10/17

War Of The Worlds

Spontaneous Combustion?...Bear market (if that is what's going on here) rallies can be spectacular, can't they?  Friday's little display of enthusiasm was quite a spectacle.  Although outward appearances were bright and shiny, internals told a different story.  Breadth was fair at best for the type of percentage moves achieved by the indices.  Just when it looked like the world was ready to come to an end, it didn't.  Although we've said this before, we hope it is worth repeating.  Bear markets are not events.  They are a process of confidence destruction.  Just as it took about a decade to build euphoric confidence among the public regarding the benefits of stock ownership, so will it take some amount of time to chip away at that now solemn belief in equities.  Bear markets play out over time.  Just as do their bovine counterparts.

We've heard talk that there was manipulation in the market on Friday.  The fact is that no one really knows this for sure.  What is important to focus on is dynamics of the market that are knowable.  One clear lesson that has been learned over the past few years is that market turnarounds can come out of the blue and can happen quickly.  Just how much of Friday's action in the big cap tech issues was short covering?  Our guess would be a lot.  The bears now have a long memory of being gored by staying short and not taking profits on quick market turns.  Likewise, mutual fund managers sitting on cash that may have come in during the downturn cannot afford to miss the train as it literally bolts from the station.  One thing is for sure, patience levels among both the bulls and the bears is thin.  Mighty thin.  Short term exaggeration in price should be no surprise.

As you may know, the almost 40% decline in the NASDAQ since March of this year has an equal last found near the initial bottom in the '73/'74 bear market in terms of decline relative to time.  You have to go back over three and one half years to find the Dow, S&P and NASDAQ all going down in harmony for five straight weeks.  (Admittedly, now it's probably an easier accomplishment given that the top holdings in each index are the same.)  An S&P decline in 21 out of 29 trading days was last accomplished in the '83/'84 bear episode.  Likewise, last Friday's little 8% move in the NASDAQ was one of the larger one day percentage moves on record.  Again, don't be surprised by exaggerated price moves.  Expect them.  Individual stocks have been telling us this for some time now. 

War Of The Worlds...Bull markets are built on dreams.  They are built on optimism.  The promise of tomorrow.  Bear markets are born as those dreams are interrupted by the realism of the moment.  An interruption in perceptions.  A clash with the reality of the now.  The anti-dream.  The two worlds are beginning to collide as we speak.  Despite the rally of last Friday, the facts regarding current economic change in the global and domestic landscape won't reverse because of a rally in stocks.  One amazing characteristic of bear markets that we have mentioned before is that information that may have been readily available for some time all of a sudden takes on significant importance.  It seems to us that this behavioral characteristic of herd mentality is more important than ever as information is disseminated at light speed in the wired world.

Whether stock prices rise or fall over the short term, the following pieces of "now important" information don't seem destined for fundamental change any time soon.  It's how perceptions change ahead in regard to this information that counts:

  OIL

What is happening in oil may be more profound than first meets the eye.  Regular readers may recall a piece we did a few weeks back called Oil's Well That Ends Well.  That piece hit the high points of crude supply/demand and production activity and capacity in the domestic market.  Fine.  What may be more meaningful in the greater picture regarding oil has its roots three decades ago in the initial and radical oil crisis of the early 1970's.  It is our contention that the original 1970's dislocation was the beginning of pushing oil based industrial activity offshore.  As crude costs skyrocketed throughout the 1970's, financial returns on domestic oil dependent businesses shrank.  As profit declined, less and less capital was attracted to those industries given imploding rates of return.  The natural evolutionary cycle from a purely business perspective was to lower alternative costs to compensate for the increased input cost of energy.  Logical answer to lowering costs?  Move offshore.  Hence, the early sightings of the transformation of the US economy to an information economy.  Clearly, this is the short version of the story, but it has been played out in the financial markets over the decade of the 1980's and 1990's.  In the 1980's, market leading returns were delivered by the pharmaceuticals, consumer non-durables, etc.  In the 1990's, it has been tech, tech and tech.   Nowhere in the last twenty years has industrial manufacturing, chemicals, etc. been anywhere near stock market leaders for any sustainable period.  The market has been a mirror of this transformation.

So here we find ourselves today with oil prices going higher.  No problem as we are less dependent on oil than ever on a total GDP basis, right?  To back up this statement, transportation now accounts for 67% of oil use in the US and Western Europe as opposed to 45% in 1970.  We have backed away from industrial manufacturing.  That may be fine for the Western countries, but it leaves a great deal of the non-Western economies at a great disadvantage.  They are more dependent on oil than ever for their economic growth.  Oil is playing a significant role in a global economic slowdown.  Exacerbating the economic growth pressure is the currency imbalance seen between the US dollar and just about every other currency on the planet.  Since global oil is priced in dollars, the effect on weak currency global consumers of crude has been anything but good.  Oil is a central influence in the global economic slowdown.

A new reality?  Not really.  The information has been there all along.  Now that global demand for all hallowed technology products is proving to be cyclical, the reasons for the slowdown are being seen and impounded into financial asset prices.  The following graph says that this newfound focus on the global effects of higher crude prices may not dissipate any time soon:

We're looking for oil to eventually back down to the $25-30 range.  Enough so OPEC is happy and not enough to absolutely kill the global economies.  Unfortunately, enough to create corporate margin pressure in a world where pricing power, at least at the retail level, seems almost completely lacking.

  IMBALANCES IN DOMESTIC CREDIT MARKETS

You know that this information has been there all along.  We report it to you each and every quarter as we review the Fed Flow of Funds data.  Swap spread data and spreads between Treasuries "and everything else fixed income" have been highlighted time and again as growing symptoms of financial and credit related strain over the past year or so.  Specific company credit mea culpa's such as Wachovia and Union BankCal were early warning shots that were dismissed as company specific.  Recently the Fed, FDIC and OCC released their annual (joint) report called the Shared National Credit Exam.  The envelope please:

   Problem loans at approximately $100 billion. (up 45% from 1999)

   Loans classified as uncollectible at $4.7 billion. (up 300% from 1999)

These facts are set against a backdrop of industry wide loan loss reserves at 13 year lows (relative to loans outstanding).  Levels even lower than the credit crunch period of the early 1990's.  The message is apparently getting through.  The following graph shows that Senior Loan Officers at banks "say" they are tightening standards.  As you can see, this compares with heightened fear periods of pre-Y2K and the early decade, but theoretically our present economy isn't in trouble - yet.

We've mentioned margin debt as a potential source of problems for many a moon.  Now that Bernie Ebbers shows up in the press as needing to meet a margin call on his Worldcom stock, margin debt is getting renewed attention.  The question is, "how many little Bernie's are out there?"  Answer: A lot.

We've highlighted margin debt in graphs so many times over the past few months that you are probably sick and tired of seeing it.  The information on margin debt has been readily available for some time.  Exponentially rising absolute levels of margin debt were simply explained away by Street strategists as inconsequential relative to asset values.  As we have harped on ad nausaum, the left side of the balance sheet suddenly sticks out like a sore thumb when the right side starts to contract in any meaningful manner.

  GLOBAL TECH SLOWDOWN

The old reality of the cyclical nature of technology capital spending is fast becoming a newfound modern day stock market reality.  The 1990's has clearly been a special decade.  Witness to the rise of the PC as a universal appliance.  The rise of the concept and initial commercialization of the Internet.  The beneficiary of tremendous corporate capital spending in modernizing telecommunication and information processing technology.  Investors priced tech stocks as if growth was to be sustainable for decades to come.  Now that the growth is moderating, the reconciliation in valuation has begun.  If you will look at the following table, you will see why we use the word "begun":

(Numbers as of 10/16)

Does a fish really rot from the head down?  Recently investors have taken out and shot their former biggest cap tech beloved.  In like manner, they appear to have no problem supporting what seems to be blatantly speculative telecom, optical networking, etc. candidates below the behemoth caps.  Supporting really isn't the word.  They have run into the group from Veritas to Verisign in the above table as the Intel's, Microsoft's and Cisco's have given way.  Running from crazy valuations to certifiably insane valuations does seem a bit perplexing, but it is a new era (for a while longer, we guess).

Third quarter preannouncement season was one of the worst we can remember in some time, especially for tech.  It would seem quite odd to see the market discount the fact that the earnings growth rate downturn in tech, as well as corporate America at large, is over.  We'll just have to wait 8-10 short weeks for 4Q preannouncement time to roll around to see what tomorrow brings.  Unless oil plummets and the global economies miraculously heal themselves, we'd say the reduction in growth rate in corporate quarterly earnings has just begun.

The reduction in earnings expectations for tech should be absolutely no surprise whatsoever to anyone who has gone through the simple task of looking at revenue and operating profit growth at various former darlings over the last year or so.  There has been a clear deceleration in growth rates.  Companies have been "making the numbers" by dipping in the bag of tricks and pulling various rabbits out of the hat.  Lowered tax rates.  Realized gains on investment portfolios.  Debt financed stock buybacks.  You know the routine.  And now it's all of a sudden meaningful?  That's a bear market speaking.

    STAGFLATIONARY PRESSURES IN THE US ECONOMY

Clearly oil is a big piece of the macro CPI and PPI equation.  Grains, lumber and various other assorted components have been heading south while oil has taken center stage.  Nonetheless, the following chart didn't suddenly appear out of thin air.  The trend has been in place for some time now:

In the background, health care prices have crept higher.  In some cases of individual businesses we see, double digit higher.  The following chart sets the trend for rate of change, but is unfortunately not updated with the latest rate of change data:

Real estate prices simply speak for themselves.  If real estate is not an example of escalating hard asset values, we just do not know what is.  Clearly CPI figures understate the rising cost of housing, especially in the major metro areas.

Given the current "softness" in stock prices, how much longer can it be until corporations actually have to entice employees with the antiquated carrot known as cash?  As you know, employee stock option dreams are turning to mush in the current environment.  Many a dotcom stock option has already vaporized.  This time around, it's employees of America's "core" stock holdings that are receiving the wake up call.  The folks at Intel can't be too complacent about watching half of their stock options related net worth dissipate in about one month.  The clerks, drivers and warehouse people at Home Depot are probably taking one step back from their former options related retirement dreams.  The list of Fortune 500 casualties goes on and on, day by day.  Now that annual bonuses and salary reviews are just around the corner, will more stock options do the trick this time?  When corporations are actually faced with increasing cash compensation, which is probably in the not too distant future, margins will receive a tailwind in their current southern trajectory.

We're not saying that the US is headed for stagflation.  Just that the pressures normally seen in a stagflationary environment are building.  Again, these pressures have been building for some time.  They just seem to be recognized for the reality that they are when the economic environment is finally recognized for the cycle that it has always been.

The War of the Worlds is not a battle that will be won or lost in a few days, weeks or months by either side.  Perceptual change is a process that ebbs and flows buffeted by human greed, fear and sometimes outright panic.  A market that has been priced for perfection for sometime now is finding out that it's not so perfect a world after all.  How far will perceptual readjustment take stock prices?  No one really knows.  What we do know is that this sure appears to be the first perceptual war fought on the battleground of the New Era.  Will the New Era battle field ultimately become a national treasure?  Or will it become a historic monument to be visited by future market participants studying the history of human nature and decision making in the financial markets?

Oh Behave, Mr. Bond...Liquidity is a coward!  Thanks to Ray DeVoe for the forgoing truism regarding the behavior of individuals in a crowd.  "It's never there when you need it most and there is always too much when it is least necessary."  The cowardice of liquidity in unsettled environments is nothing but a reflection of human nature and patterns of choice.  The vanishing of liquidity in the general credit markets recently certainly is a cause for concern.  Quite unfortunately, we have the feeling that the lack of liquidity in the broader sense has only just begun.  The imbalances created over the last half decade or so ultimately need to be resolved.  The process will not be painless.  The 30 year Treasury chart below is a reflection of the slowly vanishing liquidity in almost all other sectors of the fixed income markets.

Crazily enough, there may be more upside from here based solely on liquidity evaporation in the non-Treasury credit markets and global flight capital.  Tensions in the Middle East may be turned to simmer, but clearly the boiling will not stop completely.  Many Asian countries such as the Phillipines, Thailand and others are witnessing strain in the financial characteristics of their markets and economies.  We showed you on our Chart Room page that sell signals have been triggered on many of the longer term MACD charts of the major global markets.  The globe needs a strong US consumer/economy to continue moving forward.  The test of the reliance of the US consumer and overall economy on continued stock market gains to keep moving forward seems to lie directly ahead.