Monet or Picasso?
- John Mauldin
- Thoughts from the Frontline
- February 28, 2001
Monet or Picasso?
Where the markets are headed
Is Elvis in the House?
The Millennium Wave Investor Sentiment Index is 77, and moving down.
The Millennium Wave Sentiment Momentum Index is 35.25, still trending down.
The Millennium Wave Sentiment Percentage Uptrends is 29.52, and has gone flat!
The Millennium Wave Sector Model has moved to Basic Services (RYBIX) from Energy Services (RYVIX). We entered and left Energy Services with a slight loss, so that means 7 of the last 8 trades have been losers. I still think the market is too volatile for sector trading, and will continue to be for some time. I look forward, more than you can possibly imagine, to the time when the markets have some reasonable value and basis to them, so we can use sector rotation and other systems profitably.
Can you spell w-h-i-p-s-a-w?
I am a voracious reader. I read reports, special newsletters, etc. from dozens of sources in an effort to try and glean some wisdom to pass on to you. Last Friday, as I sat down to write this letter, I was confronted by the startling difference of opinions in the recent writings among those analysts/observers whose opinions I respect. Each tome or writing had a set of facts which the writers read like tea leaves trying to discern the direction of the economy.
Sidebar: One of my favorite writers is Bill Bonner and his Daily Reckoning. Bill is the founder of Agora Publishing, one of the largest international investment publishing companies. I have known Bill for almost 20 years. Since he is generally more bearish than I am, I find he challenges me and causes me to think through my basic assumptions more than any writer I know. More than simple economic content, he helps me think through the philosophy of why the world works the way it does. I get facts and figures and ideas from him I find nowhere else. Besides, he writes so beautifully that I would read him just for the sheer pleasure I get from his style. He writes a daily letter, and I strongly suggest you read him for one month and see if you get hooked. After you read my letter, click on this link and subscribe. It is free, as is my letter. The only caveat is that you cannot stop reading me just because he writes better than I do. Let me know what you think about his letter.
Back to my letter:
I must confess that I looked at the various facts and was ready to do my bit of reading tea leaves as well. But upon reflection, it seemed to me that somewhere in this pattern of confusion was a more important message. I know I write at length from time to time, but I try to make what I send you provide you some insight into the workings of the market or a useful investment idea. Last Friday, I was not sure I could do that. So instead of writing, I decided to drop back and meditate.
That night, as luck would have it, my wife took me to the Kimball Art Museum in Fort Worth to view the magnificent collection of Impressionist paintings from the L'Orangerie Museum in Paris. I am rather fond of Impressionist paintings, particularly Monet.
If you look too closely when examining the individual strokes of a Monet painting, they make no sense. But as you stand back, the strokes blend into a masterpiece of art. The odd brush strokes, viewed from the right distance, give you the impression the artist is trying to convey.
I am looking at the brush strokes of massive amounts of economic data. I will go over some of them and then will return to this analogy as we try to get an impression of what they are telling us.
In no particular order:
The economy only grew at a rate of 1.1% last quarter, and if it actually manages to eke out a gain this quarter it will be small. Coming off 5.6% growth in the second quarter of 2000, this certainly feels like a recession to many people, and indeed consumer confidence numbers came out yesterday showing a steep drop in the mood of the nation. Since I continually argue that sentiment is crucial to the understanding of the market, I must also argue that consumer confidence is crucial to the economy. People buy when they feel good and don't buy when they are worried. It is that simple. While January sales were relatively good, anecdotal evidence for February is not as rosy.
The head of research at our office relates to me a discussion he heard with a behavioral economist. Essentially, what the economist said is that consumer confidence is directly related to job confidence. If I believe my job or income is secure, then I am confident. If I think my job is in jeopardy, then I am not confident. His assertion was that all the stories of lay-offs and job cuts is what is driving consumer confidence down. It makes no difference whether or not the employment rate is actually quite good. It is the perception of problems that creates the "crisis of confidence."
This makes some sense. We will see if he is right if consumer confidence rebounds on news of hiring and expansion. But as we will see below, consumer confidence is crucial.
At today's Greenspan testimony, he talked in general terms about inventory build-up. But let me give you some specifics. We are currently manufacturing at only 80% of capacity, and yet inventories grew 15% faster in the last half of last year than during the first half. GM dealers now have 101 days of inventory of cars rather than the historical 80 day average. Andy Serwer in Fortune reports huge cuts in production of housing materials like lumber and gypsum, caused by overflowing warehouses. Inventories in the tech world are monstrous. Sony's inventories grew 29%, much of it in computers. Cisco has seen its inventory level grow to $2.5 billion, or doubling in six months, when actual sales only grew at 25% The suppliers of products to Cisco are feeling pressure, as Cisco slows orders. But they built capacity to serve the forever 30% growth machine and now for the first time have to sit and wait for demand to catch up with over-supply. The list could go on for pages, but you get the idea.
Fred Hickey of the High Tech Strategist warns that bloated inventories at tech companies almost guarantee that the economy won't magically rebound in June as some hope because it will take "many moons" to work off the excess inventory. This argues against the return to growth in the second half of the year.
And For Some Good News
Many writers lament the low savings rate in this country and are worried about personal consumer debt. I have always been puzzled by the fact that we have a low savings rate but the individual wealth of our citizens is growing. Ed Yardeni, who has a long history of good economic forecast and seemingly good intuition explains some of this dichotomy by pointing out some problems in the way savings are figured. Let me just quote him:
"American households have never been more prosperous than they are today. Many have two income earners. Many have very good jobs. Indeed, almost half of the 25 million jobs created since 1987 are categorized as managerial or professional positions by the Bureau of Labor Statistics. In other words, consumers are in a position to carry more debt than in the past. The personal income data both before and after taxes may be underestimated, which would exaggerate the level of the debt to income ratio. I'm sure that the data for taxes is more accurate. The consumer debt to personal taxes ratio has been relatively stable around an average reading of 1.3 since 1960. It is now below that average at 1.1 .
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"The ratio of consumer debt to the value of money market mutual funds held by individuals is actually at a record low. Previously, I've argued that the personal savings rate is much higher than zero. It is widely known that the government statisticians treat capital gains taxes as a tax on personal income to calculate disposable income. But they don't add the capital gains to pre-tax income. A more symmetric approach would also exclude the taxes on capital gains, thus boosting disposable income and the personal savings rate.
"Another statistical issue is that the government data include corporate contributions to pension funds as personal income, not benefits paid. This statistically correct approach is behaviorally weird. Retirees think of their retirement income as income, and spend it accordingly. In 1999, benefits paid exceeded contributions by $256 billion, explaining at least four percentage points of the weakness in the personal savings rate.
"Finally, I do expect that consumers will respond positively to easier credit conditions. The Fed only started lowering the federal funds rate in January. However, the government bond market started easing early last year, when the 30-year yield peaked at 6.7% during January. It is now down to 5.5%. Unlike most corporate yields, mortgage rates fell along with the Treasury yield. Last year, the yield on 30-year fixed-rate mortgage loans peaked at 8.6% during May. It is now down to 7.1%. Housing activity, construction employment, and housing-related retail sales have all responded well."
I know that housing starts in January were down, but this is from a December which was huge. Construction hear to year is flat, so the January housing figure is nothing to get in a funk about, unless it is followed up with continued drops for the next few months.
Yardeni argues above that we can handle the debt load. However, if worried consumers decided to start paying down their debt and buying less, this would slow the economy, reduce profits at many companies and could be a start of real problems, depending on how seriously they reduced debt instead of consuming.
How many consumers, hearing the debate about how important it is to pay down the national debt, are wondering if it would be good for them to lighten up as well?
I read that we have seen $4 TRILLION dollars in stock market valuation drop from our balance sheet. That is HUGE. As an investment advisor, I talk to a lot of investors. I know many of them saw their net worth drop last year. If you don't feel as wealthy, you don't buy as much. It is as simple as that. You start to save a little more to try to get back to where you were.
But On the Other Hand
While bears point out potential crisis points, it is hard to actually find some US financial market breaking down. The dollar is holding its own, bank debt seems manageable, even junk bonds are coming back from December lows, maybe signaling a quicker rebound.
Greenspan is arguing for a "V" shaped economy where we see a quick bottom and a quick rebound. Indeed, today he says everything is speeding up, and that is why the Fed is responding more quickly. But has he responded quickly enough? Today, he indicates that the Fed is not likely to cut rates before March 22. The market is not reacting well. He should cut rates by 50 points tomorrow and then again on March 22.
Is Elvis in the House?
The market keeps seeing a Greenspan cut around every corner. Any day now. And, oh, did you say Elvis was on the exchange floor? This waiting is annoying. If everyone knows he is going to make the cut, then why not just do it? If it really is supposed to make things better then why should we wait another month? Why should the economy be held down any longer than it has to be?
Don Wellenreiter, in his highly respected and daily "Index Predator" utters this heresy:
"Our much-respected Fed Chairman will speak today to the House Financial Services Committee and traders will be looking for hints of yet another rate cut. Instead they should be looking to string him up. I know this is not a popular viewpoint but hear me out. Mr. Greenspan said back in December of 1996 that the stock market was showing signs of "irrational exuberance" -- which is also about the last time I think he was correct. Instead, he allowed the market to race ever higher until he decided to raise interest rates to battle yet unrealized threats of inflation -- at least that was his excuse. The only place where inflation existed was in the stock market. His thinly veiled attempt at slowing the beast down was to raise rates -- and that he did. Now he has been forced to cut rates twice in one month by 50 basis points each time. What Mr. Greenspan should have done back in 1996 was to raise the stock margin rates from 50% to 75% or even as high as 100%. Instead of inflicting unnecessary higher interest rates on all of America he should have raised the stock margin rates to reign in the stock market and its excesses. It is probably too late now so we will all have to pay for the Chairman's blunder. Mark my words, history will not be kind to our current Fed Chairman."
I agree with Don that Greenspan should have not used interest rates to bring the market down, but his PR team will probably still get him a solid place in the history books.
Let me quickly repeat a few themes I have written on in the past to fill in a few more brush strokes and then let's start stepping back.
Inflation is dead. Cooked. Toast. Nada. Deflation is the worry, and the Fed is worried. They are inflating the money supply like there is no tomorrow. Future inflation numbers will show little inflation in spite of this. Last month's inflation numbers were a statistical fluke. (OK, maybe I exaggerate for emphasis, and I fully recognize that someday inflation will resurrect, but not this year.)
There is a glut of capacity in the world (except, it seems, energy in California), and the ability of companies to increase prices is disappearing. A little deflation is not a bad thing. But finding the sweet spot of just the right amount of deflation is tricky. If someone wants to know what worries me, it would be too much deflation. Deflation makes all the worst nightmares of my bearish friends much more real possibilities.
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Oil is going down, maybe below $25 for a while. Japan is getting worse and the Nikkei is back down to where it was in 1985 and going lower. Japan is in serious trouble, and that spells problems for all of Asia and the world export economy. Europe, however, is getting its act together.
The recent increase in gold is a short squeeze. A few speculators are getting their heads handed to them, but when that is over, gold could continue its drift down, although I hope not. Gold is not telling us to worry about the dollar or inflation. Not yet, anyway.
The dollar is probably going to drop some more, because it just simply got too strong. No market goes one way, and this one will find an equilibrium soon.
There is plenty of room, in my humble opinion, for the Fed to cut rates and increase the money supply. The sooner the better, to stave off a serious recession.
Let's drop back and play "Where's the Bear?"
I have argued in these pages that we are not in a classic bear market, but we are watching a technology stock market bubble burst. Yesterday I was forced to turn on the TV to get some market news as some worker for MCI in Oklahoma cut the fiber optic cable that gives me my DSL in Fort Worth from Birch. Go figure. But I heard a figure which I rushed to check. The tech stock component of the S&P 500 was recently as high as 32%. Today it is less than 20%. Tech stocks are down by 50%. Nearly all of the drop in the S&P 500 can be explained by the drop in tech and telecoms. Much of the rest of the stocks are doing quite well, or holding their own.
A client has asked me to manage their company's 401k, so I have had to go through the process of picking a reasonable number of mutual funds to put in their plan to allow their employees a sufficient choice. Most plans I see are woefully inadequate in choices, and assume investors only want to make one-way investments.
The process has been difficult in part because there are so many good funds from which to choose! Not surprisingly, the equity funds which have done well have an emphasis on value. There are quite a few that are up this year. I will mention some in later letters as we finish our research.
Where do we go from here?
So, as we start to drop back to see where we are, I find myself wondering if I am looking at a beautiful Monet which inspires me, or an incoherent Picasso from his Cubist period which I simply do not grasp.
I told you last January in my predictions that we would not be able to really tell anything about the direction of the economy until the end of the first quarter, and that is still true. We are going to have to drop back some more until the picture becomes clearer.
We are on the edge. It could go either way.
If we can start to see a turnaround in March or see some evidence it is on its way, the stock market (except for tech stocks) is probably near a bottom. When Greenspan cuts rates again, we will see a bounce if he does it before the March 20 meeting. If he waits, we could see a gradual rise in anticipation of the cut. Then, more worry will set in and the market will start back down waiting for more evidence of a turnaround.
If we begin to see evidence of a turnaround in our near future -- if the Greenspan Put (as his rate cuts are called) have their magic effect -- then the bull will be back in town, but a very different bull. For the next few years, this is going to be a value bull.
Here is the kicker. Confidence is critical to economic growth. Alan Greenspan is critical to consumer confidence. If he can talk or rate cut his way to a happier, more well adjusted consumer, then we will quickly rebound. That is why I want rate cuts this morning! It will make at least me feel better.
BUT, and this is a big BUT, if the evidence comes in that we are not in for a quick turnaround, then we have problems. If rate cuts do not change the concerns about "my job" then we have problems. Remember, the yield curve tells us that the real recession is not due until the third quarter. If it is over by the third quarter, it will give credence to Greenspan's claim today that the business cycle is much faster today than in the past. Maybe he is right. My hunch is that he is, as I can see evidence in a lot of sectors that things are happening at a much quicker pace than a decade or so ago. If the bounce comes quickly, we could see the S&P 500 at 1500 a year from now. Today will be seen as a buying opportunity.
But if he is wrong, then we will have to confront earnings problems not just in tech stocks but throughout the economy. In an average recession, the stock market drops over 40%. Investors turn gloomy.
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If we see a recession really picking up steam in the third quarter, we could see a drop in the stocks that have held up well. A 50% drop in the over-priced techs and a 20% drop in the rest of the market takes the S&P 500 below 1000 and maybe even approaching 800. The NASDAQ will drop to 1500. It will get ugly on Wall Street.
I really think the former scenario is more likely, but from today's view, you just simply cannot rule out the possibility of a longer recession and a serious drop in the markets.
Investor Sentiment is different from consumer confidence. The only way I can explain the high Investor Sentiment numbers is to use the Pavlovian analogy. Greenspan is ringing the bell and investors are salivating. They have been taught to respond to rate cuts, and are trying to buy the dips. If we see the economy respond soon, they will be the smart ones. If the economy does not respond, they will get hurt.
Last month, I mentioned that there was strong buying from mutual funds and that they must be getting huge inflows. January showed the strongest flows of money into mutual funds on record, although most of it (70%) went to money markets. Flows to mutual funds topped $140 billion last month, according to Thursday releases from New York-based fund consultancy Strategic Insight and Summit, N.J.-based fund tracker Lipper. (The firm's figures varied slightly.) For perspective, this inflow shattered the previous record of $86.9 billion set exactly two years earlier, according to the Investment Company Institute, the mutual fund industry's trade group.
But a substantial portion did go to the equity funds. Reflecting my view of a move to value, a higher percentage than normal is going into value and conservative income funds than usual, although growth funds still got more than value funds. By the way, almost 50% of the money which went into bond funds went into high yield bond funds. It seems that my view that high yield bonds can be solid performers as an economy comes out of recession is popular.
I keep thinking we are going to see a run-up in the market, either because of a rate cut or in anticipation of one. The market keeps disappointing me.
I would use the potential run-up hopefully coming soon to lighten up on any tech stocks or tech funds you own. I won't spend three pages making the same argument I have made before about tech stocks and Price to Earnings ratios, trees growing to the sky and so forth. You know my position. If you are on the sideline, I would stay there for another month. The downside risk is not worth the upside potential, and you won't miss much. There will be places to invest soon enough.
By the way, we track dollar flows for the last hour of the day. Lately, it seems like the big money is waiting to the last hour and then buying. The pattern is becoming very pronounced. I don't want to say conspiracy, but I do think there is some tacit group-think among the biggest traders that if they hold off buying until the end of the day, letting prices fall, they will benefit. Their strategy is working for them. For now.
Things will get Better - I Just Don't Know Exactly When :)
Whether the turnaround starts in a month or next year, the American Economic machine is a powerful one. While the immediate future is uncertain, the long-term picture will be quite good. We just have to be patient and pick our targets carefully.
That is why we are tracking the sector funds, letting you look at the shifting sands. Someday, we will shout all clear and start to actually invest in sector funds. But for now, volatility is too much.
If you are investing, you should have some system with stops. Our timing system does, let me assure you. If we hit our stops, it will frustrate the @#%$#@ out of me, but if you have a system, you must stick with it. I would rather lose a little now and still be able to stay in the game than keep hoping things will turn around. That is why so many lost so much in the Tech Wreck last year. Telling yourself you will sell when you get back to even is one of the biggest investment mistakes you can make.
We are still long high yield bonds, by the way, even though they are down a little less than 1% since the beginning of the month. It is not clear we are not getting a false signal from the bonds yet, but you should have a 2% stop.
30 year government bonds are jumping. I promise within the next month to do a letter on why interest rates on long bonds are going down. In my opinion, there is still plenty of profit left in long term treasuries.
The next issue will not be as pretty as my daughter and tech savvy assistant is going to Greece and Italy on vacation and Dad is going to have to send the next e-letter. It will also not be on the web until she gets back.
My heart and prayers go out to those of you who live or have family in the Northwest.
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Your still waiting for the bounce analyst,
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