November 2001

Stool Pigeons 

You Can Tell It Goodbye!...For the second time in the same season, two Bonds' have established records.  Both Barry and the 30 year Treasury Bonds are big news.  For one, it's homerun history and for the other, the side is simply being retired.  Possibly for good.  As you know, Treasury Undersecretary Peter Fisher announced that the US Government will simply stop issuing 30 year debt.  The ho-hum reaction was just the largest one day up move in long bond price since 1987.  Nothing special.  In broader terms, all maturities of longer dating, especially the now more perceptually important 10 year, rallied nicely.  There is no question that this move was directly intended to force long yields lower.  After all, just how many consumers or corporations can borrow at the Fed Funds rate?  That's right, none.

Fisher was quoted as saying, "Looking out to the future we saw we just didn't need to be borrowing money this far out on the curve.  And it's a pretty expensive financing device to keep doing".  Expensive?  We guess it depends on your perspective.  Here's ours:

Right after the release of the NAPM number, the thirty year Treasury yield was within four basis points of all time lows put in during 1998 and the ten year Treasury yield broke the 1998 lows.  So in addition to the real economy doing it's part to dampen expectations of growth and coincidentally boost bond prices, the Treasury deemed fit to throw a little gasoline on an already lit fire.  

So what does the Treasury announcement really accomplish?  It's a direct effort to stimulate vis-à-vis the rate mechanism.   But this time via pushing down longer dated rates.  As you know, mortgage rates in this country are largely tied to the ten year.  With a forty basis point drop in ten year yields over the last month or so, the following may be in for another run to record territory:

Just in time to help an ailing consumer faced with substantially increasing layoffs, significant moderation in personal income growth and resultantly putting the brakes on personal consumption.  We're sure it's simply a mere coincidence that the Treasury announcement came on the very day of the official 2001-2002 US recession kick off (first quarterly negative GDP reading).  Likewise, one day in front of one of the worst NAPM (National Association of Purchasing Managers) reports in a decade.

While the US is embarking on long dated fiscal spending plans, anecdotally witnessed by the $200 billion ten year Lockheed contract this week, it will be shortening its financing activities.  Spending long and borrowing short.  Potentially mismatching assets and liabilities.  Interest payments becoming much more sensitive to the vagaries of short rate movements.  More sensitive to the ultimate ebb and flow of global capital movement over time.  The Treasury plan to eliminate 30 year bond issuance is an implicit bet that the US will not embark on anything more than temporary deficit spending.  That shorter dated rates will stay low for the foreseeable future.  That the dollar will remain strong relative to it's global competitors.  And that the US will continue to be the beneficiary of global capital flows, or at worst, maintain stability of current global capital investment.  Fisher expects that current US "heightened financing requirements will be short lived".  As you know, at the press conference on the next TV channel, Bush is counseling Americans to be prepared for a long and drawn out engagement against terrorism.  As we have mentioned too many times now, the Fed, Treasury and greater US government simply have no choice but to pull out all the stops in supporting the US economy and financial markets at the moment.  Bubble deflation management is simply a bitch.

Game On...So the first salvo of a negative GDP reading after one of the longest economic expansions in US history has been fired.  As you know, this is just the first guess as revisions will be coming down the pike in short order.  Do you think the last 3300 point drop in the NASDAQ was a tip off that this was just bound to happen?

We've begun the academic process and now it's a matter of rate of change ahead.  As you know, it's a darn good bet that that GDP contraction gets worse in the quarter(s) ahead.  3Q GDP included all of two weeks of post Sept. 11 influence.  Since that time, the increase in announced layoff count has been nothing short of staggering.  Extremely important to the economy ahead will be personal consumption trends.  As of 3Q, quarter over quarter personal consumption expenditure growth was as low as any time during the now officially concluded new era.

Will The Cycle Be Unbroken?...Although unknowable at the moment, the key question for the financial markets and economy ahead is whether the period we are entering will be characterized as cyclical or something that feels more secular in nature.  We can make a million arguments as to why a more secular experience lies ahead, but as you know, jumping to conclusions can often be fatal to one's shorter term financial health.  For the moment the jury is out, but history suggests that the numbers can get worse from here and still be within the confines of a cyclical historical experience.  The rate of change dynamics in macro economic and corporate specific numbers ahead will tell the story.  Just listen.

We found it rather amusing that Treasury Secretary Paul O'Neill suggested that "...there's still a plausible argument the fourth quarter could be mildly positive (GDP)"  if Congress passes a stimulus package forthwith.  It would appear that he may have to convince a much broader audience:

The drop in consumer confidence does not bode well for the holiday season ahead.  But, as can be seen in the chart, the rather dramatic fall since the top in May of 2000 is not without precedent.  The similar period seen during the Kuwaiti invasion a decade ago has been relived in current action.  What the above chart also suggests is that consumer confidence could still fall to the approximate mid-50 area and still be within recession experience of the last three decades.  It's the ultimate trajectory of change upward that will be the important marker for the economy and financial asset valuations.  In like manner, a broader view of personal consumption expenditures than what was shown above likewise suggests that further weakness is not only within historical precedent, but should be expected as part of an at best cyclical experience:

The economic and individual corporate numbers that are reported in the months and quarter ahead will really give us all a much better feel for just where this economy is heading.  The Fed, the Treasury and government officials will throw the kitchen sink at trying to arrest economic deceleration.  Make no mistake about it.  If you think the LTCM debacle and Y2K was cause for FTG (Fed, Treasury, government) action, you ain't seen nothin' yet.  Concurrently, the reconciliation of dramatic excesses system wide will provide strong cyclical, if not secular, headwinds as we as a system have clearly built up a certain tolerance for the "medicine" which has been repeatedly applied over all these years.

Stool Pigeons...Equity prices in the US have been supported by multiple "legs" of a bull market stool over at least the last half decade plus.  In trying to decipher what lies ahead, a continual review of the legs is mandatory.  Although not totally inclusive by any means, we view three of the most important drivers of the incredible bull market we have lived through as public participation, corporate participation (buybacks and M&A), and foreign sector participation.  What lies ahead for these three groups?  We can only look at the anecdotal evidence of the present for suggestions as to what lies in the tomorrow of our lives.

Main Street Mania:

It's simply an understatement to comment that the American public has been a key driver in demand for common stock over the last decade.  We've shown you the numbers before in terms of equity mutual fund flows.  But what has been commonly referred to as Main Street Mania for a number of years just may becoming Main Street Myopia.  

The above chart was done as of August month end, but just the other day the ICI released September figures.  It just so happens that after the largest one month inflow to bond funds in history (August), September registered the largest one month outflow from equity funds.  Clipping more than half of year to date inflows to equity mutual funds from the above chart.  Before getting too worked up about outflows, the fact is that the $29 billion "leakage" from equity funds in September was miniscule compared to total equity fund complex valuation.  Less than 1% of total equity fund assets and certainly a dramatic emotional response to the events of September.

What the above chart really suggests to us is that mania has turned to myopia.  Despite the September outflow, the bulk of equity fund participants are simply staring in the headlights.  Frozen.  Although more than willing to pile into equity funds at mania high valuations, now scared to death to buy when prices recede.  In fact, too afraid to buy and too afraid to sell.  As we have mentioned to you many a time, the public has established a pattern of buying after the market runs up.  The above dramatic example of public investor action during 2001, coupled with the economic uncertainties numerically assaulting us on a daily basis, suggest that for now, the Main Street Mania leg to the bull market equity stool has been ripped away.  When it will return in a meaningful way is anyone's guess.  It could be tomorrow or maybe not for decades.

As a quick tangent, do we really need to tell you what happens if significant redemptions occur?  Keep your eye on the consumer confidence report.  It just so happens that confidence has deteriorated most significantly among the over 55 crowd.  Likewise in almost lockstep fashion, the further one ascends in the income demographic numbers, the worse the confidence readings.  Do we need to remind you which demographic owns the most common stock?  And which has the shortest time until retirement?  We'll certainly be discussing this little dynamic in the future.

The Corporate Jungle:

On the corporate front, a multiplicity of common stock support drivers have changed.  First and foremost?  Revenues, earnings and cash flow.

The above chart is almost two months old but does help tell the story of contracting corporate profits.  We've shown you the chart of corporate debt relative to GDP in our last issue and won't drag you through it again.  Suffice it to say that between the P&L and the balance sheet, financial flexibility in terms of share repurchase potential has diminished greatly for corporate America over the last 12 months.

Much like the public, corporations paid through the nose in terms of valuation to buy back their shares.  The one group, corporate insiders, who clearly should have known better.  And all the while public shareholders never made a peep.  In the greater picture, supporting stated EPS growth and stock options programs through share buyback schemes has peaked for this cycle.  Despite a few buyback addicts like IBM who spent $1.8 billion of shareholder cash to buy back stock in 3Q.   Maybe that was just Lou's December retirement going away present.

Lastly, another important leg of corporate common stock price support was M&A activity over the last half decade plus.  In cyclical fashion, much of that has ground to a halt at the moment.  Over the past five years at least, cash buyouts had become very popular as opposed to having to issue equity (and possibly dilute stock option programs) in M&A deals.  Not only has M&A activity died down significantly, but sources of financing like the banks and public capital markets have all but shut the door at the moment.  Will M&A activity revive any time soon given what are now business prices well down from what was seen in the past few years?  Maybe, but you would not know it by looking at Street actions.  Most firms have forcefully thinned their overgrown gardens of investment bankers.

The Foreign Sector:

As we have mentioned a number of times, the US has successfully conducted one of the greatest global recycling efforts ever witnessed on the face of this planet.  How "green" of us.  Well, green only if you are talking about dollars.  The following has put more dollars in foreign hands than at any time in history:

But, the fact is that as the synchronous global economic deceleration has deepened, the trade deficit has begun to reconcile in slow but steady fashion.  Foreign capital has been attracted to US financial assets not only because of excess dollar holdings, but also because of performance.  In fact, foreign money has been late to the equity party:
  

Hand in hand with US macro stock price acceleration and the ballooning trade deficit, annual foreign allocation to US equities exploded between 1995 and 2000.  What is also clear is that relative to the US public and corporate "investor", the foreign contingent has been no slouch in 2001.  The important questions ahead are will the foreign sector continue to support US stock prices by remaining a net buyer and at what level of participation will they continue?

Anecdotally, what is changing at the moment is the relationship of US imports to exports.  A little history lesson:

We have to believe that as the relationship between US import and export levels shrink, the global dollar recycling (into US financial assets) operation becomes less of a support to the macro US equity complex.  Through the latest report, US imports are down 11% year-to-date while exports have fallen 8%.  The gap is staring to narrow and it's not good news for foreign economies depending heavily on the US consumer.  Certainly the fallout from this developing trend remains to be seen ahead.

Although topic numero uno among Street strategists these days is trying to call the bottom in prices and the shape of an ultimate rebound in the US economy, keeping an eye on the dynamics of what has supported the equity bull market most significantly over the past half decade appears a worthwhile exercise moving forward.  For the moment, the public and corporate sectors appear sidelined as being current sources of demand.  Although foreign players continue to allocate capital to the US financial markets, the dynamics of trade driven global capital flows appear to be changing at the margin.  The equity markets certainly reflect the changing characteristics of these legs of the bull market stool over the past eighteen months.  What lies ahead is anyone's guess, but we see little in the way of catalysts for rejuvenation in public or corporate demand anytime soon.  We may be much more dependent on the immediacy of the kindness of strangers than is generally perceived.