January 2004

Dealing With Our Issues

Dealing With Our Issues...As opposed to our normal routine of addressing one or two issues pertinent to the financial markets in these monthly discussions, we thought we'd kick-off 2004 by briefly covering a multiplicity of items we believe will be important as we move into the year ahead.  The topics are more random than not and could comprise full discussions by themselves.  We believe the following are important to both the financial markets and real economy.  We wish we had the answer to eventual issue resolution or outcomes, but no one does.  Our hope is that trying to understand and monitor these issues ahead will keep us on the right side of market movements and allow us to anticipate the inevitability of change.

The Influence Of Stimuli On The Patient

There is absolutely no question that fiscal and monetary stimulus went a long way toward shaping the real economy and financial market related events of 2003.  Back in May of last year, we penned a discussion entitled "The X-Games" where we discussed extremes in Fed and government sponsored stimulus to come over the latter half of 2003.  But even having stated our belief that a whole new level of economic and financial market stimulation was about to unfold, even we were surprised at what this new round of stimulation was to leave in its wake in terms of headline GDP growth and levitation of financial asset prices.  Post the reduction in marginal personal tax rates and the unleashing of tax related cash rebates in the summer, retail sales popped in July and August of last year, only to recede in terms of growth rate intensity as the initial rush of consumer related stimulus abated.  As we look into 2004, from the standpoint of fiscal stimulus, consumers will be on the receiving end of excess cash tax rebates in the mid-to-latter portion of the first quarter and early second quarter of this year.  The mid-year 2003 drop in marginal personal tax rates that was retroactive back to the beginning of 2003 is responsible for this phenomenon that will clearly act to at least in part support the consumer in the early part of the year.  Our view of the consumer in 2004 is one of stability to mildly positive strength early in the year and then a fade as the year progresses.  Absent significant acceleration in payroll employment growth, perhaps a very significant fade beginning late in the second quarter and throughout the remainder of the year.  Of course, the markets already know this.  In our minds, the important question in terms of the consumer's ultimate influence on the financial markets directly ahead is how much of this near term tax refund support to the consumer has already been discounted in stock prices?  As you can see in the following chart, the S&P retail index recently peaked within about four points of its late 1999 high.  A failure to break above that prior 1999 peak ahead will say a lot about a market that has already priced in potential consumption strength in the first and second quarters of this year.
       

We suggest that the tax rebate stimulus to come in the early part of this year may have a more muted influence on aggregate consumer spending than was the case in the third quarter of last year.  Without sounding wage discriminatory, the cash tax rebates of last year were made available to those with adjusted gross income under $100,000.  Above $100,000 in AGI and you got zip.  The tax refunds or lowered cash tax liabilities to come in the first and second quarter of this year will disproportionately favor the upper income strata who are essentially "collecting" on the lowering of marginal personal tax brackets in July of last year.  It's simply a fact that the upper income strata have a lower propensity to consume than do lower income brackets (per unit of increased disposable income).  Despite the tax cuts and rebates of last summer raising de facto household disposable income, the national savings rate at third quarter end was essentially unchanged from the end of the second quarter of last year.  It's no wonder 3Q 2003 GDP was a blow-out as the tax rebates were spent.  That may not be the case with the bulk of tax refunds to come in 1Q and 2Q of this year.    

Unless payroll employment begins to pick up dramatically in very short order, we expect a fading consumer to be a meaningful theme for 2004.  In fact, accelerating in terms of fade as the year progresses.  Moreover, it's not just jobs that count for consumers, but also wages.  Despite what was simply a blow-away headline GDP number for 3Q of last year, the year over year change in economy wide wages and salaries was actually down from 2Q.  For those believing that we have achieved a perfect economic recovery, what's wrong with the following picture?
        

One last point to monitor in terms of the consumer as we move into 2004.  Although this appears perhaps naively simplistic, we'd suggest watching bellwether Wal-Mart.  As you can see, the following chart of Wal-Mart clearly shows a longer term wedge formation.  Despite the "booming economy" of 2003, WMT's declining tops trend line remains firmly intact.  The stock is below it's 200 day MA and the 50 day MA has broken through the 200 day MA to the downside.  Is this stock telling us that the market has already anticipated any stimulus related early year 2004 consumer strength?  It sure appears as much.
             

The second area of fiscal stimulus that will remain in force throughout 2004 is related to corporate capital spending.  You'll remember that much of 3Q GDP commentary was riddled with anecdotes of capital spending strength.  Primarily spending related to autos, aircraft, and tech equipment led the way.  Accelerated depreciation schedules for 2004 and the ability to completely write off the first $100,000 of capital equipment employed will most assuredly pull what might have been 2005 spending into 2004.  The question remains just how meaningful this will be to the overall economy.  Those bullish on the domestic economy for the year ahead are banking on corporations firmly grasping the spending baton being handed off by the consumer.  Although we believe these tax breaks will certainly influence corporate behavior in the year ahead, a potentially fading consumer would dampen total corporate capital spending strength regardless of tax incentives.  It all depends on the degree of consumer fade.  Although tax incentives can be a strong economic motivator, there is no way that a substantial capital spending boom of the magnitude experienced in the mid-to-late 1990's lies ahead.  As you can see in the following chart, substantial capital spending booms are separated by decades, not by quarters or years.
      

Moreover, as is perfectly clear in the chart above, which has been updated through 3Q of 2003, non-residential fixed investment (a proxy for corporate capital spending) currently accounts for only about 10.5% of total GDP.  Again, the markets know these capital spending related incentives exist and do sunset legislatively in December of this year.  Will the financial markets reward what may be temporary capital spending strength with yet higher stock prices?  As we have mentioned a few times now, we believe it will be important to monitor the relationship between the cyclical stocks and the broader equity market as represented by the S&P 500.  Cyclical's have been leaders of the market advance over the past year, along with techs and small cap issues.  A breakdown in the relationship between the cyclicals and the SPX would signal that the markets have already discounted the "good news" on capital spending to come in 2004.  We're not quite there yet.
      

We at least need to be open to the possibility that the the recent spurt in capital spending strength is also temporary.  Corporate managements aren't exactly stupid.  They too know that recent broader economic strength has been driven by many a one shot factor, be it tax cuts/rebates or record mortgage refi activity.  Phenomenon that will not be repeated during 2004.  Unless these folks truly believe that economic growth is sustainable without the need for extreme stimulative measures, as was the case in 2003, they will certainly not undertake meaningful capital spending programs.  Although diffusion surveys such as the ISM series continue to show strength, November durable goods orders a few weeks back experienced the largest one month decline in over a year.  Moreover, weakness in durable new orders was widespread.  After listening to many a bullish commentator gush over communication equipment strength in recent months, theoretically validating the tech equity rally, orders for communications equipment dropped 40% in November.  The largest one month drop in seven years.  More broadly, orders for computers and electronics dropped almost 11% in the November report.  Could it be that some of the recent capital spending strength in tech was simply channel stuffing?  If so, it's a very good bet that tech stocks lose their leadership mantle in 2004.  (We expect this to happen anyway regardless of a potentially high amount of tech inventory in the channel.)  With a fading consumer, government defense spending already clearly slowing from earlier 2003 rate of change levels, an economy-wide capacity utilization rate barely off the cycle lows, and significant office vacancy rates still being experienced, are tax breaks alone really going to motivate corporations to embark on sustainable spending?  Corporate capital spending could be one big area of disappointment in 2004.  We'll see how it goes.

Keepin' It Real (Or Not)

The evidence is already starting to mount that residential real estate has given us its best for this cycle.  You already know that residential real estate has been an important domestic real economic underpinning during the past two to three years.  Much like auto sales of the moment, financing of this asset class has witnessed characterization extremes.  0% down financing is all too common.  There have been plenty of voices calling for a top in real estate for many moons now.  Likewise, there have been plenty of voices calling for a crash in real estate prices.  Although either of these may ultimately be correct, we suggest that the important issue looking into 2004 is that we have a US consumer, and really broader US economy, extremely dependent on asset values.  Real estate asset values being probably the most important.  Absent meaningful payroll employment growth, in addition to weak at best wage and salary growth, asset inflation has allowed the US consumer to buy the very things he or she really doesn't need with money he or she really doesn't have in terms of personal savings or household cash flow.

It goes without saying that stimulus throughout the last three years has influenced the residential housing market importantly.  In the following chart we detail existing US home sales.  As you can see, there have been significant spikes in activity during periods of significant fiscal and/or monetary stimulus.  Although existing home sales still remain high in absolute terms, it's a very good bet that we may have already seen the peak in mortgage activity for this cycle, unless US interest rates implode from here.
               

Although it may be hard to remember, near the early part of 2000, conventional 30 year mortgage rates hovered near 8.5%.  They subsequently bottomed near 5.25% during the middle part of last year.  We find it hard to imagine that we will experience another drop in mortgage rates like the one experienced over the past four years any time soon.  For now, home prices remain high.  In November, median home prices soared almost 11%.  It was the largest monthly increase on record.  Average prices also spiked to a one month gain not seen since early 1988.  Rates of change such as these are anomalies, not normal patterns.  With refi activity having dropped a good 90% since the peak in the summer of last year, it sure appears that the ability of the US consumer to monetize real estate price gains in the current environment is running out of steam.  Existing homes sales appear to be the last bastion of real estate monetization at this point.
        

As a final comment, it has just been in the last few months that existing home prices as a percentage of median family income broke into all new high territory.  Back in the early 1980's, this ratio peaked at 305% and subsequently declined for almost ten straight years, bottoming at 260% late in the decade.  The latest reading is 320%.  This is extremely important because, unlike equities, the average US consumer is extremely levered when it comes to residential housing.  Mom and pop America were able to live through the decline in equities from 2000-2002 due to the fact that they were not levered in equities.  A potential downturn in housing would certainly be a horse of a different color.  We look for the rate of change in housing activity (new, existing, refi, etc.) to slow as we move through 2004.  And that means that consumer activity related to and as a result of mortgage finance activity will also slow.  There is certainly little to no pent up demand for residential housing relative to historical post recession experience after what has happened in this market over the past four years.  Much like other areas of consumer finance, the housing cycle of the last three to four years was driven by extremes in financing opportunities.  Humble question.  Does it get any more extreme than 0% down payment real estate financing schemes? 

The Dollar And The Deep Blue Sea (Of Liquidity)

We expect the dollar to be an important issue as we move into 2004, not that it wasn't in 2003.  But issues regarding the dollar, and the influence of exchange rate movements on the real economy and broader financial markets, are far from simplistic.  On face value, there is no question that fundamentally there's a lot to worry about when it comes to the US dollar.  Assuming that the dollar is a mirror of the collective thoughts and ultimate trust of the global financial community, one should clearly be cautious on the dollar with respect to record US debt relative to GDP, record trade and federal budget deficits, a veritable explosion in the US money supply over the last few years, a substantially levered US consumer of the moment, etc.  But it sure seems pretty clear to us that a declining dollar of the last few years has engendered greatly differing responses from various components of the financial markets and real economy.  As we explored in a recent discussion, it's pretty clear that at least a meaningful portion of the advance in commodity prices of the last twelve to eighteen months is in good part explained by the declining dollar, as well as strengthening real global demand for raw materials and commodities.  As we also concluded in a discussion devoted to gold a month back, the advance in the yellow metal has technically paralleled the decline in the dollar over the last few years.  Alternatively, it sure appears that the US equity and fixed income markets have given very little attention to the fact that the dollar has been in a very noticeable downtrend.  The equity markets have continued to push higher despite the declining dollar really having no positive influence on the US trade deficit for what is going on close to two years now.  Likewise, US fixed income markets appear virtually blind to the declining currency.  The blinders, of course, being gladly provided by continued foreign investment in US fixed income assets.  When it comes to the longer term meaning of a declining US dollar relative to foreign currencies, and the potential for dollar related asset class pricing adjustments as we move into 2004, just who is right and who is wrong?  Are the commodity and precious metals markets on the right track in terms of inflating against a punctured dollar?  Or are the US equity and fixed income markets correct in their apparent complacency in the face of one of the largest dollar declines since the mid-1980's?

The most recent historical experience of a significant dollar decline occurred during the mid-1980's.  The lesson we take from that experience is that there can be a meaningful lag period from a dollar peak until a potential reaction in the equity and bond markets is realized.  In early 1985, the trade weighted dollar witnessed a very significant peak.  At the time, the G7 nations had struck an agreement (the Plaza Accord) regarding the need for the dollar to decline relative to major foreign currencies.  As you can see in the chart below, the trade weighted dollar declined 31.2% over a 29 month period before the equity market finally decided to care about the cascading value of the dollar.
      

The dollar likewise declined 29.2% over 22 months post the dollar peak in 1985 before the bond market began a meaningful sell off.  A sell off that also helped precipitate the 1987 equity correction.  In the current environment, we now find ourselves 22.9% below and 22 months past the most recent peak in the trade weighted value of the dollar.  Although we will not drag you through yet another series of charts, what is noticeably different in the current dollar decline experience is that commodity prices are rising in almost directly opposite fashion with respect to the declining dollar.  That was not the case in the mid-1980's.  As the trade weighted dollar began its decline in early 1985, the CRB index had already peaked and continued falling for almost two years along with the concurrent decline in the dollar at that time.  The picture today looks a whole lot different.  
        

What is different this go around is that there has been no lag at all between a peaking dollar and a bottoming CRB.  So far into this cycle, the CRB bottomed three months prior to the dollar peak and has been ascending almost non-stop as the dollar has continued its decline.  Commodities have so far been definitive in their statement regarding the significance of the decline in the dollar for this cycle.   To us, if this relationship continues to hold ahead, regardless of where the equity or fixed income markets travel near term, it will be a very telling sign that ultimately the dollar decline will be much more far reaching for the real economy than was the case in the mid-1980's.  Although the commodity and precious metals markets appear to be pricing in the influence of a declining dollar of the moment, history suggests that a lag in recognition of a declining currency in both the equity and fixed income markets is perhaps to be expected.  At least that's the lesson of the 1980's dollar decline experience.  Looking ahead, the simplistic question is, of course, for how much longer can US dollar denominated equities and, in part, fixed income securities continue to ignore dollar machinations on the downside (assuming there is more downside to come, of course)?  Again, if history is any guide, it could very well be that this question is answered in 2004.

What has certainly offset the declining dollar in US markets over the past few years has been a steady rise in liquidity.  During the time that the trade weighted dollar has declined almost 23% over the last few years, money supply growth in the US as measured by M3 has increased by $800 billion nominal dollars.  As was the case with excess liquidity in the US financial system during late 1999 and early 2000, that money has to go "somewhere".  The following chart quite simply tells the story of a significant offset to the declining US currency over the past few years.
         

But perhaps more importantly, given the global economic and financial imbalances of the moment, the declining dollar has spawned the creation of excess global liquidity in a manner never experienced in any post recessionary environment on record.  And that liquidity is largely being created in Asia.  As Japan has literally printed Yen that have been sold against the dollar in an effort to buoy the dollar/yen relationship, the monetary base in Japan has exploded over the past few years.  The same deal goes for the process by which China has pegged their currency to the dollar.  It is plainly obvious that we find ourselves in a period of incredible global liquidity creation.  In essence, the ultimate global reflationary effort.  From our standpoint, the precious metals and commodities markets are reflecting the very real negative fundamentals of a declining dollar.  Alternatively, the financial markets are reflecting excess domestic and global liquidity.  Because this has been going on for a few years, market participants appear to have become quite complacent about the longer term implications of a weak domestic currency.  Ironically, the weaker the dollar becomes, the less profitable exporters to the US become.  Alternatively, as commodity prices increase, the more expensive becomes the cost of global production to those export driven economies.  Quite simply, this is not the picture of a virtuous circle of global economic expansion.  In fact, quite the opposite.  This is the picture of imbalance.  As we stand from afar and look at the global markets and real economy, we see the following going up in price:  stocks, real estate, energy, gold, GDP, broader commodity prices, and bonds.  For all of these asset classes to move higher in almost synchronous fashion, we can come up with no other explanation than excess liquidity on a global basis.  For now, there is really only one thing going down - the US dollar.  So although history suggests that at some point a declining dollar will negatively affect US equities and fixed income markets, is excess liquidity holding back or delaying this assumed rational reconciliatory path?  As we look ahead into 2004, which of the following three will be the most powerful in terms of influencing the pricing of various asset classes - a declining dollar, excess global liquidity, or foreign flows of capital into US dollar denominated fixed income assets?

Although we believe the dollar is a huge key to the future of the US financial market, drawing simplistic conclusions regarding shorter term dollar and global currency movements is anything but shooting fish in a barrel as we move ahead.  Factors offsetting the academic ramifications of a dollar decline are both many and powerful at the moment.  Massive global liquidity creation and the continued significant flows of foreign capital into US dollar denominated assets have largely offset the negatives for US financial assets.  And of course the Catch-22 is that our large trade deficit has supported the flows of foreign capital back into US dollar denominated financial markets.  As crazy as this may sound, if our trade deficit were truly to contract meaningfully ahead, we would expect foreign flows of capital into the US to likewise contract, clearly pressuring US fixed income prices.  But we're not there yet.  Certainly the foreign community could also decide to place their capital elsewhere in the global sphere, but foreign purchasing of US financial assets has much less to do with investing than with promoting and sustaining their export driven economies.  We need to remind ourselves that over the short term, anything can happen when it comes to currencies.  But we see no way around a continued dollar decline as long as the US continues to "create" an unlimited supply of dollars.  Quite simplistically, it seems pretty clear that the US is simply creating more dollars than is being demanded by the global financial community at the moment.  We believe this simple comment explains a lot of the near term dollar decline as the foreign community is doing anything but shunning US dollar denominated assets as of now.  But to everything there are limits.  As we look ahead into 2004, if the rate of change in foreign buying of US financial assets slows, the impact of a declining dollar at that time will have serious consequences for US financial assets.  In our minds, the flow of global capital is one of the major keys as to when a theoretical orderly decline in the dollar becomes something much more ominous for US financial markets and the real economy.  Until that time, it's simply a good bet that current imbalances will continue to grow.  Lastly, another clue as to when the foreign community will have "had it" with the dollar decline is when import prices start to rise quite noticeably.  So far, the foreign community has eaten the profit eroding decline in the dollar as they export into the US.  Low cost global sources of labor have been a big factor behind this ability of foreign exporters to conceptually ignore the dollar decline, but that only goes so far.  At some point the declining dollar will cut into the foreign corporation profitability bone.  As we move through 2004, we suggest keeping a very sharp eye on global capital flows, US import prices, and global money supply growth.  We believe changes in these factors will foreshadow an end to the in place lag between a declining dollar and levitating US financial asset prices.

Paint By Numbers?

We've always been strong advocates of the marriage between technical and fundamental analysis when it comes to approaching investment decision making.  But of course the trick is knowing which of the two to emphasize at any point in time.  As we move into 2004, the tension between the current messages of technical and fundamental analysis is quite polar.  By almost every measure of basic valuation (P/E, Price/Book, Price/Sales, Price/Cash Flow, Dividend Yield, etc.), aggregate equity indices sell at levels much closer to historical highs than not.  We've shown you the following picture of 120+ years of S&P trailing twelve month GAAP P/E numbers before.  The chart requires just about zero discussion in terms of its message.
         

We've seen many a bullish rationale for S&P price expansion based on the recent change in tax laws as it applies to common stock dividends.  But do these tax changes really make up for the fact that except for only three years of what is close to the last eighty, the yield on the S&P has never been lower than at present?  From our perspective, the change in law regarding common stock dividends in no way negates or softens the valuation perspective provided below.
        

Certainly corporate profits are improving.  We know that.  It may very well be that common stocks "grow" into their current valuations as earnings expand in the years ahead.  It's just that current earnings are benefiting from many an anomalistic factor and former accounting concerns have simply been forgotten.  The precipitous drop in the dollar has allowed multinational corporations to repatriate higher dollar adjusted foreign sourced profits at the moment.  The worst US labor market recovery since the depression, conjoined with the explosion in foreign sourcing of labor needs, has allowed corporations to benefit from relatively low labor costs on the bottom line relative to sales.  As you know, despite former bear market period worries over pro forma earnings reporting, lack of stock options expensing, and pension accounting issues, nothing has been done on either a legislative or regulatory front to address these real accounting concerns.  In fact, legislatively, it appears that further "breaks" in pension accounting are set to be enacted for a period ahead.  Point blank, the quality of earnings being reported remains an issue.  But in straight up momentum driven bull interludes, it's just better not to ask too many questions, right?

Alternatively, the technical condition of many major equity indices simply could not be better.  Higher highs, higher lows.  Breadth expansion.  Individual stocks and macro equity indices comfortably above 50 and 200 day moving averages.  Price breakouts relative to significant technical demarcation lines established over the last two to three years.  Technically, the markets are in gear and appear set to move higher.  Globally, given the true nature of widespread excess liquidity of the moment, we see worldwide major equity indices moving up in synchronous fashion.  Ignoring the numbers, the equity markets look simply fantastic on a technical basis.  But we all know that from a longer term standpoint, the numbers will ultimately collect their due.

From our vantage point, we know fundamental valuations are stretched.  That's basically a charitable characterization.  We also know that liquidity and the institutional need to participate in momentum borne of that excessive liquidity cannot be ignored.  It's been the story of this in place rally.  From a short term 2004 perspective, we'd suggest that technical work will be very important.  We'd also suggest that decisive action is the order of the day.  Although it appears that many investors have simply forgotten the lessons of the prior 1999-2000 bubble peak, we believe they do indeed remember the pain inflicted.  In fact, we believe many investors clearly intend to sell at the first sign of real technical trouble, especially given that valuations offer little guidance in the here and now.  During the next correction/downturn, we expect there to be a veritable rush to the exits, much unlike the lingering hope implicit in holding on during the 2000-2002 period.  

Will The Markets M-"UTATE" In 2004?

We simply can't tell you how many times we have heard the phrase "until after the election".  We've lost count.  The stock market will hang in there "until after the election".  Interest rates will remain low "until after the election".  The Administration will do everything in its power to kick start payroll employment "until after the election".  As you know, financial markets are anticipatory animals.  They will not wait "until after the election" to start discounting the reality of the economic environment to come.  As we move through 2004, the influence of both in place and already unleashed stimulus will begin to seriously wane on a rate of change basis.  The markets know this.  After perhaps a burst of equity fund inflows early in the year, the markets will be looking ahead and asking whether our economy can continue to move forward at 4%+ GDP growth rates.  We are convinced that extraordinary stimulus supported the consumer and the broader economy in the third quarter of last year.  Stimulus working its way into capital spending will ultimately help support yet to be announced 4Q 2003 GDP.  But what happens in 2004, especially during the second half, as most in place stimulus has already peaked in terms of intensity?  We are going to need to experience significant follow through in corporate spending as well as reasonable consumer spending throughout 2004 to hold up the equity averages.  Likewise, the declining dollar is already intensifying inflationary pressures in just about everything except domestic wages and imported consumer goods, despite headline inflationary measures suggesting otherwise.  The contrarian in us is screaming that "until after the election" is going to be a tested assumption or truism in 2004.   

Our little list of issues and concerns for 2004 is far from exhaustive.  It's a starting point for anticipation of change as opposed to definitive coverage of the important issue or theme waterfront.  Can mere mortals continue to alter the natural course of economic and financial mother nature in 2004?  Up to this point they've given it one hell of a try.  But in the ultimate financial and economic game of rock, scissors, paper, we're keeping our bets firmly placed on the rock as opposed to the paper.