May 2001

The Newtonian Market 

For Every Action There Is An Equal And Opposite Reaction...Newton's Third Law clearly describes the basic dynamics of securities trading, now doesn't it?  From a broader perspective, it appears that the Fed governors have pulled out their old high school physics books in the last few months and applied the Third Law with vigor to monetary policy decision making and execution.  For every act of real world economic deceleration in the recent past, there seems to be a violent reaction of monetary stimulus forthwith.  Much like the heightened volatility in the equity markets of late, the characteristics of monetary ease have been rapid and significant change.  Unlike any series of decisions in the entire Greenspan tenure.  The heightened physical properties of current monetary orchestration suggest greatly heightened stress.  A surprise rate cut 13 hours prior to options expiration that causes positive and negative derivatives atoms to collide into each other with such force that an extreme amount of emotional and financial energy is created.  A blatant attempt to create heat in what was once a thermo-nuclear equity market that now finds itself in the cooling stages.  A tremendous amount of spent monetary fuel in the last four months.  How long will the fuel now spent keep investors bathing in a sense of warmth?  How long before the Fed needs to again fire up the atomic financial particle accelerator?

The Acceptance Of Duality...We find it almost ironic that relative to the eternal quest for investment certainty, current economic and financial conditions display marked duality.  Maybe it's just the nature of the bear to create as much confusion and uncertainty among both bulls and bears alike.  It's clearly a time to stay focused on the facts beneath the headlines and be willing to accept that bear markets are characterized by trading emotion and volatility that are descriptive of human decision making.

The 1Q GDP report surprised a few folks in its strength.  After what has been a first quarter of 2001 filled with gloomy economic news, the 2% quarterly growth number came as a perceptual surprise celebrated by the financial markets...for a while:

Behind the headline, the party horns were not blowing quite as loudly.  A good chunk of the unexpected strength in GDP can be attributed to a large increase in government spending (salaries), a trade deficit that was narrower than expected (anyone watching the trade report last week already knew this), and the largest one quarter draw down in inventories since the last recession which was offset by what may prove to be temporary strength in consumer spending during 1Q.  Consumer spending that vaulted ahead of last year's 4Q number.

The first quarter of the year was marked by the fact that corporate capital spending continued to decline while consumer spending held up remarkably well.  Surprisingly well given the current reality of corporate cost reconciliation.  Coexistence.  Duality.  The yin and the yang.  Darkness and light.  The last time corporate capital equipment expenditures declined two quarters in a row was during the recession of 1990-91.  In stark juxtaposition to corporate spending trends, consumer purchases of new homes hit an all time monthly high in the latest report and sales of existing homes saw their second highest monthly sales on record.  Corporate America has hit the brakes while consumer America has hit the accelerator.

As you know, so much of what is happening in the consumer arena is predicated on the availability of credit.  The duality of the moment being that for much of speculative corporate America, liquidity has vanished from the scene.  Telecom companies breathing their last.  DSL carriers DOA.  Growth in commercial paper issuance is off 40% this year as the capital markets refuse formerly trustworthy borrowers whose balance sheet troubles have become bright PowerPoint presentations against an ever darkening economic projector screen.  Dotcom bankruptcies are a daily occurrence as VC, mezzanine and IPO money is increasingly discriminatory, to use words that are kind.  Not so for the consumer.  Credit available to the consumer is still a wide open spigot.  The latest numbers for revolving consumer credit growth simply speak for themselves:

Credit availability for consumer real estate activity flows like water in the streets.  The GSE's displayed significant balance sheet expansion in the first quarter.  Well above annualized levels of last year.  The facilitators.  Recently Countrywide Credit noted that March lending activity was close to $10 billion.  Their loan funding was up 89% over the like period last year.  It's not just new and existing purchases, but also refi activity that is quite strong:

57% of Countrywide's activity was for refi loans.  Their data also show that the bulk of refi activity was take-out financing (taking out cash, that is).

Lastly, auto sales in 1Q have not blown the lights out, but have continued at a decent pace.  The consumer did not back away from spending in the first quarter.  Why?  Most likely, the answer is that they still had paychecks and full access to credit.  In what is almost contradictory fashion, consumer confidence data revealed a sharp slowdown in confidence in 1Q accompanied by consumer responses of increasing reluctance to purchase autos, homes, and appliances.  Despite the sentiment, actions clearly spoke louder than words.  Will consumers continue to spend?  In like manner with the corporate world, surely credit markets will continue to cooperate (vis-à-vis incredible Fed accommodation) until consumer credit problems accelerate significantly.  Given the economic reality we see before us, we expect real consumer actions to catch up with the increasingly negative confidence with which they speak as labor markets continue to weaken.

Labor Pains...Increasingly the economic downturn seems like anything except a pregnant pause.  Fed governors have run around the nation in the last month or so proclaiming the validity of the impending second half recovery.  Greenspan continues to characterize the current experience as an inventory correction.  Investors have made a so far feeble attempt at trying to believe that with the latest GDP number.  Street strategists far and wide, who missed the entire last 12 month equity market downturn mind you, have "visibility" that we're just in a short few quarter inventory adjustment.  A buying opportunity for the strong companies.  As you know, at ContraryInvestor we try to keep it factual and simple.  Hence, simple question.  If this is a two quarter inventory correction, then why are corporate management's delivering the following message of their own?

The current announced layoff experience of the last three months has no precedent in US history.  It is now showing up in real unemployment claims numbers.  We've been convinced that the lag this go around has been due to the Warn Act (requires 60 days notice to laid off employees) that was not in effect during the last recession.  The Fed may believe it's a two quarter inventory adjustment.  The Street may believe it's a two quarter inventory correction.  Unfortunately, corporate managements are signaling that this is anything but a two quarter inventory adjustment.  After all, it makes absolutely no sense at all to dismiss the numbers of employees being handed walking papers today, given the significant costs in finding and training employees over the last few years, if second half 2001 economic recovery was to be realized.  It was only 12 months ago that Cisco was handing out multi-thousand dollar bonuses to current employees who found someone from the outside to join up.  Now this same company is in the process of getting rid of 20% of its workforce.  Corporate managements are telegraphing to us that they are simply scared silly that the current corporate profits recession will be much longer and deeper than the strategist folks on Wall Street or the Fed governors would have you believe.  For our investment dollar, we want to be on the same side of the table as corporate insiders.

No Tears And No Hearts Breaking, No Remorse...The growing change witnessed in the employment situation begs the question of the consumer's ability to continue to support economic growth ahead.  The Newtonian Third Law will be addressed at some point if corporate profits continue to sink in the mire.  Will the action of layoffs in the corporate sector cause an opposite reaction in terms of consumer strength relative to what has been experienced in 1Q?  We're about to find out directly ahead as the layoff process broadens as the corporate profits recession broadens.

The signs of recent economic weakness during this downturn clearly started with cracking in the manufacturing sector.  Likewise employment weakness as modern corporate management displayed new found "e-time" decision making abilities:

So far, manufacturing jobs have borne the brunt of employment reconciliation.  During the first quarter, 270,000 losses were announced.  To put this in perspective, the 270,000 quarterly figure is 70% greater than the experience of the six month period ended 12/31/2000.  Acceleration has become the name of the game.  At the moment, the absolute level of manufacturing employment seen is as low as anything we have experienced in the last thirty years.  The current experience is what historical recessionary periods have displayed.

Yes, we are a more service oriented economy today.  No question about it.  As you can see in the following chart, the growth rate in service sector employment has already been declining for a number of years.  Acceleration to the downside is increasing.  Again, the current experience is what we saw just as we pulled out of the last recession.  At that time the rate of change of the rate of change was positive.  Today it's about 180 degrees from that:

Lastly, the easiest group of all to quickly eliminate has been and continues to be eliminated quickly - temp employees.

Year over year growth in unemployment for this group is as high anything witnessed during this entire economic cycle.  The tech industry is taking a hatchet to temp employees, but it does not stop there.

To add salt to the open wound, existing employee compensation costs continue to rise.  Benefits paid are the major driver of this phenomenon:

Good for the employee, but bad for corporate profits.  It suggests that if there is no turn upward in corporate profits anytime soon, further layoffs seem all but assured.  In the recent report, average hourly earnings vaulted higher by an annualized 4.3%.  As you know, most CEO's would kill right now to show that kind of top line or bottom line growth.

The Yin and Yang duality of higher corporate layoffs and sustained consumer spending in the first quarter should be tested directly ahead.  Make no mistake about it, the immutable laws of physics as we know them have not changed.  The Newtonian Third Law will be served.  For every action, there is an opposite reaction.  In the meantime, the Fed will most likely do everything in its power to continue making liquidity available to the Street and the economy in general.  As we described in last month's discussion, we just can't see how the consumer has the ability to take on increasing debt burdens primarily to fund consumption while the reality of economic deceleration and layoff announcements increases.  Corporations are calling it quits.  So too will consumers?  Just stick around.  It's not long until we all have an answer.

Liquid Dreams...With physics books firmly in hand, the Fed is attempting to provide a counterbalancing reaction to economic weakness with not only rate decreases, but also monetary accommodation of a concurrent form:

Relative to any "crisis" we have experienced in the last decade, the Fed is pulling out all of the stops in terms of monetary largesse at the current time.  The "go with what you know" theory.  Clearly the gusher of liquidity that's hit the Street in general can find its way into stocks, real estate, or, God forbid for the economy, savings.  It's still a question mark as falling stocks hit the Fed's little science experiment of monetary Newtonian Law as to what happens to those stock prices and for how long.  In the real world, consumer spending and corporate capital spending will determine profits.  Stock prices are much more susceptible to liquid dreams.

The best we can do is leave you with perspective.  The largest bear market in US history was punctuated by seven very significant rallies on the way to a final conclusion.

Are we trying to imply it's 1929 all over again?  Of course not.  We are merely pointing out that short lived rallies are a part of what defines overall bear markets.  Volatility defines the bear.  Not linear action.

Crimes Of Passion...Although surprise Fed rate cut sniper attacks can cause incredibly violent stock price reactions, history cautions that one day manic moves in prices are not bullish by any stretch of the imagination.  Just have a look at the following table:
 

Notice anything?  Of course you do.  Nine of the ten top one day NASDAQ percentages gains occurred within the context of the worst bear market in NASDAQ history - the current one.  In fact, as you know, these moves have occurred within the greatest singular 12 month drop of any equity index in the entire history of the US.  

Yes, we know that market is currently very volatile.  And yes, the NASDAQ more volatile than most other indices.  Need more proof about one day moves?  Coming right up.  Have a look at the Dow:

Once again, nine of the ten largest single one day percentage up moves in the Dow occurred during the worst Dow bear market in financial history.  The so far historical experience of the NASDAQ and the Dow caution investors to beware of record setting one day percentage up moves in equity indices.  They have all happened at what seem the worst possible times to have been invested in the markets.  The record is clear.

We have often heard the buy and hold adherents argue their case in stating that investors cannot afford to be out of the market as they risk missing some of the biggest moves that occur in short spaces of time.  We bet some of today's buy and hold investors wish to God they would have missed the last nine record setting NASDAQ days during the last 12 months.  Oh well, maybe next time.