Market View

October 26, 1999

The blue chip averages pulled back around 10% during the last few months, but the overall damage is more serious than that. Several sectors are down sharply and many high quality issues are down 30%-50% or more. Market breath is very poor and new lows literally swamp new highs almost daily. As a result, valuations in some areas now appear quite sensible. Others (like technology) remain in the twilight zone. Essentially, the sectors offering the best long-term investment value keep getting cheaper and the areas of the greatest potential excess keep getting driven higher by day-traders and other momentum based investors. This divergence is making for tough performance comparisons for many "value investors" (myself included). I guess that's why they say, "patience is a virtue".

Overall, the market is still trading at about twice its long-term average based on a variety of valuation criteria. This poses some unique questions for investors.

Should investors take advantage of the opportunities that are being presented?

Should investors exercise a greater degree of caution due to the general credit and financial excesses?

To be honest, I'm really not sure. I am reminded of a comment made recently by an investor acquaintance of mine who has one of the best investment records I have ever seen, "A tidal wave washes everything out to sea".

On the economic front, "government measured" inflation figures have risen about 1% over the last twelve months. Bond yields have more than followed suit. The "new era" folks continue to dismiss any and all bad news, but some analysts believe the Fed has now fallen behind the inflation curve. Others are becoming progressively suspicious of the government inflation data. I have no confident view on either matter, but I do have some insights to offer.

The government made a significant number of changes to the inflation and GDP measurements in recent years. These changes resulted in an increase to the reported GDP and productivity statistics and a decrease to the reported inflation rate. Additionally, there's another set of changes to be made shortly that will make the data look better still. Several economists have made the case that U.S. economic growth is now overstated. (and CPI understated). I'm not expert enough on these matters to come to any confident conclusions. However, in the past I've used valuation models that incorporated both interest rates and inflation rates. In fact, I favored the inflation models because my personal research indicated that stock prices historically tracked changes in the CPI more closely than changes in interest rates. Now, due to my concern about the quality of all government data, I am focusing exclusively on my interest rate models. I suggest that other investors might want to do the same. At a minimum we know that the current data is not comparable to the past. We also know that interest rates represent reality. I believe it makes more sense to focus on reality. No matter how you slice it, it's tough to justify current aggregate stock prices.

Despite the 1% up-tick in inflation, the Fed Funds rate is still a 1/4 percent lower than it was before the financial crisis last year. One could argue that monetary policy has been eased in 1999, not tightened. This reinforces my view that the Fed has fomented a significant financial asset bubble by ignoring the rapid rise in asset prices and choosing to focus on the CPI. There's simply way too much cheap money and credit sloshing around the system.

I also believe the Fed further damaged the situation by repeatedly injecting liquidity into the system at every sign of free market correcting distress. These bail outs of the capital markets, asset markets, bankers, Wall St. firms, and hedge funds have fueled the speculation and convinced many investors that the Fed stands ready if the bubble starts to burst. The Fed has now backed itself into a corner and ultimately I believe we all will pay the price.

A few readers have asked for my view on Y2K. Until very recently I maintained a very benign view of the situation. As a data processing professional I am keenly aware of the efforts being made by our major corporations to address the problem. However, I'm becoming a little less comfortable as time passes. Recent observations lead me to believe that the U.S. is less prepared than I once thought. It isn't that the effort is not being made, but rather that problems are slipping through the cracks. The whole picture is distorted further by the unknown position of foreign suppliers and others in the chain. I am coming around to the view of a very good friend of mine, "I can't see how it can be a positive for either our financial markets or our economy". I am now personally deferring all equity purchases until after the beginning of next year. I can't see much plus side in rushing into equities at this time, but I can see some downside. I suspect that lots of other investors feel the same way.

Following is an updated table of earnings, PE ratios, and interest rates as of the end of the 2nd quarter of 1999. I suggest you focus some attention on the differences between operating earnings and reported earnings. One time charges are clearly a routine event. You should also take a look at earning growth. It has been no faster in this business cycle than is typically the case. Those stategists who are trying to justify current stock prices conveniently overlook one time charges and measure earnings growth from trough to peak instead of the more appropriate peak to peak. The one area of corporate improvement has been profitability (Return on Equity). There are a variety of things contributing to this.

1. Higher corporate leverage

2. The proliferation of non-expensed stock option compensation

3. Bull market effects on pension contributions

4. Bull market effects on trading results

5. Late business cycle margins

Overall, corporations are more profitable than has historically been the case, but not nearly as profitable as they look.

Here are a couple of definitions.

Operating Earnings - Earnings before one-time charges.

Reported Earnings - Earnings after one-time charges.

Normalized Earnings - An attempt to analyze both the above and produce a smoother picture of the changes in earnings and business value so that stage of business cycle considerations and variations in one time charges are removed.

Year

Close

Operating

Reported

Normalized

Operating

Reported

Normalized

30 Year

 

 

Earnings

Earnings

Reported

PE

PE

Reported PE

Treasury

 

 

 

 

 

 

 

 

 

88

277.72

24.12

23.75

20.65

11.51

11.69

13.45

9.01

89

353.40

24.32

22.87

21.89

14.53

15.45

16.15

7.90

90

330.22

22.65

21.34

23.20

14.58

15.47

14.23

8.24

91

417.09

19.30

15.97

24.59

21.61

26.12

16.96

7.70

92

435.71

20.87

19.09

26.07

20.88

22.82

16.71

7.44

93

466.45

26.90

21.89

27.63

17.34

21.31

16.88

6.25

94

459.27

31.75

30.60

29.29

14.47

15.01

15.68

7.87

95

615.93

37.70

33.96

31.05

16.34

18.14

19.84

6.06

96

740.74

40.63

38.73

32.91

18.23

19.13

22.51

6.55

97

970.43

44.01

39.72

34.89

22.05

24.43

27.82

5.99

98

1229.23

44.27

37.71

36.98

27.77

32.60

33.24

5.06

99

1313.00

46.86

41.02

39.20

28.02

32.01

33.50

6.04

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."

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