Review and Outlook
To My Clients, Friends & Observers:
March 9th, 2001
The Future Just
Ain’t What It Used To Be
What is the optimal rate of economic
growth? It’s more than a rhetorical question. It’s one
that keeps economists employed. In the fourth quarter, the going estimate
for year 2001 GDP growth was 2 ½% to 3%, and we stated "upward revisions
would be a market catalyst" in our January commentary. Shortly thereafter
Mr. Greenspan projected growth of 2% to 2 ½%. Not the catalyst we
were hoping for.
The inflation of the ‘70’s
made a deep and lasting impression on American economic thought and
politics. We will bear the costs of that decade for generations. Having
learned by 1980 how to fight inflation (thank you Messrs. Friedman
and Volker) the Fed continues the task today, inflation-fighting being
one of Mr. Greenspan’s most noted themes. One of our themes
of the last several years has been that inflation is not dead –
it’s alive and well in the financial markets. Mr. Greenspan
didn’t cut rates the end of February, disappointing many. And
while the street waits for the March meeting and hopes for a half-point
cut, let me make the case against that scenario, with regrets.
First, money supply has boomed, particularly
since January. M2 and M3 increased 7% and 9.5% respectively in year
2000. For the thirteen weeks ended February 26th M1 increased 1%,
M2 increased 8.5%, and M3 increased 10.7%, all at seasonably adjusted
annual rates. The Fed is providing some stimulus to a slowing economy
with doses of liquidity and cheaper money. However, the slowing economy
isn’t going to get inflationary doses of both and Mr. G is not
going to roll over because the stock market is working out its own
inflation. Look for a quarter point cut at the next Fed meeting.
Second, oil prices remain over $28
a barrel (Nymex spot crude). OPEC announced last week their agenda
for the March 16 meeting. Among other items, if oil prices drop below
$23 a barrel they will propose cutting production by one million barrels
a day. That suggests to me that there is at least a possibility of
$23 oil, and a willingness to support it there. I would welcome $23
oil and so would the markets.
Consumer sentiment and, finally, investor
psychology, has begun to turn negative if not deflationary. Cash is
king. The economy is de-leveraging. Money market assets, which increased
over one billion in January, total $2.03 trillion. Eventually
some of that is going to find its way back into other investments
when discounts improve to the point that a risk premium is
restored. That could be a while.
We are suffering the results of over-capitalization,
which brings us back to economics, the dismal science. In a broad
generality, technology companies have become vastly overbuilt, over
inventoried, over-capacitied, over-acquired-or-acquiring beyond rationalization,
and over-confident, all the result of having to utilize all this capital.
The growth was capital, not market, driven. We’ve noted in prior
commentary that technology takes time to be assimilated and that many
technologies, even though they be superior, are never used. The new
frontiers in communications, networking, telephony, and optical transmission
are still out there. They’ve just been pushed back a couple
of years until all the aforementioned overages are corrected. Supply
exceeds demand. Net accumulations have turned to net distributions.
Just about a year ago I ran into my
good friend Steve, who is a talented and very successful stockbroker.
At the time I had just finished reviewing a raft of tech companies
which had breathtaking run-ups from the first of the year. Mentioned
to Steve that if Cisco, which was trading at $75 and a P/E over 200,
increased earnings 50% a year for five years, it was trading at a
P/E of 34 on earnings expectations five years away. Cisco had not
generated a 50% increase in earnings for the last three years. "Denny,"
Steve said, "You don’t do it that way. You don’t use existing
earnings. Analysts use this years expected earnings to get
a more realistic P/E." Oh. Don’t use real, use expected
to get more real. What an epiphany! That would have put Cisco’s
"more realistic" P/E at, oh, maybe 150 to 180, depending on your favorite
analyst’s expectations. I cordially thanked my friend for the
education and refutation but added that the damage was done as we’d
already started liquidating Cisco, among others. I walked away humming
an old Led Zeppelin tune: What Is and What Will Never Be.
Money to Burn, Part One
It is well worth considering some
current events in the world’s fifth largest economy, California.
Two of the state’s largest power companies are facing bankruptcy.
To briefly recap: the state government deregulated wholesale power
prices while at the same time capping retail prices. If any further
explanation of the problem is necessary please find the nearest link
out of here or push the back button on your browser.
If you’re still reading, consider
the solution, which isn’t much brighter than the problem. California
has long been on the cutting edge of creative financing. When I lived
there in the mid- 1970’s I was impressed with the pricey new
automobiles my friends drove, easily acquired with a de miminus
credit check and a seven year lease.
If the November elections didn’t
give us enough of a civics lesson about the efficiency of government
in carrying out complicated functions like accurately counting votes,
California’s creative financing of energy consumption should.
The Sacramento solons who capped the
voters’ utility bills were not generous enough to cap their
taxes. So, because California utilities, specifically Edison International
and PG&E Corp., have run up $13 billion in debts for higher wholesale
power costs, the Department of Water Resources has borrowed $2.3 billion
from the general fund since January to buy power for the utilities.
Better if they had capped taxes and let consumers buy their own power
in a free and open market.
Worse yet, though probably the only
recourse, are the steps being taken to remedy this arithmetic. The
state is attempting to secure $10 billion in "revenue" bonds to buy
power. They intend to use long-term bond capital to buy current energy.
We’re not talking infrastructure capital, we’re talking
light bills. Then again, in the "new economy," on the information
super-highway, perhaps energy is the highway. The bonds, according
to the state treasurer, will be priced to yield 5.45% on a twelve-year
maturity. By way of comparison, other twelve year, triple-A rated
California revenue paper currently yields about 4.25%. The official
statement for the offering should make for good reading. But even
without it, I can assure you, it would be far cheaper for the citizens
of California to buy their own power rather than pay the taxes to
have the government buy it for them.
Meanwhile, the rolling blackouts continue
and they are taking their toll on California GDP, which will effect
U.S. GDP. Elsewhere this winter, the bad weather in the midwest and
northeast is also taking a toll on productivity.
What To Do Now
Many investors are shell-shocked,
static, numbed by the numbers, afraid. Many investors have been wooed
by hypothetical illustrations that project long-term returns, straight-line,
based on the "historical average" return of the equity indexes. These
illustrations do not address the probabilities of actually achieving
these projected returns. A Monte Carlo simulation is necessary for
that. Many investors are seeing for the first time what one bad year
can do to their average returns. Many are wondering how many years
might be needed to recover and how many years they can afford to wait.
And most people have a downside limit, a minimum portfolio valuation
they can live with.
The prevailing advice for the investing
public seems to be "sit tight, stay the course, it’ll come back."
And the broader market will come back. What investors should be doing
now is positioning themselves for the next move up. There are times
to do nothing. Now is not one of them, however late it may be. Every
security should be examined. There are still opportunities to raise
cash for repositioning. Mutual fund owners should look at the securities
in their funds. Many if not most funds are guilty to some degree of
"style creep." What was stated in the glossy brochure does not reflect
what’s in the fund. In recent months I’ve examined utilities
funds (that you’d expect to be rather conservative) that are
overweighted in telcom tech stocks. I’ve reviewed funds that
are represented as having conservative, long-term, buy-and-hold strategies
whose average annual turnover is 30% to 40%. How long-term is that?
Get cash flow. Investors can take
losses and carry them forward as needed against taxes, while earning
a positive return from fixed income securities. When the bull market
returns, as it will, they can participate again, in fairly priced
companies that survived the bear. One does nothing here at the cost
of time, opportunity and further risk. And doing nothing now will
not change the damage that has already occurred. If not now, when?
Investors have to refocus on real
economic growth and get back to rational expectations for returns
better than the inflation rate and get paid an appropriate risk premium.
Sooner or later, they always do.
Finally, Brae Head performance figures
are posted to the website. I am pleased to announce that Brae Head,
which I started in August 1997, has significantly outperformed the
S&P 500 Index for each of the last three years.