ContraryInvestor - Market Observations

MARKET OBSERVATIONS

We Are Not Alone

MARKET OBSERVATIONS - 7/18

Money, Honey...Did you see that M3 increased approximately $22.4 billion last week? It had been widely reported and is yet another testimony to that fact that liquidity generation is alive an well in the financial markets. As you know, money creation is not solely in the hands of Greenspan and friends. The Fed can act to increase money supply, but the general credit markets (money market funds, CP, etc.) can also act without prior approval. We find the following a chart a bit interesting from a near term historical standpoint:

From a layman's definitional perspective, net free reserves is representative of excess liquidity sloshing around the banking system. It can be seen as a measure of relative level of liquidity. Not credit creation, but existing liquidity. Simplistically, the more money in the banking system, the more the firepower for lending. From mid to late 1999, the banking system was preparing the liquidity storage tanks for potential Y2K disruptions. Hence the dramatic spike. Given the non-event of the millennium, banks clearly stepped up the pace of lending in early 2000. As we mentioned a few weeks back in looking at the 1Q Fed Flow of Funds data, where the GSE's had cooled down, the commercial banks had picked up the pace.

Clearly some of the swing in net free reserves is seasonal in nature, but low points have also generically coincided with points where Greenspan has turned on the money machine in the few years past. Is last week's rocket fuel injection to M3 the beginning of yet another spiking of the liquidity punch bowl? Is this the reason for the recent brisk activity in Fed open market operations? Yes, the elections lie dead ahead. The current government administration wants a Clintonesque showing (perceptual perfection). And yes, the banks have done a good bit of lending over the recent past and have partially drained the reserves piggy bank. We'll have to see how these factors play out ahead, but we thought we would point out the chart showing net free reserves that currently stand at a point marking a bottom range seen over the last 8-9 years. As hard as it may be to believe, the implication is that more liquidity injections may be on their way. Don't be surprised.

We Are Not Alone...Last week we made the case to you that we believe that neither a hard nor soft economic landing has arrived...yet. In fact, with the stock market attempting a dramatic recovery, we may be in for minor economic acceleration ahead. We felt further vindicated in this stance Friday as reported June retail sales were brisk and May's numbers revised upward from -.3 to a +.3. (Once again, we wonder how that happened? Merely an original calculation slip, we're sure. Riiiiiight.) Additionally, seeing the M3 number for the week is pretty straightforward evidence that the ability to create liquidity strong and this liqidity is readily available to keep the party going. (Both the economy and the financial markets.)

Having said that we do not expect a dramatic economic slowdown in our immediate future, what about inflation? Disregarding for a moment all of us who do actually eat and drive, looking at reported PPI and CPI figures conveys the message that inflation is no problem at all. The Fed can point to the reported numbers as justification for its recent inaction. Crazily enough, looking at several components of overall PPI tells a bit of a different story, as we will proceed to show.

Let's start our little story right here. Once upon a time there was a trade deficit:

And this trade was so big that it allowed the country sponsoring this trade deficit to import deflation over a number of years where its trading partners were having a bit of a rough go economically. It's trading partners to the East and the South had suffered severe financial market, economic, and currency setbacks a number of years earlier that made their exports enticingly cheap. Being the good neighbor that it was, the apparently strong economy country bought all the cheap goods it could from its forlorn neighbors so that its neighbor's economies could grow strong also. Over a number of years, its neighbors did grow strong and began to experience good economic times themselves. So, did everyone live happily ever after? Not quite.

Clearly the strengthening Asian, Latin American and even European economies have caused global inflationary characteristics to begin to normalize over the past few years. The depths of the global (ex-US) downturn in '97-98 were the anomaly, not the rule. Oil at $10/barrel was the aberration, not the new paradigm. Just what are we getting at here? As long as the US continues to run a significant trade deficit, the inflationary fires will continue to build. Market bulls would have you believe that the trade deficit is a blessing from the heavens and proof positive of the strength of the US economy. Unfortunately for the bulls, the law of unintended consequences is waiting to pull the rug right out from under them. The strengthening foreign economies have been and are continuing to put upward pressure on global commodity prices. We have to believe that at this point it has become a Catch-22 situation. Foreign economies will not turn down until the US consumer stops borrowing from them to fund imports to the States. (And maybe they do not turn down even then.) US consumers most likely won't back off until the US economy cools significantly. Inflation is not a phenomenon controllable only by the Federal Reserve of the US. Simply put, we are not alone. In the meantime, market participants and central bankers stateside refuse to look at their own PPI factor data and acknowledge the trends. You know we won't refuse.

Ready? Here are the results of our government's own PPI data. As usual, the pictures speak so much louder than any Fed chairman speech at the current time:

That's right, double digit price increases for industrial chemicals. Pulp, paper and other paper related products are just not far behind:

Lumber and wood pricing on the producer side has been stable for a good while now, but at a high level:

Broadly, intermediate goods PPI is a telling measure that prices to the manufacturer are going higher. Just ask Procter and Gamble what it's all about. Clorox is probably next. Pepsi can cite you chapter and verse of what PET bottle price increases mean. Anyone shipping palletized product has absolutely first hand knowledge of price increases in corrugated boxes, packing film, etc., to say nothing of actual physical shipping costs themselves. The intermediate materials PPI chart is simply too representative of the broad manufacturing economy to ignore (but, ignored it has been):

Finally, given that we are really a consuming nation, who cares about industrial manufacturers? As long as consumer products are cheap, to hell with the industrial economy. Right?

Whoops, guess we spoke too soon.

We have one very simple observation. If these charts (derived by numbers put out by the US government) are correct in that the cost of doing business for corporate America is rising, then either inflation is a huge problem, or corporate earnings are heading for a massive implosion. Which is it? As you would expect, our answer is a little bit of both. It probably isn't too long until US investors realize that the sword of economic globalization cuts both ways. We are not alone.

Global Stimulus... Just continues. As you know, Japan passed (at least temporarily) on abandoning their zero interest rate policy this weekend. Maybe it was the fact that the large department store Sogo declared bankruptcy last week. Sogo was the second largest bankruptcy ever in Japan. $17.3 billion in debt. Although Japan can move glacially when it comes to financial reform, actually allowing Sogo to go under was a step in the right direction (as crazy as this may sound). Clearly the powers that be decided one economic shock per week was most certainly enough for fragile Japan. With the maturation of public funds in the Japanese "postal" system, interest rates in Japan are destined for higher ground even if they have to be dragged kicking and screaming. Domestic capital flight, or higher interest rates. Which is it going to be? At this point, we pick higher rates. In the meantime, the Japanese zero rate policy is stimulative from a monetary standpoint. Stimulative globally.

You probably also saw the news that both personal and corporate tax rates are coming down in Germany. If this isn't fiscal stimulus, we just don't know what is. Personal tax rates are destined to drop from a high rate of 53% to 42% by 2005. For lucky German corporations, the news is even better. The main tax rate on corporations will drop from 40% to 25% starting right now. That means that 60 cents (convert to Euro or marks at your convenience) of after tax earnings on each dollar jumps to 75 cents - a 23% increase. These two "right in our face" stimulative global actions further argue that global growth and inflationary pressures are not destined to settle down anytime soon.

A Body In Motion Tends To Stay In Motion...Until a countervailing force acts against it. In the renewed charge of the NASDAQ light brigade, the young soldiers originally wounded in battle are again charging the front lines. The Ariba's, the AMCC's, the JDSU's and SDLI's helping each other scramble ahead of the generals (CSCO, ORCL, DELL, SUNW, MSFT, etc.). The generals seem battle weary and tired. These bloated old men just don't seem to have the fight left in them. The young foot soldiers are carrying enormous valuation baggage in their knapsacks. How long and fast can they run under this weight? The stochastics stand at overbought levels.

The Dow has broken its stairstep descent for the moment. The super caps such as GE and INTC have helped the cause recently. Like the NASDAQ, the Dow stochastics are "toppy".

Lastly, the S&P to this day remains in a well defined trading range begun last October. This is as tightly defined a channel as we have seen in some time. You can bet traders could draw these lines with their eyes closed.

For the moment, investors/traders seem willing to pay anything for perceived growth. Biotechs and optical networking companies especially. These are the very companies least hampered by interest rates. Admittedly, unlike their former speculative brethren in the Net crowd, many of these companies do have earnings. Valuations are spectacular. In our minds, the availability of credit in the general financial markets is rocket fuel for these issues. Any percetion of a slowing economy can only reinforce the race to buy fast growth companies. Do you really believe that this is what Greenspan had in mind when he and the Fed started to raise rates 18 months ago? The unintended consequences of the new economy.

Going Limp?...It's super Tuesday. You know that. After the bell, the Street was hit by a barrage of earnings reports from corporate America's best and brightest. Two big heavyweights gave off mixed signals. Mr. Softie reported its slowest annual growth rate in five years. Operating earnings actually declined year over year by about 13%. Of course a $1.13 billion gain from investments saved the day. The company specifically cited "sluggish PC business". Moreover, they expect the slowdown to continue through 3Q. Alternatively, new era behemoth Intel chimed in with an opposite message. Apparently things in the PC biz for Intel are just great. It a true Clintonian moment, INTC Chief Financial officer Andy Bryant imparted optimism for the third quarter. "This is the most comfortable I've been with the third quarter. This is the first time Intel has said that revenue simply will be up, and not up slightly or flat to slightly up." (Wink, wink.) Surely this should be nothing short of cannon fodder for those "in the know" wizards at CNBC. Is there a hidden meaning to this? Well, it depends what your definition of is is. We soon expect Bryant to be promoted to CSO. CSO? Of course, Chief Semantics Officer. God knows there aren't enough of these around on Wall Street today. Did we forget to mention that wonderful INTC pulled $2.34 billion out of the investment gains grabbag in the quarter? Silly us. To put this into perspective, the $3.47 billion in gains number realized by the dynamic INTC/MSFT duo exceeds the total market cap of about 5000 public companies in existence today. Who says small is beautiful?

One last look at numbers (you know, with us they just always seem to be getting in the way). The following graphs are a look at now $438 billion market cap INTC's historical PSR (price to sales ratio) and annual revenue (sales) growth over the 1992-2000 period. We've specifically used high PSR ratio for each year so as not to skew prior years down in any way:

Notice anything funny? Well, that depends what your definition of funny is, now doesn't it.