FINANCIAL FACTORS OVERPOWER FUNDAMENTALS
Stocks Enter Second Half of 2003Priced for Perfection
Chris Temple, Editor
The National Investor
www.nationalinvestor.comOsama who? Saddam who??
The two bogey men who for so many months gave stock traders nightmares and contributed to a lethargic performance during this year's first quarter have become virtually irrelevant to most investors now. They are but a memory; a footnote in the history books. Whether they should be is another matter.
Instead, investors have focused on-well-the same things they have focused on now on and off for nearly three years. Fiscal stimulus from the Federal Reserve. Tax cuts from Washington. Bullish prognostications from many of the same pundits who have predicted several times previously that a return to the 1990's was finally at hand. It matters not that those forecasts have been wrong each time before; things just have to turn around sooner or later-and maybe this rally will last, and reveal itself as a new bull market.
The result at the least has been a cyclical bull market since the March lows, during which time the major stock indices first erased their losses since January, and then powered well into positive territory. For the year's first six months now, the leader of the pack, the Nasdaq, has moved solidly into perceived bullish territory, posting an impressive 21.5% gain. The broader and less exciting S&P 500 tacked on 10.8% to its January 1 levels. The Dow Jones Industrials brought up the rear, but still with a welcome 7.7% advance.
The market's bulls-and there are uncomfortably many of them, if you're a contrarian-are telling us anew that this is the real deal now. More probable, as you'll be reading, is that we've witnessed a cyclical, financially-driven bull market-one made possible by momentum and liquidity-within the context of a secular bear market. Or maybe we need to come up with a new set of descriptive phrases. Personally, I like the ones offered rather tongue-in-cheek recently by UBS Financial's Art Cashin. He quipped that this rally started as a "bumble bee rally." Like that insect, the laws of aerodynamics argue against it being able to fly-yet it does. More recently, Cashin offered, the market's steady advance has been more of a "religious rally," based on faith and hope.
Whatever your preferred moniker, it would do us well in handicapping what we might see in the second half of the year to first take stock (pardon the pun) of those factors that led to such a strong performance thus far, as well as those which, so far, have been ignored.
"STOCKS AND AWE"
"Stock and Awe continues. Get your chips in play!" Such was the recent urging by CNBC personality Larry Kudlow, hawking that network's evening program Kudlow and Cramer whose unabashed bullishness is indeed one thing already similar to the environment of the late 1990's. Damn the fundamentals-full speed ahead! After all, the fundamentals will catch up…we think.
Moved by Kudlow and other high-profile market bulls, individual investors have started following institutions into buying stocks first and asking questions (and hoping for the economy to ratify their investment choice) later. Besides worrying about their patriotism being impugned if they fret about the future and keep their money on the sidelines, investors have been prodded into dipping a couple toes back into the stock market by financial factors: the perceived "competitiveness" of stocks as opposed to short-term savings and most other safe havens.
Both the Federal Reserve and policy makers in the federal government have long been trying to "force" some of the more than $5 trillion off of the sidelines and back into stocks (NOTE: Refer back to "The Fed's Hail Mary Pass" in the November, 2002 issue and "The $5 Trillion Prize" in February, 2003.) The Fed has done this by once again cutting short term interest rates; Washington has helped by lowering income taxes on most dividend income and on long term capital gains. Put it all together and-if you believe that the economy's worst days are behind it, and that all the monetary and fiscal stimulus are finally going to cause a great, new expansion in the economy-it makes stocks look more attractive. Besides that, jumping on board the increasingly giddy stock bandwagon will insure that you aren't laughed at or scorned if you attend a Republican cocktail party.
Helping to make the bulls' case is a fairly modern gauge which compares the "earnings yield" of the stock market to the "earnings yield" of the 10-year Treasury note, the current bellwether. Here's how it goes: you take the expected operating earnings for the S&P 500 for this year (about $55.00, give or take a little) and divide it into the current level of the index, which we'll round off at 1,000. That gives us a 5.5% earnings yield for the S&P.
The current yield for the 10-year Treasury-also referred to in these enlightened and bullish times as "earnings yield" has risen back up to around 3.7%, or considerably less. "Voila!" say Kudlow and the rest-stocks are still cheap, and this rally has a lot further to go, since their earnings yield is higher than Treasuries. Stocks must rise, so that their earnings yield moves down to that of the 10-year Treasury note.
Now, you might be so crass as to contend that, for all its other warts and potential risks (which I detail elsewhere in this month's conglomeration of commentaries, news and more) the Treasury at least pays out that whole 3.7% on its note. The S&P 500 companies do not pay out all their earnings. Comparing apples with apples and judging stocks' valuations by the S&P 500 dividend yield reveals a different picture, since that yield is a much smaller 1.6%. You might also point out that the Treasury guarantees you'll get all your principal back in 10 years (it's a different matter what those dollars will be worth by then), whereas there is no such guarantee with the stock market.
Of course, if you pointed out all these contradictions with the latest bullish orthodoxy-let alone question whether the economy's weak performance justifies this latest manifestation of irrational exuberance-you'd be right. But none of that matters right now. The push is on to reinflate the stock market eve further, no matter how much history has to be rewritten or no matter how many dopey new excuses come out arguing how cheap stocks are. The forces driving shares higher are indeed powerful; after all, much is at stake here. If the Fed, the Bush Administration and their shills on Faux (Fox) News, CNBC and elsewhere can convince you to follow their enlightened and even "hip" thinking, you'll buy them all some time. But in the end, those like us who warn that the stock market has no clothes will be right; for now, we just carefully enjoy the ride made possible by others' blind faith.
FUNDAMENTALS WEAKENING
While stocks have enjoyed a surge due to their perceived competitive advantage as opposed to bonds and money market funds, the economy's fundamentals as well as still-deteriorating fortunes hitting entire sectors are being brushed aside. In fact, it's been stunning how stock traders over the last couple months seem unfazed by a variety of maladies and nasty news items that not too far back would have had them rushing for the exits. Wall Street really has seemed of late to be made of Teflon, with nothing-job losses, chronically high energy prices, little pricing power for companies, a big mess in Afghanistan, a bigger one in Iraq and more-sticking. The $64,000 question, as one market maven rhetorically asked recently, is when the Teflon will turn back into flypaper.
In my humble opinion, it won't be long before mediocre economic activity and a worsening of fortunes on some fronts no longer escape traders' notice. Not necessarily in order of importance, consider the following:
LONG TERM INTEREST RATES: Though (as I write elsewhere this month) it could still be a bit too early to write the epitaph to the Treasury market's bullish run, the odds have greatly increased that we've seen the lowest levels in yields. Watch the yield now on the 10-year Treasury. Any move North of 4.0% on the yield will make Wall Street more nervous. Simply put, everyone is so leveraged now and the economy (and especially its anchor, the housing boom) just can't tolerate even a modest rise in long term interest rates.
ENERGY: Alcoa kicked off earnings season on July 8 by citing high energy costs as one reason why earnings ended up essentially flat compared to a year ago. In the coming few weeks, Wall Street might get a little better appreciation of what $30 plus per barrel oil and $5.00 plus per mcf natural gas (both commodities significantly higher than forecast at the beginning of the year and-in the case of gas-almost guaranteed to go higher still) are doing to corporate profits.
CONSUMER SPENDING: Businesses are not about to open their wallets in a big way to increase capital spending or hire back workers until they have seen solid, sustained evidence of an increase in consumer spending beyond the baby steps that have come since the end of the initial phase of our war/invasion/whatever in Iraq. They'll have a long wait.
In spite of more incentives in more industries than anyone can remember, consumers-even bolstered by new waves of home refinancings-have suddenly decided that they're no longer in a hurry to go out and blow every penny of their tapped equity. The nation's retailers have been posting a steady stream of disappointing (in the case of higher-end stores, downright frosty) sales numbers. Even Wal-Mart has seen relative lethargy among its legions of shoppers, publicly offering anecdotes-such as more shoppers using pocket calculators-describing their customers' newfound thrift.
And by the way: if you think things will get any more robust, consider what the first two factors cited above will do to slow down retail sales and overall consumer spending even more, if not send them into outright contraction. After all, even Larry Kudlow's soothing rhetoric won't help consumers feel good about patriotically borrowing and spending with abandon when millions of them face 30-50% increases in their heating bills by the end of the year.
JOB LOSSES: Another thing that won't help consumer spending a whole lot is the continued bleeding of jobs by the economy. Since early 2001, 2.5 million jobs have been shed. According to a recent Manpower survey, three out of four employers plan to put off new hiring or lay off workers this summer. The current environment has been described as the worst for employment since 1991, when a "jobless recovery" did manage to get underway, but took painfully long before transforming itself into a job-creating one.
Americans looking for decent work won't be so lucky this time around. For starters, this is not the early 1990's, where the Fed had LOTS of room to cut interest rates and eventually boost consumption which, in turn, led to greater business confidence and, thus, more hiring (which led to more consumption, etc.) Interest rates are already at or near rock bottom; so the chances for employment picking by this means are nil.
Further, there is a greater push than ever for companies to hire foreign workers. One of the disingenuous ways in which much of the media is covering what spotty increases there have been, for example, in information technology (IT) spending is in how they don't specify what and who the spending is on.
To its credit, CNN/Money Online did go into some considerable detail in a piece back in March detailing the radically different fortunes in the IT industry from country to country. While spending on new IT services has continued to contract here in the U.S., the IT sectors in countries like India, China, Israel, Ireland and the Philippines have seen robust business. You guessed it-much of it has come from outsourcing of technology service positions to lower-cost employees overseas, or from those countries exporting IT services, software and such to U.S. companies.
According to a recent study by Forrester Research-based, in part, on their polling of major U.S. firms-the next 15 years will see 3.3 million service industry jobs and $136 billion in wages moving to foreign countries.
I don't know whether these are included in Forrester's number, but the firm A.T. Kearney predicted recently that up to 500,000 jobs would be sent overseas in the next five years by U.S. financial firms, or about 8% of the existing total of banking, brokerage and insurance positions. Quoted in a recent piece on CBS Marketwatch, Kearney's Andrea Bierce said the exodus has already begun, with some already moving back office and call center operations overseas prior to moving some white collar positions.
"A person coming out of college in India with BA in accounting and starting a job will make about $5,000 per year," she pointed out. "Someone with an MBA from the Indian Institute of Technology and two years experience will make about $12,000 per year. Now contrast that with a Harvard business school graduate who's close to $100,000 or even over $100,000. It's the wage differential that's motivating companies."
More than ever-and at an accelerating pace-Corporate America no longer discriminates among classes when it comes to jettisoning American workers. I'm glad Mr. Kudlow and his friends have figured out how all this is going to bolster consumer spending anew, lead to a new burst of capital spending by business, and justify current (and higher) levels of stock prices. It's sure lost on me, though.
STATE GOVERNMENTS: Though a few states like California are noticeably late in meeting the June 30 fiscal year deadline to balance their budgets, most made it. But they did so by a combination of tax hikes, layoffs and spending reductions that virtually everyone agrees will have a deleterious effect on the overall economy. As with energy costs, rising levels of property, school and other local taxes will be taking a far larger bite out of consumers' wallets as a result.
PUSHING ON A STRING-WITH A BULLDOZER
The Federal Reserve knows all this, which is why it cut short term interest rates further recently (albeit by a disappointing 25 basis points) to try to do what in the end will be revealed as mathematically impossible and, perhaps, financially disastrous.
The Fed has made plain its intentions to do whatever is necessary to keep consumers borrowing and spending, keep the stock market afloat and all the rest.. Never mind that history shows that the proverbial "pushing on a string" doesn't work when an economy is already plagued by high debt levels, overcapacity and the rest; all of these natural consequences of the kind of debt-fueled boom we had during the 1990's. Never mind as well that it's already fairly clear that the first 12 cuts did not quite have their desired effect.
The only way an economy such as ours can heal itself is by an extended period of "digestion" of its current debt levels. However, this Federal Reserve seems to feel that high debt levels, over consumption and overcapacity caused by plentiful credit in the past can be fixed by more of the same. Greenspan and Company are obviously of a mind that they can fight both the laws of nature and of simple mathematics by using a bulldozer to push on the string. In the end it still won't work, any more than it has worked in Japan, even if in the near term we see some continued reinflating in the stock market.
-Chris Temple
www.nationalinvestor.com
July 14, 2003
PLEASE REPLY TO: chris@nationalinvestor.com
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