2001 Forecast

January 8, 2001

2000 was a year in which the stock market cult's faction was challenged.  Even horror stories have beginnings…

"Stock prices are dependant upon one thing and one thing only; what people are willing to pay for each individual share.  That is why investing is such an enormous task; the atmosphere is never entirely predictable because the price which people will pay for a share of a company in the future is highly debated and influenced by many independent and non-fixed ambient factors.  These factors include economic surroundings, financial results, analytical perceptions and psychological manifestations of what each individual investor deems valuable and/or possibly profitable."
Jan 2 - Preview 2000

The markets continue to stand at the cross-roads; tech has fallen but not completely apart, and the economic situation, while grim, still offers the hope of a so called 'soft landing'.  These themes, tech stocks and a possible recession, will be important 2001.  However, perhaps of more critical importance will be the actions of investors – actions which will directly steer investor and consumer perceptions down Recession Street or up the 'The Bull Is Back' Avenue.

We should not forget that prior to 2000 a greater percentage of Americans than ever before were involved with stocks.  For this reason the vague estimates done concerning the wealth effect are of particular importance.  How rich does a consumer that expected 20+% portfolio appreciation feel if they lost 30% last year?  How willing will those being laid off or watching stock options become worthless be to take on even greater debt loads in order to consume?  Questions not easily answered…

To begin with, investors have not given up hope.  Contrary to popular opinion, investors are acting just as irrationally as ever before.  As an example, the Dow in mid-March was dipping below 10,000, and today the average is nearly above the 11,000 barrier.  Yes, the earnings estimates have declined but no, investors have not sold off the majority of the index's 30 components.  Has the economic situation improved since March, or have investor perceptions of where value and risk lie merely changed?  We think it is the latter.

This rotational market momentum leads to the premise that mutual funds and investors alike have not changed their equity outlook to coincide with their increasingly negative economic outlook.   All that has changed is the perceptions surrounding technology – so, out of one irrational area of the market (tech) and into another (anything but tech).  This new 'anti-technology' order has formed a dangerous derivative that rests inside of the newest areas of momentum.  These areas include drug stocks, REITs, utilities – the primary common characteristic being that those companies appreciating the most are large and liquid.   The double L's such as Coke and Wal-Mart are now pricing in, not a recession, but nearly their largest premiums in history. 

With a recession being a real possibility the Dow will have a tough time sustaining any strength in 2001.  For this reason one could conclude that the bull market, what is left of it, now rests clearly on the shoulders of blue chips.  This contrasts to the market 9 months ago when tech was the leader.

There remain similarities to the bull in the 1950s where investors spiraled capital into the biggest and brightest names, the only difference being that big tech (PC and internet related companies) have already witnessed fantastic drops while some Dow components (IP, WMT, AA, KO, MRK) have, comparatively, held up strongly.  Contrary to the last 9 months of stability, the Dow remains a 'nifty-fifties' risk – a grouping of 30 stocks which can act as a potential casual agent, perhaps solidifying an economic recession as the wealth effect ratches further into the poverty effect.

The Federal Reserve Board
It is a lock that the Fed will cut interest rates at the January 30 FOMC meeting.  All one needs to do is look at the consumer confidence index over the last 4 months to foresee that the Fed wants to, at the very least, stem the bloodletting in confidence.  As well, the Fed switched focus from monitoring excessive growth rates in early 2000, to inflation fears in mid-2000, to the current concern over an economic recession.

Predicting the Fed's actions or directives after January is nearly impossible to do.  Nevertheless, be assured that if a recessionary environment does develop and stock prices continue to slump even after the FOMC meeting, Greenspan and company will intervene further.  This is the sole absolute to be drawn.  Just as many economists had previously downplayed the business cycle, there is little reason to believe that a series of rate cuts are looming simply because of a bias switch.  This economy has shown itself to be more resilient to adversity than any other, and until the irrationality in the current investor and consumer condition becomes completely understandable the Fed is sure to be on guard.  The last thing anyone wants, besides the sickened tech investors, is to see the Nasdaq rebound up past 5,000 in a short period of time.  Suffice it to say, the chances of this happening are slim.  This is why the actions inside of the Dow and consumer markets (spending, housing, and credit) remain critically important.

Inflation
Not unlike 2000, there is little reason to believe that there will be a dramatic uptick in the headline inflation numbers in 2001.  Demand has begun to slow and energy prices, baring massive spikes in isolated areas, are expected to be tamed by years end.   A decline in economic growth (ERCI) has firmly lowered the outlook for inflationary pressures in the future.  But what this, or any other reading, cannot tell us is exactly what the future holds.  In 2001 there remains some concerns even as slower growth is expected to develop.  These concerns largely rest in the jobs market and the potentially dangerous byproducts of a slumping U.S. dollar.

Gold
It was not a good year to own or trade gold and its shares, but the outlook in 2001 remains positive.  The complications the price of gold (POG) has encountered is largely related to its long-term trait as being a hedge against inflation and crisis.  Even with energy prices skyrocketing inflation did not even come close to producing a similar impact to the 1970s, and with Treasurys and alternative 'value' stocks receiving much of the attention as tech got slammed, there was little hope for a golden rebound. 

Especially important will be the movements in foreign capital out of U.S.  With Treasurys alone being backed by nearly $7 Trillion in foreign capital it does not take a great deal of foresight to foresee these possible outflows.  Moreover, contrary to the popular belief that money will head to Euroland, and possibly Japan – if indeed the damage done inside of the U.S. economy is prolonged, the result will be fewer choices for capital.  Perceptions can radically change, and gold remains a solid resting spot when doubts over the stability of the global financial markets rise.

Owning gold in your portfolio may be wise for the long-term regardless of whether or not crisis is a word that comes to symbolize 2001.  If you plan on buying a few gold stocks and selling them in a few months time for a handsome profit, you are getting involved for the wrong reasons. 

Corporate Earnings
If anyone is correct in predicting next years earnings situation they are not mortal.  Further steps by the FASB to control pooling of interests and Goodwill will be undertaken in 2001.  As it stands now, the FASB is looking to amortize goodwill rather then get rid of it completely.  Bullish investors like the sounds of this as earnings numbers could be influenced to the upside.  The attack launched in late 1999 on pooling of interest is not nearly complete, and just as earnings grow more frightening, a non-friendly resolution could result in a further deterioration in many companies EPS figures. 

On the whole earnings are in decline and expected to continue on that path until at least second quarter 2001.  By placing faith in an earnings rebound an investor is also placing faith in an economic soft landing.  We foresee a hard landing.  The lowering trend is in place, and this trend was tipped off because the vast majority of estimates were too high and influenced by many factors dependant upon U.S. bull market euphoria rather than sound economic analysis.

Severe drops in Dow components' earnings estimates (which have in many cases increased as the economic situation has deteriorated) should add a haze to those investors who look 5 years down the road.  As it stands now, 5 years of superb results above the historical norm are in place – clearly the vast majority of analysts on Wall Street envision a 1987 type rebound rather than a 1929 grind.  A lot has to do with what Greenspan does or does not do, and how investors maneuver themselves in the financial markets. 

Investing
Philip Morris was a true value stock a few short months ago when it traded at under $20 a share, but today at $44 it has become a momentum stock.  The difference is that for $4.10 projected earnings in 2001 (recently revised upwards) you previously got a company trading with a PEG of under 0.7 - now that ratio has contracted to 1.09.  Just as many investors missed out on the Microsofts of this bull market, those who missed out on Philip Morris will follow the trail with anxious dollar bills in hand.  This is a boom that is ongoing and the bust, be it 1 or 5 years from now, will ultimately arrive.

Find companies that you like, understand, and think will do better business tomorrow than today.  But also find companies that are fairly valued.  Typically, but not always, a stock which has appreciated over 100% inside of a few short months is not the best 'value' money can find.  Admittedly, the word 'fairly' is hardly fair.

One Of Our Picks
One company we like is Deswell Industries.  We like what they do (injection molding) and we like where they do it (China).  It trades at $16 a share and has an 8% dividend yield.  We fully realize that in a global recessionary environment Deswell could be trading under $10 and slash its dividend in order to conserve cash.  We are prepared for this to happen.  But as investors what we do not do is pass up a value today on the hopes that a greater value will appear tomorrow after a severe and horrific global recession/depression.   Such is the landscape today – pecking at value while preparing for the future. 

If this indeed is the beginning of the bear, and not the end - having cash, gold, and a list is the wisest course of action.

China is poised to become world's biggest gold consumer.