Some Fear, Little Loathing
The Prudent Bear suggests that despite the current rally we’ll soon enter a new stage of the market where the bad news about the economy feeds on itself and leads to a lower market, then more pessimism, then less spending, then more pessimism… a vicious cycle and continuation of the secular bear market.
Earlier this year bulls said the market had it wrong. Economic numbers were coming up rosy but stocks continued to sink. Bulls blamed investors’ bad behavior on disillusionment with corporate America. Surely, once investors realized that accounting scandals and corporate mismanagement were temporary phenomena, a new bull market could begin in earnest.
Lately, however, the economic numbers are noticeably weaker. Now bulls argue that attractive valuations today and stronger profits tomorrow will move stock prices higher. Maybe. Certainly [as we’ve seen over the last few sessions] stocks could rally as we move toward year- end (stocks can rally at any time, and bear market rallies are especially fierce), but in our view, the story remains the same. This secular bear market has further to go.
One argument for improving corporate profits relies on easier comparisons going forward. Corporate profits have been so depressed, bulls say, that earnings are virtually guaranteed to trend higher. That could be the case for a quarter or two, but implicit in the "easy comparison" theory is that once profits bottom, they will march higher, quarter after quarter, taking stock prices with them.
Such a view ignores some of the more troubling aspects of the 1990s bubbles.
We’ve long argued that corporate earnings in the ’90s deserve an asterisk because they were "wind-aided." This has long been a theme of ours – that the peak earnings of ’99 and ’00 are unlikely to be surpassed anytime soon. That’s because the current economic weakness wasn’t born out of Fed tightening like most post-War downturns.
Today’s malaise was caused by too much capacity created during the easy-money ’90s. With the profits of so many companies so uncertain, it’s difficult to believe earnings will march indefinitely higher and take stock prices with them.
After all, earnings in 1972 were virtually the same as those produced in 1969. Earnings in 1986 were below those of 1979. Can earnings in the wake of the biggest stock market and economic bubble in 100 years be strong and long enough to spawn a brand new bull? Recent warnings by Honeywell, Nokia and Lucent, and the announcement that the largest chip foundry in the world will cut this year’s production by half, illustrate the difficulty of increasing profits in a world of too much stuff. "We are revising our 2002 outlook because it is clear that the broad economic recovery is not materializing," Honeywell CEO Dave Cote explained.
Even the consumer appears unable to save the day. This year’s mortgage refinancing boom is longer and stronger than last year’s and the Great Boom of 1998. Yet, retail sales are sluggish and carmakers have had to renew subsidized financing plans to keep hope alive. One day the house will no longer function as an ATM. Couple that scenario with a savings rate that inevitably will move higher, and you have a recipe for years of weaker consumer spending.
If we are right about this being a secular bear market, investor attitudes hardly indicate the bottom is in. A few months of mutual fund redemptions and some finger wagging at CEOs hardly signals the long-awaited "capitulation." For a reminder of what sentiment is really like near a bear market bottom, check out this money manager’s quote below from a Business Week article published in December 1979: "People have been predicting massive bull markets for years, based on the premise that equities are undervalued. How long does a statement like that continue to be operational?"
The BW piece complains that investors seem determined to speculate in the futures, options and gold markets rather than buying stock in American industry. BW also notes that the "conservative banking industry" has begun to include hard assets in its pension accounts, and that the governor of Alaska wanted to allow his state’s retirement funds to invest in gold and real estate.
Compare the disdain for stocks near the end of the ’70s bear market to the recent attention given to the "Fed model" that shows stocks to be attractively valued. The model compares the market’s earnings yield (based on next year’s estimated earnings) to the 10-year Treasury yield. Currently, stocks look attractive vs. bonds in the model. But with the 10-year in the 4% neighborhood, a market P/E in the 20s looks attractive. Besides, next quarter’s earnings are suspect. Earnings a year out are as about as certain as the continued success of American Idol.
The investor who finds stocks cheap based at 20+ next year’s earnings relative to bond yields after a six- month melt-up in Treasuries is hardly as bearish as the one who sells stocks to buy diamonds.
In fact, Gail Dudack of Sunguard Research recently reminded her clients that investors once demanded far more from stocks than merely an attractive relative valuation:
"Prior to 1958," writes Dudack, "stocks were viewed as high-risk investments and dividends (or total returns) were required to attract investors. In the ’90s dividend yields fell to record lows as investors chased capital gains and hopes of 30% per year returns."
The BW article even provided scientific proof that stocks perform poorly over the long term. The piece refers to a Salomon Brothers’ study that found that stocks had not only under-performed inflation, but gold, diamonds and housing as well since 1968. That period is hardly representative of stock market returns, but neither is 1982 to 2000. The point is, stocks can perform poorly over the long term, when long-term is defined as 10 or 20 years. I suspect, for example, that the last 12 years sure feels like "long term" to investors still holding Japanese stocks. Business Week concludes, "even a prolonged bull market in stocks would probably not be large enough to make up for the massive losses that investors have suffered from the inflation of the 1970s."
They were wrong, of course. Today, however, investors who figure that holding for the "long term" will make up for losses they experience along the way could be on the wrong side of that bet as well. Sure, we’re on our way to the bottom of this bear market. We’re just not there yet.
for The Daily Reckoning
October 15, 2002
p.s. Financial stocks have really been starting to under-perform the rest of the market, and the gloomy outlooks recently presented by JP Morgan/Chase and Morgan Stanley are important and indicate trouble ahead for the entire economy, especially for financial stocks. Stay with your current shorts and tell your friends there’s more bad news to come.
Editor’s note : David Tice is founder and director of David W. Tice & Associates, a capital management firm in Dallas, Texas, and manager of the Prudent Bear fund. Tice’s work has gained national recognition through Barron’s articles he has authored and from his appearances on business television. He has appeared on the Nightly Business Report, Wall Street Week with Louis Rukeyser and CNBC, warning investors about the dangers of investing near the end of a bull market.
Why did stock prices keep falling, the analysts kept asking, when the economy was recovering so nicely?
Maybe the stock market knew something the analysts didn’t, we replied. Maybe the economy was not really recovering. Now we discover that payrolls fell by 43,000 jobs in September and industrial production has dropped off. The "economy might have already fallen back in recession in September," says MONEY magazine.
Anything is possible, we readily concede. But what we can’t figure out is how a consumer economy can recover when consumers have no money to spend. "Americans spend $1.22 for every dollar they earn," MONEY informs us. Debt to income ratios are already at record highs. Something’s gotta give…
"Is Real Estate next to go?" asks FORTUNE.
We don’t know the answer. My friend Steve Sjuggerud notes that property in most parts of the country is not terribly overpriced. The trouble is not the property, but its owners. They may fall apart before their homes do.
Not that the credit industry isn’t making an effort to keep them going. Low rates, for example, allow homeowners to borrow more…and still make the same monthly payment. Often now, mortgages are interest-only for the first few years. The buyer figures he will have sold and moved on before he ever makes a payment on the principle. And now Fannie Mae says it will let borrowers miss a payment or two…without putting so much as a tiny stain on their credit records.
In fact, we wouldn’t be terribly surprised to see Fannie and other credit mongers loosen up even more. Whatever the nominal rates of interest, deflation and recession are pulling down real rates…and, we believe, will soon drag nominal rates down with them.
"Judging by the deceleration in the growth of the credit the Fed creates," writes James Grant, "the Bank of Alan Greenspan is propping the rate up rather than pushing it down. It is withholding credit from the market to support a rate that, in the absence of Fed open-market operations, would probably be lower than 1 ó%. So we expect the rate soon will be lower – 1%, to guess."
With this sharper spade in his hands, the homeowner may dig himself an even deeper hole of debt. Shoveling out every lump and grain of ‘equity,’ he might go on another spending spree. But perhaps not. He is already in over his head. He might look up and decide he is deep enough.
We will find out. But first, we turn to the latest news from New York. Eric, over to you…
Eric Fry in New York City…
– The nightclub bombing in Bali over the weekend threatened to trigger a secondary explosion in the stock market on Monday. This fresh incidence of terrorism in the Indonesian archipelago seemed all but certain to cause a steep sell-off in the global stock markets. But investors did not panic… not much, anyway. After dropping about 100 points shortly after the opening bell, the Dow recovered to gain 27 points to 7,877. The Nasdaq also bounced back from an early slide to gain about 1% to 1,220.
– Perhaps stocks rebounded from their morning losses because the tragedy in Bali has little, in fact, to do with the trading on Wall and Broad. Or maybe, as Bill suggests, investors have merely "regained their insanity." Either way, the stock market escaped with its third straight gain.
– Gold responded tepidly to the latest terrorist activity by inching $1.40 higher to $318.60 an ounce. Crude oil jumped back over $30 a barrel to $30.03.
– I have a confession: I did not spend the entire day yesterday watching the stock market trade tick-for-tick. Nor did I spend it sharpening up on my knowledge of the Austrian school of economics. Instead, I opted to attend a lavish outdoor party at "Harvest-on-Hudson," a gorgeous restaurant on the banks of the Hudson River in Hastings, New York. (The restaurant is a must-see for anyone visiting that part of New York State).
– On a beautiful autumn day, from early afternoon until dusk, the hosts provided a limitless array of great wine and delicious cuisine. I would have been content with the fried chicken "fingers" and French fries on which my children "dined." Even so, I didn’t mind having the slow-roasted lamb or the seafood salad.
– Anyway, as I sipped wine and gazed out over the Hudson, I spoke with various folks about the stock market. Almost no one had anything good to say. A couple of them mentioned that they no longer cared to follow the stock market. "I’ve lost so much money in the market," one guest admitted to me, "that I just don’t watch it anymore."
– No one seemed to care that stocks have rallied more than 500 points in just a couple of days. Instead, they shared innumerable tales of stock-market woe. They related stories about friends or family members who had lost substantial sums in the stock market. One of the guests mentioned that a friend’s mother’s portfolio that was once worth $200,000 is now worth no more than $40,000. Another guest shook his head and said, "There are SO many stories like that… they’re endless." He then mentioned an acquaintance of his whose tech-stock heavy nest egg had crumbled from "something over $1 million" to "something less than $100,000."
– On the face of it, these stories are not terribly surprising. In fact, on the face of it, they may even seem so run-of-the-mill as to be inconsequential. But they aren’t, and here’s why: In almost every tragic tale I’ve heard about large investment losses, the largest portion of the losses occurred THIS year. Not in 2000 or 2001. In other words, the negative wealth effect is a brand new phenomenon and is just starting to kick in.
– Many of the folks who turned $500,000 into $100,000 still had about $300,000 or so as recently as January. And even though they had already lost $200,000, they still expected to recoup the losses. (Remember, all the Wall Street analysts were predicting big gains in 2002 and were assuring investors that stocks couldn’t possibly drop again because the stock market hadn’t fallen for three straight years since the 1940s.) But, inconveniently, stocks continued to fall.
– Only recently have the cumulative losses become very large and very real. So even if the stock market continues to mount a substantial rally from here – an outcome that the Daily Reckoning team is not predicting – the macro-economic damage has been done. The negative wealth effect is likely to take a big bite out of consumer spending. At best, consumer spending is unlikely to grow. And that means that the economy could remain sluggish for quite a long time.
– We would not bet against the heroic American consumer’s will to buy things he doesn’t need with money he doesn’t have. Sometimes however, even when the spirit is willing, the pocketbook is weak.
Back in Paris…
*** Well, the times are changing. It snowed in Berlin yesterday and Paris is so cold and gray that your editor found himself humming Christmas music on his way home yesterday. The Ice Age, fretted about in this space just last week, seems to have arrived early.
*** Another surprise arrived last week. A New York publisher called and asked if we would write a book comparing Japan’s economic epizootic of the last 12 years with America’s current malaise. We had proposed the idea more than a year ago. No one was interested. The economy was clearly recovering; who would want to read a book that was obviously off-base, they wanted to know? But now the Japan comparison is on every pair of lips – even those at the Fed.
We could not resist the chance to see our names in print, so we accepted. Now we actually have to write the book. What’s more, the publishers want it by January 1st.
So, we bring you good news, dear reader. Though I will continue to write daily with these notes, you will get a break from my letters – which will recommence after the first of January. (In the meantime, we will continue to publish letters from our many contributors and guest editors.)
*** The French press loves to make fun of Americans… and Americans can’t seem to resist giving them cause.
Yesterday’s Le Figaro included a front-page article about the absurdity of America’s tort law system. It seems a group called Citizens Against Lawsuit Abuse has begun giving awards for the most ridiculous abuses of the courts.
In one case, for example, the families of 11 would-be immigrants who died while trying to come ashore illegally are asking for $41 million from the Coast Guard. The authorities knew that illegal immigrants often landed in the area, says the complaint. They should have provided a safe place for them. Defendants replied that if they had aided people to illegally enter the country, they could be charged with breaking the law themselves and be subject to 6 years in prison.
In another case, Le Figaro continues, enjoying itself, a couple is suing Air Canada for $15 million for "negligence, emotional prejudice, fraud and false advertising" after the company lost their cat on a flight from Toronto to San Francisco. "It’s not a question of money," said the pet lovers.
Then, there’s the man who escaped from a Maine prison and got frostbitten toes. He is suing the local police for untold millions on the grounds that they should have caught him before his toes gelled and put him back in the hoosegow where it was warm.