April 2003

Yesterday Once More?

A Beautiful Day In The Neighborhood?...As you know, the third week of March witnessed the largest one week percentage gain in the Dow in over twenty years.  It was also the fourth largest one week gain in postwar financial history for this headline index of substantial perceptual importance.  Is this the beginning of the end (of the current bear market) or the end of the beginning (of yet another bear market rally)?  For now the jury is out, although it's pretty clear that original perceptions of a swift and decisive military outcome in Iraq have met up in a dark alley with a near term reality that is something quite short of those original perceptions.  We have to admit that 8%+ one week gains in the Dow are not something that come along too often.  Historically, these occurrences seem to have taken place within the context of highly emotionally charged market environments:
            

The epic secular bear market of the early 1930's was filled with pretty sizable one week Dow gains, both prior to and subsequent to the ultimate bottom.  And as you can see, at least in postwar history to date, these types of events have occurred quite near major bear market bottoms.  1974 and 1982 being prime examples.  Although many a market participant has been chomping at the bit to anticipate a current market and economy related post-Gulf war outcome similar to what was experienced in 1991, never did the early 1990's see this type of compressed time period positive price thrust.  Before jumping to conclusions, we suggest taking a bit broader view of the financial market neighborhood.  The landscape has changed quite dramatically since the early 1990's, and certainly since periods such as 1982 and 1974.  Largely due to the wonders of technology, it truly is a new era at the moment as is clearly dramatized in the following chart:
          

Although we'll refrain from dragging you through all of the charts and data, equity index price volatility has been running well above historical averages over the last half decade plus.  As you can see above, in just the short period of the last seven years, program related trading has literally exploded as a percentage of average daily NYSE volume.  Relative to the moment, this ratio in the early 1990's fit on the head of a pin.  Likewise, since a lot of program related trading can be directionally self reinforcing as it relates to risk management overlays, we should probably consider short and sharp price bursts of the major equity averages in either direction as more normal than not in today's neighborhood, as opposed to these occurrences being some type of anomaly.  Lastly, although certainly not exhaustive in terms of explaining volatility, the use of ETF's (exchange traded funds) has proliferated significantly over the course of this in process bear market.  We've watched many a pundit attempt to cite breadth thrusts (90% upside versus downside volume days) as the earmarks of a potentially significant equity market bottom several weeks back.  We only caution that attempting to navigate while reading yesterday's Street signs might be a bit tricky in a changed neighborhood.

Yesterday Once More?...Once again, we're on the cusp of yet another quarterly earnings reporting cycle.  And it should be no surprise to anyone that it's shaping up to be somber at best.  It will be important to watch market reactions to upcoming economic statistics and corporate earnings reports in terms of trying to get a feel for general perceptions regarding a potential post-Iraqi economic environment.  Will the markets assume that the reflections of here and now economic reality are one off events entirely related to Iraq?  Will the markets look beyond the supposed Iraqi related economic and corporate profit valley?  Will the financial markets perceive and be willing to discount a future similar to the post-Gulf War environment of the early 1990's?  In our minds, this is the key question of the moment.  And thankfully enough, the answer lies dead ahead.  If we can come close to correctly gauging the price clues that characterize perceptions, only then can we assess the potential risk in a possible collision course of those perceptions with probable realistic outcomes.

In case you have not guessed quite yet, and in spite of the fact that it has already been an overworked theme, we fully expect "geopolitical uncertainty" to be the rationale de jour for upcoming corporate earnings softness, lowered guidance, etc.  As you know, when the Petsmart's of the world are blaming geopolitical concerns on earnings shortfalls, we're pushing toward the edge of credibility.  Is it possible that if or when the Iraqi situation is resolved in some type of acceptable manner, that both the real economy and the financial markets can arise from what has been their clear downward trajectories of the past year, let alone multi-year paths of deceleration?  Are Street strategists and corporate chieftains correct when they suggest that much better days lie ahead post an Iraqi conflict resolution?  Is it possible that it could be yesterday once more as we attempt to replicate a post-1991 Gulf War experience in both the economy and financial markets?  For now, although the ultimate outcome remains a question mark, it's important to get a handle on the current perceptions regarding that outcome.  As always, we'll let the data do the talking.

The Launching Pad...To declare that valuations will not allow equities to rally substantially ahead is a rather brave statement.  Over very short periods of time, as we know all too well, valuations can take a distinct back seat to supply and demand factors as well as sentiment and institutionally related investment performance concerns.  Longer term, valuation is certainly an important guidepost.  At the moment, we'd suggest to you that valuations may be more properly characterized as a reflection of investor confidence as opposed to an absolute and definitive guide to near term price movements.  After all, it seems self obvious that a rational investor would be willing to pay what would be considered a high price (valuation) for an asset if that investor believed earnings growth prospects looking forward were substantial.  Rather than allowing the following chart to infer that investors in the broader S&P are delusional at the moment, let's accept the fact that their perceptions reflect confidence in the future:
         

In the above chart you are looking at the S&P 500 P/E multiple based on trailing twelve months GAAP earnings.  We are fully aware that GAAP earnings contain a fair amount of recent non-cash write-offs at the moment.  But, we believe this is much more than compensated for by the fact that what may very well be the substantial net present value of forward corporate pension fund cash contributions cannot be found at all in these numbers.  We know valuations are high.  Higher than they were in the early 1990's.  Clearly during the post-1991 Gulf war period, investors were less confident than today in a favorable forward corporate earnings and system wide economic growth outcome.  When in fact that very reality came to pass, financial market prices adjusted higher on the back of both expanding earnings and expanding valuation parameters.  The best of both worlds.  The chart above tells us that investors today expect a very favorable corporate earnings and economic outcome post the current Iraqi situation.  As you know, the reality remains to be experienced.  As does a potential financial asset price adjustment to that ultimate reality.

Another view of perceptual  confidence can be found in Mike Burke's wonderful Investor's Intelligence sentiment reading.  The difference between the sentiment of "professional" investors in January of 1991 and that of today is striking to say the least.
       

As you can see in the above chart, current bearish advisors stand near the level where bullish advisors stood in early 1991.  And likewise bullish advisors today just aren't that far off where bearish advisors perched at the start of the 1991 Gulf War.  Again, as perception collided with reality in early 1991, a change in perception drove a positive adjustment in financial asset prices.  As is clear, professional advisors already expect a positive outcome looking directly ahead.  

In our minds, what is probably the ultimate statement of confidence and complacency regarding a positive economic and financial market outcome ahead can be seen in the chart below:
      

According to ICI (investment Company Institute) data released late last week, cash as a percentage of total assets in domestic equity mutual funds ended February at 4.15%.  As you can see in the chart, there is only one other month during the last quarter century at least where cash in equity funds was this low.  And, of course, that month was March of 2000.  If this isn't a perceptual vote of confidence regarding a very favorable price outcome for the equity market directly ahead by these fund managers, we simply do not know what is.  In fact, it appears to us that this nearly fully invested position is a de facto assumption by the equity mutual fund complex that the significant redemptions from these funds experienced over the last seven to eight months has come to an abrupt end.  For indeed if that is not the case, these managers will surely be forced to sell.  Not only are equity fund managers betting on a favorable stock market outcome, but also on a change of sentiment and direct action on the part of current equity mutual fund owners.  Can the implied perceptual bet be any more clear?

When Worlds Collide...If the reality of the post-Iraqi conflict environment is one that is favorable for the real domestic economy and financial markets, the current perceptions of equity investors revealed in the charts above will have been prescient.  There will be no collision between current perceptions and an unfavorable reality or outcome that potentially leads to a dramatic adjustment in asset prices.  Under a scenario such as this, the most important question for investors will be just how much of a favorable environment has already been discounted in prices up to this point.

In large measure, a favorable financial market outcome is going to be dependent not only on an acceptable resolution to the Iraqi conflict, but also on a quantifiable resurgence in economic activity and corporate profitability.  In like manner relative to financial market differences between the Gulf war periods of yesterday and today, data points that characterize the real economy in early 1991 and that of the present can be considered worlds apart.  It just so happens that not only did equity markets in 1991 bottom as the conflict started, but so did a number of very important reflections of the real economy.  Bottoms in various measures of economic activity that to this day are still within their cyclical up trends.

With laser guided pinpoint precision, a half century low in housing starts was seen in January of 1991.  Subsequent to that month, housing starts entered their most time extended cyclical rebound in at least fifty years.  As of now we cannot say with any certainty yet that this cycle has concluded.  Furthermore, current housing starts at the moment are light years away from what has been the area of consistent cyclical lows over the past half century.
            

In virtual synchronous fashion, auto sales for the current cycle (also the most extended in time over the period shown below) saw their birth in a dramatic early 1991 January bottom.
        

As far as autos and housing are concerned, our current experience looks nothing like the experience of early 1991.  Certainly pent up household  demand was simply a coiled spring at that time as far as these sectors were concerned.  Clearly a big question for the economy ahead is what influence a resolution to the current Iraqi conflict will have for auto and housing sales.  Given that recent strength has been driven by anomalies in financing costs, the answer may be very little.

The last perspective we will leave you with regarding the real economy concerns leverage.  At the moment, much like in the early 1990's, we find a corporate sector in the midst of debt reconciliation.  The difference this time being that current corporate debt relative to GDP is significantly higher than it was in the early 1990's.
          

Couple the above with the fact that capacity utilization is much lower today than in early 1991 and it opens up the question of timing in terms of an ultimate corporate capital spending recovery.
       

Suffice it to say that the corporate sector faces greater structural headwinds today than was the case in early 1991.  Of course the key ingredient for a recovery ahead is final demand.  If the pundits and the corporate CEO's are correct in their "once the war is over" prognostications for tomorrow, final demand better pick up about ten minutes after the last shot is fired.

Finally, although a potential top in the following relationship is unknowable in advance, household financial flexibility today is a bit more constrained than may have been the case twelve years ago.
        

Post the Desert Storm campaign of 1991, consumer confidence went straight up for a solid half year before plunging to a new low for the cycle.  As you know, we have just moved into the territory of a historic bottoming range for consumer confidence with recent monthly readings.  Households very well maybe become more vocally confident with a hoped for near term end to the Iraqi conflict.  But the key for the real economy will be their ability to continue to spend on such items as cars and homes that you see in the charts above.  Without too much guesswork, that necessarily involves continued expansion in the relationship between household debt and GDP.  

In many number of ways, economic anecdotes of the moment look quite different than was the case in January of 1991.  As opposed to potentially beginning, many economic cycles such as housing and autos look to be completing.  

Let The Numbers Lead The Dance...As is probably a self obvious observation, the never ending dance of financial asset prices is all about the interplay between investor perceptions and realistic outcomes relative to those perceptions over time.  In early 1991, dark and brooding investor perceptions could not have been more incorrect relative to the ultimate unfolding of economic and geopolitical reality.  Although there is a fair amount of bearish chatter around today as compared to any time over maybe the past half decade-plus (understandably so given the generational bear market in equities playing out before us), equity market related data tell us that in a macro sense, investors are expecting a favorable economic and financial market outcome in the quarters ahead.  At the moment, real world economic anecdotes and geopolitical facts don't yet confirm these perceptions.  Let's hope an end to the Iraqi conflict does lie immediately in front of us.  With certainty, first quarter corporate earnings reports do lie directly ahead.  Let the numbers lead the dance.