11/30

YESTERDAY, TODAY AND TOMORROW

Yesterday, Today And Tomorrow...Long time readers of Contrary Investor know we have been bearish for quite some time now regarding equities.  In fact VERY bearish.  Probably the most important lesson we learned long ago in this business is that flexibility is the key to longevity in the investment world.  Balance is a necessary ingredient for long term success.  The financial markets are all about change.  The human condition is all about change.  By nature, we are skeptics.  Skeptical of emotion.  Skeptical of consensus thinking.  Skeptical of excessive bullishness and skeptical of excessive bearishness.  After all, nothing creates contrarian financial opportunity like excess.  We count on it.

Bull markets are all about the process of discounting the promise of "tomorrow".  Corrections and bear markets incorporate the process of discounting the problems of "today".  Severe bear markets are about the process of extrapolating the problems of "yesterday and today" into the tomorrow's of our lives.  As hokey as this may sound, we continually need to remind ourselves to maintain a proper balance as we look into the future.  As we have documented and commented on for some time now, the excesses created in the equity market over the last few years would ultimately result in a mirror of negative excess on the darkside.  Well, we're on our way now aren't we.  In no way do we want readers to construe that we are ready to act in a bullish manner in a macro sense at this minute.  Believe us, we'll let you know when we are ready to take the bigger conceptual plunge.  We just needed to get these thoughts on balanced thinking off our chest and remind ourselves that the world always seems to stop short of coming to an end.  The worse the equity markets act, the more we need to reinforce balance in our thinking.  Action will ultimately follow an adjustment in the thought process.  As the market rips, tears, screams, and adjusts for excess, begin to adjust your own thinking.  We've clearly arrived at the end of the innocence, but by no means will the world as we know it go by the wayside.  If it does, we have the sneaking feeling you won't be worried much about your portfolio anyway.

Paying The Piper...No, we're not going to go into a doom and gloom diatribe about the end of the modern financial system.  We hopefully want to spend a few minutes taking a critical look at where we are in terms of the economic scheme of things.  The economy has slowed.  Stock markets around the globe are adjusting to this change.  The important questions are what happens from here in terms of economic growth and are financial markets reasonably discounting the outcome?

As we have discussed before, monetary policy is a tool that produces lagged effects both on the upside and the downside.  Perceptual change regarding the effects of monetary policy may be somewhat immediate (and potentially fleeting), but the real effects are characterized by lags.  On average throughout history, interest rates have "led" real effects in the economy by about twelve months.  As can be seen in the chart below, twelve months ago, the Fed was about half way into their possibly already completed tightening cycle:

This would argue that there is more economic weakness still to come.  (Remember, we're talking about the real world here, we'll get to the unreal world of stock prices and valuations soon enough.)  Moreover, monetary action in the US is not isolated by any means.  Global monetary tightening has been an ongoing theme over the past 18-24 months.  Unquestionably global economies are slowing right alongside the US, if not more so.  Is monetary ease right around the corner?  Let's put it this way, with current trends in the domestic and global economy, it's getting closer everyday.  Our best guess is somewhere in the first to second quarter of next year unless the financial markets or economy go into virtual freefall from here.  Suffice it to say that a slowing economy and slowing corporate earnings will be with us in the quarters ahead.

Gas 'Er Up...Have you been watching the price of natural gas lately?  Of course you have.

The fact is that we are moving into the heart of the winter cold period and prices are significantly higher now than one year ago.  Oil prices are likewise significantly higher than one year ago.  Energy price effects on economic growth will simply not be a positive anywhere over the near term.  Earnings expectations are adjusting to that fact.  So are stock prices.

This go around, the slowdown in the global economy is shining a light on the cyclical nature of technology capital spending.  The unseen reefs and shallows of tech cyclicality were there from the start, it's just that now the ship is supposedly surprisingly running aground.  Tech driven capital spending has been a major driver of (global) economic growth on the upside.  The process of the downward adjustment in tech capex spending is not yet complete.  In many ways it is just getting started.  Take a look at the following table for a little perspective:

Although the slowdown in tech capex is definitely here, will quarter over quarter growth rates in tech capex spending go negative before we see a bottoming?  Quite possibly.  Be prepared.  Since tech capex was so much a big part of the reason why total economic growth has been so strong over the past few years, a slowdown in tech capex will necessarily mean a slowdown in overall economic growth, which will in turn mean a further slowing in tech capex, and so on.  Once again, rate of change of the rate of change is our favorite tool in assessing approaching bottoms as well as tops.  You can be rest assured that we'll keep you posted on these numbers ahead.

Smooth Operator...As part of the slowdown we are living through, operating earnings growth in corporate America is slowing.  Could it go negative?  Sure it could, but we are not there yet and we have to believe the Fed as well as the broader coordinated G7 central bank fan club will do there damnedest to keep us from going there.  (The real question for another discussion being "can they keep the controlled economic burn within the perimeter, or will the fire jump the line and run wild?")  Nonetheless, this is what the world of reality and expectations look like at the moment:

As you would imagine, we have chosen to focus on operating earnings here as in all bear markets, questions begin to be asked.  It simply was not that long ago when an Intel or a Gateway or any other former darling could report an earnings number loaded with non-operating items and be rewarded significantly.  In a bear market, that game is over.  The focus now is on operations, plain and simple.  Anyone choosing to hide the reality or fudge the presentation will be treated in a manner Gateway was treated today when the truth eventually comes out.  (By the way, Gateway in a press release was "comfortable" with the numbers just nine days ago.  Maybe their lawyers tipped them off to SEC rule FD, do you think?)  With commodity cost pressures boiling up from underneath, executives clamoring for more cash compensation (WSJ article earlier this week), and the ability of corporations to raise prices practically nil, expect margin compression and operating earnings deceleration ahead.  That being the economic fact, the market is in the process of reconciling the following:

Our last comment on the current domestic economic situation is that the dollar relative to foreign currencies presents a bit of a pickle.  We have shown you all of the currency charts over the last month or so and won't repeat them in this discussion, but in a slowing global economy, the strong dollar lessens the competitiveness of US corporations in the global arena entirely due to the effects of relative currencies on pricing.  (Clearly the dollar is a catch-22 for many other reasons such as the US being dependent on global capital, but we will not get into that here.)

The aforementioned points are a very brief and generic description of the headwinds facing the real economy in the US at the moment.  These headwinds will not die down in a day or a week or a month.  The reality of economic deceleration will not change on a dime.  Again, given the lagged effect of monetary policy on the real economy, a change in monetary policy to one of ease will clearly precede a change in the real economy by at least a few quarters.  Suffice it to say that it's our bet that the real world gets a bit tougher as we move ahead.

The Stockyard...Having given you our generic comments on where it appears the real world of global economics is headed over the intermediate term, what about the stock market?  As you may have guessed from our writings over time, in addition to flexibility and balance, we are also huge believers in non-linearity.  Non-linearity in economic growth.  Non-linearity in the development and application of technology.  Non-linearity in human perceptual change.  And, of course, non-linearity in stock prices.

At the moment, the stock market is adjusting to the fact that the perceptual TNT (tech, net, telecom) bubble has burst.  As with our reading of market history, the adjustment in stock prices in general will be non-linear over time.  As you know, stock prices are clearly effected by the true reality of domestic and global economics we discuss above, but quite importantly they are also influenced by perceptions.  Sometimes in large part by perceptions.  Tim has graciously produced the following chart for us of the NDX that is clearly perspective on the collapse of a mania:

We attempt to replicate Tim's conceptual thought process in a chart of the NASDAQ itself:

The important message of these charts is that we may have entered a consolidation zone for these indices.  Once again, we are not arguing the bullish case here.  We are merely pointing out that market history teaches us that manias are unwound in a series of stages.  If one looks back at 1929, the 1990 Nikkei period and the work we showed you on Tuesday regarding the 1973/74 bear, it is clear that the movements to the ultimate bottoms were anything but strictly vertical.  Anything but linear.  These above charts tell us that the initial movement to the bottom of these consolidation zones is one good bet.  It's just that timing becomes more uncertain and choppy now that the technical "gap" into the original mania zone has been filled.  Who knows, maybe it's straight down from here, but we would not bet on it in terms of days or weeks.  If we had to guess, the real bottom in this market is multiple quarters away.  Bear markets are characterized by hope, despair, hope, despair again, hope again...and ultimately public capitulation.  Recent action has the earmarks of redemptions and forced margin call selling.  Additionally, we have been hearing of a hedge fund or two being forced to shut their doors by year end. ( By the time any real news is public, the portfolio(s) will have been long since liquidated.)

The Perception Express...You know the negatives.  We've screamed that SEC FD (fair disclosure) would have a big impact in the 4Q.  Early preannouncements.  Potentially violent reactions.  It seems it's starting to happen.  It's not over yet, but the proverbial preannouncement season may also end a bit earlier than usual given the jump start out of the blocks.  The Supreme Court hearing tomorrow may bring some type of clarification or resolution to the election problem within days.  (The election problem is a moot point against the backdrop of the bubble bursting, but remember that the short term is ruled by perception as the longer term reflects fundamental reality.)  Club Fed meets on the 19th of December and there's probably a better than 50/50 shot that we move to a neutral bias given the recent unemployment numbers, consumer confidence report, durable goods number and potential NAPM weakness based on the Chicago PMI today.  The Fed is now fully armed with reasons.  Again, not that a neutral bias means anything to the real economy short term, but the perceptual response to a Fed change is what we would be assessing.

The Global Damage Report...Tech has been a wreck across the planet.  See what we mean?

Incredible damage has been inflicted.  There's more to come, but it may be that the "easy" short money has been made. It's just a shame that there weren't really many short investors left to capitalize on it. The above tale are the tech indices for Japan, Europe, Korea and "you know where".  One of the perceptions that will need to be broken before we truly find some type of bottom is the "It's down x % from the highs" rationale.  In a bear market, relative prices are a lethal lure.  Investments need to stand in absolute attraction to justify action.  Forget where they've been.  The market's have already told you that was just a dream.

Where Are They Now?...The true speculative stocks in any mania environment are the first to disintegrate, the broad market weakens and buckles in subsequent action.  Just for fun we prepared the following table of "The Best First Day IPO's In US History."  Are you really surprised that all of them occurred in the last two years?  Of course you're not.

Will the last one turn out the lights when the mania is officially over? (On second thought, the lights have already gone out for many dotcoms, and are flickering for a good number of the above.)

Dress Up The Pump?...Well apparently the SEC has come out and put strict definitions to "portfolio pumping" and "window dressing".  Oh yeah, they've also launched a probe into the alleged month and quarter end practices by mutual funds.  Low and behold, they have already requested records from some fund families over the past three to five months.  In their words, portfolio pumping refers to "pumping" up the price of individual stock for month end/quarter end performance.  Window dressing is just making the portfolio perceptually look good at the last minute by including prior winners and eliminating prior losers.  Who knows where all of this will lead.  For what it is worth, we thought we would go back and look at a bit of month end data for the S&P and the NASDAQ over the past few months.

There isn't any huge messages or patterns that jump out at us here.  Maybe funds were on their best behavior while these records were being collected.  It's just too bad the SEC was not on the ball during the heat of the mania.  The little we can decipher here says that the first seven days following the end of a month during a bear market are terrible.  Based on this, maybe you should do yourself a favor and take next week off.  What do you think?