12/5

SKY BLUE AND BLACK

The Color Of The Sky Reflected In Every Storefront Windowpane...You've heard us mention a few times in the past that one of the characterizations of the current financial environment is that "the stock market is the economy".  This description seems about to be put to the litmus test in the weeks ahead.  As you know, approximately two thirds of US GDP is driven by consumer spending.  We may be in the information age, but without consumer spending this economy would not be going anywhere.  Importantly, we cannot fathom how a slowdown in the general economy, driven by a slowdown in tech spending, manufacturing, exports, or whatever other drivers, is not accompanied by a pretty serious slowdown in consumer spending.  During this economic slowdown, we feel consumer spending is particularly at risk given the unprecedented leverage the American consumer has taken on during this cycle.  We'll go into much greater detail on this as we review the Fed Flow of Funds report scheduled to be released in the next week or so.

Will the colors of the sky reflected in storefront windowpanes indicate a blue Christmas?  Or will the color turn black?  On the Friday after Thanksgiving, WalMart recorded a $1.1 billion dollar sales day.  In the annals of US retailing history, a record for singular company one day sales.  Just today it was reported that US retail same-store sales fell 2.6% last week, the largest one week drop in four years.  (The prior week was in the month of May, not December.)  This Christmas includes an extra full weekend in which to ring up purchases.  It will not be long until markdowns start in earnest as the overpopulated retail base in the US fights for the almighty consumer dollar.  As with last year, many a dotcom retailer will be celebrating their last Christmas with us.  The interesting connection in our minds is how Christmas spending will correlate with the passions, emotions and spending patterns engendered by stock market action over the past few months.  The proverbial fourth quarter stock market rally has so far been stolen by the Grinch.  Every Who down in Whoville is feeling the pain.

The following is a retrospective of fourth quarter financial market and retail experience over the past half decade:

The recent action of the equity markets does not bode well for nominal retail sales growth this Christmas.  The following chart corroborates this statement as monthly retail sales growth has been anything but robust recently.  In 1998 and 1999, consumers had not only the equity market wind at their back, but also stockings stuffed with liquidity thanks to a Fed clearly in the spirit of giving.  Or more aptly described as scared into the spirit of giving.  Like the ghost of Christmas past, current retail  and stock market experience has taken on the tone of a bad dream.

By this time in each of the last two years, the retail stocks were a tip off that a happy consumption holiday was just around the corner.  By early December of 1998 and 1999, the S&P retail index was above where in started October.  So far, this year is a bit different.

The reason we bring up this topic of retail sales is again to highlight the current state of affairs in retail land and reflect on the importance of consumer spending to the health and growth of the overall economy.  As we show in a chart below, the overall US economy experienced very nice growth during the first quarter in each of the last few years.  Surely the reinforcing "feedback loop" of liquidity, 4Q stock gains and strong retail sales was a strong contributor and support to this 1Q GDP strength.  Has the loop been disconnected this year?  We've been waiting for feedback, but so far all we hear is silence.  Storefront windowpanes are darkening.

Heading For The Borderline, Leave This State Of Mind...It's no secret that a new shade of blue is descending over the entire economy.  For the moment, the actions of investors assume a temporary pause.  Just last week we chronicled to you an $8.5 billion outflow from equity mutual funds (the largest in almost one year) for the four days ended November 21.  We surmised that the outflow was not driven by fear, but rather by tax avoidance (capital gains distributed from mutual funds) as a rational response on the part of taxable investors.  For the week ended November 29, the flows into equity funds again went positive to the tune of $1.5 billion with the majority of all inflows again accruing to aggressive growth and growth oriented funds.  Small cap and bond funds were shunned.  Clearly the "feedback loop" or learned response of investors over the bull market has not yet been broken or changed.  Of course two weeks of activity does not a trend make, but investors have continued to favor aggressive funds (read tech oriented) in their equity allocation choice over the past 18 months.  Has the bursting of the new era tech driven bubble just been a minor inconvenience?  

As we have discussed many times, we believe the positive reinforcement interrelationship of stocks, the dollar, continued Fed liquidity, excessive financial leverage, global capital flows, etc. have been the infrastructure feedback loop necessary for the sustenance and longevity of the current economic expansion and bull market in equities in the US.  The removal of any one component could break the daisy chain.  Moreover, there is no question that the fast forward motion of this loop could be thrown into rewind with the breakdown of the linkages.

Putski-ing Things Into Perspective...Despite today's little Greenspan inspired short covering rally, have the dynamics of corporate earnings and the momentum of the real economy changed?  We don't believe so.  Will a quarter point or 50 basis point change in interest rates near term redirect economic momentum overnight?  Not likely.  A number of recent economic statistics have surely been more than troubling.  The orders index of the Chicago PMI plunging in October to levels below those witnessed at the bottom of the 1990 recession is simply not comforting and cannot be turned with a speech.  The broader NAPM itself has been suggesting trouble for some time.  Again, this is not going to be turned with words.

As you know, 3Q annualized GDP posted its slowest growth in four years.  As we mentioned, over the last three years, the economy and the financial markets have been the beneficiary of a liquidity turbocharge in the 4Q by the friendly Fed.  So now Greenspan chooses to fight with words as opposed to a financial sword?  Does he really expect to achieve the same result as in the last three years?

Durable goods orders have also fallen sharply over the recent past.  They do not suggest impending financial chaos by any means.  But likewise they stop well short of suggesting that corporate profitability growth is without a huge question mark looking ahead.

The following charts on growth in personal consumption expenditures and overall consumer confidence also suggest perceptions regarding consumption are moving from blue to black in their own fashion. As in the equity markets, perceptions are also key to how consumers act in the real economy.

Lastly, despite stepping up repo operations lately, month over month growth in money supply has slowed recently.  A crucial link in the interrelationship chain, money is one of the key components to the "feedback loop".  The heavy machinery of the credit markets, the equity markets, and the general economy cannot move forward in what may be the last vestiges of the new era world without the continued use of a high grade lubricant to keep the gears from seizing up.  Clearly that lubricant is money.  Clear enough?

The economic components of the daisy chain are weakening, if not in the process of completely breaking down.  The stock market component (public participation) is still being held together by the adhesive of faith.  Although Greenspan has now officially jawboned, he has not yet "shown us the money" (degree and depth of a monetary ease).  What may seem obvious to some, but clearly not to the many, is that when speculative bubbles burst, the economic video tape or financial infrastructure linkages begin to run in reverse.  The capital created and used to support the dotcom, telecom and speculative tech industries suddenly vanishes, taking with it the landlords, advertisers, equipment suppliers, banks and other associated lenders.  The reverberations of the disappearance of excessive capital being thrown at prior economic speculation directly effects the now real economy.  This process will not be reversed because the Fed might ease.  These former real world dreams have been destroyed.  The re-creating of potentially excessive liquidity does not mean that the newfound liquidity will again be spent recklessly chasing dreams that have already been shattered in the real economy.

In today's little soliloquy, Greenspan urged the banks not to be to restrictive or tight.  Do you really think they will now fund telecom again?  How about dotcoms?  Try asking BofA how they feel about this comment.  Somewhat ironically, Greenspan mentioned that "our current circumstances are in no way comparable to those of 1998".  For that we credit him.  The Merrill Lynch High Yield Index now stands above 14%, whereas in 1998 it was below 11%.  Today's yield number surely suggests something is wrong in the credit arena in much bigger fashion.  Financial derivative exposure in the US banking system today is at least 25% higher than 1998.  Despite the back off in the major equity indices, valuations today are little changed from those seen in 1998.  In the case of the NASDAQ, valuations are much worse.  As we said earlier, we will be reporting on the upcoming Flow of Funds statement shortly.  As you will then see, leverage at the personal level, corporate level, and throughout the economy at large, is much higher on an absolute dollar basis than seen in 1998.  Lastly, our trade deficit has sunk to levels thought unimaginable in 1998.  Also, the value of the dollar has skyrocketed against foreign currencies, leaving us ever more dependent on the confidence of the foreign community to finance our consumption.  You are right Alan, our current circumstances are in no way comparable.  It's like comparing blue sky's with black.

Among Those Left To Test Their Fortune And Their Will...Last week we counseled against thinking in a linear fashion about stock prices.  Stocks had entered the consolidation zone of the NDX and NASDAQ charts we showed you.  Having said that, we would not have bet that a 10.5% record one day move in the NASDAQ or an accompanying record 11.8% move in the NDX was in our near future.  The unwinding of the new era continues to twist and turn as the education on human decision making unfolds before us.  Although we are just guessing, we have to believe today's action was the result of incredible short covering.  You may remember that we spoke some time back about the inability of the mutual funds and large investment pools to reconcile their tech positions given the incredible weight tech had become in their portfolios.  One of the only efficient methods of protection was to short NDX or NASDAQ futures to hedge against further slides in individual stock prices.  A day like today is made for instantaneous and simultaneous unwinding of those types of positions we have to believe had been put on in size.  Is it any wonder that the biggest movers in the NASDAQ and NDX were the top weighted stocks?  Of course it isn't.  The real question is whether this short position is cleaned out.  Again, it's hard to believe it could be in one day.  Likewise, couple the NDX shorts with the commercials in the S&P having one of the largest short positions on record and you have the making for one hellacious bear market rally.  Once again, nothing ever happens in linear fashion.  EVER.

As you know, bear markets are punctuated by reversals or rallies that are very sharp and usually very short.  As hard as it may sound to hear, the NDX could run to 3700 and still have the primary bear market remain intact.  See what we mean?

In the meantime, the economic numbers will not be good over the near term.  Preannouncements will continue in the days and weeks ahead.  The big boys such as Intel are still to come in terms of dark sky preaanouncments.  In like manner, Greenspan has made it clear that the Fed will act to attempt to forestall financial bubble reconciliation.  What else would you have expected?  As we have said far too many times now, we believe one of the defining moments of the in process bursting of the  financial and equity bubble will be the characteristics of investor confidence shown in the aftermath witnessed post the first Fed rate cut.  The belief in the new era may have come to an end, but the belief in the Fed as savior of the equity markets has not been shattered...yet.  In time, the conceptual confidence bubble surrounding the Fed will also be popped.  History teaches us that there is little chance at this point for an alternative outcome.  Watch the Greenspan bubble deflation report card (it's updated every day):

 In the meantime, patience and short term flexibility are the keys to survival.  After all, we want you to be around to read Contrary Investor during the next market cycle, capeche?  Don't obsess over the minor patches of blue seen against the ominously darkening sky.