11/9

THE WINTER OF OUR DISCONTENT

The Winter Of Our Discontent...Maybe we should have really made that winter, spring, summer and fall. The major indices have been nothing short of an exercise in frustration over the last 12-18 months.  Coincidentally, much of this period of performance frustration began with the first Fed tightening action back in late June of 1999.  The following chart is a little retrospective of interest rate experience using 3 month T bills as a proxy:

Relative to this, have a look at the following:

The Dow and the S&P have clearly been in nothing but a big trading range since June 30 of 1999 (the first Fed hike).  An investor would have been miles ahead of these two averages in terms of investment performance by simply hiding in a money market fund since that time.  The Dow ended June 30 of 1999 at 10,971. Today's close was 10,834.  The S&P closed 6/99 at 1,372.  As you know, today's close was 1400.  See what we mean?  Of course investors in these indices could take a bit of extra comfort in the generous dividends paid to them.  (Right.)  The NASDAQ has been a bit of a different animal.  As you know, volatility in the index since the first Fed tightening experience is nothing short of unprecedented in US history.  You hopefully read our piece last week on volatility.  The blast off that occurred in the NAZ beginning last October has almost been completely taken back in market action over the last seven months.  As you know, we strongly believe it will be completely wiped away before it's over.  Just stick around for 4Q earnings and watch how quickly it can happen.  From the action in the major indices over the past 16 months or so, it's easy to see why both the bulls and the bears are so frustrated.  No trend.  Loss of definable leadership.  Increasing volatility.  And all of this during the greatest twelve month inflow to equity mutual funds in the history of the US.

What will happen to change this period of frustration?  This period of discontent.  Maybe it's the uncertainty regarding the election that pushes this market out of the range to the downside, at least temporarily.  A continued period of declining corporate earnings (which has just begun) may also do the trick.  At the moment, cash levels in mutual funds are low.  The beginnings of significant bull moves in the past have not been accompanied by low cash in funds.  Quite the opposite.  You can see what cash looked like at real market bottoms:  

On the other side of the equation, the Fed will ultimately look to ease interest rates as the economy slows and corporate earnings falter.  The stock index range of frustration has headwinds blowing in both directions.  At the moment, energy prices and wage inflation preclude the Fed from making an interest rate stand here and now, but the Fed's hands will not be tied forever.  Be prepared for the possibility that the real test for stocks comes when the Fed starts to ease.  Clearly the knee-jerk (and we do mean jerk) reaction of mainstream investors may be to expect a fireworks show in stocks.  Fed ease = higher stock prices, right?  This time around it may not be so easy as the slowing in the economy and corporate earnings are what is different this time.  The new era Internet dreams have been shattered.  Tech dreams are melting as we speak.  Couple this with a public who has already transferred huge amounts of their personal financial wealth into stocks and the demand vs. supply equation for financial assets may not be what it was over the last five years during periods of monetary ease.  

The macro financial characteristics of the US financial markets and economy are nothing short of eerily reminiscent of Japan in the late 1980's.  Bubble economy.  Massive transfer of personal wealth into stocks already completed.  Foreigners fully participating in the domestic Japanese market.  You know the rest.  As in Japan, the real test for the equity markets came when monetary policy was eased.  The one major difference between Japan of the late 1980's and the US now is that the US and European economies were there to pick up the global slack when Japan faltered.  Today, the US economy stands alone as the biggest driver of the global marketplace.  Europe and Japan are in no shape to counteract a US contraction in terms of the fallout for the global economic growth.  At some point lower interest rates just don't matter any more.  Macro asset allocation concerns take precedent for the individual investor.  This important test lies ahead.

Too Much Of A Good Thing?...Economic soft landing bulls would have you believe that the probability of a potential recession in the near future is quite small in that businesses today just don't carry the inventory they once did in the Old Economy.  True enough.  Current inventory to sales ratios are quite low from a historical standpoint.  The ratio has turned up recently, but it's nowhere near levels that could be considered alarming.  What is often overlooked in this analysis is that the corollary to efficient just-in-time inventory is increased industrial capacity to meet variation in levels of product need.  As we have discussed and chronicled to you over the past half year or so, capital spending to ramp up production capabilities has been a major driver of the economy over the last half decade.  Specifically, capital spending on technology.  Well, just how do you think this outsized demand for technology products was met?  Simple, a massive increase in technology manufacturing capacity.  How else?  Have a look at the following chart that is generic to the "technology industry":

The build up in capacity during the 1990's has truly been remarkable.  What may be more remarkable is that capacity has been expanding between 35-50% annually over each of the last five years.  Although there have been ups and downs in the rate of change, the annual growth rate in capacity has been huge.  Clearly the annual rates of growth experienced over the last five years are not sustainable on any kind of a linear basis.  Not convinced?  Try the following chart specific largely to semiconductors:

Spending and capacity building in semiconductors uniquely has seen a wider range of growth rates than broader "tech" in general.  From 30% growth to almost 70% annually over the last five years.  Don't get us wrong, we are truly witnessing secular growth in societal "digitization" on a broad basis.  It's just that once again, growth never happens in a completely linear fashion, although sometimes stock prices mistakenly discount this type of experience.

Simple question.  Now that it appears we are witnessing a cyclical slowdown in technology capital spending, how will tech companies utilize all of this built up capacity in an efficient manner?  Simple answer.  They won't.  Just because revenues slow down, depreciation does keep right on going in a linear fashion.  Often times the collision of declining operating earnings and fixed depreciation charges is not a pretty sight.  Couple that with sticky labor costs and the picture can become downright ugly:

Advancements in technology have created an expectation of lower prices over time.  The infamous Moore's Law applied to prices.  This expectation will not instantaneously vanish after three straight decades of experience.  We're trying to remember the last time we saw individual chip and/or computer prices actually rise.  Oh yeah, we remember now.  NEVER.  Lastly, innovate or die is the mantra of the new era technocrat.  Tech companies of today cannot stand still in terms of research and development, otherwise they risk tracking error - tire tracks that is.  On their backs.  The continual need to spend on infrastructure development within the tech industry will not simply go away just because tech capital spending in general decides to take a breather.  All of these forces add up to some pretty serious margin compression potential for the tech industry in general.  As of yet, we haven't even mentioned the incredibly strong probability of price wars just to cover the costs of capacity that has already been put into place.  Do you really think tech stocks have bottomed?  We didn't think so.  Cyclical downturns simply don't end in one quarter.

From Venture To Vulture...We all know that most dotcom companies are for the birds, but the larger of the avian predators may be slowly gliding into town.  VC dough allocated to the dotcom crowd has slowed in 3Q for the first time in years.  Is it really any wonder?  As we have mentioned too many times in the past, VC companies late last year and early this year had received outrageous allocations from major plan sponsors like CALPERS - right at the top.  It sure looks like we're on the other side of the peak for the time being.  Have a look at VC dotcom funding recently:

The Gartner Group recently did a study predicting that 95% of the world's currently existing dotcom companies will fail within two years.  Their counterparts at Forrester Research put out the following update survey of sources of expected funding for dotcom companies in the B to C "retail space":

The picture is not pretty.  There is certainly more rationalization to come.  There is more money to be lost.  As with the evolution of any emerging technology or market, investors usually take things to emotional extremes on both sides of the equation.  Valuations that were insane are being rationalized.  Some possibly too far.  Companies are being shuttered.  Dotcom layoffs are skyrocketing.  From all of this, something new will be born.  The Internet will not die.  Evolution never happens in a linear fashion.  Ever.  We suggest you watch the vulture groups that are beginning to circle the industry.  There is not a lot of activity quite yet.  A lot of movement is private.  We'll be sure to keep you up on what we see ahead.  As you know, vultures play where angels fear to tread.  The vulture community is what we consider much smarter money.  They have a generic history of not throwing money down a sink hole.  Angels have been much more willing to commit their capital to "money heaven".  Whenever the world looks like it's coming to an end, it doesn't.  At least there is no historical precedent quite yet.

Mover, I Feel All Of Your Moves.  When You Cross The Floor, You're In Argentina...Clearly all is not well south of the border.  For those of you following the foreign currency markets, the currency/financing problems being faced by Argentina at the moment are nothing new.  Trouble has been brewing out in the open for more than a few weeks now.  The Argentine government conducted a $1.1 billion auction on Tuesday and received the following reception:

Clearly these kind of numbers are not sustainable.  Devaluation and default questions are the hot topics of the day.  Couple this with the general lack of liquidity globally for almost any questionable debt and you have a situation in Argentina that could come to a head over the next few months.  As we are sure you are aware, the Argentine currency is "pegged" to the US dollar (at least perceptually).  Additionally, approximately 95% of the country's governmental and corporate debt is dollar denominated.  A break of the "peg", in essence a devaluation of the currency, would mushroom actual debt and interest costs denominated in dollars.  At the moment, it is estimated that Argentina has $19 billion in financing needs looking into 2001.  There is no easy solution.  Foreign creditors, especially those in neighboring Latin American countries are getting more than nervous.  Brazilian exporters to Argentina with acute memories of the Brazilian real devaluation a few years ago are taking action.  Scaling back business, hedging, and converting dollar denominated debt to peso denominated debt are the favored techniques of risk reduction.

Why do we bring this up?  After all, Argentina is a pin prick in the global economy, right?  We mention this as an example that liquidity and credit concerns are slowly growing globally.  Global credit markets are shifting, and not just for "emerging" economies.  Are we headed for "bailouts" next year?  Maybe.  As with a bear market in stocks, a bear market in credit is a process of confidence destruction.  In an arcade shooting gallery, the ducks fall one by one.  The Argentinean currency situation is anything but a positive for the slowly deteriorating perceptual health of global currency and credit markets.

Bank On It...Oh really?  The global bond market is certainly telling is that credit risk is a major issue of the moment.  Is the following chart of the bank index hinting at the same message ahead for bank stocks?  It sure appears so.