9/28

Capital Spending - The Fly In The Ointment
Of The New Era?

The New Era's "First Time"...The new era appears to be running into something new itself.  Virgin territory for the new new economy.  Since the new era is really only three to four years old (officially), it has really never confronted a domestic economic slowdown before.  As you may remember, the new era was just a babe in the woods when the global economies blew with the Asian, South American and Russian crises of a few years back.  Not a problem.  The new era didn't miss a beat as e-investment banking dollars were just beginning to gush forth from the venture capital cognoscenti (and from mere mortal folks too).

The current go around is a bit different.  Now the economic slowdown is on home turf.  The question remains to be answered as to how the new era will fair during its first new era domestic US economic slowdown.  Investors have pinned their hopes on a soft landing for the general economy.  Quite unfortunately, many of the poster children for the new era such as Yahoo, Amazon, CMGI, etc. have already landed a bit prematurely - crash landed, that is.  Nose first.  Careening toward the runway closely on their tails are also their big brother and sister counterparts, the big tech monoliths such as Intel, Cisco, Dell, Microsoft, etc.  Can they avoid a nose first collision with the tarmac?  From the looks of it, there isn't a whole lotta time left to pull back on the throttle and ease their noses up.  For fully invested mutual funds and the general public, let's hope the mantra of "we're in it for the long term" doesn't change to "Mayday, Mayday".

Capital Idea, Governor...As you know, one of the key drivers for the tech industry and the perception of the new era environment over the last 3-4 years has been corporate capital spending on technology.  The public buying personal PC's is just a drop in the proverbial bucket.  Companies have spent oodles and oodles of dinero buying bigger and faster computer hardware and networking/switching equipment that allowed them to communicate at the speed of light.  Have a look at the raw numbers:

The numbers we have exclude farm businesses.  Sad, but not the end of the world.  More unfortunately, these numbers exclude the financial sector.  Quite importantly, the financial sector is a mega consumer of all things technology.  Financial services as we know it today would not exist without enormous capital spending on technology.  Nonetheless, the trend in non-financial corporate America is plain to see.  It has been up, up and away for cap spending over the last six years.  We have seen estimates that put component spending on technology at 50+% of the total cap spending number.  Suffice it to say, real corporate capital spending on tech equipment has been huge and incredibly meaningful to both the perceptions and reality of overall economic growth.

Now that it appears the economy is contracting a bit, at least that's what the soft landing folks are hoping for, how sustainable is future corporate capital spending?  Given the preponderance of total corporate capital spending dedicated to technology spending over the last half decade (or more), this is one serious question for the stock market.  (Remember we showed you on Tuesday that technology currently comprises 33% of the total S&P 500 market capitalization.)   

Houston, We Have A Problem...This time around it is a bit different.  Much like 1997 and 1998, we are currently experiencing softening global economies.  Unlike that period, though, energy prices are now high.  Much higher than a few years ago.  One of our major trading partners and a global economic powerhouse - Europe - is facing a very inconvenient currency meltdown.  This time it's not a small Asian nation that is feeling currency pain, but rather an integral player in the global economy.  Not only here at home, but central bankers globally have been tightening for some time.  Ed Hyman at ISI has counted 129 central bank tightenings globally over the last 24 months.  The US consumer is showing signs of strain.  Consumer debt levels are high and savings is at a record low.  We are seeing many signs of margin compression in the early 3Q 00 preannouncement season.  Clearly pricing is tough as costs of sales rise.  The environment today is different.  The American consumer may not be able to be persuaded to consume their way out of a domestic economic slide.  The house has already been refinanced and the plastic is maxed out.

The earmarks of a global economic slowdown are in place.  It's simply a question of degree.  As you know, classical economic slowdowns have been accompanied by reductions in capital spending on the part of corporate America.  In an effort to conserve cash (and reported earnings), capital spending slows as profit growth contracts or turns negative.  Will it be so again?  Growth in capital spending over the past four years may offer a clue:

Once again, we are using nonfarm, nonfinancial corporate capital spending numbers in the above chart. (By the way, the source for these capital spending numbers is good old 2Q Federal Reserve data.)  Undoubtedly the effect of the financial sector would only skew the annual year over year growth rate higher.  As is plain as day, growth in capital spending has outstripped GDP growth in each of the last four years.  This year and 1997 being particular standouts.  We believe this chart additionally emphasizes the importance of capital spending in driving tech sector earnings over the last half decade.  Reversion to the mean would argue that at some point growth in capital spending slows as economic growth slows.  We've witnessed extraordinary capital spending efforts on the part of corporate America.  Is it time for a breather as profits at best slow in growth rate ahead?  It seems a darn good bet.

The Irony Of It All...We are strong believers that the wealth effect created by the surging stock market has been a main driver of the economy (consumption) over the last few years, and hence capital spending by a flush corporate America.  The wealth effect and credit creation have been the American consumers best friend.  Now that all of the storm clouds have seemingly passed (Asian crisis, Russian crisis, Y2K, etc.), the Fed has realized the need to slow things down a bit in the last 12 months as inflation is clearly here.  Assuming the slowing economy cools capital spending, tech profits will be directly effected.  No two ways about it.  The very sector that caused most of the stock market wealth effect in the first place.  Aye, and here's the rub.

Assuming capital spending contracts as it has done in virtually every economic slowdown known to man, spending on tech may bear the brunt of the falloff as that's where the excessive and outsized spending has been all along.  If this comes to pass and tech earnings slow, the stocks will be hit hard.  We are already seeing it begin to happen.  On Tuesday we showed you tech stock charts that appear in trouble.  If tech stocks are seriously questioned, just what do you think the overall tenor of the stock market will be?  Answer:  It won't be good.  You are already seeing the initial signs of disenchantment.  In many areas of the "old economy", pricing power has been an issue for some time now.  It's really never been questioned in tech.  The following chart explicitly says that pricing will become a problem in an environment of slowing or falling unit demand.  An environment that would accompany a period of a general capital spending slowdown.

As you know, the bulls have sung the praises of Moore's Law for some time now.  Implicit in the message is that technology gets cheaper over time.  The above chart clearly bears witness to that fact.  The unfortunate aspect of the message is that in good economic times, lack of pricing power is masked by unit volume growth.  In a slowdown, lack of pricing power and slowing unit demand are in plain view for all to see, including new era investors. 

Sun Set?...If the above PPI chart isn't enough for you, just yesterday the generous folks at Dell dropped prices on their servers anywhere from 14 to 47%.  Do you think they did this because Michael Dell woke up in the morning and "decided to give something back to the world?"  The company also dropped prices on notebooks 12% and PC's up to 15%.  According to Dell, the most dramatic price drops were in enterprise-level server equipment.  This has all the earmarks of significant price competition due to falling growth in demand.  An attempt to retain market share.  Has the tech related capital spending slowdown cycle already started?  The folks at Dell would never admit that, but their price reduction press release already says it all.  

New era proponents abhor the thought that tech spending could be cyclical, as it has been in virtually every other economic downturn experienced in the last 30 years.  They better hope it is different this time as it appears the technology capital spending slowdown test lies directly ahead, accompanied by a general slowdown in the global economy.  Maybe that's why the tech related stocks and indices (JASDAQ, German tech stock index, Korean tech stock index, etc.) in foreign markets have literally blown up this year.  Do you think?  We would counsel that you keep a sharp eye on capital spending ahead, but unfortunately by the time the capital spending numbers truly show a slowing, the tech stocks dependent on capital spending will already have joined the ranks of the old economy fan club. 

What A Bunch Of BLS...Sh*t happens, right?  By now were sure you've seen the John "Mr. Leaky" Berry article in the Washington Post Wednesday describing how the Bureau of Labor Statistics has "understated" the CPI report over the last twelve months.  You know, it's kind of like finding FBI files that have been missing for 12 months lying in plain view on a desk in the White House one day.  In fact, if the BLS had not admitted the problem, we NEVER would have guessed there was anything wrong with the inflation numbers.  Today the BLS came out and announced the change at .1%, blaming the error on something to do with "air conditioner quality measures".  Sounds more like a lot of hot air to us.  Secretly we've heard talk of a conspiracy at Gore campaign headquarters to influence the senior citizen vote.  After all, every one tenth of one percent revision upward in the CPI is worth 79 cents per month to Social Security recipients.  If it isn't influencing votes, then we're convinced it's a plot to get liquidity into the hands of seniors so they can jam the market higher in 4Q.

Don't be alarmed about costs to the government, though.  If elected, we've heard Gore is planning legal action against seniors everywhere for raping and pillaging the Social Security fund.  He'll embark on this just after he finishes suing big tobacco, the HMO's, the price gouging pharmaceutical companies, those profit hungry SOB's at big oil, and Microsoft.  Just like every other pro-business politician would do if he were president, right? 

Eight Miles High...And falling fast?  Thanks to Tim for updating the following NDX chart we showed last week.  For those technically inclined, the important numbers to keep in mind are 3630 and 3350.  A cash close below 3630 is a violation of the bull market continuation channel.  A close below 3350 is the maximum Fibonacci retracement allowed for the NDX bull market to still be considered a bull market.  If we drop decisively below 3350, the chances are that it's lights out for this (tech inspired) bull market. 

If the NDX goes, will the SPX and the Dow magically hold up?  Our bet is no.  Confidence in this bull market rests with the promise of the new era.  Tech is the new era.  Anything that breaks confidence in tech most likely results in punishment across the board.  As you know, we closed below 3630 on the NDX Wednesday only to come ramping back Thursday with the quarter end activity.  The action of two days clearly does not a trend make.  A market that laughs at a Cisco downgrade (Sanford Bernstein) for the very reasons we discuss today (capital spending slowdown) is clearly being influenced by non-fundamental drivers.  There is obviously a reserve of liquidity out there that had decided enough was enough, for the moment.  Watch this chart over the weeks and months ahead.

Something Rotten In The State Of Denmark?...Well apparently not as citizens voted down the inclusion of Denmark in the Euro club.  Whether you realize this or not, this was one big statement for the Danish people to have made.  Borrowing costs in Danish kroner right now are about 1% higher than had the currency been on a Euro basis.  As a result of this vote, the Nationalbank of Denmark will most likely be forced to raise interest rates in Denmark in the next few days to defend the kroner over the short term.  As you may have gathered, this isn't a good thing for the Danish economy.  Adding Denmark to the Euro fold would not have been a seismic economic event for the Euro clan, but the rejection by the Danish voters sets a perceptual precedent that clearly is anything but positive.