Market Commentary – March 2003

My work tells me the market is not going anywhere, and if it does the direction is likely to be down. We are probably in one of these extended flat periods that can serve as an alternative to a gut wrenching bottom. I hope so, but what is the evidence we may go down?

First, this appears to be a major bear market in the category of 1929-1932 and 1973-1974. Such declines are marked by major changes in the economy and the way the investors perceive equities. So far there is evidence of important change in the economy, though it is probably not yet reflected in stock prices, but investor perceptions have barely begun to adjust. The lack of attitude change is reflected in the way high technology stocks lead every rally, even though their earnings remain terrible and pricing high. High tech products continue to sell well, Dell for instance is selling more computers every year, but profits are down. That is not the magic formula to success, but you would not know it from the price of Dell’s stock.

Wall Street thinks it is 1994, with its strategists recommending high equity exposure, and cash in mutual funds at low levels. Investors are waking up, but their minds are still influenced by Wall Street bulls. Bull/bear opinion statistics are positive (heavily bearish), but the all day stock market show has a parade of money managers selling the bull case. Mixed into the bull crowd are a few quiet bears. I suppose it is because I share their point of view, but these people sound thoughtful and intelligent, while the bulls sound like they are pushing stocks for a living. It is also comforting to have Warren Buffett and John Templeton in your corner (maybe you have to be seventy and have gone through a previous secular decline to get a feel for these things).

The consumer held the economy together, but now consumer support is weakening. The downtrend in consumer sales gains has not reached zero, but getting close. It could weaken further with employment numbers making no progress and an indication consumers are tightening their pocketbooks because of worry about the future. Some of this tightening is from necessity, revealed in high and rising credit card and other consumer credit delinquency. The buying inspiration from no interest loans is old hat now. More directly, the great mortgage refinancing boom that injected hundreds of billions into the economy in the last two years appears to be over. Lower long term interest rates would extend refinancing, but that is likely only if the economy weakens, so the medicine is worse than the cure.

Experienced hands have an uncomfortable feeling about the strength in housing. Every instinct says it can’t last. Enthusiasts say there is no housing bubble, but if not a bubble certainly a boom. If it ends, important support for the economy is removed. Some of the housing boom comes from conversion from apartment living, but apartment vacancies are rising and rents falling, so the mathematics is working against the trend. An end to the housing boom could mean trouble because, not only would the money coming out of refinancing disappear, but prices are likely to weaken, reducing the wealth affect and discouraging consumption. Housing will probably level off or slump a bit, not a catastrophe, but adding to the sluggishness of the economy.

The dollar is going to weaken further, perhaps substantially. The happy folk say that is great because the trade deficit will ease as foreign goods rise in price and domestic products become more competitive, but the dollar is already off a lot and the trade deficit continues to rise (many far east currencies, notably China’s, are pegged to the dollar). The trade deficit guarantees that foreigners will be getting a large dollar inflow, but the weakness is leading to unloading those dollars.

Our image as the land of opportunity has gone up in the smoke of internet and high technology disintegration. The exploding deficit is not a confidence builder, and our fecklessly aggressive foreign policy is alienating the rest of the world. Not only does this leave us isolated to pick up the cost of the foreign ventures, but it strains any desire by the rest of the world to help us out. We are in a bind. We probably ought to be raising taxes, but can’t in a weak economy, and Bush is so committed to tax cuts he would never reverse course, especially as his father’s responsible tax increase may have defeated his second term. Assuming Bush gets a second term and vigorously pursues the war on terror, we will be breaking new ground on deficits with unknown consequences.

We have no trouble financing the exploding deficit at the moment, but suppose the economy picks up and there is demand for money. The right wing economists claim deficits have no influence on interest rates, citing the experience of the last year, but that is ridiculous, of course rising deficits influence interest rates. If the economy picks up enough to create demand for money, interest rates could go up rapidly.

Then there is fiscal policy. A swing from a couple of hundred billion surplus to several hundred billion dollar deficit and interest rates going from over 6% to 1 1/4%, has merely succeeded in ending the decline. These numbers suggest that our problems are not the traditional ones. We are suffering a hangover from the greatest speculative blowoff of all time. Bush has no ideas for directly countering this drag. His only proposal is lower taxes, mostly for the upper brackets, under the theory they produce greater savings and greater investment, the old trickle down that lifts all boats. But upper bracket taxes were far higher during our years of greatest growth. There seems to be no connection between upper bracket tax rates and investment, it is a matter of opportunity, not tax rates. Good investments will find funding.

With Wall Street having directed investment dollars down a rathole of sexy internet and non-earning high technology companies, and talked industries like utilities into idiotic diversifications, while the government acts like a spendthrift with low return weapons, we are not getting much return on capital. The apparent absence of good investment opportunity expresses the hangover of the speculative bust, and in time will correct, though less so than in the past because we are a mature economy.

Not only are investors turned off by losses, the lack of investment opportunity in the U.S. is influenced by, to use one word where I mean many, China. We may be a consumer economy, I think the data is that industrial employment is only 15% of the total and industry makes up only 30% of GNP. It is a precious 30%, however, and the 30% is eroding. I wonder, what percentage of the products sold in Wal-Mart comes from abroad? And what is the trend? We bought a stock called Salton a few years ago. Salton has become the king of kitchen appliances, an original American business. GE, Westinghouse, Sunbeam, and many others in kitchen appliances, are disappearing, some of the brands names bought by Salton. Everything Salton sells comes from China, or a neighboring country. George Foreman grills, new innovative stuff, it all comes from China. Though undoubtedly included in our industrial base, Salton is not a manufacturer, it is a distributor of Chinese goods. We have been able to hold onto larger appliances like washing machines, ovens, and refrigerators, but GE is planning to get out, just as it did small appliances. Is there a message? Have you seen a U.S label on any item of clothing in recent years? Textiles, the foundation business of the industrial revolution, now going. We did save the automobile industry when it seemed headed abroad, so it isn’t a battle we must always lose, but we are losing.

I feel the change when it comes to picking stocks. There is nothing exciting out there any more. I feel as if I am picking over the same old tired lists, looking for a stock whose only attraction is its price. Perhaps declining opportunity is why investors lost their head over internet stocks, though the absence of profits told experienced hands it made no sense. I recall visiting WD-40 thirty years ago when it had six employees and distribution only in the west. The opportunity was easy to see, the product was simple, and the manufacturing process was two men stirring a not very large vat in the back room. We hit a home run with Movie Gallery, but that was a special case of combining a weak market for small company stocks and recovery from a troubled period, allowing us in at an extraordinary price. There will be more of those, but how much better to find consistent growth companies. Movie Gallery has a couple more good years, but its market is tenuous, it’s not something to lock away in the safe deposit box. I see opportunity in health care, HMO’s for instance are very cheap, but the medical care area is in a crisis of rising costs, and HMO’s have not proven to be the hoped for answer.

Being a price opportunist, I operate well in a flattish market, but I hoped a major bear market would allow us to get into solid long term situations in my old age. Drugs, maybe, but the growth rates are skidding and they are coming under more and more pressure because of runaway health costs. Remember how drugs plunged under the Hilary threat in 1993 and 1994? Well, we are going to end up with a Hilary-like plan to control medical costs (though not under Bush). Considering everything, I think it will be a break if the market follows the hinted direction and goes a lot lower. Then we can get the opportunity to make real money before I lose my eyesight. Maybe I should become an expert on China, but its too late to teach an old dog new tricks. Besides, those guys who claim to know all about foreign stocks don’t do as well as I do.

I have been too gloomy lately. Next month I will write about the good stuff. I smell a good year out there, if I can avoid losing too much of your money first (we are off 4-5%, not bad considering that our companies are issuing one bad news bulletin after another, though discouraging with a 30-35% cash position and another 20% in conservative high dividend payers).

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