January 2001

THE CURVE BALL

The Curve Ball...We view the US Treasury yield curve in the current environment as an important barometer of sentiment and expectations.  In our minds, a bit more sane barometer than the stock market at the moment.  As you know, we have lived with an inverted yield curve in the US markets for some time now.  When the inversion appeared in 2000, many of the bulls simply laughed off the potential message in the curve of an impending economic slowdown.  After all, it was a new era, wasn't it?  In hindsight, the Treasury curve was a correct indicator of the fundamental reality that was to come.  So what about the current curve and what it may be saying?

Now that Greenspan and friends have begun waltzing the Federal Funds and Discount rates down the slippery slope of ease, the juxtaposed forces of slowing corporate earnings and monetary loosening have been thrown into the WWF grudge match ring of investor perceptions and ultimate investment decision making.  The way things are going, it promises to be a fight to the death.  Will the power of positive thinking driven by the perception of "monetary easing cures all" win the day?  Or will the market be dragged down in a negative perceptual spiral of a fundamentally slowing economy and swiftly declining corporate earnings growth?  As we are sure you are well aware, these are the forces that will be reconciled in this new era bear market.  (For those of you that have been around for some time, you already know that these are the same forces that are reconciled in virtually all equity and real economy bear episodes.)

The current shape of the curve as of midday today is as follows:

Excluding the 30 year for the moment (given its diminished role in the current history of modern man), the yield curve is inverted out to ten years.  As we are sure you know, the bulk of UST's outstanding are really at the shorter end of the curve.  That is where we place importance and the message of inversion is loud and clear.  Another 50 basis points of Fed ease will still leave us with a flat to inverted curve.  Another 100 basis points of ease with leave us with a flat curve at best.  We are going to have to drop short rates another 150 basis points to get some semblance of a minor positive slope in the curve, assuming all else is equal.  The yield curve is currently betting on the side of further economic weakness to come.  The yield curve is betting that the Fed's work is far from over.  Is the message of the yield curve that corporate earnings are bottoming near term?  Hardly.

It has been the market's history that as Fed easing has continued in each recessionary easing cycle, the yield curve has returned to a positive slope with easing action subsequent to the first round.  It's really out in the second or third easing where the curve begins to slope upward either through the lowering of short rates or the yield increase (price sell off) in mid to longer dated maturities (as, academically, future growth and anticipated future inflationary pressures begin to be discounted).  At the moment, we are no where near that point.  Conceptually, a positive slope in the UST yield curve is found in a market that is expecting or anticipating a better economy ahead, and hence, better corporate earnings.  Over the near term, it appears that the only way we are going to realize any positive slope in the curve is either by a massive (panic?) short rate reduction by the Fed, or by a significant sell off in most all parts of the current Treasury curve.  It's either one or the other.  We would not consider either a positive near term.

How Low Can You Go?...In terms of Fed easing, that question remains to be seen as the economic slowdown unfolds ahead.  Just like Greenspan's financial bubble that can't really be detected until it bursts, it's often difficult to pinpoint an academic recession with precision until it has already started.  With the incredible deceleration in the economy in the last few months, it may already be here, or the downward trajectory of the economy may have us there in short order.  Clearly, there still remains a chance we don't go there at all, at least in strict definitional terms.  Whether we do or we don't, we thought it would be instructive to have a peek at what has happened to the Fed Funds rate in each of the recorded recessions of the past thirty years.  What is becoming consensus wisdom on the Street now is that the Fed will simply keep lowering rates as much as is needed to avoid recession or kick start the economy back on the upside.  Here's a brief review of recessions past:

As can be seen, Fed Funds rate reduction from top to bottom was pretty dramatic in each of the last four recessions. An aerial view of Fed Funds history and changes in each recession can be seen graphically below:

On average, the Fed Funds rate has dropped approximately 63% during recessions over the last four decades.  Admittedly, in every recession, Fed Funds peaked at a level much higher than we have experienced today.  If we do go into a recession and the Fed were to drop the Funds rate an amount equal to the average of the last four recessions, short rates would be destined to bottom at roughly 2.4%.  Hard to imagine, isn't it?  It would be a new low in Fed Funds not seen in over 35 years.  If we really experience a drop this significant, we'd have to guess that the US economy (to say nothing of the global economy) would be one sick puppy.  Alternatively, in sympathy with our earlier comments on the perceptual investment struggle between declining corporate earnings and monetary easing, an ultimate travel distance to a 2.4% Fed Funds rate would suggest to us that corporate earnings growth is currently precariously balanced with one foot off the cliff.

No one knows how low is low until we get there, right?  You can be sure, though, that along the way certain roadblocks will pop up now and again.  Roadblocks such as the following:

We won't dwell on the dollar as the potential saboteur of lower interest rates ahead except to say that current Street strategist commentary suggesting the Fed will simply cut rates continually until domestic economic growth is assured seems a bit cavalier, don't you think?  We find statements like "We believe the Fed will do whatever it takes to keep the US economy from going down the tubes" a bit short of historical perspective.  A bit shy of the assessment of global flows of capital driven by currency movements and differentials at any point in time.  At minimum, we would prefer to insert the words "try to" between the words "will" and "do" in the above quote.  Oh well, just the hard core realist in us.

One quick tangent.  The chart of the dollar above currently finds the trade-weighted dollar being supported by the fact that the Yen is dropping like a rock.  We'll have more to say on this in the weeks ahead, but Japan is not looking good as it careens towards the runway of its fiscal year ending in March.  Just this week, Japan's 3Q GDP (quarter over quarter) was revised down from .9% to (4.0%).  Additionally, it was reported Tuesday that November household spending declined (1.3%).  That's two months in a row now of spending decline.  Can you imagine domestic investor reaction if these numbers characterized the US economy?  Ten years of lower interest rates have done nothing to spark Japan's economy.  Almost like a third world or emerging country, Japan is now reduced to currency devaluation as what seems a desperate economic measure/policy?  Suffice it to say that this isn't a good thing.  For Japan or the global economy.  We're just so lucky to live in a country where the Central Bank can always cure any economic problem. Can't it?

Climb Every Mountain...The Fed Funds rate table above is some pretty dramatic testimony that it took a lot of monetary juice to right the economic ship in prior US recessionary periods.  A lot of juice.  We will admit that for certain reasons, this time around may be different.  Here are the certain reasons:

In the early 1970's and the early 1980's household debt levels were much lower than today by a number of different relative measures.  As you know, we are not using absolute dollar "shock value" numbers here.  To keep ourselves honest, we are showing you debt relative to GDP and household disposable income.  As you know from our prior discussions, the numbers come directly from Federal Reserve reports.  We have manipulated or adjusted nothing.  Even as late as the early 1990's, debt levels were much lower than today.  As you can see in the table, the need to drop the Fed Funds rate surrounding the early 1990's recession was the most dramatic in percentage terms in the thirty year spread to date.  Will the American consumer magically lever anew as interest rates drop?  That is the $64 question.  Well, in the case of the current stock market, it's now the $13 trillion question.

Although we have not seen a whole lot of chatter about it, domestic US consumer credit numbers were reported on Monday.  For November, consumer credit growth registered a 10.25% annual rate, up from 7.5% in October.  Despite the preponderance of the month over month increase being driven largely by non-revolving items, we find it quite curious that auto makers have recently reported such glum news.  Likewise, on the back of this kind of consumer driven credit growth increase we have one of the worst Christmas retail sales growth periods in years?  God forbid consumers are levering up to pay the gas, electric, and food bill.  And lower interest rates are supposed to accomplish what here?  Help us people.

We'll end this little segment of the discussion by simply saying that the UST yield curve just may be yet another indicator by which to judge the potential future health of corporate profitability growth.  Clearly, currency movements, changes in inflation perceptions, etc. can wreak havoc with the curve over short spaces of time, but these elements also effect corporate profits in the final analysis.  Watch the curve so you won't be taken by a stock market curve ball surprise.

Do The Wave...Otherwise known as "The Death Of (Buy And Hold) Equities".  We've been meaning to bring this up for some time and now seems as good a time as any.  In fact it is a theme we may be harping on for years to come.  We'll just have to see what happens.  If the history of human decision making is any guide, we just may be in for a period when the buy and hold mentality needs to be discarded for a while.  And just when the popular media pretty much has the American public convinced that buying stocks and holding for the long term is the only way to go.  Wouldn't you just know it?

When we look back at periods that in hindsight can be described as the collapse of stock fever or stock mania, the period to follow is usually characterized by rolling waves of investor optimism and pessimism.  Drivers of this characterization are the human emotions involved in the process of the breakdown in the ultimate confidence in equities, the desire to "get one's money back", not wanting to miss the next up cycle, etc.  You know, being human.  It's the process of confidence destruction we have alluded to time and again.  This type of environment usually ends once market players are simply worn out and most have departed the game.  Along the way, history teaches that it has been imperative to trade in order to make money.  Not day trading, but rather trading the up and down waves of optimism and pessimism.  Trading sectors that come in and out of favor in what seems more rapid fire fashion.  Who knows, in today's world of instantaneous gratification and decision making, maybe this entire process will happen in digital time.

Let's have a look at memory lane.  The first chart may be a different market.  Different culture.  But, it was driven by the same human being character actors we find here at home.

The chart of the Nikkei is simply self explanatory.  Trading was the only strategy that has worked in Japan in the last decade, post the collapse of the bubble.  In fact, it may be just now as the Nikkei heads toward a more than decade long low that the Japanese bear market drama is reaching a chilling climax.  This remains to be seen, but would not be inconsistent with the human history of secular bear markets.  The 1968-1982 period in the US is a bit different than the Japan experience (1929-1939 in the US is closer to the Nikkei in characterization), but there was a 14 year pausing process (admittedly widely swinging) that played out after the secular bull market of the 1950's-mid 60's.  It was a period where point-to-point, the S&P went nowhere.  Once again trading was the only strategy for wealth accumulation, outside of collecting dividends, of course.

We suggest you be open to the idea that we may be in for a period of market activity where trading and market timing become quite important in the years ahead.  Again, we do not mean day-to-day or week-to-week, but rather over periods of quarters and years.  Being the wonderful contrarians that we are, our job is to try to shed light on sector attractiveness or caution as well as cyclical turning points for the indices (and capitalization tiers) as a whole.  Much easier said than done, but we'll give it our best shot.  Be open to the prospect that buying and holding equities in the next half decade or so may be an experience in frustration.  Before it's over, we have the feeling you will be sick and tired of us referring to this concept.  You have been duly warned.

Lunatic Fringe, I Know You're Out There...Well, well.  Three up days in the NASDAQ in a row.  Big institutional "get back in" sign.  Right?  So what if Nokia blew.  So what if Chambers effectively pre-announced and described Cisco as not exactly knocking the cover off the ball.   Motorola in a slump?  No big deal.  Yahoo, Shmahoo.  Tech earnings reports aplenty next week.  Go ahead.  Disappoint us.  We dare you.  Eeenie Beanie, Chili Beanie, the charts are about to speak.  The NDX and the NASDAQ are pushing the top end of their respective downtrend channels.  Thanks to Tim for the following:

The NASDAQ is displaying similar characteristics:

A bolt of lightening to the upside should surprise you not.  Really, it would be typical bear market action.  Remember, investing is not about the maximization of return.  Successful investing is about the MANAGEMENT OF RISK.