I Joined the Wrong Mob

Around the time of his deportation to Italy, mobster Lucky Luciano granted an interview in which he described a visit to the floor of the New York Stock Exchange. After he visited the floor of the NYSE someone explained to him the role of the floor specialist, he commented, “A terrible thing happened. I realized I’d joined the wrong mob.”

Three years ago, Federal agents commenced a campaign to root out the wrongdoing on Wall Street that Luciano eluded to decades earlier. After the Ebbers, the Sullivans, the Fastows, Quattrones, the Koslowskis and Stewarts now made their way to court, the question is asked: where does Wall Street go from here?

It was not all that long ago when media outlets routinely headlined charges brought against company directors, insiders and some outsiders.  Today, news comes on a somewhat irregular basis that one defendant or another has agreed to pay penalties or serve a prison sentence. Naturally, the aftermath of prison sentences does not have the news sizzle of a real-time guilty plea handed down by the justice system.  However, the consequences may be just important as the verdict itself.  Without having a great deal of quantitative news data due to the exact reason mentioned in the previous sentence (viz. less media attention).  We will gander to say that many more corporate financial reports would pass the “white glove” test today vis-à-vis the number that would have passed, say, in the year 2000. Long remarked that a typical board of directors meeting today finds not only directors in attendance but also the director’s attorney in-tow. [1]

Interestingly enough, investors’ memories proved quite short in terms of scandals unearthed at mutual funds.  “In Dalbar’s scandals study, 75 percent of mutual fund investors could not even name one of the dozens of firms involved  in the scandals. Not one!” [2] 

Of several notions that come from (a) a move to a police state-type environment and (b) investors’ reluctance to concern themselves with wrongdoing, one cannot shake at least one of these notions.

Several years have prompted securities salespeople to promote the notion of – “safe-ness” – in their practices.  Safe is being sold with the caveat that big is better. Case in point, of all the analysts covering the largest U.S. companies

(according to Zack’s), 67% advise a STRONG BUY/BUY, 30% advise a HOLD and 4% a SELL.  It is notable that those professing a belief in the superiority of cash-laden mega companies vis-à-vis alternatives represent such a large portion. Compliments of Mssrs. Ebbers, Fastow, Sullivan et al., the herd has moved to perceived safety.  That, in our opinion, opens up vast territory of “un-promoted” investment amidst improving economic numbers.  “The market rarely accommodates the majority.”

Several years have prompted securities salespeople to promote the notion of – “safe-ness” – in their practices.  Safe is being sold with the caveat that big is better. Case in point, of all the analysts covering the largest U.S. companies (according to Zack’s), 67% advise a STRONG BUY/BUY, 30% advise a HOLD and 4% a SELL.  It is notable that those professing a belief in the superiority of cash-laden mega companies vis-à-vis alternatives represent such a large portion. Compliments of Mssrs. Ebbers, Fastow, Sullivan et al., the herd has moved to perceived safety.  That, in our opinion, opens up vast territory of “un-promoted” investment amidst improving economic numbers.  “The market rarely accommodates the majority.” [3]

Let the Data Do the Talking

Question #1: With oil prices holding the world ‘over a barrel’, why haven’t alternative energy forms taken hold?

It’s not (yet) cost effective. “Using coal, the most common source of electricity in the US today, consumes around four times more energy as the resulting hydrogen can produce.” [5]

Question #2: Does Europe still have anything to offer?  Germany’s unemployment checks in ~ 10% with percentages four times that figure in Eastern Europe.

Consider: Europe’s Research & Development [R&D] (read: the future) shows remarkable strength. Although General Electric’s market capitalization is over five times the size of, say, Siemens, Siemens spending on R&D last year was over three times that of GE’s. In defense and aerospace, the UK’s BAE Systems is roughly one-fifth the size of, say, United Technologies.  Yet BAE’s R&D spending is approximately 3 times that of United Technologies spending on R&D.

Question #3: Are the health care expense and pension woes a real threat to U.S. companies’ balance sheets?

Consider:  These costs can have a profound impact; particularly at larger U.S. companies.  For instance, at Honda Motors “each car costs the company $107 in pension and health care costs. But at GM, the cost is $1,360. You can imagine

what the cost is for Chinese manufacturers.”

In 1964, Republicans were reduced to a minority of 140 as against 295 Democrats.  “There was nowhere to go but up” the Hoover Institute wrote. In 2004, Democrats were reduced to a minority of 203 as against 232 Republicans

To carry recollection a step forward, only four years later Strom Thurmond changes affiliation and moves from the Democratic to the Republican party. In 2004, leading Republicans led by Specter have already begun the move towards the Democratic ideology.

Ten years after reigning as House Minority leader, Gerald Ford found himself in the White House following Watergate.  The important point to drive home is: we ARE NOT necessarily inferring that the Pelosi administration will occupy in the White House in 2014.  What we ARE inferring is: when levels fall to statistically remarkable levels a re-balancing may be in the cards.

We will watch for any significant movement among politicians to fill the vacuum of this majority gap and more importantly the type of platform purported by such potential move.  Washington IS power and if and when power begins to change, we believe, opportunity for investors will present itself.

Sources

Our point for spouting off such seemingly unrelated data is: It is not outlandish should most Arlington Hall Research readers find they were unaware of this data – this makes sense as there has been little media attention on these data points.  Due to this lack of media attention, those readers who DID know one or more of the points mentioned above probably found this information through unconventional sources (trade journals, inside communication, etc.). In our opinion, if pertinent information such as that found above is unknown to most investors, surprises may be likely.  If surprises are likely, it is important for investors to resist the temptation to PREDICT outcomes and instead try to PREDICT THE PROBABILITIES. Even geniuses understand this approach.  For when referring to Heisenberg’s Uncertainty Principle, Einstein’s biographer suggested “all that physicists could hope to predict are probabilities that it will behave in certain ways.” [7]

Question #3: Are the health care expense and pension woes a real threat to U.S. companies’ balance sheets?

Consider:  These costs can have a profound impact; particularly at larger U.S. companies.  For instance, at Honda Motors “each car costs the company $107 in pension and health care costs. But at GM, the cost is $1,360. You can imagine what the cost is for Chinese manufacturers.” [7] The per-person cost of health care in the United States has risen to $5,440, which is double the amount spent in European countries.

Our point for spouting off such seemingly unrelated data is: It is not outlandish should most Arlington Hall Research readers find they were unaware of this data – this makes sense as there has been little media attention on these data points.  Due to this lack of media attention, those readers who DID know one or more of the points mentioned above probably found this information through unconventional sources (trade journals, inside communication, etc.). In our opinion, if pertinent information such as that found above is unknown to most investors, surprises may be likely.  If surprises are likely, it is important for investors to resist the temptation to PREDICT outcomes and instead try to PREDICT THE PROBABILITIES. Even geniuses understand this approach.  For when referring to Heisenberg’s Uncertainty Principle, Einstein’s biographer suggested “all that physicists could hope to predict are probabilities that it will behave in certain ways.”  [8]

 

 The Jeweler’s Eye

Recent economic-related topics that you WILL find covered in-depth at media outlets include: the U.S. budget deficit, Social Security reform, the trade deficit with Asia, U.S. dollar strength, etc.  One item that has appeared to escape attention is a seed that was planted the morning after George Bush declared electoral victory and ushered in his second Presidential administration.  We acknowledge that its consequences are longer-range and not fit for consumption of a media aimed at an audience which revolves on an instant gratification axis. Nevertheless, the situation is remarkable and a severe dichotomy exists in the world’s most powerful city – Washington D.C.  Let’s turn back the clock forty years.

 

2004 Democratic House Minority Leader = 1964 Republican House Minority Leader

In 1964, Republicans were reduced to a minority of 140 as against 295 Democrats.  “There was nowhere to go but up” the Hoover Institute wrote. In 2004, Democrats were reduced to a minority of 203 as against 232 Republicans

 

To carry recollection a step forward, only four years later Strom Thurmond changes affiliation and moves from the Democratic to the Republican party. In 2004, leading Republicans led by Specter have already begun the move towards the Democratic ideology.

Ten years after reigning as House Minority leader, Gerald Ford found himself in the White House following Watergate.  The important point to drive home is: we ARE NOT necessarily inferring that the Pelosi administration will occupy in the White House in 2014.  What we ARE inferring is: when levels fall to statistically remarkable levels a re-balancing may be in the cards.

We will watch for any significant movement among politicians to fill the vacuum of this majority gap and more importantly the type of platform purported by such potential move. Washington IS power and if and when power begins to change, we believe, opportunity for investors will present itself.

 

Sources

1. R. Long interview with R. Arnold
2. P. Farrell, Marktewatch.com, “Zombies”, Sept. 10, 2004
3.  Analyst Recommendations for: GE XOM MSFT PFE C WMT AIG BAC JNJ IBM, Zack’s Investment Research Inc., Jan. 11, 2005, 1:00PM EST
4. M. Hulbert, Marketwatch.com, “The dog that did not bark”, Nov. 11, 2004 
5. P. Norton, “Breakthrough in Hydrogen Production for Fuel Cells”, Nov. 29, 2004
6. MIT Technology review; R&D Scorecard 2004, Dec. 2004
7.  B. Bonner, Daily Reckoning, Sept. 23, 2004
8. .B. Bonner, March 1967 in Einstein: the man and his achievements edited by G.J. Whitrow 

 

I Made All My Money Selling Too Soon

120-second Summary:

J.P. Morgan’s observation remains as insightful at the beginning of Anno Domini 2004, as the day he uttered that sentence.  Rewards have been heaped upon speculators in the last quarter of 2003. Stocks tripped through sell limit levels with regularity not seen since 1999. Some believe a phase of market consolidation will materialize where a trading strategy will best a buy and hold strategy. Our work tends to support this approach, ceteris paribus.

The attention given to market sentiment indicators has grown to levels unlike any we can recall. Wall Street soothsayers read tea leaves on no less than three different dimensions of market action; a bet on a bet on a bet, as it was. This work refers to one analysis made at the price level (e.g. the S&P 500), one at the option level (e.g. the Chicago Board of Exchange) and one at the sentiment level (e.g. the OEX sentiment level). What one finds is that “analysis of an analysis of an analysis” creates a “new math” that makes less relevant comparison to past analysis of market performance. A phenomenon was explored in 1927 when physicist Heisenberg turned the science community on his head when he proposed his uncertainty principle. He contended that “the more precise the measurement of one position, the more imprecise the measurement of another, and vice versa” (The American Institute of Physics, 2004). In terms of investment management, this concept translates to ‘the more precise the measurement of a stock price’s independent variable, the more imprecise the measurement of the stock price (dependent variable).’

Applying this notion to the stock market can lead one to build a case for potential investment returns possibly residing in more risky stocks which have already experienced significant price appreciation. “While the market may be overvalued from a fundamental standpoint, sentiment indicators as a whole are not showing that the market is overvalued” Schaeffer opines. “Short interest on Nasdaq stocks growing by 3.3 percent in December is not indicative of an overvalued market.”

Let the Data Do the Talking

Biderman fingered three sources of fuel for rising stocks prices in 2003.

Hedge funds funneled “about $200 billion into equities.”

Pension funds funneled “roughly $100 billion into stocks since the end of March.”

Individuals poured “about $130 billion into U.S. equity funds since the end of March.”

The first two are spent and the individual investor is the left to support funding of equities, according to Biderman.

Tax law plays a role. Capital equipment purchases, for instance, spurred by a complete write off of the first $100,000 may have pulled 2005 spending into 2004, according to Contrary Investor. This tax legislation will sunset in December of this year.

Liabilities continue to mount:
320%
Existing Home Price: Avg. Family Income (last record 305% early 1980s)
21.1%
Annual growth rate of Pension Liabilities at S&P 500 cos. (per Newman)
$119,442
Total Debt per man, woman and rug rat in America ($34 trillion total)
Price fluctuation could be driven by shifts, perhaps significant, in investor sentiment.

One would expect sentiment to shift as various market imbalances slow or reverse course. Contrary Investor suggests these imbalances include foreigners’ purchases of dollar denominated assets, excess global liquidity and dollar devaluation.

Do not forget increased program trading has led to increased volatility in the past and program trading is increasing at roughly 35% per year. Program trading “will overtake all other trading by March 2005,” according to Newman’s calculations.

Who’s going to Tell You to Get Out?

Though less probable than the scenarios noted above, the biggest surprise which could occur in the first half of 2004 would be for the market to move lower in the first half of the year, according to Katz. Indeed, this possible scenario existed in early 2003 as well. When an imbalance of this sort occurred in the past, we enjoyed wide positive out-performance of the indices. To be sure, trillions of dollars of investor assets vanished under the tutelage of Wall Street strategists.

Newman reports that Bearish strategist advice outnumbered Bullish strategist advice only 9 weeks out of the 190 weeks since the Bear market began in December 2000.

The Jeweler’s Eye

Inflation: A Debtor’s Best Friend

Wiggins reminds us that debtors do indeed have friends. As the indebtedness of the United States escalates, one can surmise the question is not “If inflation will rear its head?” but “When will it rear its head?” One could base this comment based of a self-serving need.

Over the past three years in these pages, we have drawn out possible paths for stocks and bonds in the event of a collapse of economic growth in the United States. As a supporting corollary to that work, we propose that in the event the Federal Reserve’s loose rate policy is able to continue to fan the embers of economic growth inflation may become an obstacle to stock price appreciation.

In order to “size up” the current level of indebtedness in hopes of making a case for inflation’s value to the United States’ policy, we turn to Hazlitt’s work in the area.  Hazlitt stated that “It is true, no doubt, that an artificial reduction in the interest rate encourages increased borrowing.” Bonner illustrates current debt trends

In the 1960s, Americans borrowed $1 for every $3 of extra income they earned.
In the 1980s, they were up to borrowing $1.50 for every $3 in new income.
In the 1990s, they borrowed $4 for every $3 in new income.
By October 2003, they borrowed $9 for every $3 in new income,
Richebächer notes.

Historical stock price performance demonstrates that inflation is no friend of bull markets. As such, one should carefully monitor price reports over the coming year in order to discern the extent to which inflation may be used to offset the country’s debt burden.