Review and Outlook
To My Clients, Friends & Observers:
January 11th, 2001
One year ago we were optimistic for yet another double
digit year from the major indexes predicated with several caveats regarding
Fed actions, oil prices, consumer spending and statistical improbability.
The first quarter of 2000 saw a rapid run-up in equity prices, in the
face of interest rate and oil price hikes. The run-up to March 31 end
of quarter valuations was clearly greed and window dressing and we sold
into it. By early summer the rout was on. The Fed had inverted the yield
curve, oil prices were stuck at $35, earnings warnings were regularly
released, and valuations, particularly of the NASDAQ, were ridiculous.
Second quarter earnings as they were reported in July clearly identified
the sellers. "Investment Income" on the income statements of many of
the largest-cap corporations was commonly in the range of 25% to 35%
of earnings, with generally 3% to 5% of that from interest income. Supporting
earnings per share by realizing gains in corporate investment portfolios
roiled the markets with selling pressure but more importantly took future
gains in those portfolios out of the foreseeable earnings picture for
those same companies. This is the very definition of a negative feedback
loop. The last one out of the restaurant picks up the check. By end
of summer we were experiencing a dramatic increase in calls from non-clients
who were interested in the Brae Head system because their portfolios
were tanking and they didn’t know what to do. Cheers to those
who listened and sincere sympathies for those who didn’t.
The P/E of the NASDAQ composite in June was over 120.
As of the end of November it was still 107. In prior commentary we noted
the Nikkei index had a P/E of 90+ back in the late ‘80s, at a
value of 45,000 which has not been seen since. Nikkei P/E today is about
50, value 13,800. When we interview potential clients we try to qualify
for them the concept of risk. One of the ways we illustrate risk is
by using a couple of the most basic accounting principles and methods
to value an investment, i.e., the going concern principle, and the payback
method. Using these first, a company’s P/E ratio tells one how
many years it would take an investor to get paid back using the existing
level of earnings. Of course the common shareholder is not actually
being paid back all or any of those earnings. Those earnings should
accrue to the equity value of the investment. This helps sharpen the
focus before discounting the value of future earnings. The S&P 500
Index P/E is at 25, down from 33 a year ago.
The idea that high-risk investments result in high-rewards
is dogma for the unsophisticated. High-risk investments offer the potential
for high rewards and the potential for high loss. Robert Arnott, of
First Quadrant LP, Pasadena, California and Ronald Ryan of Ryan Labs
Inc., New York, published a report recently titled "The Death of the
Equity Risk Premium: Consequences of the 1990s." The sum and substance
is that the premium investors historically have been paid to assume
the additional risk of investing in equities instead of bonds is no
longer there. In fact it is negative 0.9%. One reasonable translation:
investors are paying a premium to be in equities, and presently, paying
a high price. Appropriately enough, Brae Head fixed income, time weighted,
total return for 2000 was 9.8%. It was a good year to be properly positioned
in the bond market.
Dr. Scott Brown, Senior Economist for Raymond James
Financial Services, grabbed our attention with some interesting numbers
last spring. They showed historical market capitalization as a percentage
of GDP, to wit: in 1960, 73%; in 1970, 81%; in 1980, 38%; in 1994, 88%;
in June 2000, 207%. Woof…
Make an assumption that 90% of domestic households are
within $1,000 of making it or breaking it in any given year. At 30 miles
per gallon, 15,000 miles a year, each car consumes 500 gallons a year.
If gas has increased from $.70 to $1.50 a gallon, $350 of the $1,000
has disappeared at the pump. Throw in a 100% increase in the cost of
heating oil, or 150% for natural gas, and a return to colder winters,
and the cost of heating a house has increased perhaps $800 on average.
Poof, that $1,000 usually left over isn’t there this year. Apart
from cut backs in available investment funds it’s worth speculating
on what will be cut back in household expenditures. Housing starts have
slowed. Retail trade was anemic at Christmas. The automobile cycle is
finally winding down. Average age of the fleet is 8 years, yet sales
are slowing. What else could be cut back? Premium cable service cut
back to basic? Cell phone usage? Disney World? Dine out less and/or
cheaper? It will be a challenging year for earnings, eventually rewarding
the lowest cost producers with the best market share.
We are entering the third presidential term in a row
where the sitting president has been elected with less than 50% of the
vote, in a country that most recently split 50-50 on their most admired
public figure: Pope John Paul and Bill Clinton. This divided nation
could unite with one refrain on behalf of the consumer economy: "Give
us more money or we’ll stop shopping!" Politicians on both sides
of the aisle ought to be receptive to tax cuts of some sort this year.
The Fed has reversed course finally and has begun cutting
short term rates. We are in the midst of a credit squeeze, Bank America
and Fleet two of the most recent to write down huge loan portfolios.
The junk bond market suffered record defaults in 2000. The Fed will
cut in steps. It will take several cuts and perhaps a year for the effects
to take hold though the yield curve should be positive before year end.
The stock market will react ahead of the curve. The U.S. dollar remains
the strongest global currency, reflecting the Fed’s hikes and
the Euro’s difficulty.
Technology is still vital and vibrant. As an industry
it is in a secular period of consolidation. Old economy rules still
apply – a business has to make money. Capital budgets have become
constrained. M&A activity will slow. There is not the appetite to
support the IPO calendar of the last couple of years. Many tech companies
will fade away. Many will not see their share prices recover for years.
Many good ones are at bargain basement prices. Companies that are successfully
assimilating and using technology for enhanced productivity and earnings
present great opportunities and real value for investors. And most of
these are "old economy" stocks. By way of example, in the last quarter
we have positioned Diebold Inc., the premier manufacturer of ATM systems.
.The markets are laboring with uncertainty about earnings
and about valuations. Uncertainty is the definition of a "trading range."
Expect a period of consolidation and base-building. The longer the process
takes the better will be the next move up. Dollars in money market funds
increased almost 14% in 2000. To the extent those dollars chase bond
prices even higher the door will open wider for a renaissance, if muted,
of the bull market. Market psychology, put-call ratios, and sentiment
are still too bullish to represent a bottom or a capitulation, undoubtedly
reflecting the fundamentally sound, if slower, economy. However, breadth
finally showed marked improvement across all the major indexes in December,
probably indicative of some value shopping. It leads me to suspect a
continuation of base building and slower growth. 2001 GDP expectations
are in the range of 2 ½% to 3%. Upward revisions would be a market catalyst.
Targets for 12/31/01: Dow Jones Industrial Average 11,542;
S&P 500 1425; NASDAQ Composite 2594. For the yield curve we forecast
a 5% Fed Funds rate, a 5% five year note, 5 ¼% ten year and thirty year
bond. Better flat than negative.