Past Commentaries
Current Commentary,
Review and Outlook
January 14th, 2000
To My Clients, Friends & Observers:
Another New Year, Century and Millennium
Two thousand years passed since the birth of Christ, a roomful of
40 human lives laid end-to-end, a long time for one constrained to
1/40th of the time line, a heartbeat in the greater scheme of things.
What are the things that last? What are the things that grow? Eskimos
have over 30 words for snow, we have half a dozen. Our perceptions
are constrained by our realities. Our realities are constrained by
our perspectives. Are things better, worse, or unchanged after all?
So many can get different meanings looking at the same picture, so
too in investments. In 1986 Jack McCarthy, who was chief investment
strategist for Lord Abbett Funds in New York, made a compelling case
for a bull market. He compared the market to the popular TV show "Wheel
of Fortune." Vanna’s turning letters over, one by one, until, all
at once, 80 million Americans jump up off the couch and shout "I got
it!" His point was that for investors, once they’ve finally "got it,"
they’re probably too late. Certainly since 1986 the longer term investor
has not been too late and I don’t think it’s too late yet.
Let’s turn a few letters over. Remarkable improvements in the human
condition continue. The world produces more than enough food to feed
every person on the planet to United Nations FAO standards, including
a surplus (FAO Supply/Demand Roundup, Nov. ’99). Where there is starvation
it is because of political and distribution problems, not production
problems.
There is no population explosion problem. World population of UN
World Health Organization member states is 5.9 billion and has grown
at a rate of 1.6% since 1978. Infant mortality has declined from 8.7%
in ’78 to 5.7% in ’98. Life expectancies have increased from 60 to
65 since 1978 for males and from 65 to 69 for females. World Gross
Domestic Product per capita, adjusted for purchasing power grew at
a 2.5% rate from ‘82 to ’92 (last census available). The world is
a better place to live and live longer.
Economics is the study of choices available to society to employ
scarce productive resources for consumption. Those "scarce productive
resources" are land, labor and capital. Land to include all raw materials.
Capital to include productive assets like machinery, technology, and,
more recently, knowledge and creativity which over the last ten years
or so has earned academic attention as "human capital." Looking around
it is hard to see the scarcity. Human capitalism is triumphing. Technology
born of human creativity and economic incentive mitigates or remedies
any temporary shortages of labor and raw material.
Bill Gates didn’t create Microsoft. Thousands of people did – and
he’d be the first to tell you that. Robert Galvin didn’t invent the
Motorola of today, the organization of thousands invented and reinvented
it. The same is true of Ford, Honda, Sony, Cisco, EMC, Amgen and on
and on. One of the unintended, serendipitous effects of the ERISA
laws of 1974 was the gradual proliferation of profit sharing plans
as opposed to pension plans and the subsequent broad distribution
of common stock in the work force. The workers have become the owners.
Stock is a far more effective currency than cash in mergers and acquisitions.
In finance debt is always cheaper than equity for the firm, at least
initially. When investors bid up share prices to double and triple
their IPOs it’s tantamount to free money. Whatever happened to the
equity risk premium? Certainly it is lower because of the tax structure
and broader distribution and liquidity. More importantly, it is lower
because the perceived risk is lower, an issue of market psychology.
And this while real interest rates (coupon minus inflation) are at
historic highs.
The Economy: Equilibrium or Nirvana?
Third quarter GDP came in at a 5.7% annualized rate vs. 3.7% a year
ago. Unemployment rate 4.1% vs. 4.3%. Average time spent unemployed
14.1 weeks vs. 14 a year ago.
Inflation through November was 2.6% vs. 1.5%, not at all alarming
considering that a year ago our fear was a deflationary recession.
The increase in inflation can be attributed to oil price increases
($12/bl a year ago vs. $26 today) and the expansionary money supply
over the last year and a half. The DJ-AIG Commodity Index increased
15% over the year. Gold was unchanged, ending ’99 at $288/oz.
Money supply as of 12/27 showed increases year over year of 3.64%
for M1, 5.8% for M2, and 8.98% for M3, rational enough for the growth
of GDP. Having checked the increase in the value of the dollar in
’98, Fed policy has allowed the dollar to remain virtually unchanged
in ’99 at 106 (J.P. Morgan Index vs. 19 currencies).
Personal income was up 9.6%. Personal consumption up 16.4% (the American
Way!) Consumer installment debt up 7.2%. New housing starts as of
November data down –3.26%. We characterized the record pace of new
housing starts a year ago as "clearly unsustainable."
Durable goods orders +3.2%. Factory orders backlog +1.3%. New factory
orders +8.6%. Non-durable goods orders +8.8%. Business inventories
+3.2%. Factory inventories -.42%. Wholesale inventories +5.2%. Electric
power generation 1.48%. Production capacity utilization practically
unchanged at 81% in November.
New business starts December ’99 vs. December ’98 up 81%. Indexes
of coincident, lagging and leading indicators all up. Consumer confidence
up 11%.
This is a remarkable economy. The objective of managing the economy
isn’t "beating inflation." The objective is defeating or minimizing
the "cycle." We have learned enormously in the last 20 years and we
have the tools to monitor and manage the inputs and constraints of
economic growth. And while there is compelling evidence for optimism
the economy had better keep chugging along to support the enormous
debt we have assumed, personal, corporate and federal.
According to the Wall Street Journal (12/31/99) corporate debt has
never been higher, at 46% of GDP, and household borrowing is at a
record $6.3 trillion. They note however that corporate profits are
four times their net interest expense, up from two times in the early
'90’s, reflecting good earnings and lower interest rates. Household
debt, as high as it is, remains at 13% of disposable income, unchanged
in recent years. And the Federal debt is shrinking with budget surpluses,
another result of brisk economic activity. An economic slowdown would
trigger a debt squeeze and defaults.
The U.S. pays nearly the highest interest rates of the developed
nations, second only to Australia, the price demanded by the credit
markets. A stable dollar has kept up demand for U.S. debt.
Balance of payments deficit, including services, increased over 40%.
Exports were up 9% but imports were up 14% through the third quarter.
The Market Outlook
The macro problems that loomed a year ago were phantoms. There was
no recession. Deflation was checked. Inflation remains in check. Asia,
particularly Japan, has begun to rebound. The yield curve is still
positive. Y2K was insignificant.
Biggest mutual fund cash flows in the fourth quarter were to money
market funds. Total money market funds are up 17% year over year.
First quarter is the season for new cash flows to mutual funds for
retirement plan contributions. These cash flows will be invested.
S&P 500 P/Es, which peaked over 36, ended the year at 33 reflecting
strong corporate earnings. Investor sentiment readings at year-end
were 52% bullish from Investors Intelligence poll and 39% bullish
from Market Vane poll. These are not high enough to suggest a market
top.
The advance/decline index continued to be horrible for most of ’99.
Over 50% of S&P 500 companies were down on the year. Almost 70% of
NYSE companies were down on the year. After reaching new records last
summer, in the face of daily negative breadth, the markets corrected
10% to 15%. Five consecutive, strong, positive breadth days in early
October suggested pent-up demand and was immediately followed by huge
run-ups to new records. These new heights have yet to be confirmed
by positive A-D index readings. It doesn’t take much to turn the bulls
loose.
The DJI closed up 25.22%; S&P 500 up 19.52%; the tech-heavy NASDAQ
up 85.58%, Russell 2000 (small caps) up 24%. Brae Head, Inc. Equity
Composite will be posted to the website by 1/28. All Brae Head growth
(equity) accounts beat the S&P 500 and the DJI indexes. All Brae Head
growth and income (balanced) accounts beat the S&P 500 index. Unweighted
average total return for all Brae Head accounts (excluding fixed income)
was 34.217%; weighted average total return was 29.044%. Standard deviation
was 11.479. Warren Buffett’s Berkshire Hathaway was down 17.5% for
the year.
The poor breadth of the market is worrisome and should contribute
to volatility in the market in 2000. It also suggests a bifurcation
of valuations in the large cap market. Money is chasing the biggest
and best stocks, driving up valuations, and ignoring second tier companies.
The hottest sector has been technology and technology companies are
far outnumbered by non-tech companies in the large indexes.
The onset of 24 hour global trading will help large caps continue
to outperform small caps. Liquidity, visibility and reasonable predictability
will merit a premium.
The statistical probabilities of the markets continuing to outperform
their long-term median returns are small, but having said that, there
are few obstacles in the way of better than 20% returns from the Dow,
S&P, and NASDAQ this year. We’re overweighting pharmaceuticals, chips,
software, fabs, networking, storage and boxes. We’re ignoring direct
internet plays, although AOL has scored a breakthrough with the Time
Warner acquisition.
That merger will trigger many more. Anti-trust in this country, with
the anomalous exception of Microsoft, is dead. Expect to see mega-mergers
in financials, drug companies, and more entertainment/internet plays.
The blooming of the internet will compel new breakthroughs in chip
speed at a magnitude of 5 or 10 times current speeds. The whole thing
won’t fly without greater speed. It will happen and soon.
A political brouhaha looms over the cost of health care and the price
and profit margins of drugs. This is a cyclical argument, resurrected
every 5 or 10 years and buried again. Of course we pay more for health
care in this country. It is the best in the world. We also pay more
for better cars, bigger homes, more clothes, better education, etc.
99% of drug company development concepts never reach the market. Out
patient therapies, control not cure, are far more favorable, and more
economical, than surgical or in-patient therapies. The ethical pharmaceuticals
industry is politically savvy, well represented, and wealthy. After
withstanding a legal and political shakedown they will prevail. And
we should hope so.
Oil prices have probably peaked but that doesn’t preclude positioning
oil stocks, not service or drillers. Gold looks reasonable under $290/oz.
but with little near term upside. Real estate will probably have another
difficult year. In the bond market I would be surprised to see the
long T-bond at 7%, would expect to see it at 6% or less by year-end,
and Fed Funds at 5.25% or lower.
I close with some millennial perspective, excerpted from W. B. Yeats’
poem, Lapis Lazuli.
All perform their tragic play,
There struts Hamlet, there is Lear,
That's Ophelia, that Cordelia;
Yet they, should the last scene be there,
The great stage curtain about to drop,
If worthy their prominent part in the play,
Do not break up their lines to weep.
They know that Hamlet and Lear are gay;
Gaiety transforming all that dread.
All men have aimed at, found and lost;
Black out; Heaven blazing into the head:
Tragedy wrought to its uttermost.
Though Hamlet rambles and Lear rages,
And all the drop scenes drop at once
Upon a hundred thousand stages,
It cannot grow by an inch or an ounce.
To my beautiful children who review this site, I’m sorry there aren’t
any pictures.
Best regards,
