Tag Archives: Investing

Monthly Commentary – April 2003

After years, of negative commentary, I promised to lay out the positive case. The promise was lucky because the events of March indicate that we may be looking at a fresh bull market. A major rally or new bull market was widely expected with the opening of hostilities in Iraq. In part that belief rested on the idea that the market and the economy were held up by uncertainty about the situation in Iraq. War is positive by removing the uncertainty. The rally forecast also rested on mirroring off 1991, when the most powerful bull phase in history was launched on the very day the Kuwait War began. In 1991 we had been in a bear market, stocks had rallied off an October low then fallen back, and the economy was in recession. You could not have a more perfect likeness of events. The hangup is that mirroring, while popular and enticing, rarely works out. As we now know, the rally opened five days before the war began, reflecting bullish anxiety to get things going. In only eight trading days the market was up 12%, or about 60% of the total three month first stage bull market rise in 1991. The swiftness reflected the high degree of anticipation, but the move was too big to be sustained. The market then sold off, but the decline was not serious enough to break the upward bias. So far, so good. Despite wide expectation of a rally, investor sentiment indicators were predominantly bearish in early March, which is positive. These surveys have moved up only slightly since the rally began. A considerable swing to bullish sentiment can be expected before the up move is threatened. Technically, the market looks good. We have a triple bottom: a low in August, a slightly lower second bottom in October, and a third higher bottom in early March. This leaves us with a technically strong base extending over five months, and suggests a new bull market, not just a rally. Individual technical indicators are also positive. My most telling directional indicator is daily advances minus declines. Although we hit new lows below those of October on both NASDAQ and ASE, NYSE A/D held. The NASDAQ and ASE are better indicators than NYSE, but A/D is not a good indicator at bottoms anyway. It is terrific at showing a building top, but not a bottom. Overall, a positive showing. Daily new highs and new lows are positive in that new lows at the March bottom were way down from October, when the level was extreme, probably climatic. A nice progression of rising new highs has unfolded as the rally continued. While not useful day to day, high-lows are excellent long term indicators. Aside from sensing a bottom in unusually attractive pricing, the only timely signal I have ever found is a nine to one up volume day. As a new bull market kicks off, one of the early days will have volume on the NYSE for stocks going up that is nine times greater than volume for stocks going down. This is a rare event and indicates such depth and breadth of buying as to create a momentum that lasts for a while. In 1991 we had something like five such days in the first two weeks, but usually only one is required. We had that big volume day on March 17, the fourth day of the rally, and it was an impressive 13 to 1. Follow through on the big mo signal was weak, but the sell off was not too bad considering disappointing news from the front. Another positive factor is time. Bear markets last six months to a year, serious bear markets (say 1973-1974) last at most two years, and even the depression market declined for only two years and ten months. March would have been the third anniversary of this decline, so we were close to setting a record (if the bear market is over, last October will be the bottom). The problem with this analysis is that at the end of the 1929-1932 and 1973-1974 bear markets, stocks were extraordinarily cheap. The foundation of those bottoms was that stocks had gone down as much as they could with values so extreme. Smart money could no longer resist. That is not the case this time. Over the long term, markets work from extremes of valuation at either end. Eventually we are likely to have an outstanding buying opportunity, but it will be hard to see because the economy will look worse than it does today. A somewhat similar positive argument is that the economy must improve. There is no such thing as a double dip, it exists only in government economic data. A double dip recession is merely a longer than usual one. The economy looks terrible now, but only because of the long time we have spent bumping along a bottom. Things always look worst just prior to a pick up. This is not a normal inventory recession, and I suspect things will remain slow for some time, but eventually there will be a pick up. Why not this summer? For the market timer, tops are easy. Bottoms are another matter. The reason market timing is unpopular is not that it can't be done, but the fear of missing bottoms, and that fear is justified. Bottoms are always hard to call. I use a strategy of going ahead and buying stocks that are extremely cheap and seem to have run out of steam on the downside, knowing there is no way I will be able to call a bottom. The worst that can be said about the market is that if we reached a bottom, it is by far the highest priced in history. The absence of genuinely cheap stocks after such a lengthy bear market will limit gains. Bear markets have always produced attractively priced stocks, and here we have a really big bear market and few bargains. The reason is the extremely depressed level of earnings. If the economy does not bounce back, and fairly strongly, a rally is far more likely than a bull market. Interestingly, many of those looking for a big up move still do not think the bear market is over because of deep rooted economic problems that are either not being addressed or are too intractable for the usual cures, and may be worsened by a deficit getting out of hand. The absence of attractively priced stocks supports that viewpoint. Although I am not yet convinced that the trend has reversed to the upside, the odds are decent that we have seen a bottom. There is no law saying a bear market must produce great value. As to the economy, I don't believe in basing my investment stance on something so unpredictable. I don't like that right wing economists see nothing but sunlight despite the clouds, but these people are in control of the government and they may well give us another big tax cut. You have to ask, if the economy really is picking up, why in hell are we going for another tax cut with an exploding deficit (the answer is that the right believes any tax cut any time is a good one). On the other hand, that cut is likely to be positive over the short term. Aside from what is shaping up as a good rally or bull market, the long term picture is not positive for more reasons than high stock prices. I am reminded of a comment by a man who builds his economic theory around historical precedent, a long perspective I much favor, who said, you would have to be crazy to be bullish on the U.S. economy. Our venture into aggressive warfare, the historical curse of leading nations, on top of a loss of interest in fiscal responsibility, has inspired me to begin reading The Decline and Fall of the Roman Empire. But that decline took centuries, and I will be long gone by the time of the fall.

Market Commentary – April 2003

After years, of negative commentary, I promised to lay out the positive case. The promise was lucky because the events of March indicate that we may be looking at a fresh bull market. A major rally or new bull market was widely expected with the opening of hostilities in Iraq. In part that belief rested on the idea that the market and the economy were held up by uncertainty about the situation in Iraq. War is positive by removing the uncertainty. The rally forecast also rested on mirroring off 1991, when the most powerful bull phase in history was launched on the very day the Kuwait War began. In 1991 we had been in a bear market, stocks had rallied off an October low then fallen back, and the economy was in recession. You could not have a more perfect likeness of events. The hangup is that mirroring, while popular and enticing, rarely works out. As we now know, the rally opened five days before the war began, reflecting bullish anxiety to get things going. In only eight trading days the market was up 12%, or about 60% of the total three month first stage bull market rise in 1991. The swiftness reflected the high degree of anticipation, but the move was too big to be sustained. The market then sold off, but the decline was not serious enough to break the upward bias. So far, so good. Despite wide expectation of a rally, investor sentiment indicators were predominantly bearish in early March, which is positive. These surveys have moved up only slightly since the rally began. A considerable swing to bullish sentiment can be expected before the up move is threatened. Technically, the market looks good. We have a triple bottom: a low in August, a slightly lower second bottom in October, and a third higher bottom in early March. This leaves us with a technically strong base extending over five months, and suggests a new bull market, not just a rally. Individual technical indicators are also positive. My most telling directional indicator is daily advances minus declines. Although we hit new lows below those of October on both NASDAQ and ASE, NYSE A/D held. The NASDAQ and ASE are better indicators than NYSE, but A/D is not a good indicator at bottoms anyway. It is terrific at showing a building top, but not a bottom. Overall, a positive showing. Daily new highs and new lows are positive in that new lows at the March bottom were way down from October, when the level was extreme, probably climatic. A nice progression of rising new highs has unfolded as the rally continued. While not useful day to day, high-lows are excellent long term indicators. Aside from sensing a bottom in unusually attractive pricing, the only timely signal I have ever found is a nine to one up volume day. As a new bull market kicks off, one of the early days will have volume on the NYSE for stocks going up that is nine times greater than volume for stocks going down. This is a rare event and indicates such depth and breadth of buying as to create a momentum that lasts for a while. In 1991 we had something like five such days in the first two weeks, but usually only one is required. We had that big volume day on March 17, the fourth day of the rally, and it was an impressive 13 to 1. Follow through on the big mo signal was weak, but the sell off was not too bad considering disappointing news from the front. Another positive factor is time. Bear markets last six months to a year, serious bear markets (say 1973-1974) last at most two years, and even the depression market declined for only two years and ten months. March would have been the third anniversary of this decline, so we were close to setting a record (if the bear market is over, last October will be the bottom). The problem with this analysis is that at the end of the 1929-1932 and 1973-1974 bear markets, stocks were extraordinarily cheap. The foundation of those bottoms was that stocks had gone down as much as they could with values so extreme. Smart money could no longer resist. That is not the case this time. Over the long term, markets work from extremes of valuation at either end. Eventually we are likely to have an outstanding buying opportunity, but it will be hard to see because the economy will look worse than it does today. A somewhat similar positive argument is that the economy must improve. There is no such thing as a double dip, it exists only in government economic data. A double dip recession is merely a longer than usual one. The economy looks terrible now, but only because of the long time we have spent bumping along a bottom. Things always look worst just prior to a pick up. This is not a normal inventory recession, and I suspect things will remain slow for some time, but eventually there will be a pick up. Why not this summer? For the market timer, tops are easy. Bottoms are another matter. The reason market timing is unpopular is not that it can’t be done, but the fear of missing bottoms, and that fear is justified. Bottoms are always hard to call. I use a strategy of going ahead and buying stocks that are extremely cheap and seem to have run out of steam on the downside, knowing there is no way I will be able to call a bottom. The worst that can be said about the market is that if we reached a bottom, it is by far the highest priced in history. The absence of genuinely cheap stocks after such a lengthy bear market will limit gains. Bear markets have always produced attractively priced stocks, and here we have a really big bear market and few bargains. The reason is the extremely depressed level of earnings. If the economy does not bounce back, and fairly strongly, a rally is far more likely than a bull market. Interestingly, many of those looking for a big up move still do not think the bear market is over because of deep rooted economic problems that are either not being addressed or are too intractable for the usual cures, and may be worsened by a deficit getting out of hand. The absence of attractively priced stocks supports that viewpoint. Although I am not yet convinced that the trend has reversed to the upside, the odds are decent that we have seen a bottom. There is no law saying a bear market must produce great value. As to the economy, I don’t believe in basing my investment stance on something so unpredictable. I don’t like that right wing economists see nothing but sunlight despite the clouds, but these people are in control of the government and they may well give us another big tax cut. You have to ask, if the economy really is picking up, why in hell are we going for another tax cut with an exploding deficit (the answer is that the right believes any tax cut any time is a good one). On the other hand, that cut is likely to be positive over the short term. Aside from what is shaping up as a good rally or bull market, the long term picture is not positive for more reasons than high stock prices. I am reminded of a comment by a man who builds his economic theory around historical precedent, a long perspective I much favor, who said, you would have to be crazy to be bullish on the U.S. economy. Our venture into aggressive warfare, the historical curse of leading nations, on top of a loss of interest in fiscal responsibility, has inspired me to begin reading The Decline and Fall of the Roman Empire. But that decline took centuries, and I will be long gone by the time of the fall.

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).

Monthly 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).

Market Commentary – February 2003

Having progressed about half way through the quarter's earnings reports, I am altering my view that the market remains severely overpriced. That judgment is true as determined by the price earnings ratio on the S&P-500, still about twenty-eight times earnings, but the reported number is skewered to the high side by many companies with losses and the high price of its high technology components. For most stocks, the price is neither high nor low, but some where in the middle. I am finding one company after another with a PE ratio in the fifteen to eighteen range, neither attractive nor notably unattractive. What I am not finding is bargains. After such a severe bear market, this is disappointing and unusual. Every bear market in memory has generated great buys, so the absence is not encouraging for the market. From these observations, I draw a number of conclusions. First, the direction of the market will be determined by whether or not the economy comes back and earnings advance. Off a low base, profits have jumped back, but at a level far under the previous peak, and there is no sign that the economy is picking up to serve as a basis for further gains. The majority of companies continue to warn of slowness. In each of the last two years, the experts assured us of a second half rebound, and it didn't happen. Will it this time? Who knows. Optimism about a pick up seems to be based less on solid evidence than the feeling that an upturn is inevitable after such a long period of slowness. On the other hand, the economy looks slower from a long term perspective. One industry after another is losing out to foreign sources. Sometimes the company is merely contracting out its manufacturing and profits do not suffer, but domestic jobs do. The latest I have come across is furniture. We are winning the arms war, but losing the economic war. Also suggesting non-growth is a worldwide trend is to flatness. It started in Japan long ago, and for years Europe has failed to achieve a sustained pick up. Why not us? The Fed has shot its bolt, though it could simply print money. The administration shows little interest in programs to boost the economy, rather it is using the need for help as an excuse for more tax breaks for the rich. Not much stimulus there. Second, forget the talk of Iraq war fears holding back the market, that is baloney. The economy is what counts. Will Iraq help or hurt the economy? Again, who knows. One thing for sure, we will pay the full cost of this war and its aftermath is going to be very expensive, so no war is probably the best alternative. And the market seems to do better when there is hope for no war or a coalition war. If we do get war, the already declining dollar will weaken, foreign money will continue to come out of our market, and deficits are going to explode (they already have). Sooner or later, that will lead to higher interest rates, not exactly a help to the economy or the markets. The Bush administration's international aggressiveness introduces a new equation to the stock market, and it is not likely to be a positive one. Third, if the bear market is over, any recovery is apt to follow the pattern of recent months: a hesitant back and forth movement. Major bottoms of the past, 1932 and the end of 1974 come to mind, were made because stocks had gone down too much and were extremely cheap. On both occasions, the economy remained weak, but prices had reached an extremity of valuation, and stocks went up regardless. That is not the case this time. As I suggest, stocks may be close to fairly priced, but they are not cheap, the norm at the end of a major bear market. As a result, any recovery in stocks will be gradual. Finally, I see nothing in the technical pattern to suggest that we have entered a new bull market, therefore as a believer in the trend, I have to presume that we remain in a bear market. New bull markets identify themselves by broad based strength. On a stock by stock basis, bad news has little affect because stocks are washed out and ready to go on favorable news. In recent months we are still experiencing disasters of the day. The market does not look right, and when you wonder why, there is no difficulty finding reasons. I never try to guess the economy, I look at what the market is doing and assume the economy will take the cue. The present cue is stagnation, with a high risk that the outcome will be negative because there is no indicated trend change. The non-taxed dividend proposal is the most interesting new front for investors. Double taxation of dividends has been around for a long time without harm to the economy, and the timing for a change is terrible since it provides only minor stimulus at the cost of adding to a soaring deficit. But our economy seems to need help, and the Bush proposal may indicate a movement toward comprehensive overhaul of the tax code (I think Bush is reckless, but that is not all bad). Making dividends non-taxable to corporations, rather than to individuals, would be a telling move, so that in its present form the proposal is not all that bold. If the benefit went to corporations, they would increase dividends significantly, at ultimately greater benefit to stockholders, earnings would get a considerable boost, and the stock market would probably recover. Moreover, the preference for debt to equity would be substantially reduced and balance sheets improved, a plus for the bond market as well (though a lot more stock coming into the market is negative). The present proposal has not been well received, even by Republicans, but resistance may work out best. Once the debate is under way, the benefit might be shifted to corporations. In turn, that would mean such a loss of revenue at a time of mounting deficits that the entire tax code would have to come under review. The Bush idea has stirred the pot, maybe something unexpected will happen. Although we are unlikely to get the fully untaxed dividend, we will get something. Investors were already looking at dividends as a surer way of making money in stocks, and whatever we get will further stimulate interest. Our stocks have been in a strange pattern since the October low, particularly this year. We ran way behind the sharp upmove in early January, then did much better than the market once it sold off. That pattern continues on a day to day basis - we don't do much on the big up days, but decline only slightly, sometimes even have a small gain, on the big down days. Since downers have predominated in the last three weeks, we look OK. But the pattern is strange. I think it says we are in the right stocks, that the rallies have been led by the wrong stocks, and if this market ever gets straightened out, with sound stocks going up and speculative ones trailing, we will do well. If a third bottom in the range of the August and October lows holds, we should get another strong rally. If so, I have solid candidates warming up in the bullpen that have not been bought because the market looks so bad.

Utility Stocks – September 2002

One of the most confounding aspects of the bear market is the collapse of stocks that were seen as safe. I am not referring to GE, which was known to be playing games with its accounting and was selling at much too high a price, but specifically to utility stocks. The collapse would not have been a great surprise if investors had understood the extent to which utility companies had turned away from their conservative past and gone off in speculative directions. The stocks are down so much that they probably offer one of the best opportunities in the market, but figuring out how to act on the opening is difficult because the condition of the companies is up in the air. With the arrival of de-regulation, utilities moved their plants formerly dedicated to the system into unregulated companies. Most set up trading departments whose inventory was their own power now available to be sold out of the system. After trading off much of their own production, they bought someone else’s as a substitute, creating a temporarily huge market in energy trading and a lot of short term trading profits. Once the initial swap-around was completed, they were left with little to do. As a result, trading departments are being abandoned or severely cut back. Left behind were trading “profits” using Enron type front loaded accounting for long term contracts, a decent portion of which are now uneconomic. The companies are now faced with writing off previously booked profits. The full extent of the losses is hard to guess, but may be substantial. Any losses could not come at a worse time because the companies are overextended in other areas and their financial condition has become precarious. Under the stimulus of de-regulation, a lot of new capacity was built and old plants re-started, creating a surplus, and price weakness. This threatens outstanding trading contracts, leaving some companies committed to buying energy at a loss, and others to abandoning contracts. Bankruptcy at Enron and near bankruptcy at Dynergy, the most active traders, threw a monkey wrench into the contractural structure because many of the contracts in which they were involved are defunct because of being uneconomic. The regulated distribution function is required to buy the cheapest electricity on the open market (the concept behind de-regulation to begin with), leaving the companies as a whole with higher priced purchase contracts they had expected to sell into their own distribution. The surplus capacity created by a rush of new plant building based on forecasts of a rapidly growing economy places many plants on a marginal basis. Companies like Calpine were not been alone in the mad rush to build new facilities. That is not all. Anxious to diversify, many plunged into foreign utility markets, often with unfortunate results. Desperately trying to get out to shore up their precarious balance sheets, many of the foreign operations are up for sale in a weak market. This means more writeoffs. TXU will take a $4.2 billion write off as it abandons or sells pieces of its U.K. operation for less than debt. That loss represented almost half TXU’s stockholder’s equity before a summer stock offering. And then there is debt. As capital intensive regulated operations with limited return on equity, utilities have always been relatively highly leveraged. In the exuberance of de-regulation, and supported by the liberal conditions in the capital markets at the end of the 1990s, they borrowed to support the new directions, leaving them in a bind now that things have gone wrong. Analyzing the companies takes me back to my banking days. Good bank lending is short term in nature and based on the balance sheet, not the income statement. Utilities are still reporting good profits, though the outlook is questionable. It is the balance sheets that are in crisis. Write offs, of goodwill, of trading contracts, of assets already and to be sold, are inevitable. While these write offs can be seen as a clean up that will allow the companies to get back to selling electricity (it is amusing that they are now emphasizing their traditional operations), the losses are important for highly leveraged balance sheets. Many of the bond indentures have requirements for maintaining balance sheet ratios that will be difficult to meet (which is why they are dumping assets for liquidity). Indentures also call for maintaining a decent bond rating, which they are having trouble meeting. Most of the losses have yet to be taken, so the threat is growing. One major utility, Allegheny Energy, admitted to not being able to meet the requirements and more or less dared bondholders to do anything about it. Therein probably lies the eventual answer. It makes little sense for bondholders to put them into bankruptcy, for these are steady operations that will eventually work out of trouble. But eventually could take a while, and the threat complicates current analysis. Some of the stocks undoubtedly are selling way under their true value, but patience is needed until the picture is clearer. I expect a wave of year end write offs and some divisional bankruptcies (some already), after which sensible analysis may be possible. One reaction of utility companies has been to flood the market with equity offerings without revealing the depth of the problems. Investment bankers have been up to their usual tricks, putting another one over on investors, and most of these offerings are now deeply in the red. Buyers should have been suspicious of massively dilutive offerings that made sense only if the companies were in trouble. Without the flood of stock offerings, there might already be blood on the street in a partial rerun of the telecommunications disaster. This makes the stocks all the more intriguing. Just think, some of the companies can be bought at 50% of what supposedly knowledgeable institutional investors paid in large quantities earlier this very year. I made the mistake of buying some of these stocks for conservative investors looking for dividends when prices plunged. Allegheny Energy, for instance, was seen as a relatively conservative company whose stock was cheap and the dividend extraordinarily high. The problem for conservative investors is that many have cut their dividends, and more cuts are inevitable. Management has been swearing by their dividend, but reality is getting through. Longer term these will remain dividend oriented companies. As the smoke clears, yields over 10% should be available. This kind of return should lead to a doubling of the stock price. In the end this is still a steady and needed business, and the problems will be worked out far more easily than with massively overcapacitied telecommunications. Measuring the affect of overcapacity is one of the current imponderables. Many partially completed plants will have to be finished, but everything possible has now been cut off. Incidently, many of the new plants involve gas turbines made by GE. GE is booking cancellation fees and still delivering some turbines, but it is looking at the sudden cut off a business that has been a substantial contributor to profits in recent years. Between jet engines, gas turbines, and a squeeze on GE’s massive spreads in its financing operations from any increase in interest rates, GE’s earnings could be down sharply in a year or two. The braggadocio gushing from Immelt after he took over (he promised a higher growth rate than the already impossible rate achieved by Jack Welsh) never sounded right, and is becoming increasingly hollow. Will Jack ever cash in those 13 million plus options, presently worthless after having a value over $200 million two years ago?

Enron – January 2001

This chapter was written long before the Enron debacle came to light, in fact it is about the inevitability of Enrons because of wholesale cheating to boost reported earnings. Enron was not the exception, it was the rule. Enron undoubtedly passed the line and broke accounting rules, but the majority of publicly held companies push as close to the line as possible in order to enhance reported earnings. Arthur Anderson, its auditor, is not a rotten apple, all the major accounting firms aid and abet the process of overstating earnings. Solutions do not lie with cleaning up the accounting profession, it is the source that must be attacked - the tremendous payoffs corporate management derives from stretched accounting. Will the sensational disclosures lead to a clean up, or will the affair blow over with a few revisions to the rules for 401K plans? I am not optimistic. Enron points out once again the overwhelming power of aggressive corporate management to use company funds to benefit themselves. Sound rules carried out in a vigorous manner can solve the problem. Accountants will give us honest figures if freed from the pressure of management wielding big money for compliant manipulation. Enron paid Arthur Anderson $52 million for accounting services in 2000, $25 million just for auditing, a figure topped by only a few other and much larger public companies. That kind of money buys a lot of cooperation. The answer to the mess is truly independent auditors, both in setting rules and enforcing them. I am utterly fascinated by Enron. A day never passes without at least two new revelations. Its tentacles are so widespread that new chapters will be unfolding for a long time. This is a much bigger story than realized. The war is a tiny affair in comparison because Enron and America are about business. Enron brings into focus many deeply troubling problems that have been swept under the rug by the long bull market. Enron says a lot about what is wrong with the stock market, for its revealed evils are not at all uncommon. Too many public companies are managed to elevate the stock price, rather for the long term good of the enterprise and the economy. The result is unwise activities that boost earnings over the short term, bad acquisitions, restructuring to erase past mistakes, manipulative accounting that makes investing a guessing game, and an immense waste of capital resources in frivolous ventures. There is a lot more to running a company than hyping the stock. Some of the revelations about Enrons accounting are mind boggling. Even more amazing is that many are legal, and therefore in common use. Arthur Anderson, Enron's accountant, is no different from the other big accounting firms. They are all thoroughly enmeshed with management in exaggerating reported earnings in an effort to elevate stock prices. Every knowledgeable person is aware of this scandal, but no one wants to think or do anything about it for fear of hurting the price of their stocks. Now the mess is out in the open. Why not start at the top. George W. Bush had no qualifications for the presidency, he was selected by big business because as governor of Texas he demonstrated political skill and unqualified support for business. He was elected on big corporate money, though not bought, for he is wholeheartedly their man. The question for his presidency was going to be, can big business run the country? Enron says the answer is no. Destruction of the surplus with tax cuts crowded into the high brackets says no. Give Bush the benefit of the doubt, though, the jury is still out on big business's governmental management talents, but the signs coming out of Enron are not encouraging. Next, there is Congress. Enron was built on stock hype and bad accounting. The accounting profession was well aware of spreading misrepresentation, and its governing bodies tried to slow the trend. In the crucial decisions, notably accounting for stock options and separation of auditing and consulting, reform lost because of the intervention of campaign contribution stuffed senators and congressmen. How could these people intervene where they had no expertise when the rule making bodies were doing the right thing? Because corporate management paid them to. The connection is being made between business excesses and campaign contributions. At yet another level, Enron demonstrates the dreadful practices that overwhelmed leading investment banks. These people are willing to finance anything they can get away with simply because the fees are large. In Enron's case they raised the money to support many of the fraudulent partnerships and offshore entities that covered up the company's true condition. They sold a large institutional placement offering information on the company withheld from stockholders, probably illegally, though judging by the subsequent results, the treasured information should have alerted buyers to stay away. A major commercial bank/investment banker provided a vehicle for hiding losses from recent annual reports. Why did bankers engage in these probably illegal activities? The answer is huge fees, just as with underwriting hundreds of dreadful high technology and internet IPOs. They sold manure through unqualified boosting. Lacking full disclosure, deals that violated the intent of the securities laws became everyday. To an extent investors deceived themselves, but they bought the reputation of the underwriters and the hype they provided more than the companies themselves. American capitalism works because of a blending of the free market and government regulation. Left unfettered, the free market gets caught up in intense greed and self- destructs. Karl Marx was about the inevitable self-destruction, except Marx was wrong because government stepped in and controlled the instinctive unfairness in the free market. We operate under a delicate balance between the free market and government regulation that swings back and forth. The free market self-destructs, the government steps in and over-regulates, then the free market regains its energy and outwits government controls, only to once again self destruct in its excesses. The end of the great bull market and the Bush election probably mark the high water mark for the up phase of the free market. Now that its bad aspects are revealed in all their ugliness, the pendulum will swing back toward government control. The problems are profound and the swing to more control will take time, especially with the Bush administration manning the free market ramparts. Many of the best minds on the market think stocks will go no where for a good many years until pricing returns to reasonable levels. Those of us who felt the market was reaching a long term peak a couple of years ago did not know what forces would end the long rise. Now we know - bad corporate practices arising out of the market's own excesses. A flat market will be supported by modest earnings growth, making extreme overpricing stand out. Improved accounting standards will be a force holding down earnings. A slow period for the market will be helpful, as all would be forgotten if we once again entered euphorialand. One of the most intriguing questions arising from Enron is why otherwise respectable people use manipulative accounting. The answer is the tremendous incentive in stock options. Options allow management to become extremely rich in a short period of time. We are going to find that twenty or so people at Enron became very rich on options. The present secretary of the army, a former Enroner, was a second line executive who became an eight figure multi-millionaire as the second in command of a division that was guilty of gross figure manipulation. Apparently his job was sales and he did not know the ridiculous accounting tricks being played with the long term energy contracts he brought in. Is it comforting to know that one of Bush's cabinet members was too dumb to understand what was going on in his own division? He stretched out his sales of Enron stock, required by his government position, so clearly he was ignorant of the gimmickry. Bush shares that kind of innocence. If Clinton's number one backer had come out as has Enron with Bush, everyone would be screaming because of knowing he had probably given something in return. In Bush's case, his standard bewilderment about anything complicated makes it easy to believe he failed to understand the implications, particularly when catering to big business is what brought him the presidency. There is little appreciation of the extent to which management of public companies has been stealing ownership out from under stockholders. In the more popular companies, options often represent 30% of outstanding shares. Counting already exercised options, management and employee shares can end up representing over 50% of ownership on a free ride. Management gets away with this theft because options, while obviously a form of compensation, never appear as an expense on the income statement because of a special exemption earned through congressional intervention. In addition, Enron, Cisco, Microsoft to a large extent, and practically all high technology companies because of their particular abuse of options, have never paid income taxes because they are permitted to take options as an expense at the highest valuation. The option system is crazy. It encourages earnings enhancement because even a temporarily high level for the stock can fix management up for the rest of their lives. The set up involves no risk and no investment, because the stock is usually pay for simultaneously with cashing in the exercised options. Being fully aware of the hype that elevated the stock, management is in position to make timely purchases and sales. While options are supposed to be an incentive for good management, in fact they are just the opposite. The popular slogans, pay for performance and aligning management and shareholder interests, are baloney. One of the subtler entanglements coming to light through Enron is the role of boards of directors. Why have boards allowed management to get away with huge stock option awards, a highly anti-stockholder form of compensation? The answer is that management buys their cooperation through large fees, stock options, and inclusion in company pension plans. The total package is so fat that directors would be acetic spartans not to follow management's lead and forget their purported job of representing stockholders. Enron brings the highly conflicted position of boards of directors, and their decisions in favor of management and against stockholders, out into the open. On management's part, the temptation to become very rich overrides fear of dishonesty, aided by many of the figure enhancing practices being perfectly legal. If you want to hear insistent pleas of innocence, don't go to death row, listen to top managers pleading their devotion to Generally Accepted Accounting Principles. Management is no longer concerned about the day of reckoning that goes with bad accounting because restructuring allows the cheating to be erased. An interesting undertone to the corrective process is that Bush, ever catering to business interests, brought in as head of the SEC a man totally conflicted by being a leading SEC lawyer for big companies and accounting firms. He began to dismantle many of the progressive moves initiated by his predecessor. He reminds me of Joseph Kennedy, who FDR named as first SEC head under the theory it takes a crook to know a crook. Now Pitt, the new head, looks like a fool, so maybe he can turn himself around and stop protecting the thieves. The cards are face up on the table, and what used to be easy to get away with no longer is. Dick Cheney's claim that he was only consulting the experts in dealing with oil executives while drawing up energy policy might have been accepted a year ago, now it is greeted with the guffaw it deserves. Suddenly we appreciate the extraordinary greed that has overtaken corporate culture.