12/28

Anticipation

The Confidence Game...Well, the anticipation of a happy Christmas holiday for the retail community is now but a memory.  You may remember that a few weeks ago we spent a few minutes discussing the possibility of a blue Christmas (Sky Blue and Black).  Same store sales for the retail community rose 4+% for the week prior to the Holiday, but the preceding three weeks since Thanksgiving were some of the worst retailers had experienced in four years.  For December in aggregate, retail sales will probably clock in somewhere above the 2% line.  Maybe 2.5-3% if lucky.  The current "week after Christmas" period in which we now find ourselves is an important one.  On average, 11% of total Holiday sales occur in the week after Christmas.  9% is typically rung up over the Thanksgiving weekend.  Is the world simply coming to an end?  Not quite, but for many it may feel like that after 6.5-7% same store sales gains experienced one year ago.  Although quite illustrative, you don't need the following chart to know that we are living through a rather dramatic period of retail sales growth deceleration:

Over the last ten years, average annual same store sales gains in December registered 3.8%.  God forbid, we've now returned to normalcy?  As you know, the much bigger question is where we go from here.  In essence, do we overshoot to the downside in terms of deceleration?  The ultimate swing of the pendulum.

During the Holiday season, online sales were estimated to be up approximately 30%.  Again, a far cry from last year's 100%+ numbers, but we are watching the evolution of the online retail delivery channel.  Undoubtedly it will continue to be super important ahead, just not at breakneck pace.  With these kinds of online numbers, it's simply a sure bet that more e-tail dotcom's will be surfacing as DOA's in the months ahead.  You may have noticed the recent Priceline ads proclaiming "we'll be here in 2001".  Just who are they trying to convince?  Themselves?  In a clearly anecdotal post close story today, GE shut down Montgomery Wards after a "disappointing Holiday season".  As you may know, Bradlees, another discounter in the Northeast, announced a liquidation earlier in the week.  There go the employees.  There go the guaranteed property rental leases.  These actions scream that America is too "over-retailed" within the context of an economic slowdown.  There is more pain to come.  Although our memory is clearly fuzzy, we cannot remember a time in the company's history when Home Depot offered 10% off everything in the store sale, as it did recently in the days before Christmas.  With all of the discounting that was sure to have occurred to eek out the aggregate retail sales gains for December, retail bottom lines will not be a sight for sore eyes.  They'll just be sore.

The reason we brought up retail sales a few weeks back and choose to briefly address it again is because we believe retail sales may be making a much bigger statement on confidence in general.  Consumer confidence.  Confidence in the financial markets.  Confidence in the domestic and ultimately global economy.  Confidence in the balance sheets of the American public.  America is a country that has been built on self confidence.  And yes, it has lived through periods of over confidence before, only to rise again after a usually drawn out period of financial and emotional reconciliation.  It just so happens that the Conference Board announced the Consumer Confidence number for December today.  The number was not good, as you would expect.  The worst in two years.  The drop in consumer confidence during the last three months has been one of the four worst quarterly experiences on record.  One being just prior to the 1980 recession.  Another being just prior to the 1990 recession.  The last being in 1998.  The following chart is a near term retrospective:

The Ultimate Discounting Mechanism...By and large, economists and Street strategists are confident that the current economy is headed for the proverbial soft landing.  Talk of recession creeps up now and again in the mainstream, but professionals are far from fully anticipating this type of eventual outcome.  Confidence and anticipation in the Greenspan Fed's ability to "stop the leaking" still reigns the day.  In our minds, what happens in the months ahead in terms of both the direction of the real economy and the financial market's reaction to interest rate cuts and potential tax cuts is critical in trying to develop some assessment of how bad this economic deceleration may become.

Over the weekend, Gene Epstein in Barron's opined that until real estate sales taper off, it's too early to call for a recession.  The implication was that bear markets in stocks (this time the NASDAQ) don't necessarily mean that the economy will follow into a recession.  We happen to agree that this train of thought has a lot of validity.  What must be monitored, though, is market action post the initial stock index declines and early economic deceleration onset.  The 1962 bear market was not followed by an immediate recession.  The 1987 crash/bear market was not immediately followed by a recession.  The 1998 mini bear market was also not followed by a recession.  The common underlying element in each case is that the stock market quickly recovered from these brief bouts of confidence implosion.  Stock prices were on their way back up in a very short period of time.  Will that also be the case this time?  The answer lies directly ahead.  As a last comment, housing sales may not be the indicator they once were in this special environment as excess credit creation of the moment is clearly not flowing into either stocks or retail sales.  Real estate seems to be the last inflating asset left standing...for now.

LEI-I-I...The leading economic indicators have deteriorated pretty rapidly and consistently over the last eight months.  Only a revised September number provided a temporary break in an otherwise eight month losing streak:

What is clearly anecdotal in the chart above is that during 1998, despite the stock market fall, the LEI was trending upward.  This time around its movement is coincident with the financial markets.  Moreover, nominal GDP growth since the market's high last March has been the worst three quarter deceleration since the 1990 recession.  Likewise, the current yield curve is more inverted than that experienced during the last recession:

Chicago PMI is currently the weakest recorded since the 1990 recession.  Unlike most anything we have seen in the last decade or so, give or take a few months, capex spending on technology is in trouble.  Layoffs have begun to rise.  The Wards closure action just today meant 37,000-plus jobs.  Most disturbing to us is the marked escalation in debt related problems for the corporate sector.  A financially crippled Xerox.  LTV contemplating bankruptcy after today's close due to lack of cash.  Chrysler running out of cash.  ATT cutting the dividend significantly to preserve cash against a heavily levered balance sheet.  The Pacific G&E and So. Cal Edison deregulation financial squeeze episode.  Auto production cutbacks at Ford and GM's shuttering of the Olds division.  Lucent and Cisco paying for the sins of overconfidence in customers.  Lastly, the Japanese economy seems to be heading for a recession itself.  At best, it's clearly a weak link in the global economic chain.  Corporate bankruptcies reached an all time high in Japan during 2000.  We're not ready to scream recession dead ahead, but it's sure beginning to feel that way.  As we stated, we will be intently watching the economic numbers ahead and, quite importantly, the action of the stock market.  According to Paul Samuelson, the stock market may have predicted 9 of the last 5 recessions, but if it does not perk up soon, we're going to have to bet that record is moving to 10 out of the last 6.

ANTICIPATION...The stock market is about nothing if not anticipation.  Discounting the future is its sworn solemn duty in life.  The job of the investor is to try to decipher just how much of the future has already been impounded in current stock prices at any point in time.  Much easier said than done.  Maybe that's why we have never met a "system" that works on a continuous basis.  The only system we know is to attempt to use every fundamental and technical tool in our arsenal to try to arrive at some type of common sense judgment regarding values set against the backdrop of the consensus anticipation of the crowd.

We ask you, what could be more widely anticipated at the moment than Fed interest rate cuts?  This has to be one of the most anticipated events we have seen in years.  Sure, Y2K was anticipated, but it's outcome in foresight was uncertain.  From our vantage point, a cut in interest rates by the Fed in the near future is an event characterized by certainty in anticipation.  Enough philosophical diatribe. (If we don't watch it, the anticipated rate cut will soon take on the aura of existentialism.  I choose it, therefore it will happen.)  What we want to explore is the discounting mechanism.  As we listen to Wall Street strategists and many economists, the promulgation of thought is that once rates are cut, all will be on the mend with financial assets and the real economy.  We've already documented to you in past discussions the lag effects of monetary policy in the real economy.  Although ultimately important to real world events and relationships, the rate cut may potentially be important over a near term basis on Wall Street for one reason and one reason only.  Perceptions.  Perceptions and the confidence they either do or do not instill.

Anticipation has already set in in a big way in UST bond prices.  The following chart of the Fed Fund futures already incorporate the anticipation of a pretty dramatic drop in rates over the next few months:

God help the bond market and Fed Funds futures players if the anticipated almost 100 basis points of cutting does not transpire over the next six months.

The chart of the Treasury curve we show above was done at the close on the 27th. Today's curve closed as follows:

Maybe our observations are too simplistic, but all else being equal and assumed static, a 100 basis point cut in the Fed Funds rate in the next six months will still leave us with an inverted yield curve out to ten years.  Has the bond market already fully discounted a significant short rate decline?  Of course it has.  The real question is "has it more than discounted the eventual total short rate decline?".  That remains to be seen over the next half year to year.  Again, quite simplistically, if the bond market has correctly discounted the ultimate need to cut short rates drastically, it is implicitly arguing that the economy is poised to fall directly into recession.  Again, if true, just what has the stock market discounted?  Is Oracle priced for a recession?  Is GE priced for a recession?  Is Wells Fargo priced for a recession?  We could go on and on.  Possibly the bond market has discounted too much and the stock market not enough.

The following charts of the five and ten year Treasury price action over the last month demonstrate that yields are already within fifty basis points of the bottom seen in rates during the 1998 monetary easing exercise.  As you know, rates reached these bottom levels after short rates had already begun to be cut.

Could this possibly be one of the biggest examples of "buy the rumor and sell the news" we have experienced in many a moon?  Be prepared.  And not just for bonds.  With recent retail sales clearly indicating consumption apprehension on the part of the American public, do you really believe Americans will be in the mood to "consume" more stocks just because interest rates have been cut?  Maybe...for a while.  After all, that's what bear market rallies are made of, aren't they?.

Stand And Deliver...Having laid out our thoughts on price anticipation in the bond market surrounding what seems to be impending interest rate cuts, we have to give our fearless forecast for what may lie ahead.  Are we certain?  Not in the least.  Just trying to anticipate probable outcomes.  Be prepared for a possible 50 basis point rate cut out of the box for the Fed.  We would guess it would be 50bp's on the Jan. 31 FOMC meeting, but it could be an early 25 and a Jan. 31 25 bp rate cut if Al hits the panic button in advance.  Why 50 basis points?  As you know, the Bush regime will most likely make an income tax cut issue numero uno after the inauguration.  (This is also a point of anticipation, as you know.)  Knowing this in advance, the Fed may just choose to go into a little quiet period while the Congressional/Presidential sparks fly regarding fiscal tax policy.  50 basis points may be what the Fed would feel is necessary to "tide the market over" while the tax issue is decided.  Also, once the tax drama is played out, the Fed may be in a position to make more intelligent decisions regarding the combined effects of simultaneous monetary and fiscal policy ahead in setting further monetary actions.  How would the financial markets take this?  Well, in one of two ways, of course.  It's either YIPEE, LET'S PARTY!!  Or, oh cr*p, this (the economy) is worse than we thought.

Deferred Liability...You may remember that we wrote a piece a while back about the embedded unrealized capital gains in many an equity mutual fund.  Incredibly enough, we pulled up the Vanguard S&P 500 fund record for 2000 and this is what we found:

Unless they are going to declare a capital gain tomorrow, we cannot find them either having paid or declaring a capital gain in the 500 fund during 2000.  As you can see, this is the first time in eleven years where this has happened.  As of the close today, there are $91.42 per share of unrealized gains in this fund on a closing price of $122.66.  That's right, 74.5% of this fund is made up of unrealized gain.  We're not trying to pick on Vanguard by any means.  In fact, we have a lot of respect for them.  This little display during 2000 was a masterful job of experiencing a down year and not distributing tax pain to investors on top of it.  Fine for 2000, but this is one fund where the possibility of redemptions would take a heavy toll on taxable investors.  The industry wide problem of embedded capital gains is not over by a long shot.

The Daily Breadth...Will the January effect visit us this year?  Especially after the "educational" September through December effect we have just lived through?  Certainly possible.  Tax selling pressures will have subsided. Anticipation of monetary and fiscal largesse should heat up.  A lot of bad earnings preaanouncements are out of the way (of course, with a few to follow post Jan. 1).  Investors have not bailed from equity mutual funds.  That tells us the psychology of the faith in stocks has not been broken yet.  We would not be surprised at all to see a potential lift in 1Q of next year.  If not, we will make the bet that recession lies within 6-9 months.

Chart Courtesy of StockCharts.com

Chart Courtesy of StockCharts.com