PERFORMANCE ANNOUNCEMENT
As Of: April 30, 2003
Optimism Won't Pay
Still too early to commit long term. It is a trader's market.
After three years of a slack economy and a falling stock market, the recent tension of war in Iraq, threats of nuclear war with North Korea, and numerous other dreary worries, people are desperate to feel good. Better weather and the rebirth that comes with spring tends to promote that "feel good" feeling that everyone desires; but when it comes to investing, hope is not a strategy. Just because we want the worst to be behind us doesn't make it so.
There are some very legitimate reasons to believe that the stock market should start to perform better. 1) Inflation is still low. Additionally, with the recent drop in oil prices (now that the war in Iraq is over) the "energy tax" will disappear, giving a boost to consumers. 2) Interest rates are still low. The housing market has remained remarkably strong, and people keep refinancing their real estate to reliquify. This allows a paydown in debt and/or additional consumption. 3) The government is spending heavily. Although the expenditures are largely defense related, the spending does flow through the economy and provide a stimulus.
The selective perception of optimists tends to emphasize the positive forces at work in the economy; but it is a mistake to think that better economic news will translate into higher stock prices. The biggest impediment to the stock market is that the good news is already priced in. Looking at two popular stocks as an example, Bed Bath & Beyond is not cheap with a price earnings ratio of 43. Ebay is even more expensive with a PE of 92. The market is being priced by the optimists, the very people who are not willing to consider the many negative forces that threaten to pull the economy down and prevent growth in stock earnings.
A Pension Disaster. While individuals are crying over the losses in their investment portfolios, pension administrators are facing double the problem. Not only have corporate pension investments plummeted in value, the discount rate that is used to calculate minimum funding requirements has also dropped with interest rates. This means that not only are pension fund values down, minimum funding requirements have gone up (creating twice the gap in funding). Where will the difference come from? Out of corporate profits.
Hidden Losses. Considering an estimated seven trillion dollars of wealth was lost from the stock market's fall, why hasn't there been more of an impact? Part of the reason the losses haven't cascaded through the economy is perhaps because they have not been fully recognized by the intermediaries. Banks and insurance companies are naturally slow to write down losses. The negative trickle down is still trickling.
Debt Is The Boogie Man. If there is anything we should be scared of, it is debt. Americans became addicted to debt in the recent inflationary era that began in the 1960's. Debt can provide positive leverage when prices are going up with inflation; but debt provides negative leverage that can quickly result in bankruptcy when the economy shifts to disinflation or deflation. Low interest rates and a strong real estate market have allowed homeowners to add an immense amount of debt to their balance sheets. This is a time bomb that could potentially wreak havoc not only with the homeowners, but also with all the intermediaries (such as Fannie Mae), and with the ultimate mortgage and bonds holders.
A Plan Too Simple. The Bush administration has promoted a very simple plan to stimulate the economy. Its message to the consumer is spend, spend, spend! The administration believes that placing additional funds in the hands of the consumer will solve all economic problems. It has lost sight of the foreign trade deficit. It is giving scant lip service to the domestic deficit. There is no mention of the deferred maintenance required to rebuild the nation's infrastructure. And there is no solution to the health care crisis. The result of this policy is that we had a recession that did not promote the traditional debt liquidation and strengthening of balance sheets that provides the cure for an imbalanced economy. Instead, we actually saw an expansion of credit as consumers took on more debt. Our position is precarious and it is unlikely the economy can grow from such a weak foundation.
The Government Giveth & The Government Taketh Away. The Federal government has increased spending due to the war on terrorism. Additionally, President Bush is trying to sell tax relief to Congress as a necessary ingredient to boost the economy. There is a lot of disagreement regarding how much this government action will help the economy; but regardless of the correct anser to this question, it is meaningless in light of what is happening at the state and local level. Whatever the benefits might be that are flowing from the Federal government, they are going to be more than offset by increases in use fees and taxes levied by state and local governments. The states are required to balance their budgets, and the shortfall is going to come out of the taxpayers' pockets.
No Country Is An Island. Japan's stock market is hitting twenty year lows. Germany's economy has been faltering. If our economy is going to grow, we need the global markets. Our stock market cannot go up in a void. The United States is dependent on foreigners to support our national debt. The dollar has been dropping on the foreign exchange markets. To believe that our economy can revive without growth in the rest of the world is wishful thinking.
Higher Stock Prices Depend On Earnings Growth. In the first quarter of this year, a number of companies have been able to meet the greatly lowered expectations for their earnings. The Dow Jones Index has recently rallied 1,000 points on the hopes of optimists. Whether you like the earnings or not, reported earnings are almost meaningless due to the confusion caused by changes in reporting from pro forma to GAAP. If you want to believe that earnings are improving, it is important to look behind the numbers and understand that there isn't any top line growth. Better earnings are coming from cost cuts. Since there is a finite limit to how much costs can be cut, there is a limit to earnings growth until we see real top line increases. So far, real top line growth just isn't there.
For every buyer, there is a seller. If you are an optimist, you would be wise to ask yourself who is selling and why. The stock market can certainly continue up on momentum (another rally in a bear market), but in the current economic environment, and with the Dow Jones Index over 8500 and the S&P 500 Index over 900, it is hard to believe that there are sufficient fundamentals for any lasting support. I will change my mind when I see debt go down, real economic growth (not artificially stimulated), and real top line earnings growth. Remember, optimists may live longer, but pessimists are right more often.