To My Clients, Friends & Observers:
March 3rd, 2000
Valuing the Markets
There are 3 predominant factors "spooking" the markets - the price of oil, interest rates, and inflation. GDP in í99 came in at 6.9%, phenomenal growth. This has caused Fed Chair Greenspan to be concerned about an "overheating" economy and inflation.
To slow the economy and reduce the potential for inflation the Fed is raising interest rates and slowing money supply growth. The Fed increased rates 4 times in í99 and is threatening more increases. The Chairman has established a pattern of jawboning the markets over the last few years, with the effect of a least temporarily stifling total capitulation to the stock market. The Fed has also put the brakes on money supply growth, a reversal of policy of the last two years. This will slow the velocity of money through the economy and this is good for financial stocks and the bond market. Bear in mind that the Fed is, in charter and in fact, a private bank. Raising rates and tightening money supply has the effect of strengthening the dollar. This is good for our bond markets, bad for our trade deficit. That is less of a concern than it used to be because our GDP growth is capable of supporting more debt.
An inverted yield curve (short rates higher than long rates) is usually a sure-fire indicator of recession and it is getting close to inversion.
|Fed Funds ||3-Mos Tbill ||1-Yr Tbill ||2-Yr Tnote ||5-YrT note ||10 Yr Tnote ||30 Yr Tbond|
|5.75% ||5.58% ||5.82% ||6.5% ||6.58% ||6.39% ||6.13%|
It cannot be the intention of Fed policy to let the Fed Funds rate exceed long rates.
Oil prices have risen 200% in 14 months. This has its own effect on slowing the economy. To the extent that consumers are spending more on gas and oil there is less to spend on other goods and services. The inflationary effects of oil price increases are far less than they were 20 years ago. The U.S. is less a manufacturing economy and more a service economy. According to an American Petroleum Institute report last year, the power of technology has reduced the drilling, refining, marketing and distributions costs of oil by over 30%. Technology will continue to put upward pressure on oil productivity and downward pressure on oil demand and oil prices. This would at least suggest that the run-up in oil prices is excessive and unsustainable. OPEC oil is traded, globally, in U.S. dollars, and because of the its increasing strength, those dollars are more expensive for other nations. This should contribute some global political pressure to get oil prices back down. We would expect to see oil much closer to $20/brl by the 4th quarter.
On the stock market, we cannot reasonably expect to see 20% gains year in and year out, yet some polls show that investors are expecting this for the next 10 years. That would put the DJIA over 60,000. Using the historical performance of the major indexes we are statistically at the outer right edge of the bell curve, and while the mean has been increasing over the last ten years, everything eventually reverts to its mean. The stock market indexes are inflated, skewed by very large capitalization technology stocks.
In fall í98 the Price/Earnings ratio of the S&P 500 hit a record high 36. At the end of í99 the P/E was 31 while the index was at a record year-end high. This reflects 2 things: strong growth in corporate profits (the E in earnings) and lower prices (the P in prices) among most of the S&P 500 stocks. In fact almost 55% of S&P 500 stocks were down year over year and 70% of New York Stock Exchange stocks were down. We have a bifurcated market, hence the recent characterization of "new economy" and "old economy" companies. Have old economy companies exhausted most of the applications of the breakthrough technologies in manufacturing, inventory control, supply and distribution? Certainly itís possible that applications may be slowing. Every new technology has a lead time before its application and a lot of good technologies are never applied.
Regardless there are many fairly valued companies with good earnings visibility that are out of favor for one reason or another. These stocks will be back in favor and many "old economy" (NYSE) stocks will find equilibrium with "new economy" (NASDAQ) stocks, particularly when it becomes apparent that earnings expectations for many technology stocks have been overstated and the NASDAQ reverts to a more realistic valuation.
Some good companies that can be positioned now are PPG Indís, Fannie Mae, DuPont, Merck, Abbott Labs, Eli Lilly, Emerson Electric, J. P. Morgan, Bank of America, Bell Atlantic, EMC, MCI Worldcom. The best way to participate in the technology market is to position a price-weighted, not market-cap weighted, technology index. We are constructive on the bond markets as well and would take advantage of higher yields from quality corporate paper.