10/24

A RETURN ACROSS THE FIELDS OF GOLD - FROM HERE TO REALITY
(Part I)

IT TOOK A DAY TO BUILD THIS CITY.
WE WALK THROUGH ITS STREETS IN THE AFTERNOON.
AS I RETURN ACROSS THE LAND I'VE KNOWN
I RECOGNIZE THE FIELDS WHERE I ONCE PLAYED.
HAD TO STOP IN MY TRACKS FOR FEAR
OF WALKING ON THE MINES I'VE LAID.
(Fortress Around Your Heart - Sting)

The Art Of War...The last decade has been nothing if not an historic journey for investors.  In the battlefield of the stock market, investors have side-stepped many a landmine and unexploded artillery shell in making their way to the euphoric front lines.  Not that the field has not been full of potential disasters.  It's more that the market has been extremely lucky in charting a course where explosions and the occasional casualty have not derailed the progress of the indices.  Only recently have investors begun to step on more than a few hair-trigger and formerly hidden explosive devices.  The casualty count is mounting.  Ironically, many of these landmines were laid by the "home team".  Landmines such as aggressive corporate accounting - ignored.  Stretched valuations - ignored.  An overwhelming demand for financial products that would someday reverse - ignored.  Historical economic anomalies such as a staggering trade deficit, soaring currency, significant credit and debt expansion - ignored.  Quite possibly, the period of the charmed existence is over for now as market participants tip toe their way back toward the reality of the fundamentals that underpin stock ownership.  The trenches of reality are still off in the distance.  Investors find themselves disoriented in the middle of the battlefield.  The comfort of euphoria is fading fast.  The landscape is taking on a darkened tone.  The education is beginning that all is not fair or friendly in the art of financial war.

The View From Above...When navigating the battlefield on a moment to moment basis, it is really the singular step right in front of you that counts.  It isn't easy to distance oneself from the chaotic noise of the situation and view the action from afar.  Especially in today's world of gap up or down stock price moves, information and sensory overload (whether Net or alternative media driven), and split second market response times.  Once again, our counsel is to take into account the big picture in navigating your way across the battlefield ahead.  Possibly, by knowing where you have come from and how you have gotten there can intelligent decisions be made about how to traverse the field before you.  As in any battle, let common sense and realistic thought guide your actions.  Leave emotions out of the picture.  Nothing convolutes decision making like fear (or greed).

The Terms Of Engagement...Bull markets don't happen as a matter of chance.  They are the result of a confluence of events, only one of which is public confidence.  As you know, public confidence as a support mechanism to the bull market is usually late to the party.  Forces in play well prior to significant public participation clearly get the ball rolling.  The forces that have largely brought us to this point in the bull market engagement are increasing corporate profitability, stable to falling inflation, and valuation expansion.  By necessity, they are intertwined and support each other.  Again, surely the public has played a large role as has the monetary and financial credit largesse in the system over the past decade, but the three forces of profits, inflation and valuation are nothing short of central to the theme.  Without low inflation, profitability and valuation expansion, there isn't much for the public to buy, now is there?

INCREASED CORPORATE PROFITABILITY

The following chart depicting absolute dollar corporate profitability probably describes the historical landscape better than words:

Absolute dollar nonfinancial corporate profitability hit a golden period in the 1990's.  The maturation of the boomer population into high consumption years provided a turbo charge to a domestic economy powered by consumer spending.  Corporate profits have been the beneficiary of low commodity prices, a very favorable workforce early to mid-decade, and falling interest rates.  Despite our ranting and raving, the adoption of technology in information processing and telecommunications certainly contributed to productivity.  Well less than reported government numbers, but surely north of zero.

The landmines laid throughout the decade in enhancing corporate profits were aggressive accounting techniques on the part of many corporate entities (tax rate assumptions, profitability on long term service contracts, etc.).  The aggressive use of stock oriented pooling arrangements.  Debt financed stock buyback programs.  Employee stock option plans that lowered cash compensation expenses.  Essentially vendor financing of reported revenues and earnings, especially among tech and telecom companies.  Investors and companies themselves are now tripping and falling on a few of these buried munitions.  So much of what we see in terms of aggregate profit expectations ahead (from the Street) is based on increasing "productivity" gains.  We can only guess that we are going to see the whites of real productivity's eyes ahead in the bottom line numbers for corporate profits.  Was it all just a dream or will productivity save the earnings day?  Do investors yet remember where all of the mines were originally laid in terms real and perceptual corporate profit growth?

STABLE/FALLING INFLATION

Once again, the following chart puts the battlefield into relative perspective:

The 1990's has been almost an anomaly relative to the prior two decades when it comes to a stable inflationary environment.  Clearly post the Gulf War period of the early 1990's, oil has been behaving itself, the late decade activity being supported by the Asian and Latin American crises of 1997/98.  The real estate price blow off of the late 1980's coupled with the effects of corporate restructuring (employee layoffs, cutbacks, etc.) in the early 1990's helped keep a lid on consumer and real estate prices well throughout the entire decade of the 1990's.  The movement to offshore manufacturing not only supported corporate profits, but also kept the price of consumer goods relatively stable for the past ten years.  It has truly been a period of stability that has acted to change expectations and perceptions, after two decades of relative inflationary tumult.

The landmines laid in terms of inflation may be just that - expectations and perceptions.  Not only were corporate profits enhanced in this environment, but investors had impounded continued inflationary stability into stock price valuations.  The risk premium (as an academic part of the capital asset pricing model) shrunk as the decade moved forward and valuations paid by investors for underlying earnings and cash flow expanded accordingly.  Now we are in an environment where status quo inflationary expectations are being questioned.  The unrest in the Middle East and the already high price of oil are no longer one-off events.  Likewise, real estate pricing is at or approaching absurd in many geographic areas, ultimately contributing to the cost of doing business in those areas over time.

(While we are on the subject, deflation may in fact become a future perceptual obstacle as investors attempt a crossing of the financial battlefield with the liability portion of their personal balance sheets weighing them down more heavily than at any time in the last few decades.  This is clearly a topic for another discussion.)

A tangent to calling into question both bull market props of corporate profits and inflation is government spending.  The slowdown in the rate of change in government spending over the past decade has tangentially reinforced both corporate profits and lowered inflationary expectations.  The simplistic theory of "crowding out" goes a long way in terms of explanation.  Although government debt has continued to expand, credit market growth has really been fueling corporate and personal balance sheets.  As you know, the rate of change in government debt growth has been falling.  (We have been chronicling this in our quarterly Fed Funds Flow reports.)  This slowing in debt assumption and expenditures has helped keep inflationary pressures in general at bay on a relative basis.  Consumers and corporate America do not have to compete as heavily with the government for "scarce resources" (anyone remember Econ 101?).  The following chart graphically explains:

With the scheduled rise in defense spending, regardless of which candidate assumes office, the period of a slowdown in the growth rate of government spending may be coming to a (temporary?) end.  Tax cuts and the spending of the theoretical government surplus is clearly burning a hole in political pockets.  The real question is can government spending growth remain low if we approach or enter a recession at some point (the dreaded "hard" landing)?  History says no.  

VALUATION EXPANSION

Should valuations of financial assets expand in an environment of low inflation and "enhanced" corporate profitability?  Sure they should.  As in any bull market, it's just a simple question of degree.  Valuation is always in the eye of the beholder.  The "new metrics" of the modern age can blur the picture a bit.  The following is a simplistic chart of the history of the S&P P/E multiple over the decade of the 1990's:

High multiples early in the decade were reflective of relative corporate profit pressure during the "restructuring" period of corporate America.  The high multiples anticipated perfectly the improved profit performance to follow.  P/E multiples contracted a bit as reported earnings began to take off near mid decade and stocks prices were starting to catch up with the growth rate in earnings.

A more staid view of a broader cross section of companies (the NYSE composite) is the following nearer term retrospective:

These charts represent a broad cross section of stocks, but simply do not do justice to the euphoric valuations seen in the top NDX 100 components, the heights formerly achieved by the Dotcom crowd, and the still dizzying earnings and cash flow multiples of the new age optical telecom/networking stocks.  In the aggregate, valuations have expanded tremendously over the course of this bull market.  The real question, as is the question in every bull market turned euphoric event episode, is how high is too high.  Given that the rate of change of the rate of change in corporate profitability is beginning to falter and perceptions of inflation are beginning to move from complacency to concern, valuations in many areas of the market that were very stretched have begun to contract.  Some contraction has been violent.  The valuation landmines erupting at the moment are those that were buried based on the belief that it is "different this time". "Traditional valuation measures no longer apply." "Investors today are in it for the long term", etc.

The market of the moment appears to us to have begun the journey across the financial battlefield from euphoria towards realism.  How far this journey will lead is anyone's guess.  Most assuredly the trek will not be linear.  It will most likely play out in fits and starts.  The landmines and unexploded munitions planted along the way will undoubtedly alter perceptions as the pilgrimage continues.  What we can infer from above the landscape is that the three primary fundamental drivers of the bull market in the 1990's are being seriously called into question.  The increasing growth rate in corporate earnings, especially experienced in the latter 1990's, is decelerating.  The stability of inflationary pressures is no longer a constant.  Commodity price volatility, to a modest extent at the moment, is replacing the perception of inflation as being non-threatening.  Lastly, financial asset valuations have been stretched to the upper boundaries of historical precedent are are now being pulled back down to earth by financial and perceptual gravity.  Around this, the emotions and perceptions of public investors as well as the systemic effects of excessive credit and leverage make the stock market battlefield a much more hostile environment than at any time in recent memory.

In Part II of this discussion on Thursday, we address what we hope are the practical realities of navigating the battlefield in the current market environment, knowing full well that unexploded landmines lay all around us.  Discussion items include the current mandate of most institutional investors to be fully invested at all times, what the bond market may be telling us, the effect of the current mutual fund complex on capitalization oriented investment allocation, and why investors may need to temporarily discard the buy and hold mentality.  See ya then.

Unexploded LandMines?...Well, maybe already partially exploded landmines.  Here's Tim's update of the very important chart he produced for you last week.  Ignore this at your own risk.  The target ranges displayed are not only viable, but probable over the near term:

You may have noticed that after hours today, wonderful Nortel reported and investors weren't exactly thrilled.  (As of now, we are hearing that the TSE is considering changing NT's symbol to TNT.)  As a result, value stocks such as JDSU, Sycamore, Juniper and Ciena were getting creamed in after hours antics.  You may recall the table of NDX 100 valuations we showed you last week.  Is the shoe ready to drop on the NDX darlings ranked below the top five?  You know, the ones still sporting P/E multiples above 200x's - at least sporting them for now.

Take A Load Off Fannie...Patty cake, patty cake, Baker's man.  Bake us a cake as fast as you can.  We're sure by now that you have seen the hasty deal between Fannie Mae, Freddie Mac and representative Richard Baker announced at the tail end of last week.  As you may have known, Baker was threatening to make GSE reform issue numero uno post the elections.  The political deal is one where Fannie and Freddie will pay a very small price (termed self regulation) to forestall potentially adverse legislation.  According to a recent study done by Goldman, Fannie and Freddie are set overtake the US government in debt outstanding by 2004-5.  That of course assumes business as usual and mortgage credit growth in a linear fashion.  (Usually nothing ever works out quite that cleanly.)  Nonetheless, the acceleration in debt outstanding for the GSE's has been an eye opener over the past half decade:

Ya Put The Load Right On Me...You know all of this.  Nothing here is new.  The agreement between Fannie, Freddie and Baker may take the issue of GSE driven systemic risk off the political table for the next year or two, but it does nothing to change the real risk in the real financial markets.  God help us if the illiquidity spreading like a cancer in the current fixed income markets ever blossoms in full force.  Of course the ultimate safety net can be found right on your IRS Form 1040.