue sky investing is all about?  At both cyclical earnings highs and lows, never has this number been higher than now.  Again, we are not trying to pick on AMAT.  They are an industry leading company and one we would own in a heartbeat, at an appropriate price, of course.  This is just an example of modern day faith.

Yes, we are clearly aware that earnings of the moment for corporate America are depressed.  The as yet unanswered question is what the trajectory off of an eventual bottom will look like.  Something normal, following an abnormally strong period of economic and financial market performance?  Or something shy of what has been considered normal in the past, given that we are still in the process of returning to some type of balance for the economy and financial markets?  The process of natural reconciliation.  At the moment, macro valuations are currently in blue sky territory.  From our vantage point, investors are going to need proof of corporate and economic blue skies quite soon to maintain blue sky valuations much longer.  The gangs on the Street are lined up by colors.  Sky blue and deep blue.  Left to test their fortunes and wills while, for the moment, tangled up in blue.  

Hey, Bail...And we're not kidding.  We've been a bit amazed that investors have been willing to put so much faith in an impending economic recovery by bidding up stock prices with so little tangible proof of the recovery's  proximity.  What may be a bit more amazing is the market's recent laissez-faire attitude toward heightened financial stress in the form of here and now bankruptcies of the past few months.  Enron, Bethlehem Steel, Polaroid, Swiss Air, Burlington Industries, Alamo rent-a-car, Renaissance Cruises, American Classic Voyages.  The problems at Providian, Nextcard, Americredit, etc.  And now the inevitable Enron fallout in terms of derivative counter party risk.  With all of the real world financial bombs going off, you can expect the Fed to remain in full bail-out mode for the time being.  Liquidity as far as the eye can see.  At this point there seems little alternative to a group of folks accustomed to making these kinds of choices:

Excess liquidity operates under the same dynamics as hydrostatic pressure.  That pressure has to be released somewhere and somehow.  It doesn't just "go away".  Just how many new investments in plant and equipment do you see happening at the moment?  Alternatively, we await the upcoming Fed data on mortgage credit expansion for signs of becoming water logged.  Stock shorts focused solely on many of the fundamentals we have just described have quickly found themselves underwater over the last few months.  Hydrostatic pressure never rests until dissipated.  Stay focused on the total picture.  Watch the money (financial system perspective) as well as the money (corporate bottom lines).