June 2001

The Summer Of LUV 

All You Need Is LUV...No, this is not a plug for Southwest Airlines.  We've decided to give you the keys to the kingdom in this little discussion.  The secret to market riches.  And just think, you don't even need to pony up the dough to take a Wade Cook investing course.  All you need to do is figure out, in advance of course, whether the US faces an economic future characterized by a "V" shaped economic recovery (from the so far recession that never was), a "U" shaped recovery, or an "L" shaped recovery.  It's easy. All you need is LUV.  We hope you are ready for a graphically intensive discussion this month, because here it comes.

There's Nothing You Can Say, But You Can Learn How To Play The Game...In the economic fits and starts of life, the Fed certainly does not need to learn how to play any games.  They clearly know how to play the only game in town.  Despite an economy that has not officially entered a recession, Fed actions suggest something much more than concern.  The 250 basis point decline in short rates seen in the last five months has no precedent in Greenspan Fed tenure.  Maybe we spoke too soon as this certainly is a new game plan for this Fed in terms of action over a compressed period of time.  All of the rate hikes of the past tightening cycle have been reversed and then some.  From recent Fed comments there is more to come.

The following is the historical Fed Funds rate set against the annual CPI figure for the last ten years:

In the chart above we have annualized the experience of the first four months of 2001 reported CPI data.  What you are looking at is a Fed who has allowed the real cost of money to the banking system to fall to near zero.  At 4%, the Fed Funds rate is a stones throw from the current annualized CPI.  A gap that will surely close as the Fed seems most likely destined to lower rates by another 25 basis points in June, coupled with the fact that the annualized CPI will be losing inclusion of favorable gasoline prices from the Spring of 2000 as we move forward into the summer of 2001.  Meaning that all else being equal, the CPI is moving higher.  Throughout the Greenspan regime, this type of Fed Funds-CPI relationship has only been briefly witnessed on one other occasion.  It was seen during the 1993 when the banking system in the US was hauled into the repair shop for a capital account engine rebuild.

The chart exemplifies an extraordinarily accommodative policy stance by what has to be a very nervous Federal Reserve.  A Fed intent on pulling out all of the stops to reflate the economy.  A Fed intent on ignoring the recent lesson of unintended consequences that was the doubling and collapse of the NASDAQ.  A Fed forced to now navigate the waters between the Scylla and Charybdis of the deflationary asset retreat of stock prices and the inflationary action that is significant monetary accommodation.  A Fed Chairman whose own words now describe inflation as able to be "contained".  As you know, toxic waste spills are contained.  Forest fires are contained.  Accidental oil slicks caused by tankers hitting the rocks are contained.  This is a Fed  that appears intent on avoiding an economic collision with the letters U or L at all costs.

The Scarlet Letter...In choosing the correct alphabetical character that will describe the future economic trajectory of the US economy, it appears that the choice can be refined by viewing what we are living through as either cyclical or secular change.  Is the current contraction in corporate capital spending and coincident inventory liquidation a normal cyclical event that will have run its course by yearend?  Or will the changes that have begun to unfold in the corporate landscape be much more long lived?  Running the Boston marathon of the reconciliation of excess?  Will consumer America, with plastic firmly in hand, continue to act as the support mechanism to a faltering domestic economy by continuing to lever on top of what has already been an unprecedented secular levering of the personal balance sheet? 

For LUV Or Money...As you know, throughout the first ten+ years of the Greenspan tenure, Alan insisted that monetary policy could have no real effect on demand.  Recent statements by the Fed clearly demonstrate that this line of thinking has been tossed out the window of the FOMC offices.  In recent explanations for rate cuts, the Fed has directly cited weak corporate capital spending as the prime concern of the moment.  The big question on the minds of LUVers everywhere is whether monetary accommodation can spark a cyclical resurgence of capital spending?  If there is no cyclical "V" recovery ahead in capital spending, we may be left with the only alternative of LUsing the cyclical fight while secular reconciliation unfolds. 

Capital spending in corporate America over the last decade has been anything but cyclical in nature:

We have to go back almost ten years to find an annualized rate of change in private fixed domestic investment as low as we have experienced this year.  The initial bursting of the stock price asset bubble combined with what has up until now been an extraordinary period of corporate capital spending currently meeting up with a declining rate of change, is quite reminiscent of the Japanese experience just ten short years ago.  An environment where the capital creation mechanism that is the financial market turbocharged the corporate capital spending cycle into its final peak.

As was experienced in Japan and is now being witnessed in the US, as the actual stock market becomes less accommodative in terms of financing corporate capital spending (IPO's, VC investment, investment in startups by existing corporations, etc.), the economic system faces the twin deflationary thrusts of declining financial asset prices and declining real world fixed investment.  A coincidental correlation in movement not easily reversed.  In our current environment, each time deflationary pressures mount on one side of the financial fulcrum (stock price declines, layoffs, severe retrenchment in corporate capital spending, declining consumer confidence), the Fed accommodates with enough liquid weight on the other side of the financial fulcrum to temporarily arrest the process and maintain the perception of balance.  The very prescription for which Greenspan has criticized his 1930's US and 1990's Japanese counterparts for failing to administer.  As you know, the Fed is attempting to rewrite what has been the lessons of financial history up to this point.  The grand experiment continues.

Central to the issue of cyclicality versus something more secular is current inventories and final demand.  Street seers and Fed officials speak of the current environment as being temporary.  Transitory.  An inventory adjustment.  A pause.  So far, our experience is as follows:

If the adjustment is transitory or temporary, we may be nearing the end of the process.  So far macro economic and company specific numbers say anything but.  The backlog component of the NAPM and related purchasing managers indices (Chicago PMI, etc.) show backlogs declining more than shipments, suggesting inventory liquidation is not complete.  The prime beneficiary of the capital spending boom in the US over the last decade, the tech sector, seems to be showing anything but a bottom in either demand or the inventory to sales relationship.  

As you know, the tech industry is an industry built for scale.  Volume is the key to profitability vis-à-vis driving individual unit cost down.  An industry that needs to get product to market quickly, faces technological obsolescence issues even before new product is shipped, and largely has high fixed costs in plant and equipment.  Not an industry built for flexibility in terms of unit manufacturing.  An industry built for speed.  As of 1Q experience, the inventory to sales numbers seem indicative of both declining demand (obviously) and what clearly appears to be an insensitivity on the part of tech management's to inventory build.  Is this denial or something that can't be stopped due to the potential for an explosion in per unit costs?
 

Even companies with positive year over year and quarter over quarter sales trends accumulated an incredible amount of inventory during the last year.  From the table above, it looks like Cisco was not the only company taken by the 100 year flood surprise.

From a longer terms perspective, we ask you, is this what a bottom in tech revenues and earnings looks like?

As you know, the Fed is fighting the decline in corporate capital spending with the only tools they have - monetary accommodation and jawboning.  If the current environment is being driven by cyclical forces, there's a good chance they will be successful.  If we are living through secular change in corporate spending, they are wasting their time and monetary bullets.  One by one.  Although the hard drive of historical experience does not have to download in exact fashion, the Japanese experience with economic forces similar to those now faced in the US witnessed an ultimate bottom in inventories almost three years after the peak experience:

Show Me LUV, Baby...In the ultimate reconciliation of inventories, Greenspan and friends are betting the monetary ammunition they have provided the system will spark corporate spending.  If demand does not pick up soon, it will be readily apparent to the financial markets that the Fed is now shooting blanks.  The "bottom is in" rally in equities will most likely turn to a deeper shade of blue.  In a context much more broad than just the tech industry, the NAPM (National Association of Purchasing Managers) statistics will provide prima facie evidence of any change in the current downward trajectory of demand.  So far, no dice.

In hoped for substantiation of the current bounce in equities off the lows seen in late March and early April, sell side Street economists and other assorted fortune tellers have cited the minor bounces we have seen in a number of indicators off the lows.  Until yesterday, the NAPM was one of those indicators that had seen prior three month experience be "less negative" on a sequential basis.  The number this week ended that.  What many "let's party" prognosticators fail to mention is that history is full of economic head fakes.  We're not saying that we are destined for an exact historical repeat, but rather that each recession of the last thirty years was marked  by a brief recovery in the NAPM index reading just about ten seconds before entering the recession.  If there is a true demand driven recovery ahead, there will be plenty of time to commit precious capital to equities.  Was investing in mid-1991 too late?  How about late 1982?  Remember, the only folks who consistently pick the bottoms are liars.

Couldn't You Choose Water Over Wine?  Hold The Wheel And Drive...Although the Fed is clearly worried about the deflationary deceleration in corporate capital spending we are living through, out of the corner of their eye they are intently watching the US consumer.  A consumer that has so far shown a fair amount of resilience in monthly consumption patterns as growth in personal income begins to melt.  Drip by drip.  As you know, in prior easing cycles of the last three to five years, consumers have shown their consumption mettle accommodated by accelerated cash take out mortgage refi's, increasing revolving debt outstanding, and having not a second thought about levering to purchase big ticket items such as latest status symbol of new millennium Americana - the SUV. 

In choosing the correct letter among the three letter alphabet soup choices we have presented, the key question is whether American consumers can continue on the traditional path of headstrong consumption, or whether the secular winds of change will turn the consumer back at this critical juncture.

   EMPLOYMENT 

       The US consumer is facing a corporate personnel downsizing exercise not witnessed in many a moon.  A first quarter layoff announcement phenomenon with no historical parallel.  A vertical drop in year-over-year change in household employment:

Albeit still at low levels from a historical standpoint, an unemployment rate destined to move higher if corporate profits continue to deteriorate.  As you know, the recent downtick in the unemployment rate was really driven by a drop in the total number of people looking for work (the denominator).

   CONSUMER CREDIT

       We are not going to rant and rave about the explosion on the right side of the household balance sheet.  You already know the drill.  But, as we discussed last month, revolving credit growth recently has been quite strong.  Double digit annualized monthly growth.  In like manner, non-revolving credit has been soft.  The recent monthly reading being negative.  Expansive revolving credit growth set against declining consumer confidence tells us that the growth in credit may be for reasons of consumer distress.  A consumer caught between layoffs, higher home energy prices, higher gasoline prices, and not wanting to accept a diminished lifestyle...yet.  The backdrop under which consumer credit is expanding is anything but a positive.

   MORTGAGE REFI'S

After what has become the traditional immediate spike in mortgage refi applications with each Fed easing exercise over the last four+ years, refi apps in the current environment are once again meeting up with their old nemesis, financial gravity.  As you know, every Treasury north of 3.5 years on the curve has a higher yield today than on January 1st of this year, before the panic easing cycle commenced.  Mortgage rates are rising as the global bond vigilantes are sensing the fear communicated in Fed moves of late. Additionally, with home values starting to soften a bit, LTV's (loan to value) in recent years being quite high (thank you Fannie and Freddie), and the fact that we have seen these levels of mortgage rates a number of times in the last few years, how many folks are left to refi that have not done so already?

A good deal of the "liquidity" within the fountain of wealth that is residential property values over the last few decades has already been drained:

Refi Madness...The fact is that the current consumption "high" delivered by cash take out refi's just isn't quite as good as those delivered in prior Fed sponsored summers of LUV.  The secular winds have shifted from what was seen in the prior two refi cycles of early 1998 and early 1999.  See what we mean?

To say nothing of the differences in energy prices to the consumer:

The cash-out refi consumer of the day faces a different set of choices than faced by that same consumer just two and three short years ago.  With refi activity beginning to tail off in the face of higher mortgage rates and higher actual and potential unemployment looming large over households, how much longer can the consumer act as the sole support mechanism for the economy?  It appears the consumer is running out of "fuel" options.

I Dream Of LUV While Time Slips Through My Hands...The critical question of the moment remains.  "L", "U", or "V"?  At the moment, "V" sure seems a hope.  A dream rather than a fact driven expectation.  With an already incredible amount of Fed accommodation under the belt and what may be more incredible accommodation ahead, a "U" is a certainly a possibility.  The proof of true recovery, of course, will ultimately be when the Fed separates the patient from the liquidity IV tube.  If indeed we have reached the point of secular reconciliation or change for the corporate and consumer sector, better be prepared for something that looks like an "L".  It's just our opinion, but the market is not pricing common stocks for an "L" or a "U" at the moment.  In what is sure to be the first new millennium Summer Of LUV, is it time to tune in and turn on to equities?  Or time to drop out?