Ignore the pessimism on CNBC, Bloomberg, CNN, or me the last few months. Ignore the analysts and strategists on Wall Street. Did they advise us to get out when things were so ‘great’ in 2000? A few did, but they were the ones who were perennially negative. Listening to them would have kept one out of the greatest and longest bull market in history.
Economists and Wall Street analysts do not predict turns in the economy. They are focused on yesterday’s data. Experience tells us that they are much more likely to paint the future with the color of the last few weeks or months. In other words, they project well into the future, the experiences of the recent past. Corporate earnings and economic data reach their highs six months after the stock market does. Accordingly, the market will turn positive six months before the economy does. The market is one of the best forward indicators of the economy. Too bad the Fed doesn’t give it more credence.
It is understandable that this bear market has been longer and more painful than usual. It has been much tougher than 1987, 1991, 1994, or 1998, because of its duration and devastation. But, the circumstances leading up to it were, in hindsight, rather incredible. Manufacturers built into their normal production models some of the extreme demand created by the Y2K phenomenon. The Internet brought all kinds of promises, many of which will be realized, but not nearly at the speed we came to expect. The dot-com bubble was just silly and ended as quickly as it started. Our government’s clumsy, heavy handed, and often misguided efforts at regulating various key industries such as telecommunications, healthcare, and electricity have caused billions of investment dollars to flow elsewhere. I have long held that the heavy handed and overtly political manner in which the Department of Justice pursued Microsoft was the flashpoint of the bubble burst in March of 2000. The SEC, with its well-intentioned efforts to level the playing field by making information available to all, couldn’t have timed more poorly the release of Regulation Full Disclosure. The third quarter of 2000 proved to be a very difficult time for corporations, particularly technology corporations as they announced earnings disappointments. Their public comments were likely more negative and cautious than might otherwise have been. The effect of raw information being dumped into the public domain was to increase volatility in the markets more than had existed before. Finally, factor in an excessively tight monetary policy by our Fed and you have the ingredients for a whopper of a BEAR market.
Now for the Good News
August is historically the worst month of the year for markets. A study done by Jason Trennert of the ISI group reveals that over the last ten years, August is the worst month, in fact, it is the only month average that is down. October, given a bad name by the crash of 1987, actually leads the pack as the best year in performance with an average return of 1.85%. The past ten-year average for August is -.9%. One reason for the poor performance is no market volume. July and August have endured the weaker talents of the second string. Top investors, those who buy bargains, are on vacation during these months. Ask any salesman what his worst month is and you will most often hear August.
When the first string hits the field again, they will be especially energetic. At this moment there is more cash on the sidelines, relative to stock market valuation, than at any time in history. In percentage terms, the 2.1 trillion dollars, yes “$2.1 trillion!” represents 19.3% of U.S. equities, the highest relationship in the last 50 years. In the bottom of the 1990 recession the high reached 16.7%. The great bull market of the 80’s and 90’s began in 1982 with cash at 19%. Today’s investors will not be happy with the 3% return they get on money markets for long.
There are three classic stages of a bear market. The ‘Denial Phase’ certainly took us in. It occurred during March and April of last year. We looked for a reasonably short-lived market retreat to wash out the dot-coms followed by Fed easing and an obligatory recovery. The Fed never lowered and the market never really recovered. The next panic occurred October through December of last year when the major telecom companies and technology companies shocked the world by admitting that they too suffered the business cycle like all other companies. This period was the ‘Concern Phase.’ The bulls were concerned, but stayed in the game with the expectation that the Fed cuts that began in January of this year would surely turn things around in the next three to six months. It had happened that way 12 out of the last 13 times. This time proved different. A significant bubble had burst. These were not normal times.
The final phase is undoubtedly the most gut-wrenching for investors – the ‘Capitulation Phase.’ It’s the time when investors throw in the towel in huge numbers. A very good measure of daily fear or greed is the put/call ratio. The CBOE put/call ratio hit an unusually high 107% on August 17th. The last time it did this was in March of this year just before we saw the NASDAQ rally over 30%. Mutual fund liquidations out of equities are also at high levels. The individual investor is usually a good contra-indicator. He generally moves out en mass at market bottoms and does the reverse near market tops. Another encouraging fact is that the number of stocks making new lows has improved substantially since late March on both the NYSE and the NASDAQ.
A good friend from my Wheat days, Mr. Don Hays, shared a story in his newsletter from the January 14, 1999 issue of Forbes magazine by Marius Meland that bears repeating here. It provides an excellent historical comparison to the dot-com bubble we have just experienced. In the article he described the period of 1959-1962. “With the dawn of the space age, every electronics stock suddenly took off like a rocket on Wall Street, reaching valuation levels not unlike Internet stocks today (1/14/99). And just like a “dot com” can help an obscure offering surge into the stratosphere today, the key to a stocks success could often be found in its name in the 1960’s as well.” “I call it the tronics boom because these soaring stocks usually had some form of tron or tronics in their name.” Says Malkiel, citing such “trons” as Astron, Dutron, Vulcatron, and Transitron and “onics” like Circuitronics, Supronics, and Videotronics, as well as one company that, for good measure, put together the winning combination Powertron Ultraonics.” “Then, like now (1/14/99), the demand was huge but the IPOs were relatively thin, so the stock prices would soar at the launch.” “Investors argued that “tronics” stocks couldn’t be valued according to traditional methods because they represented a whole new era of the economy that was nothing like the past. Promoters entered the stage to talk the stocks up further. As a result, stocks soared to multiples of 50, 100, or even 2000 times earnings.” But in late 1962, “tronics” stocks and other growth issues came crashing down in a massive sell-off.” Don points out that “the pessimism that was reached when that bubble was burst, even with the threats of a major new nuclear World War overhanging the environment, was exactly the tonic that set the stage (for those able to buy in the midst of that pessimistic period) for a powerful bull market in the next four years. The Dow Industrials increased almost 100% from those 1962 levels.
I firmly believe that opportunity is NOW and that we are nearly through the pain. I have learned some very valuable lessons (I will share them in future letters). We have been vigilant for signs of recovery and believe they are mounting. Our economy is slower than it was that’s true, but we are still near what was deemed full employment just eight or nine years ago. Corporate profits have dropped quickly, but leaders are still making good profits. I have said previously that the recovery will likely begin in the ‘old economy’, but I now believe the turnaround will be sparked by America’s more dynamic corporations, those more likely found on the NASDAQ than the NYSE. You see, Moore’s Law has not been repealed by the bear market or by the government. Moore’s Law predicts that as integrated circuits get cheaper they get more capable. As they get cheaper they find and influence new markets. As they get more capable they find and influence more markets. The same cannot be said for automobiles, beverages, or entertainment. The inventory overhangs that have plagued the technology sector low these many months are increasingly less relevant because technology makes that inventory obsolete within a year or two anyway. The semiconductor manufacturers have told us they see improved conditions coming this quarter. George Scalise, president of the Semiconductor Industry Association, in an interview with Bloomberg News last week said the semiconductor industry’s inventory “is going to be largely in balance as we go through this quarter,” said. “We think the demand for our products is going to increase dramatically” toward the end of the year due to holiday-related consumer demand, Scalise said. That means that sales will be poised to increase by 20% in each of the next two years after probably falling 20% this year, he said. Semis usually lead the way. This recovery should be no exception.
Stay tuned and have a great Labor Day weekend.