Dreams of Avarice

“We are not here to sell a parcel of boilers and
vats, but the potentiality of growing rich beyond
the dreams of avarice.”

Dr, Samuel Johnson, 1781
(Prior to the opening bid of an auction over which he presided)

I am a professional skeptic, based on my career as a
security analyst, from a time when analysts really analyzed securities. My “fundamental rule of life” which includes stocks, women, sports and virtually all events is, “Reality very rarely exceeds the square root of expectations.”

Looking at two stocks I’ve panned over the last year, MicroStrategy – down 99% from its high of $333 – and Akamai Technologies – down 97% from a $345 per share – the square root of the square root of those high stock valuations would more closely represent reality in today’s world. Mathematically, the higher the expectations, the greater the potential damage.

Optimism has been referred to as “suspicion asleep,” but the bubble mania referred to would be more like “suspicion OD’d on controlled substances and in a coma.” I should point out that I have been a raging bull (Barron’s term) on the stock market since 1980, with the exception of mid-1987 to early 1988-with some periods of caution (1984, and mid-1990 and 1995-97) up until three years ago. How bearish am I now? I am truly scared about what could happen to the stock market.

There are so many things that are different about the slowdown/recession/whatever it is- that it could be quite different from the traditional “garden variety” economic contraction. For example:

The reaction of the Federal Reserve to every perceived crises since 1994 (Mexico, Asian Crisis, Russian default/Long Term Capital Management, Y2K and now, “The Recession That Isn’t Here Yet”) has been to cut interest rates and flood the system with liquidity. This has been true of other central banks. As Jim Grant’s Interest Rate Observer points out, this produced very low, occasionally zero or negative, real interest rates. This brought about a boom in business fixed investment, particularly in technology, telecommunications, and information technology.

The latter was also propelled by concerns about survival in The Internet Age. A second beneficiary has been the stock market, which became a mania and then a bubble. Because of the boom in business fixed investment there is widespread excessive capacity virtually everywhere. It would take years before they outgrow their IT equipment.

Excess capacity and rising inventories exist at many areas of technology – not only at the manufacturer’s level. These include the contract producers, the distribution channels, and as mentioned, the customer’s in-place equipment. In addition, hundreds of dot-com buyers of technology products have gone out of business, and that almost-new equipment is coming back into the market, interfering with new- product sales.

CEOs and CFOs have been intimidated by Chief Information Officers (CIOs) into buying equipment with the goal of “productivity enhancement.” As mentioned, it may take some time for this upgraded equipment to reach its full capacity utilization. With margins under pressure, and a slowdown/recession underway, CEOs and CFOs are now demanding a “bottom line benefits realization” before replacing IT equipment. This depends on the economy of course, and the technology cycle – which is a function of time.

If this is a technology and falling business fixed investment led recession, as I believe it is, it will be much less likely to respond to Fed monetary stimulation through lower interest rates. With excess capacity virtually everywhere, revenues falling and margins under pressure, there is very little incentive to expand because of lower interest rates.

Economists differ about the impact of the “wealth effect” due to rising stock prices – and some question if it exists at all. But, in my opinion, investors have been using rising stock prices and home values as proxies for savings. The savings rate near zero and in negative area illustrates this. An estimated $4.1 trillion, equivalent to 40% of GDP, has been lost in NASDAQ and NYSE stocks between September 2000 and the end of February this year. At some point, one would expect the “negative wealth effect” caused by a decline in the stock market to start to kick in.

But a 399 point surge in the Dow following the last Fed surprise and the 34% recovery of the Nasdaq from its low early last month has added a lot of wealth. Will it stabilize the stock market? Probably not.

Will it be enough to avert a recession? As I’ve pointed out, the Fed’s response to every perceived crisis since Mexico’s problems in 1994 have been Pavlovian-cut interest rates and flood the system with liquidity. This has led to a worldwide investment boom in business fixed investment, particularly technology and information technology. There is excess capacity virtually everywhere and it will take time to unwind this overhang. Technology is not responsive to interest rate cuts. Whether consumer spending holds up because of the stabilization of the stock market and possible neutralization of the “negative wealth effect” is another matter.

Weather, summer blackouts across the country, inflation, soaring energy costs are other problems, but those are perennials and may be only marginally significant “This Time.” In my opinion Fed policy will have no meaningful impact on technology companies. The PC, Internet, IT and telecommunications booms have pretty much run their courses, and some of the products are being commoditized. No amount of monetary ease will cause greater technology growth until there are new products to replace the saturated markets in place now.

The “V” shaped recovery model is becoming less and less likely. The profit picture is not particularly favorable – and I would expect continued wild emotional swings characteristic of bear markets. If the recovery pattern is a broad “U” – or “L” – I think there will be a great buying opportunity next year. That is, unless Congress, the Administration, or the Fed make some serious policy blunder(s) – which has happened before.

I never like to forecast where the Dow Industrials or S&P 500 might go – since they always go further than my worst-case scenario. But the Nasdaq holds many companies where the P/E is already high, which will only rise further as the “E” begins to shrink. Once you factor in the tremendous amount of debt, particularly by telecommunications companies, it’s easy to see that there could be further casualties… consequently the downside potential for Nasdaq is still more than that of the Dow or the S&P 500.

I have a habit developed after many bad experiences in younger days, of leaving parties when I would like to have just one more drink. Friends will tell me that I miss a lot of the fun. My response is that I would miss some of the fun – but I would also miss all of the unpleasantness at party’s end – and all of the hangover. I left the party three years ago as far as the stock market is concerned and have been almost entirely in cash since then. I missed some of the fun and all of the hangover. At some point next year I will consider getting back into the party.

Your guest editorialist,

Ray DeVoe
Paris, France
May 9, 2001

Raymond F. Devoe, Jr., editor of the Devoe Report
distributed by Legg Mason and a frequent contributor
to the Fleet Street Letter.

*** Stock moved up and down yesterday, with the Nasdaq gaining 25 points as the Dow dropped 51 points. Press reports said investors were merely marking time until Cisco Systems reported its earnings after the close. The excitement built up – like waiting for a count of the Florida ballots. The company had made 14 cents a share in the first quarter of last year. This year, it was expected to earn only 2 cents.

*** Surprise, surprise! The Cisco kids managed to beat expectations by a penny. But the number and magnitude of “one-time” charge-offs rendered the reported number utterly meaningless. Business is downright awful at Cisco. Including all charges, Cisco lost $2.69 billion, or 37 cents a share, on the quarter. And don’t look to Cisco for upbeat comments about the future. “It is also now clear to us that the peaks in this new economy will be much higher and the valleys will be much lower and the movement between these peaks and valleys will be much faster. We are now in a valley much deeper than any of us anticipated…” Chambers belly-ached.

*** Cisco rose 6% yesterday, anticipating the evening’s earnings announcement. Dell fell 4% – after the company said it was laying off 10% of its workforce.

*** But yesterday’s big news came from the federal government’s statisticians. Actually, there were two important pieces of news. You will recall that the big promise of information technology is that it is supposed to increase productivity. With the hot air of all the world’s information at their backs, people are thought to be able to work more efficiently and produce more. Alan Greenspan is so excited about it that he speaks of it often. Rising levels of productivity will not only make us all richer, they will also eliminate the threat of inflation. Greenspan may be flooding the world with purchasing power… but so what? People are producing goods and services even faster!

*** What a disappointment yesterday’s news from the Labor Dept. must have been. Instead of increasing, productivity actually went down by 0.1% in the first quarter. And to make matters worse, labor costs/unit increased – at a 5.2% annual rate. Economists had expected an increase of only 4.4%.

*** Oh la la… Greenspan is caught between the Charydis of inflation… and the Scylla of a recession. My associate, classical scholar Addison Wiggin, explains, “Charybdis and Scylla refer to the two mythical threats to Odysseus and his crew as they made the passage between the the Straits of Messina, between Sicily and Italy’s boot end. Charybdis and Scylla were the ancient world’s equivalent of a ‘rock and a hard place.'”

*** Dissecting last Friday’s unemployment report, Northern Trust chief economist Paul Kasriel observes, “Factory employment fell 104,000, construction jobs declined 64,000, in-service producing jobs dropped 59,000. The message is clear – there is a rapid deceleration in the demand for labor.”

*** But at the same time he notes, “Hourly earnings increased 0.4% in April. During the three months ended April, hourly earnings have risen at an annual rate of 5.8% – the highest since November 1983.” He concludes, “The central bank is essentially trapped – rapid gains in price and wage inflation combined with a rising unemployment rate.” Kasriel expects Greenspan to cut rates anyway when the FOMC meets on May 15th.

*** Here at the Daily Reckoning, we put little faith in our ability to predict the future. “Justifiably so” readers may be tempted to remark, unkindly. But our modesty results as much from theory as from experience. The markets are, we believe, inherently unpredictable – except in the grossest way (that is, we know that they will go up after they go down…and vice versa). In fact, we do not even want to be able to predict the market’s future. We fear we would be breaking some sort of natural law. And the day we do that, all other natural laws may cease to work too…the earth’s gravity could be turned off and we would all fly into space.

*** But yesterday my fears were allayed as I joined old friend and investment guru Harry Schultz for lunch. We ate at the Cafe de la Paix, which seemed appropriate for VE Day. “Actually, I am quite good at predicting the future,” said Harry. In fact, he allowed as to how more than 80% of his January forecasts had proven correct…and his annual predictions for the Dow often come “within a few points” of where the index ends up.

*** What is Harry predicting now? “I’m getting the first whiffs of a major change. I can see it on the charts – just little burps so far…but important ones. Everything is pointing in the same direction…commodities, currencies, gold shares, interest rates, energy prices, unemployment, consumer spending – economic stagnation and rising prices…especially prices of commodities. Stagflation, in other words.” Harry needs no other words to describe stagflation – he invented the term more than 20 years ago.

*** The price of gold fell $1 yesterday. But something is going on in the gold market. Gold shares – as measured by the HUI – continued to rise. They’re up 60% since last November.

*** A Barron’s poll of investor attitudes towards the next 12 months found 35% of respondents “bullish”…33% “neutral”…and only 19% “bearish.” A six-month outlook found 45% bullish and only 11% bearish. Remarkably, over 90% expected further rate cuts from the Fed. What a surprise it would be if the Fed didn’t cut rates!

*** Kevin Duffy, who tracks various investor sentiment indicators on behalf of Grant’s Investor, states, “Total bull fund assets dropped to 73.7% of total assets (weighted for average) on April 4, but have since rebounded to 86.6%. The greatest speculative juices are flowing in Nasdaq 100-based funds, with 90.8% of fund assets in the bull camp.”
(see: href=”http://www.dailyreckoning.com/body_headline.cfm?id=1160″>Bull Sighting)

*** The Sequoia Fund has made a name for itself over its 31-year existence by unabashedly copying Warren Buffett. Whether by prescience or sloth, the fund’s founders, William Ruane and Richard Cunniff, managed to grow Sequoia into a $4 billion fund that has returned an average of 17.2% per year since its inception in 1970 – easily besting the 13.4% return of the S&P 500 over the same time frame.

*** What do Ruane and Cunniff think of today’s market? Investors seem too “complacent,” Mr. Ruane told the Wall Street Journal last Monday. Stocks may be lower than they were last year, he acknowledges, but “we still don’t see many things out there that are undervalued.”

*** Move over Mickey Mouse. Make way for Dr. Aki Ross. Aki is the stunningly beautiful actress appearing in the new film, “Final Fantasy.” There’s just one thing: She’s not human. The uncannily life- like Aki is a true technological marvel. How life- like you ask? The International Herald Tribune reports, “Aki edged out dozens of real-life models and starlets to become the cover girl on Maxim’s ‘Hot 100,’ a supplement [although not required reading] to the babes-and-brews magazine. Forget routers and semiconductors, Aki may be just the ticket to jump-start the tech sector.”

*** “Benjamin Graham and David Dodd would be horrified,” the Wall Street Journal writes. No, not about Aki Ross nor about the Nasdaq 100’s PE ratio. Rather, about the $30,000 asking price for the first edition of their classic investment guide, “Security Analysis.” First published in 1934, the “Bible” of value-investing has helped to shape the investment skills of a generation of investors, including the legendary Mr. Buffett. Will James Glassman’s “Dow 36,000″ also fetch $30,000 per copy 67 years from now? Will a McDonald’s cheeseburger cost $31,000 in 2068? Maybe.

*** As anticipated numerous times in this column, the bear is finally starting to take a bite out of consumers’ wallets. Consumer credit increased by a seasonally adjusted $6.2 billion in March, or a 4.7% annual rate, according to the Federal Reserve. “That was a smaller increase than the $9.8 million rise in credit that many analysts had forecast.”

*** To gauge from Moody’s latest data, American corporate borrowers are not in any better shape. The rating agency reports that corporate defaults in the first quarter totaled a record $31.8 billion, equal to 65% of last year’s total new issuance volume of $49.1 billion.

*** John Myers, editor of Outstanding Investments, took a brief time-out in the May issue to congratulate himself, and well he should. “Our picks have been amassing profits the way Imelda Marco collected shoes,” John writes. “Over the past year Toronto’s Oil & Gas Index (TOG) – home to several of our picks – is up 43% while the NASDAQ is down 46%!”

*** Has the Internet already peaked out? USA Today reports that fewer U.S. households had Internet access at the end of the first quarter than at its beginning. This was the first time in Internet history that access levels declined.

*** A modest prediction: The Internet is a useful tool. But like an egg beater or a toilet plunger, people will only get it out when they need to use it.

*** Choltitz spared Paris. But Sherman burned Atlanta. “You might as well appeal against the thunder-storms as against these terrible hardships of war,” wrote the general to Atlanta mayor James Calhoun, explaining why he was going to lay waste to the city. “If the citizens of Atlanta want an end to the war,” he continued, “the only way they will get it is by ‘admitting that it began in error.'”

“We will have a just obedience to the laws of the United States. That we will have, and if it involves the destruction of your improvements, we cannot help it.”