Awaiting Visibility

Executive Summary:

The pattern that emerges is: American investors face one crisis every year. Obviously, the “Recession of 2001” garners the spotlight today. It was the “Internet Crisis of 2000” and “Y2K Doomsday in 1999”. Currency collapses in Brazil, Russia, and Thailand loomed in prior years. And those Malthusians out there among us extol – Over one million species are extinct! Yet, as Buckley notes, here we are (see “Get On With It”).

We illustrate the consequences of the unresponsive interest rate policymakers (see ‘The Federal Reserve and the Hornet’s Nest). Moreover, float evaporation’s impact on the economy remains the ‘step-child’ of federal economists (see ‘The Fed and the Float’).

Watch for manufacturing and telecommunications to rebound once the final ingredients are put in place (see ‘Is it time to be bullish on manufacturing?’ and ‘Where will the telecommunications sector find cash?’).

The Japanese banking predicament remains a powder keg of the first degree (see ‘A Melting Sheet of Ice’). However, we have reason to believe the crisis may pass without incident (see ‘Japan Speaks Up’) 

The pattern that emerges is: American investors face one crisis every year. Obviously, the “Recession of 2001” garners the spotlight today. It was the “Internet Crisis of 2000” and “Y2K Doomsday in 1999”. Currency collapses in Brazil, Russia, and Thailand loomed in prior years. And those Malthusians out there among us extol – Over one million species are extinct! Yet, as Buckley notes, here we are (see “Get On With It”).

We illustrate the consequences of the unresponsive interest rate policymakers (see ‘The Federal Reserve and the Hornet’s Nest). Moreover, float evaporation’s impact on the economy remains the ‘step-child’ of federal economists (see ‘The Fed and the Float’).

Watch for manufacturing and telecommunications to rebound once the final ingredients are put in place (see ‘Is it time to be bullish on manufacturing?’ and ‘Where will the telecommunications sector find cash?’).

The Japanese banking predicament remains a powder keg of the first degree (see ‘A Melting Sheet of Ice’). However, we have reason to believe the crisis may pass without incident (see ‘Japan Speaks Up’)

Since We Last Spoke

Get On With It

History shows the absence of decisive action frequently prolongs crises. Ironically indecisive action may delay suffering but typically ends with greater total suffering than that predicted with that of pre-emptive decisive action being taken.

The lack of decisive economic goals inherent in the 1970’s Stagflation and the 1930’s Bank Collapse serve as examples in financial policy.

The lack of decisive military goals inherent in the Vietnam and Bosnia conflicts serve as examples in foreign policy.

How can today’s financial markets benefit through understanding these debacles?

The Fed can aggressively loosen money supply and 

Japan can devalue the Yen.

Delayed action here is a thorn twisting in the side of economic growth.

Without either or both of these events transpiring, the broader markets will remain in volatile trading ranges.  At present, we have not identified a catalyst to drive these actions.  Therefore, we have looked to market sectors that may be less affected by this indecisiveness.

The Federal Reserve and the Hornet’s Nest

Feedback indicates our attempts to compare the current stock market and economic conditions to events wholly unrelated to the market meets with your support.  So here we go again.

There is a wall located near our office has the dubious honor of harboring a spring vacation site preferred by local hornets.  Like clockwork, each March a swarm of hornets appears to build a nest much to the chagrin of those of us who travel nearby.  Though we hold no ill feeling towards these hornets, those of us who walk near their nest just as soon see them move elsewhere. Therefore, early each year a pest control firm is contracted to treat the area in an attempt to dissuade the hornets from selecting this nesting site.  The key element to preventing the hornet’s arrival is early action.  If the area is treated in time, the hornets do not appear.  If the contracted pest control firm fails to treat the area before the end of February, we will spend the spring and summer fearing being stung by one of the hornets and, in general, attempting to avoid the unwanted neighbors.  More importantly, should the pest control firm attempt to schedule a meeting once the hornets arrive, a Herculean effort must transpire requiring more resources (viz. more people with more protective equipment and more repellent), more time and, overall, more expense.

To take some literary liberty, the “we” is the market pundit community (viz. economists, market strategists, investment advisors, and shareholders), the “pest control firm” is the Federal Reserve, the “repellent” is aggressive interest rate cutting, and the threat of being stung by “hornets” equates to the threat of stocks dropping in value due to falling earnings in a recession.

Our point? In November 24 of 26 economists polled “called” the Federal Reserve to treat the market with aggressive rate cuts to prevent a recession.  Some felt the treatment should call for a total of 2.5% of interest rate cuts to avoid a spring recession.  The Fed arrived late [January 2001] and with less than ½ of the suggested treatment [a 1.0% rate cut]. The result?  The hornets arrived [the Nasdaq fell in February and the Dow fell in March].

Next Tuesday, the Federal Reserve will explain its suggestion to address the hornet problem.  The Fed may suggest a heavy dose of treatment [additional 1.5% rate cuts].  Or it may conserve its reserve in order to have some treatment on hand to deal with the hornet problem that may spill over into later in the year.

Regardless of the plan of action that is selected, the problem remains – the hornets are in place.  Our response has been to spend more time away from the swarming hornets [place funds in Europe and Asia] and avoid the nest [build near-term cash reserves].

As the economy and earnings improve, or more importantly are perceived as improving, we plan to add to our portfolios in areas likely to lead the market out of its current predicament.  We know from our last issue that as long as the Fed continues to administer treatments [rate cuts] eventually the hornets will disappear (see “7-for-7”, 2001).

The Fed and the Float

Thirty years ago, a tire company’s business manager would guess how many tires to order to meet next year’s sales targets.  If for some reason he were incorrect, millions of tires would pile up in warehouses.  Next, tire inventory reports would indicate recessionary conditions and the Federal Reserve would take action to alter the market through artificial money supply control.  Today, those wild inaccuracies are practically eliminated by, in a word, technology.

Carocella notes corporations can ‘turn on a dime’. When excess inventory is identified, production is shut down immediately.  The recent six-week shut down at the Lincoln Navigator plant serves as an example.

It is precisely those wild swings of days gone by that was deemed the basis for a “hand-on” Federal Reserve.  Per Crane, blending the current efficient corporate model with the dated Fed model makes for a market sell-off that seems more like a sentiment-driven decline more than a fundamental-driven decline.

What We Are Watching 

Is it time to be bullish on manufacturing?

Not yet, there is one more indicator that must turn first.  That indicator is: raw material costs.  When raw material costs reverse, the ingredients for a manufacturing rebound will be in place.

Where will the telecommunications sector find cash?

Next on the list after manufacturing, telecommunications is positioned to profit.  The final ingredient is not raw material costs.  It is cash.  Until these companies can increase their liquidity through mergers or in the capital markets, they will remain under pressure.  Once they raise cash, the possibility of a rebound could be significant.  More specifically, the market potential has not changed since last autumn.  The “last mile” of the high-speed communications network offers a 100-fold growth potential.

Watch investor reaction in “safe havens”

Many stocks have been viewed as ‘good stocks to own’ as they supposedly profit in a post recessionary environment. Some may be impacted by a possible meltdown of the Japanese Yen.  We have issued cautionary items on the housing and financial sector exposure.  Once the devaluation of the Yen has occurred, it appears likely that several stocks will emerge as oversold.  At that time, we will access profit potential in these sectors.

Another signal to the Federal Reserve: Business Inventories

The business inventories, reported earlier this week, may add fuel to the argument for more aggressive rate cuts.

 –1 – 1 = -3: The Compression of the Lending Pool

The impact of tight money supply grows over time.  Although we have not identified the direct relation of tight money supply in 2001 to commercial lending, every day that a business is reluctant to lever itself due to high interest rates is a day that is transformed to a triple loss to the economy.  That is to say, the opportunity cost of one unconsummated business loan results in three setbacks: one to the business, one to the bank and one to both the business and the bank.

First, the company does not expand.  Second, the bank must decrease its risk exposure to maintain quality as market growth projections are decreased by lower lending activity.  Finally, a possible loan tomorrow requires higher collateral.  Both the bank (through increased risk requirements) and the company (through higher costs of borrowing) are dealt a loss.

It is for reasons similar to this that we have experienced setbacks in several growth stock holdings.  Our growth profile necessitates holding only those companies that can prosper in the most difficult credit environment.  Our focus remains on businesses that (1) add productivity to non-growth companies or (2) control a dominant share of a growing market.

Economic Commentary

A Melting Sheet of Ice

We have addressed both concerns about the Japanese financial market and acted to avoid those areas, which may be impacted by a forced devaluation. Arnold believes if devaluation remains unaddressed over an extended period of time, a Japanese stock market at 10,000 is not out of the question.  Longer-term, Japan is probably accelerating China’s move to the post of ‘most important economic force in Asia’.

In order to interpret why this potential crisis poses severe consequences to the world, consider the following:

Young ice hockey players in the North America typically spend their time playing the playing the sport on frozen ponds or lakes.  One of the problems players fear is the impact of the warm sun melting the ice. If the temperature rises to a certain temperature and the supported weight of the players great enough, the ice may crack sending some, and typically all, of the players crashing into the freezing water.  As this scenario has proved fatal on many occasions, it is not surprising that the first sound of a sheet of ice cracking sends a shrill of fear through ALL of those on the ice.  Simply, although only one player may have caused the crack, all are endangered. The first reaction to a loud crack of ice splitting is for everyone on the ice to stop all movement.  If the ice does not split completely through on the first crack (as is typically the case), the players attempt to cautiously move together to get to safety at the edge of the shoreline.  If everyone moves cautiously and no one makes a frantic, self-serving movement, typically all can escape the danger and live to play another day.

So too, the Japanese banking system’s actions, or more appropriately – inaction, has sent out a “loud cracking noise” for all the world’s central banks to hear.  Presently, the central banks are aware of this predicament and working to direct Japan and their own economies to the shoreline and escape the possibility of falling into the freezing water. This fall could be interpreted as a global economic meltdown. 

We have addressed both concerns about the Japanese financial market and acted to avoid those areas, which may be impacted by a forced devaluation. Arnold believes if devaluation remains unaddressed over an extended period of time, a Japanese stock market at 10,000 is not out of the question.  Longer-term, Japan is probably accelerating China’s move to the post of ‘most important economic force in Asia’.

So too, the Japanese banking system’s actions, or more appropriately – inaction, has sent out a “loud cracking noise” for all the world’s central banks to hear.Presently, the central banks are aware of this predicament and working to direct Japan and their own economies to the shoreline and escape the possibility of falling into the freezing water. This fall could be interpreted as a global economic meltdown.

Japan Speaks Up

Yesterday came the most assuring comment out of Japan in six months.  In a country where Mori’s self announced resignation notices remind one of the “Boy Who Cried Wolf” children’s story, the Finance Minister indicated the Japanese government would support the currency, and consequently the economy, in this time of trouble.  This should prevent the world’s central banks from experiencing a global meltdown or as it was above – all the players on the ice pond from crashing through the ice surface.

Note, in the event Japan should renege on this claim, all bets would be off. Without government intervention, the collapse of the Japanese banking system remains a possibility.  Our stance is to wait out the potential crisis and wait until the currency support is ‘signed on the dotted line.’  Once signed, we move forward. 

What we hope to take advantage of:

1) Outsourced manufacturing

Inventory management is the profit motive for outsourced manufacturers. As inventory levels increase, there may be less of a window for profitability on the part of outsourced manufacturers.  Therefore, we have reduced holdings in some of the ‘picks and shovel’ companies in commodity technology businesses.  One must assume that at some point, even those companies selling picks and shovels to the miners and mining companies of the Californian Gold Rush were pushed to expand their services to newer clients.

2) Is Capitulation Necessary for a Bull Market to Return?

Yes, market bears do not turn into market bulls.  A bull market will return when stocks are thrown out the window.  The reason an investor stays in the market is that history shows those who are in the market when capitulation occurs take home the highest profits.

3) Bush: The Tax Cut and Beyond

President Bush campaigns for his tax proposal with increasing energy.  We think many investors are overlooking potential profitability in his areas of interest apart from tax cuts.  In media circles, defense, power, energy and healthcare certainly are taking the back seat to tax cuts.  Once the tax cuts pass or fail, attention to these sectors should increase. 

 

 

Leave a Reply