Demonstrators have guts

You have to hand it to the demonstrators that came out to voice their displeasure against the on-going terrorism in Iraq.  I’m not sure what it will do, but it seems that if they’re willing to demonstrate, they’re willing to fight to create a better future for their country without having US troops hang around for the next 50 years.  Its a small point but I think it might be an incremental positive for the news flow, which has been unbelievably negative for the past month. 

From the AP report… "Thousands of mostly black-clad Iraqis protested Tuesday outside a medical clinic where a suicide car bomber killed 125 people a day earlier, braving the threat of another attack as they waved clenched fists, condemned foreign fighters and chanted "No to terrorism!"

I am afraid there might be a suicide bomber among the demonstrating crowd," said 30-year-old Ahmed al-Amiry. "It’s very possible."

But anxieties over another attack did not prevent more than 2,000 people from gathering outside the clinic Tuesday, shouting "No to terrorism!" and "No to Baathism and Wahhabism!" and demanding the resignation of interim Prime Minister Ayad Allawi.

Wahhabism was a clear reference to foreign fighters who are supporters of al-Qaida and adherents of the strict Wahhabi form of Islam, which is the version practiced in Saudi Arabia. The Jordanian-born Zarqawi, the country’s most feared terrorist, claims to be affiliated with Osama bin Laden’s organization. "

NYA already hitting new highs

While a lot of analysts and traders are pointing out that the sentiment isn’t quite as pessimistic as you’d like to see it at good market bottoms, I think you have to keep in mind that positive sentiment in a strong market isn’t that unusual. 

It’s only when sentiment reaches a positive extreme is when it becomes a problem. 

Despite all the consternation of whether the S&P or Industrials can break out to new highs, the broader NYSE Composite (NYA) has already hit new highs.  Overall, I can’t see that as a bearish sign.  I would expect the S&P 500 and Industrials to follow the NYSE Composite. 

Nyse_composite

And the Russell 2000 was hitting new highs last year…

Russell

The trend is coming to an end

One of the ways I know a market or economic trend is maturing is when every investment idea is looked at through a "themed" prism.  The classic case of this was during the late 1990s when everything from fish-oil companies to stodgy newspaper companies were looked at as an "Internet Play".   How Mario Gabelli could pitch Reader’s Digest as an internet play on CNBC still astounds me?  I lost all respect for his investment ideas the day he made that pitch. 

Today, everything is being looked at through the "real estate" prism.  After the success of Kmart, everyone is looking for the hidden real estate value in stocks.  Lots of companies have undervalued real estate on the books but few of them will ever unlock it.    It’s like my family’s home which has doubled in value over 5 years – I could sell it, but then what?  I’d have to go buy a more overvalued house somewhere else.  Kmart could sell all of its real estate but then it wouldn’t be a retailer, now would it?   I don’t think that’s what Eddie Lampert has in mind.  Similarly, Saks could sell it’s flagship store in mid-town NY for some absurd value – probably at 1/6s of the stock’s $2 billion market cap.  But then it would loose part of the cache that makes Saks, Saks – it would just be another high end department store. 

I have been pitched everything from REITs (duh!) to Winn Dixie (are run down grocery stores in the middle of nowhere worth anything?) as a real estate plays.  This says to me that the real estate bubble is coming closer and closer to a top. 

Kondratieff for Investors

I believe you have to build mental models to help you understand the investment environment and one of the mental models I rely upon are business cycles. 

“Austrian School” economist, Joseph Schumpeter, classified the following business cycles and their duration:

Kitchin – 3 years

Juglar – 9-10 years

Kuznets  – 15-20 years

Kondratieff – 48-60 years

Currently, I believe the “Long Wave” or Kondratieff cycle is having the largest impact on financial markets. 

In studying economic or technical indicators, I find it helpful to go back to the original source of the information to get a first hand understanding of the material.  Several internet sites are peddling the idea that we are in a Kondtratiev “Winter” which will be marked by the coming financial Apocalypse.   While this interpretation probably sells newsletters, I believe it presents a distorted picture of the Long Wave and what it means for the financial markets. 

Download The Long Wave.pdf (784.7K)

First, Kondratieff never mentioned seasons in his 1926 work “The Long Waves In Economic Life”.  The ideas of a Kondratieff Spring, Summer, Fall and Winter, while clever, are not really representative of Kondratieff’s theory. 

Second, Kondratieff’s observations of “long-term” economic waves started with his empiric observations of economic and price data.  He then postulated his theory based on the observed data.  It seems to me that many economists today are starting with the theory (48 to 60 year long term economic cycles) and are trying to fit the data to the theory. 

Finally, Kondratieff never mentioned stock prices or overall levels of economic debt in his theory.  He based his observations on economic data, commodity prices and interest rates.  Therefore, I’m uncertain as to whether you can draw direct conclusions on the direction of stock prices based on the Kondratieff wave.  In addition, several economists argue that the world cannot be in the beginning stages of an upswing because the total levels of debt were never “cleansed” out of the economy.   While an interesting argument, Kondratieff did not mention debt levels and therefore, I believe this has little bearing on where the economy stands in the long wave. 

Kondratieff_waves_2

Kondratieff made five empiric observations about the Long Wave in economic cycles.  I have taken the following quotes from a translated copy of the 1926 article “The Long Waves in Economic Life” by Nikolai Kondratieff.   

1)  “Our investigation demonstrates that during the rise of the long waves, years of prosperity are more numerous, whereas years of depression predominate during the downswing.”

If you look at US economic growth since the 1970s you might believe that this observation is incorrect since the US has suffered relatively few severe recessions.  However, as Marc Faber wrote in “Tomorrow’s Gold,” after the 1973/74 recession in the United States, the world has experienced more severe recessions and relatively weak recoveries.  “We had, after 1981, a depression in Latin America that lasted until the late 1980s (a depression combined with high inflation), a relatively severe global recession in 1982, the Japanese economic downturn after 1990, the post-communist economic collapse in Easter Europe and Russia, anemic growth in Europe following the 1991 recession and, more recently, first the extremely intense economic downturn in Asia, and in 2001, the slowest growth rate for the global economy in 30 years”.

As an aside, I think the fact that the US has avoided a major depression during the past 20 years speaks volumes about the success of Lazier Faire economics with some moderate government intervention.  Only in the 1970s, when President Nixon instituted price controls on energy and took the US off the gold standard, did the economy truly enter into a severe recession.

2) “During the recession of the long waves, agriculture, as a rule, suffers an especially pronounced and long depression.” 

Marc Faber makes a convincing argument that energy has taken the place of agriculture as the driver of the economy and therefore should be relied upon as the market for the beginning and end of the Long Wave.  Again, from Tomorrow’s Gold.  “Whereas wheat, corn and cotton were the most important commodities in the 19th Century, crude oil is now by far the most important industrial commodity in value terms and as a cost factor in industrial societies.” 

Therefore, if we replace agricultural prices with oil prices, we can see that energy commodities have truly been in a price “depression” during the downswing, just as Kondratieff described.  Aside from the spike in 1990 because of the Iraq war, oil has been in a basing pattern for the greater part of the 1980s and 1990s.  If we assume that the Kondratieff wave bottomed in 1998 – 2003, the current steady rise of oil prices makes sense, as does most analysts skepticism toward the sustainability of rising prices.  During the down wave, oil prices always made new lows after a run up.  However, at the beginning of this new up wave, oil prices will unlikely see the $20s again. 

Oil_1983_2005 

3) “During the recession of the long waves, an especially large number of important discoveries and inventions in the technique of production and communication are made, which, however, are usually applied on a large scale only at the beginning of the next long upswing”

Of all of Kondratieff’s pronouncements, I believe this is the most enlightened.  If 1974 to 1998 represented the downwave of the long wave, the development of the personal computer and subsequently, the Internet falls right into Kondratieff’s pronouncement.  One can take issue with the statement “applied on a large scale” arguing that the US has already applied this technology on a large scale.  However, if you take a world-wide view, the adoption of the PC and internet have only truly begun. 

4) "At the beginning of a long upswing, gold production increases as a rule, and the world market for goods is generally enlarged by the assimilation of new and especially of colonial countries"

Both these observations, gold production increasing and the world market enlarging, are currently being fulfilled.  I believe they are clear signs that the Long Wave has bottomed and is currently in a new upswing. 

Gold_1990_2005

The assimilation of China and Eastern Europe into the world economy will be a constant theme throughout the next decade as well.  This phenomenon is already well covered and understood. 

5) "It is during the period of the rise of the long wave, i.e. during the period of high tension in expansion of economic forces, that, as a rule, the most disastrous and extensive wars and revolutions occur. "   

I’ll quote Marc Faber one more time since he so succinctly states his case:  “It is interesting to note that the French Revolution, the Napoleonic Wars, the European revolutions of 1848, the Crimean War, the American Civil War, the Franco-Prussian War, the Russo-Japanese War of 1904, the First World War and the February Revolution in Russia all took place during the rising wave of the long cycle.  An exception was the Second World Ware, which took place right at the end of the downward wave of the third cycle or the very beginning of the fourth cycle….However, since the downward wave began in 1980, we have had only contained confrontations that did not have  worldwide economic impact.”

Several current or potential wars have the potential or already have a  “worldwide economic impact”:

1)    George Bush’s drive to rebuild the Middle East into a capitalistic and democratic society

2)    China’s assimilation of Taiwan

3)    North vs South Korea

4)    President Putin’s desire to re- nationalize Russia’s economy could turn into a coup or revolution

I believe one or all of these conflicts could evolve into World War.  Already numerous governments stand on one side or the other of these conflicts and as these relatively minor infractions escalate, the world could face “disastrous” wars as Kondratieff suggests.

I have quoted Marc Faber extensively because I believe he has done an excellent job in bringing the existence of economic long waves back to the forefront.  However, I think he errs in one key judgment – in “Tomorrow’s Gold” he states that the Kondratieff wave is still in the downswing.  But given the strong rise in gold and oil prices, the assimilation of China and Russia into the world economy, the increase in serious conflicts around the world and the increase in inflation – I believe investors can only draw one conclusion – the long wave has bottomed and is currently in the beginning of an upswing which will top out in 2020 at the earliest. 

I’ll ellaborate on what the upturn in the Long Wave means for investors in follow up posts. 

You can’t make this stuff up…

File this under the "You can’t make this stuff up" category. 

Home Depot’s Board thanks Tom Ridge for making the company’s first quarter of 2003 by voting him onto its board of directors.  In February 2003, the Department of Homeland Security (led by Tom Ridge at the time) directed Americans to find some "duct tape and a secure room and a couple of gallons of water to tide you over for a day or two in the event" of a chemical attack.   I still remember the pictures of frantic shoppers at Home Depot loading up on duct tape in hopes of saving themselves from the impending chemical attack. 

This of course led to the "Duct Tape Bottom" in the stock market in March of that year.  It’s one of the all-time great panic bottoms in stock market history. 

Duct_tape_bottom

And I thought the Dick Cheney – Halliburton connection was suspect.

As my favorite comedian, Lewis Black, has said "Our leaders could have calmly stood up and told everyone ‘This is a difficult time for all of us but if we all act sensibly, we’ll get through this together’.  Instead, they yelled ‘Aaahhhhh…we’re all gonna die….buy some duct tape and plastic wrap and hide in the basement!!!!’"  It’s akin to telling schoolchildren to hide under their desks in case of a nuclear attack.

Anyway, if I were long HD, I’d reconsider holding the position.   I’ve never been a big fan of Robert "Jack Welch wanna-be" Nardelli nor Home Depot’s competitve position relative to Lowe’s.  This just solidifies my negative view on the stock.

Why do I know….

Here comes the warm machine
Such a warm machine
This is the life
This is the sound
Here comes a warm machine
Such a warm machine

— Bush "Warm Machine"

Lots of blog posts start with a deep and meaningful lyric.  However, I have found that many things in life are meaningless and non-sensical…like the lyrics to any Bush song.  It’s these stupid pieces of information that seem to take up room in my brain and crowd out information worth knowing such as my wife’s birthday. 

With that, it’s time to play…

Why Do I Know….

That this man’s name is Joel Appel…and why do I have his products in my house?

Oxiclean_6    

That Lionel Richie’s adopted daugher’s name is Nicole?

Nicole2_1

That Jason Giambi injected steroids into his buttocks?

Giambi_1

And why do I still know all the girls names from Lou Bega’s Mambo #5?

Lou_bega_1

A little bit of monica in my life
A little bit of erica by my side
A little bit of rita is all i need
A little bit of tina is what i see
A little bit of sandra in the sun
A little bit of mary all night long
A little bit of jessica here i am
A little bit of you makes me your man

Large Cap Growth Lags

I’m not the first to bring this observation but when I ran the statistics for year end 2004, I thought this was worth pointing out again.  Large cap growth has underperformed by a mile compared to all other equity styles. 

Large_vs_small_chart_4

Source: Stockcharts.com
Despite the relatively good fundamentals relative to other asset classes…
 
FIVE YEAR FIVE YEAR EARNINGS
HISTORIC HISTORIC GROWTH RETURN % OF LT NET
REVENUE EARNINGS 2005 VS ON DEBT TO PROFIT
GROWTH GROWTH 2004 EQUITY CAPITAL MARGIN
RUSSELL 2000 2.0% 52.0% 11.4% 30% 2.8%
S&P MIDCAP 4.0% 7.0% 18.0% 13.1% 30% 5.9%
S&P BARRA VALUE 1.0% 1.0% 10.0% 14.3% 39% 7.4%
S&P 500 2.0% 2.0% 6.0% 17.4% 33% 8.5%
S&P BARRA GRWTH 6.0% 5.0% 12.0% 25.3% 26% 10.7%

The large cap growth stocks are trading at 5 and 10 year valuation lows…

10 YEAR PRICE TO PRICE TO 2005
PRICE TO AVERAGE EARNINGS EARNINGS P/E TO
EARNINGS PRICE TO RELATIVE TO RELATIVE TO LONG TERM DIVIDEND
2005 EARNINGS 10 YEAR AVG 5 YEAR AVG GROWTH YIELD
RUSSELL 2000 25.8 30.6 0.9 0.8 1.5 1.1%
S&P MIDCAP 18.3 20.4 1.0 1.0 1.2 1.0%
S&P BARRA VALUE 14.8 17.6 0.9 0.9 1.4 1.9%
S&P 500 17.5 21.3 0.9 0.9 2.9 1.6%
S&P BARRA GRWTH 20.3 26.7 0.8 0.8 1.5 1.3%

Source: Baseline

Obviously, the strong performance of large cap growth in the late 1990s contributed to the current underperformance.   

And you can take umbrage with the idea large cap growth stocks are "cheap".   At 20x earnings, the stocks are not cheap in an absolute sense.  And the average 10 year Price to Earnings ratio of 26x reflects the fact that large cap stocks haven’t really been cheap for the past decade.  However, they are cheap relative to other equity classes, especially small cap stocks. 

Therefore, if you believe the market will hold together at these levels, I think large cap growth stocks are your best bet to outperform the indexes over the next two to three years. 

The Greenspan Put

Lehman Brother’s incomparable Jim "Fists of" Furey has some interesting comments out this morning on rising interest rates and their effect on small cap stocks:

"We believe Euro-area & Japanese weakness demonstrates what happens to industrialized economies when they do not pursue stimulative policies.  It is our view that should the Fed tighten more than another 100 bp the US economy will suffer as a result of the absence of US demand amplifying Euro & Japanese weakness….Our point: the (yield) curve’s behavior, further tightening & soon to emerge talk of Greenspan’s replacement raises small-cap risk."

Once again, numerous commentators are expounding the benefits of rising short term rates – "it’s a sign of strength in the economy", "rates are still relatively low", etc.   However, I think in an environment of rising global tensions, high oil prices and potentially higher taxes, adding higher interest rates to the mix is a definite drag on growth. 

Balancing against those negatives, Jim also had some interesting comments about Chairman Greenspan…

"Current stock prices reflect actions nine to twelve months forward and Greenspan’s replacement will be front and center in late summer and early winter.  Traditional risk
and inflation expectations measures indicate that investors are confident Greenspan’s successor will be every bit as competent as Greenspan in maneuvering markets, psychology, and the global economy and we are not so sure that as summer approaches that will be the case, particularly if the US weakens and follows other industrial economies."

A quote from Doris Kerns Goodwin is probably very apt in this circumstance…"Once a president gets to the White House, the only audience that is left that really matters is history."  Similarly, Greenspan understands his place in history as presiding over the greatest post-war economic expansion in history and won’t do anything to damage it.

I think the "Greenspan Put" will be in full effect over the next two years.  It’s improbable to me that Greenspan is truly in "auto pilot" mode when it comes to raising short term rates.     I think the Federal Reserve will stop raising short term rates before the yield curve turns negative.  And this should be a positive for stocks.   Therefore, any serious corrections over the next twelve months should be bought, in my opinion. 

However, once investors start looking to a future without Greenspan, the market could face some problems.  Call it the "post-Jack Welsh hangover" – Welsh managed earnings to a tee to ensure General Electric (GE) stock stayed relatively high until his retirement in 2001.  However, once he left, Jeffrey Immelt was left holding the assortment of low-growth financial businesses that took him three years to re-align.  I think a similar fate could fall on the market as a whole as Greenspan enters his final year in 2006.  However, until then, I think Greenspan will make sure his "Maestro" legacy remains in tact.   

Some signs that you should double check your investment thesis on a stock:

Some signs that you should double check your investment thesis on a stock:

  1. The male senior executives wear more jewelry than your wife or girlfriend.  This should be an obvious one – if I see pinky rings, gold bracelets, or $20,000 watches, I’ve already lost interest in what a management team has to say.  I want my executives to have enough confidence in themselves that they don’t have to flaunt their success.  I want executives who think about how to improve the business, not how big their bonus is going to be next year.   
  2. Small companies that have a lot of “me-too” competitors.  In every niche market or new industry, usually three or four small cap companies will come public around the same time.  They will all experience some level of success until a larger company comes in and dominates the market with their scale and capital.  Or, the small companies will all gain fragments of market share until they stop growing because the market isn’t big enough to interest larger competitors.   Either way, it’s a lose-lose situation unless you time your entry and exit perfectly.
  3. The company is based in North Carolina.  North Carolina is a fine state and the legislators have done a great job of turning it from a furniture manufacturing state to a high tech power.  However, investors who fund companies headquartered in North Carolina often find they have invested in a soap opera, not a successful business.  Cree’s (CREE) co-founder turned out to be mentally ill brother who thought the family was trying to kill him.  Krispy Kreme’s (KKD) ex-CEO cross-owned several company franchises with his ex-wife.  AAI Pharma (AAII), which has suffered through broken merger agreements and financial restatements, has had a turnstile installed in the executive offices.  CEOs have even been replaced because of severe bouts of pneumonia. I could go on but I will spare you my dislike of investing in the Tar-Heel state. 
  4. Senior executives who openly thank Jesus for their business success.  Don’t get me wrong…but businesses are meant to make money, not be a tribute to God.  That’s what church is for. 
  5. Senior executives pay has a material impact on EPS.  My yardstick is Microsoft.  Steve Ballmer and Bill Gates each pay themselves about $900,000 a year in salary.  Let me repeat that…two of the richest men in the world pay themselves less than $1mln a year – the rest of their wealth came from options or stock ownership – in other words, from making shareholders rich, too.  If an executive thinks he deserves more salary than two of the most successful executives of the past decade, then he better have a darn good reason for it.  This is doubly true for small cap stocks where executives should be compensated with equity growth rather than cash.