ContraryInvestor - Market Observations

MARKET OBSERVATIONS

Circling The Airport

MARKET OBSERVATIONS - 7/13

What Landing?...We find it quite amusing that current market participants are embracing the "soft landing" scenario for the US economy so strongly. In our view, we're circling the airport at 30,000 feet, nowhere even near the runway. Every "adjusted" economic number to hit the Street is met with a chorus of new age economists proclaiming that the Fed is done raising rates. After the longest economic expansion in US history, a minor slowdown in growth and inflation numbers for one month is being heralded as a victory for the so called soft landing. This perception is surely being impounded in the price of common stocks. Not so fast. Do you call this a soft landing?

As old fashioned as we are, we call it the tightest labor market in over three decades. Much, much tighter than when inflation was last reported to be so low. The soft landing bulls have been placated by the fact that average hourly wage gains have not been climbing radically. Let's not kid ourselves here, do you really believe that $1 million Silicon Valley starter homes are being purchased with actual cash wages? Stock options and sign on bonuses have become such an integral part of modern day compensation that it's simply ignorant to exclude them in wage gain calculations. Wage pressures are tight and getting tighter.

In addition to real estate prices, the increase in energy costs is something staring us in the face each and every day. Of course the PPI and CPI numbers to be reported over the next few trading days are destined to come in at worst right on target with the natural exclusion of food, energy and obligatory adjusting. It's political. It's the time of the season. It seems to have little to do with what is happening in the real economy. In a recent survey by the Financial Executives Institute, 75% of all corporate respondents plan to raise prices an average of 4.75% in the next twelve months. Don't worry, we're sure the price increases will prove to be "seasonal". Don't you think?

In our minds, one of the greatest reasons that we believe neither a hard nor soft landing is in the immediate cards anytime soon is the monetary liquidity being pumped into the system. Have a look at the following chart of M3 we have shown you before:

Although down from the pre-Y2K growth orgy of late last year, the Fed continues to allow the growth in the money supply to run both above the Fed's own 5% target range and well above the current GDP growth rate. Unquestionably this type of policy is inflationary over any intermediate term time frame. This argues to us that there isn't going to be any landing at all. In addition to money supply growth, liquidity is clearly continuing to be injected into the US capital market by both the Fed and the Treasury. The Treasury repurchasing debt. The Fed doing coupon passes and repo's. In fact just today, the Fed conducted two, not one, "open market operations".

We're in an economic holding pattern, if not accelerating. We really hate to come across like conspiracy theorists, but we just can't help but believe the "data" coming out of Washington these days is heavily influenced by current political needs. Steve Hanke in the recent Forbes pointed out that both the OECD and the Bank for International Settlements have publicly suggested the US Fed deal with rising inflationary pressures immediately. In late May, the OECD (Organization for Economic Co-operation and Development) stated that "to avoid a hard landing (later), US short rates must be raised sharply now". During June, the Bank for International Settlements (BIS - the central banker's central bank) encouraged the Fed not to worry about how the market reacts when it considers monetary policy actions. The BIS suggested concern should lie 100% with containing inflation as opposed to (stock) market reaction. As you know, in its June meeting, the Fed ignored the suggestions of both of these groups. Oh well, after all, the BIS and OECD are international bodies. They just don't have the vision that Greenspan has apparently acquired. In his most recent speech, Greenspan stated that the US has made better use of "new technologies" than has Europe or Asia as justification for our relative economic performance. Greenspan is obviously of the opinion that foreigners just haven't grasped the new era quite yet.

Lastly, the recent consumer credit report suggests the US consumer has not been fazed in the least by rising interest rates. The following graph is annualized growth in consumer credit by the month over this year-to-date:

Does this suggest that the poor US consumer is ready to quietly retreat from their voracious shopping habits? We don't think so. In a bit of a disturbing report put out by Bridgewater Associates earlier in the week, the Bridgewater crowd suggested that rising interest rates and (formerly) falling stock prices were having no discernable impact on consumer spending patterns. They suggested that consumers were simply going deeper into debt to make up for their diminished purchasing power given the fact that stock values had fallen. Admittedly, Bridgewater tends to be conservative. They also have a track record of being right. As you know, trying to fine tune an economy is all about influencing individual behavior. For a society well accustomed to leverage, consumption and the continual appreciation of real and financial asset values, gauging true change in human behavior simply cannot be assessed with one month's economic statistics.

For the market to be discounting the proverbial "soft landing" is a bit premature given what we are observing. In all sincerity, we believe the Fed and the current government administration will do everything within their power to assuage financial markets going into the election. The financial markets are the economy at the current time. If it means adjusting economic statistics, so be it. If it means allowing money supply growth to run above a normalized economic run rate, so be it. If not sooner, the moment of truth comes after the election. The need for perceptual enhancement of the economy and the financial market won't be quite as meaningful. Greenspan and the Fed will ultimately be forced to address the airport landing strip at some point. Given the extended nature of so many sectors of the economy (financial assets, real estate, consumer leverage, corporate leverage, etc.), it's hard to make the case that the landing will be anything better than bumpy at best. That's, of course, when the landing finally arrives, as it most assuredly will.

Ariba, Ariba...Question: How do you report a quarterly earnings loss that is twice as bad as the same quarter last year, yet make it appear four times better? Give up? Quadruple your shares outstanding. What's wrong with you? Have you learned nothing of "new era finance"? Now you too can add $5.4 billion to your market cap in one day with the help of ContraryInvestor's all new Ariba, Ariba Financial Management Course. One word of warning. Don't hesitate on this one, seats are filling up fast.

In reality, dissecting Ariba's quarterly numbers requires a calculator with a new battery. One time gains included, charges excluded, etc., you know the rest. The company posted a $317.2 million loss for the quarter, but only $11.3 million of that was apparently operating loss. Last year they lost $11.3 million, of which $6 million was operating. Share count in the quarter ended 6/99 was 52.6 million. For 6/00, share count had grown to 235.8 million. Admittedly, revenues grew from $12 million for the Q ended 6/99 to $ 80.7 million for the 6/00 period. Big growth in revenues, big growth in losses. Crazily enough, it appears that the business model (as reflected by the numbers) of Ariba is quit similar to another popular Net company whose name also begins with the letter A. Both members of the A-black-holes club. Oh, did we forget to mention that Ariba "beat the numbers" for the quarter?. In fact, we'd suggest that they beat them to death.

Growth Stocks Forever...After a blistering decade of successful investing in growth related common equities, it's just a given today that growth is the only way to go. Primarily aggressive growth. Isn't that true? Growth stocks forever. Yeah. Reality check time. Historically, when has growth outperformed value? Well, have a look:

Data Source: Financial Resource Corp and Morningstar

Eliminating the depression decade of the 1930's for a moment as being a good bit of an anomaly, growth stocks have underperformed value issues in every decade except two - the 1920's and the 1990's. The very two decades witness to a mania in financial assets. Coincidence? You be the judge. We kid you not, the message in this graph is why we are so drawn to the contrarian philosophical approach to investing. What screws up a contrarian or value oriented approach more than anything else? Our answer would be a massively accommodative Fed. After all, why do any hard work researching companies and industries when liquidity is plentiful enough to chase popular ideas with what appears at the time to be limitless amounts of capital? Surely you will agree that the 1920's and the 1990's were periods of significant monetary accommodation in the history of US monetary policy and general credit creation.

Diamonds Aren't Forever...In fact in the case of stock charts, diamonds are often not a girl's best friend. In the virtually legendary technical analysis work of Edwards and Magee, they describe the diamond formation as a broadening pattern completed by a triangle formation. The two formations put together form the diamond. It looks a little something like this:

Whoops, this just happens to be the current Dow we are looking at. Well what a coincidence. According to Edwards and Magee, the diamond formation is a rare occurrence found "at major tops and high volume tops". Although we are really fundamentalists by nature, we have to admit to being quite open to multidisciplinary analysis. Especially during times when fundamental analysis seems of little use, looking more closely at what chart work is saying can be quite important. Like statistics, you can often interpret charts as saying anything you want them to say. But in this instance, this looks like a pattern directly out of the textbook. As for resolution? Our only comment would be that a sustained breakout either up or down would be well worth heeding from a near term directional point of view. We're currently headed directly into the sharp right corner of the triangle formation, so ultimate resolution is not far off. As you know, The Dow is trying its darndest to break out to the upside. This may not be a pleasant resolution for the bears. It may be just the beginning of another bout of frustration. Remember, the market is going to do what the market is going to do. It's not right or wrong. It just is. Stay focused on the long term fundamentals of the market and the dynamics of the real economy.

Trap "eze" Artist...Although a near term breakout to the upside in the Dow, the S&P and the NASDAQ may seem crushing to many a factual and fundamental bear, if a true secular bear market has begun, this may prove to be an incredible bear trap. Bear traps coming off of secular highs in the market are not uncommon. In fact, they are more the norm than not. After the first 45+% plunge in the Dow after the 1929 peak, the Dow retraced an approximate 45% of its initial decline before plunging anew (ultimately bottoming drastically lower). Here's the "homemade chart" of the activity.

Chart Courtesy Of Bloomberg

Although the percentage movement in the Nikkei during the 1989/90 topping process was not of the retracement magnitude of 1929, conceptually the bear traps sprang in each market. Had one been following the charts, the initial series of lower highs was broken and a series of higher lows and highs ensued during the bear trap retracement period.

Chart Courtesy Of Bloomberg

Bear traps are notorious for trapping both bulls and bears alike. Bullish sentiment is rekindled as once again the voice of the buy the dip crowd strengthens. Shake it off. It was just another great buying opportunity for equities. Bear traps can also be a time where the bears capitulate. After possibly years of being wrong and feeling a fleeting glimpse of vindication during the initial downturn, bearish hopes are dashed as the market again begins the upward retracement. Bear traps suck in the last of the buyers. They are made to confuse the greatest amount of market participants possible.

In the current environment, the action in the NASDAQ most resembles the '29 Dow and the '89/90 Nikkei. Only time will tell whether the current action is a true NAZ bear trap, or once again the beginning of a speculative orgy to the upside. Since much of the fast money these days trades the charts, watch volume and price action surrounding breakout points.