Mind The Gap (Part II)    

8/29

Driven Two Tiers...It's no mystery by any means that we are living in a very dichotomous financial market at the moment.  A select group of large cap (mainly tech) stocks have taken on unsustainable valuations relative to the majority of the total S&P 500 large company participants.  Treasury bonds have rallied significantly over the past few months while high grade corporate bond issues have barely noticed and their corporate high yield counterparts sink deeper into the mire.

As we have detailed for some time, we firmly believe that resolution to the extremes in current valuation and investment attraction bestowed upon the favored few will ultimately end in financial tears, not in a continuance of financial tiers.  From the sheer concentration of institutional ownership in the "chosen tier" stocks, it logically follows that everyone cannot reallocate capital away from that tier efficiently.  As you know, they will all want out at once.  Given the wonderful world we now live in whereby companies can watch one half of their market values be wiped away with one simple pre-announcement, by definition, every institutional investor does not get out alive.  Especially the the big fund behemoths.  (More on this later.)

Nonetheless, given our contrary nature, it's our sworn solemn duty to always look at both sides of the equation.  In this and Thursday's discussion, we want to delve a bit deeper into the dichotomies of the current market environment and explore the possibility that the unwashed masses of equities below the current "chosen tier" arise from their slumber.  Again, we firmly believe total market liquidity will give way long before the two tiers of this market are rejoined, we just can't help but "mind the gap" in the meantime.  Now may not be the worst time in the world to bring this up given our other firm belief that the current political administration will do absolutely everything within its power to "keep the game going" with a smile through the election period.  Notice the Fed right back in the repo market bright and early Monday morning?              

It's All Over Now, Baby Blue...Mix our previous thought of continued perceptual cooption by the Clinton Administration with the possibility that Greenspan is done raising interest rates, and what do you get?  (NB:  We are not espousing the end to rate increases as long as credit availability is running strong.)  Well, you have the ingredients for a rally in interest sensitive stocks, of course.  However temporary or fleeting.  Since it's a slam dunk that AG and friends will be on hold through November, that gives plenty of time for folks like the KGB (Kudlow, Galvin and Battapaglia) and others to bask in the glow of an assumed completed monetary tightening cycle that barely phased the continual upward trajectory of the major market averages.  Hurrah!  Onward and upward as the next Fed move will most certainly be one of ease.  Right?

Crazily enough, it just so happens that a good number of these interest rate sensitive stocks have been in their own little bear interludes for some time.  They have been second tier citizens.  The have-nots in the late 1990's version of the "nifty fifty".  If the market holds in the months ahead, it would not surprise us at all to see some of these groups rally.  Remember, it's not the fundamentals that count in the months ahead (as they have not counted for some time now), it's the perceptions and the actions of the crowd that are important.  It's the guy on the stage with the mic that everyone is looking at and listening to.  That "guy" is Wall Street (analysts) and the popular financial media.  With tech incredibly overowned, investment money needs to find other repositories if the market averages are to broaden.  Prepare yourself for a boatload of numbers to follow.             

   The Financials

    The obvious beneficiaries of the assumed completion of a monetary tightening cycle.  We'll get to the fundamental potholes in a minute.  First, a picture and the numbers:

          
Chart courtesy of BigCharts.com

The Philly Bank Index chart above shows that the banks basically missed the last 2 1/2 years.  It's been a sideways trip to nowhere.  And all the while the techs were doubling, tripling, etc.  Just as a note, the following table has been prepared using Value Line numbers:

If the perception of Goldilocks magically reappears in the months ahead as seems a possibility, the market may just start to fully price in an end to monetary tightening.  The Banks have room to move.  On face value (is there any other vantage point on Wall Street of the present?), the valuations on the banks are below that of two years ago.  Returns have improved and, at the moment, loan losses are not runaways.  We could easily see Wall Street talking itself into having to own banks.  At least for a while.

(Fundamentally, we are still worried silly that banks are being hit with two silent killers at moment.  First is relatively unrestrained lending into a highly inflated asset environment (real estate and financial assets).  Second, and possibly more deadly, is that lending may be a victim of mispricing.  As you know, so much of what has happened in the traditional lending markets concerning rate structure has been based on pricing relative to a spread over Treasuries.  Now that Treasury yields are being artificially pressured lower by the Treasury department bond buybacks, knowing how to price in loan risk over and above the "riskless asset" has been muddied.  Couple that with tremendous competition in the lending arena these days by both banks and non-banks and you have the making for trouble.  We believe the real potential exists for trouble based on mispricing loans to the downside while lending against very highly inflated assets.  Nothing short of a powder keg at some point.  For the sake of the banks, we sincerely hope we are wrong.  Regardless of what we think, the important matter is what Wall Street thinks and perceives in the months ahead.) 

   The Homebuilders

Yes, a potential economic slowing is not good for homebuilders, but a stable interest rate environment is.  The anticipation of a lower rate environment is even better.  Stock prices anticipate.  If investors become convinced that rates have no where to go but down, the homebuilders are beneficiaries at some point (not that they are not making oodles of cash right now).  This is a group that has been pounded in what has been one of the best real estate environments in over a decade.  Only in the last month have they picked their collective heads up.  (Just as Fed Funds futures sold down.)  The group is clearly nowhere even near the favored tier of modern day stock darlings.  Once again, the numbers tell the story (numbers source is Value Line and IBES):

If the economy is ready to implode, this is the last group one would want to own.  If we achieve the mythical "soft landing" or, more importantly, the market believes we'll achieve it, homebuilders look downright cheap.  Remember, we are just pointing out that in a potential "closing of the (valuation) gap" scenario, we are looking for sectors overdone to the downside in an otherwise assumed normal environment.  Over the last few years, intrinsic financial returns are up across the board and simplistic valuations have been halved.

This particular group has rallied double digits over the past month.  Coinciding with the growing belief that the Fed has found the holy soft landing grail.  We would also point out that as of Monday, the stocks mentioned above closed with a total market cap of $7.38 billion dollars.  Putting this in perspective, Yahoo and Ariba had one day runs totaling almost as much on their last earning reports.  Only so many dollars will be allowed into the theater to see the homebuilders stock rally if it begins in earnest.  Seats are limited.

   The Retailers 

What?  After the bombs by Costco and the like?  So soon after all the major research houses just came out and officially downgraded the stocks?  We're not saying it's a guarantee of being an investment money flow recipient, but the retailers should act better in a stable interest rate environment.  At this stage of the game, a resurgent stock market may be the very catalyst.  Monday's personal spending numbers pretty much say it all.  Personal spending outpaced income growth two-to-one as the savings rate plummeted to a new low.  Consumers aren't on fire, but they are out there spending.  As you know, the weak retail numbers were reported in the quarter during the April/May plunge in the NASDAQ.  Just what will 3Q and 4Q retail numbers look like if the stock market holds or edges higher into the election?  It remains to be seen, but, once again, the stocks may anticipate such a scenario.

   The Truckers

Are we out of our bleeping minds?  Given the price of oil, are we simply kidding ourselves?  Maybe.  And maybe not.  The price of oil is in the stocks.  

The last three years have been nothing but pain for the stock prices of the truckers.  At this point, just who is left to sell?  Again, if the economy is on the brink of the abyss, the pain in this group has only begun.  Conversely, if Goldilocks is assumed to be alive and well by the investment cognoscenti, the truckers may attract inflows.  The numbers, please (thank you Value Line & IBES):

As you can see, returns have improved and valuations are lower than three short years ago.  Stock prices over that time are stagnant.  These return improvements have occurred even in the face of rising oil prices.  The return numbers do show that the truckers have not "eaten" gasoline/oil price increases in margins or capital returns, or equity returns.  God forbid they are actually passing these higher prices on?  (Shhhhh...don't tell the BLS.)  Once again, total market cap of the group listed above is $5.73 billion.  As you know, that's merely a bad hair day for a single company in tech land. 

The groups we have listed are by no means the sole beneficiaries of a benign monetary policy environment.  The utilities had a pretty big move in late July and August, due only partially to interest rate declines (but more to the perceptions that an electrical generation capacity problem is growing).  Historically the restaurants have been beneficiaries and the list continues.

In our minds, the macro perspective of a highly leveraged consumer, logically precludes a big move on the part of interest sensitive stocks.  But, what we believe fundamentally is not the point.  The point is that a significantly dichotomous valuation gap does exist in the current stock market environment.  It also appears that the current political administration will pull out all of the stops into the election to support "the beast".  We need to continually look at the other side of the equation in assessing and hopefully anticipating all future investment outcomes.  What we have described is a possibility.  A given?  Of course not.  At this point we believe a move in interest sensitives would be temporary.  As our journey in the stock market of a lifetime progresses, we must continue to remind ourselves to Mind The Gap.

A final follow up on "The Gap" on Thursday.      

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