March 2001

The Weighting Room

The Black Diamond Economy...The current economic environment is no place for beginners.  In fact even those with intermediate skills often find black diamond economic runs a bit frightening.  The current run is straight downhill.  Barely a mogul on the course.  Very few investors in the current market have experience with black diamond economic trajectories.  In fact for many of the newly initiated, the last time we experienced a black diamond economic run, they were nursing CD and savings account hot toddies next to the warm fire in the lodge.

The deceleration in the real economy continues.  As we have mentioned before, digital decision making is hastening economic reconciliation during this cycle.  The unintended consequences of excessive credit expansion leading to a more hastened need to delever during this downturn is also forcing economic participants to go faster and faster down the slope.  Extreme black diamond runs can shake the confidence of even the most experienced.

Parallels to the current downward trajectory of consumer confidence can only be found in prior recessionary periods.  The Fed is trying to fight one of the most intense confidence battles of the last few decades.  Maybe it's only natural that confidence descends so quickly after the bursting of a conceptual (as well as financially quite real) investment bubble.  Dreams of unlimited stock market wealth are dying tick by tick.  The reality of the leverage assumed by both the corporate and the private sector against financial and real estate assets that were appreciating almost without interruption looms ever larger on the right side of the balance sheet.  So far, the Fed's lowering of interest rates and concurrent accommodation in allowing quite significant money supply expansion is having little effect on reported consumer confidence and consumer spending.  Likewise, the stock market is weakening and commodity prices are softening.  The excess liquidity is not finding its way into the real economy or the financial markets.  Where else could it be going?  To delever in terms of cash flow liabilities.  Clearly housing refi's can be used to payoff alternative forms of debt in a tax advantaged way.  Likewise, non-cash take out refi's can lower monthly cash liabilities.  New debt can replace old debt while decreasing cash flow required to support that debt.  After all, there's an incredibly long road to hoe in the delevering process neck of the woods in this country.  

NAPM In The Morning...In the real world of US manufacturing, the broad based NAPM (National Association of Purchasing Managers Index) showed minor improvement in February, rising to 41.9 from 41.2.  This black diamond has caught a mogul of sorts:

Upon release of the improved number, we immediately heard market pundits declare an uptick in the manufacturing community.  Nothing could be further from the truth.  The NAPM is a diffusion index, not an absolute gauge of activity.  Any reading below 50 spells contraction.  This number can be interpreted as manufacturing still declining at a rate that can be considered a hair less than last month.  The number strongly suggests that manufacturing remains in trouble and that the chances of any significant economic recovery any time soon are very slim.  

Are the economic numbers we see today really any surprise?  Of course they are not.  In fact the stock market knew this was coming almost 12 months ago.  So did the bond market in so dutifully inverting the yield curve.  Of course in the new era at the time, signposts of "yesterday" were being given very little attention.  What we will be looking for ahead is a deceleration in economic contraction.  You remember - the old rate of change of rate of change.  Economists predicting a "V" bottom recovery for the economy in the second half of this year should really qualify that as a hope, not a fact based economic potential at this time.  As you know, black diamond runs always end in a  leveling off of the terrain and a return to the economic chair lift.  At some point, the market will begin to discount this outcome.  In the meantime, it may be all the economy can do to stay on its feet.    

Built For Speed, Not For Comfort...It seems nothing short of highly unlikely that there will be a "V" bottom recovery in the economy during the second half of this year.  Reinforcing this message is the fact that tech companies far and wide are now routinely invoking the V-word.  In their case it's Visibility.  They don't have any.  The sales windshield is fogged up and the defroster is on the blink for the time being.  As you know, tech cap spending was a crucial component of  GDP growth over the last half decade.  Without this turbocharging, at best the economy is destined to limp along.  That's at best.  In simplistic terms, the tech industry is built for volume, not for flexibility.  Tech manufacturing is capital intensive.  Variable costs to be eliminated when demand turns down are few.  The very definition of a cyclical business.  One simply does not rationalize the following in a quarter or two:

In an industry built for volume, there is very little comfort to be found in cost cutting when top line demand shrinks.  One thing, though, does react in a fashion that is characterized by speed.  That's the bottom line.

Clearly, market participants are coming to the realization that they became just a bit too giddy about discounting everlasting profit growth in tech over the past 2-3 years.  They let their emotions carry them away.  Too far away.  Unfortunately, investors are now facing a double barreled real world shotgun simply loaded with potentially very painful tech buckshot.  Not only does the industry itself face a protracted period of manufacturing capacity reconciliation, but Wall Street is also dealing with its own form of tech overcapacity - still overweighted tech stock ownership.  Quite unfortunately, a lethal mixture for current investment performance.

The Weighting Room...Late in the third quarter of last year we wrote a piece chronicling the weightings of growth mutual funds in the tech sector.  The data was taken from the Morningstar mutual fund review service.  As you know, Morningstar data is always lagged based clearly on the lagged SEC filings of securities holdings by the funds themselves.  Nonetheless, institutional growth mutual fund weightings in tech were incredibly significant.  Well, it was just a few weeks back that the quarterly Morningstar update on "growth" funds hit the Street.  Time for a refresher course.

Remember, we are talking about mainline growth funds here.  Not sector funds.  Not aggressive growth funds.  Not emerging growth funds.  Plain old vanilla growth.  Let's look at the numbers and then on to a few comments:
 

Once again the data is a bit old, but does cover the crucial period where the NASDAQ went into its vertical nose dive trajectory.  We largely eliminated any fund below $1 billion and really tried to show you some of the popular funds that have attracted a significant amount of money from mainstream investors.  The numbers simply speak for themselves.  After having witnessed the NASDAQ walking off of a cliff in April and May of 2000, one may have guessed that into the summer rebound fund managers would have lightened their exposure to tech, having been given a second chance for redemption by the market gods.  Moreover, as you know, it was really the big cap darlings that returned to and in some cases surpassed their old highs during the summer recovery as the dotcom crowd was using the latest in pick and shovel technology to slowly dig their own graves.  The table above clearly illustrates that there was no lightening of sector weightings.  In some cases, just the opposite.      

As you can see, the mainline growth funds in this country went into the worst quarter in NASDAQ history with one of the highest asset allocations to tech ever.  Surely they must have cut back as the NASDAQ plunged toward the financial tarmac during 4Q 2000, right?  It seems a natural given the obvious deterioration in industry growth prospects set against declining corporate capital spending in the aggregate economy .  We can't speak for all the funds, but if the Janus fund complex is at all representative of mutual fund manager belief and personal behavior, the answer is not necessarily.  The following table is made up of data from the 12/31/00 Janus 13-f filing (the SEC mandated filing of quarter end holdings).  As you can see, in many of the raciest stocks, Janus hit the accelerator during 4Q:

We do not mean to pick on the Janus family by any means.  There are plenty of fund families who bought more tech as the slide intensified.  Incredibly enough, in over one-half of the names mentioned above, Janus bought at least half of its total year end position during the 4Q of 2000.  Directly before the year-to-date experience portrayed in the right most column.  Who could blame them?  After all, the standout consensus mentality of the last half decade has been buy the dip, not sell the blip.  Who was to know that fundamental industry and individual company characteristics would finally take precedence over momentum in terms of investment outlook?  Go figure. 

These numbers are testimony to the fact that sector belief in tech was so strong after the mania run up during the last few years, that professionals were willing to maintain well above market weightings in tech relative to a simplistic S&P benchmark (22% at year end 2000) and add to their holdings during the significant price erosion experienced in the initial and significantly price destructive stage of the tech bear market.

So where does this leave us now?  Most likely with a fund industry still overweighted in tech.  And this says nothing about non-mutual fund institutional money as well as the mom and pop America retail investor holding individual securities.  Tech was the mantra of the past three-plus years.  The deteriorating NYSE and NASDAQ advance/decline line during this period was testimony to the stealth bear market in just about everything except tech.  Now the tables have been turned and tech is the over owned asset pleading  for orderly distribution.  As you know, bear markets never offer the opportunity for orderly distribution. 

Feb-Blue-ary...As the economy weakens, as the manufacturing sector slides down the slippery slope, the realization that technology capital spending is declining and will continue to decline significantly is meeting head on with the institutional tech "overcapacity" in terms of stock holdings.  The predictable result?  Why this of course:

Not a pretty picture for any of the indices, to say nothing of individual stock prices.  How long will the investing public be able to maintain its "cool" with this type of experience?  More importantly, negative performance that is becoming consistent:

In the last 14 months, ten of the largest twenty monthly NASDAQ declines has occurred.  Enough to make even the most ardent of long term baby boom investors start asking questions. 

In most cases, tech stocks are not going to zero.  Likewise, fundamental growth in the industry has not been banished forever.  Quite the opposite.  It's just that overcapacity in both real world manufacturing capabilities and institutional and personal portfolios are going through a period of reconciliation.  A period that still has a ways to go.  A period that should ultimately serve up significant investment opportunities at some point in time.  A history suggests, whenever the crowd is simultaneously attempting to unwind an overpopulated trade, prices often see levels that would have been deemed absurd during the accumulation phase.  Be patient and watch the numbers.  We can assure you we'll be doing just that.           

Out Of The Blue...And into the black abyss?  Not only does the NASDAQ make the headlines in fairly regular fashion these days given the minor volatility it has experienced over the past six months, but the Japanese economy, and the price action of the Nikkei in particular, have stolen a bit of the limelight recently.  As you know, the Nikkei has been hitting 15 year lows.  An index at 40,000 eleven years ago is dancing around the 12,000 line.  Mark-to-market accounting changes are due to take effect in Japan as of April 1.  It's a real step forward in purging the rot from Japanese corporate and banking system balance sheets.  Clearly, the process is not without significant financial strain and potentially unintended consequences.  

Adding fuel to the downside fire recently has been a bit of derivatives influence.  Over the past few years, Nikkei-linked bonds have experienced relative popularity as they promised potential returns well above low paying Japanese fixed income instruments.  In like manner, the bonds could prove costly in terms of negative return if the Nikkei dropped below certain levels.  How do you protect against loss in these bonds?  Sell futures contracts, sell  actual alternative equity exposure, etc.  This exercise alone is not driving the Nikkei down, but it is not helping the situation any.

Timing of accounting reform in Japan, although needed badly, probably could not be worse.  When Japanese authorities made the decision to implement these standards over one year ago, how could they have know the global economy would be in synchronous economic downturn?  The reason we bring this up is that, as you know, Japan is the second largest economy on the planet.  They have also been a major exporter of cheap capital over the decade of the 1990's.  To have them potentially fall into a real financial abyss is simply not a good thing.  A very real concern at the moment is the following:

Of course the trade balance is absolutely on the reconciliation docket for the US, but the implications for ultimate reconciliation of this imbalance for Japan, as well as other foreign countries, is not a pleasant thing.  Last month's US trade deficit saw a bit less than a billion dollar contraction in both imports and exports.  As a corollary to this, recently reported Japanese factory production dropped 3.9%.  Why?  Declining exports from Japan played a major role.  Not only does Japan export directly to the US, but also exports to other Asian countries who in turn export to the US.  The economic daisy chain is fragile.

Japan, in its own bear market/deflation for the last ten years, has almost become an afterthought to US investors.  Our bull market experience, as the rest of the planet watched from afar, created insular market attitudes in the US.  What is happening in Japan is real and serious.  It's not the end of the world, and will ultimately put a bottom on the Japanese equity market.  But in the meantime, global market participants need to monitor the situation in terms of their own domestic decision making.  It's often the unexpected event that can seriously upset the domestic apple cart.  Especially when nerves are already a bit frazzled, shall we say?