Monday, March 30, 2009

Investors Guru Small Cap Stock Observer

Dr. Jekyll and Mr. Hyde - a tale of two US economies. The best buying opportunity of our lifetime, or the start of the next great depression?

I'm not going to answer this question - you are! Hopefully you will be kind enough to share your thoughts at our Special Topics Bulletin Board of the same title as this article.
As a backdrop, I'll start the discussion by stirring up the current macroeconomic mess we find ourselves in, and how we got here. Then I'll leave it to you to pick apart these facts, opinions and ideas, and provide your insight into where this all might be heading. I'm interested to see where the pulse of this debate goes, and if a consensus forms over time.
I'm a believer that when analysts start saying, "it's different this time", this is a serious signal to start questioning if the current trend is about to change. When they all seem to agree, I become even more nervous.
With the benefit of 20/20 hindsight, it is obvious that tech stocks were overvalued in the late 1990's and due to correct. But at that time most analysts kept telling us there wasn't a bubble and that earnings didn't really matter in the new dot-com economy.
This time, starting in August 2007, stock cheerleading TV networks continued to deny that even a recession was at hand until the end of 2008. Not even the failures or near failures of household names like Bear Sterns, Lehman, Wachovia, Washington Mutual or Merrill Lynch could shake their confidence. Even the front running GOP presidential candidate last summer insisted US economic fundamentals remained strong.
Coincidentally, or not, August 2007 was also when the down tick rule was removed. Very little coverage was given to the short-selling push down effect this could have on already spooked markets. Then after the markets had fallen over 50%, the ostrich pundits finally pulled their heads up for a breath of fresh air and started recognizing that perhaps a mild recession was a possibility. How astute and timely!
As this turned into panic in early 2009, with the DJIA up or down 700 points on any given day, with the VIX volatility index regularly making new highs, the pom-poms were finally tucked away. Instead of the usual buy criers, gloom and doomers were cast to debate if this recession most resembled that of Y2K, the 1990's, 1980's, 1970's, or some other decade. Some even suggested this was the start of the next great depression, and to sell all stocks and buy gold before the dollar becomes totally worthless.
Brokers used to tell us to look at quality stocks as shares of businesses to buy-low, hold long-term, and eventually sell-high. Panic selling was supposed to be a buy opportunity. Now that everyone is down 50%, and wondering whether to take advantage of low prices by averaging into the markets, as we were previously told to do, many so-called experts are instead saying, "it's different this time".
Do you ever get the feeling that analysts and brokers are always wrong - saying one thing like buy-low and sell-high, but doing the opposite? They say buy if the fundamentals indicate a stock is cheap, and don't follow the herd. But their buy-charts say something else, making you wonder why the stock wasn't a buy before it already doubled or tripled.
Who really is the first to panic sell or panic buy - you or your broker? Why are simple investing concepts made to seem complex? Why don't analysts, brokers and stock TV commentators provide more balanced advice, and why is it that the vast majority of overpaid investment managers never beat the markets?
These types of observations are why our investing style tends to be fundamentals first, tempered by contrarian technical's. In other words we look for fundamental values of how much a quality stock may be worth - compared to its price, its peers and the market. If the chart shows it is technically beaten-up and out of favour by the street - even better!
In January 2000 we emailed our members to look closely at a long-term NASDAQ chart. The slope of its ascent was straight up from the end of 1998, from around 1500 to 5000. We believed the dot-com bubble was signalling a major selloff by May, and that most stock markets and the overall economy would go into a prolonged recession. The NASDAQ actually started crashing in March, at a time when most analysts were still trying to outdo each other's price targets, for dot-com stocks with stratospheric P/E's.
Later that year we wrote that our site was closing, as the markets most likely were not going anywhere for at least 4-years, and that it would be higher commodity prices like oil, gold and base metals that would lead the markets out of recession. At that time oil was about $12 a barrel, gold $260 an ounce and copper .80 a pound.
Fast forward four years and the economy and stock markets had changed materially. After 911 interest rates were slashed to historic lows to keep the economy from going further into recession. Cheap money and deregulated debt markets fuelled an artificial housing boom and today's subprime/ABCP crisis. Oil, gold and base metals prices soared as we predicted, but it was a bit of a shocker when the Bush administration was re-elected in 2004. With the US sinking from fiscal surpluses into major deficits and debt, with trade deficits still at $60+ billion per month, we decided to keep the site closed until a majority of Americans finally realized that Republican hillbilly economics had to change.
In January 2000 North American stock markets were approximately: NASDAQ 5,000, DJIA 12,000, S&P500 1,500 and TSX 9,500. Now it's March 2009, so let's see what we missed: NASDAQ 1,400 -72%, DJIA 7,000 -42%, S&P500 700 -53% and TSX 8,000 -16%. US stock markets are down 50% from 2007 highs and many companies have disappeared, both large and small alike. For credibility sake, rather than try and fight a long-term losing dead horse trend, we made our market expectations clear back in Y2K by simply closing down until valuations made sense again.
Our charts tell us that March 9 signalled a major technical bottom, with the DJIA holding the 6,350 levels and bouncing +15% since. Value and risk now appear to be discounted in today's much lower prices, but there remain major cracks in the world's economic foundation. On one hand, government money floodgates have been opened full tilt in the name of all things stimulus. On the other, how will much higher debt, inflation, taxes, and currency devaluation be managed, to prevent the whole house of cards from collapsing?
If you believe the latter, perhaps you should look into gold and silver bullion, or a farm for value. But if you believe the value of paper money and the current economy will survive, you need to read, research and consult with your advisors to put money to work somewhere in the markets.
Historic charts show that equity market values generally behave like a pendulum on any given day, month or year, but in the long-term prices tend to gradually increase over time. Blue-chip stocks seem to trend this way, at least for as long as their products, services and execution remain relevant. Real-estate prices follow this tendency as well.
Any Keynesian economics or intro to business course will teach you that supply and demand determine prices. From the price of a paperclip, to a barrel of oil, to how much your house is worth, it's a simple matter of S&D. But here's my question: Is supply just another way of saying scarcity, and demand just another way of saying inflation?
Was the 2000-2007 housing boom based on sound fundamentals, or was this demand simply synthesized by creative financing? We believe the latter and that the lows these events created will return higher stock prices nearer to their long-term ROI values, at least for a few good years.
Our new logo puts this on the line, showing the NASDAQ chart from its 1971 inception. The first green dot indicates when we started our website in 1995. The red dot indicates when we emailed our members the site was closing in 2000. The second green dot indicates when we decided to re-launch in March 2009.
I believe normal long-term housing prices compound annually at about 3%, because the normal long-term inflation rate is around 3%. In other words a house will go up in value at about the same pace as overall construction costs.
I have read credible reports suggesting long-term real-estate returns of 1% to 6%, and of course it can perform significantly better or worse for short periods of time. But I can't find another time like 2000-2007, with continual +15% yearly returns, and prices doubling in just 4 years. Much of this red-hot demand for housing was based on pure speculation, a result of cheap financing with practically no government oversight.
Cheap money is another way of saying inflation - with too many dollars chasing too few houses, or so it seemed. As cheap financing dried up, not only did demand dry up, we found out supply was actually far more than ever needed. Almost overnight, millions of multiple home speculators were stuck levered into mortgages, now owing more than their investment's value. These underwater mortgages turned into foreclosures as the artificial demand created by no-money-down, no-doc and teaser-rate mortgages collapsed.
What does this have to do with stock markets? Stocks, bonds and real-estate compete for investment capital, which flows to the best-perceived return. As the dot-com bubble burst, the stock market became a bad bet. Investment capital needed a new home... literally! And why upsize to just one McMansion when you could have 2 or even 5?
Some anticipate these trends early and understand that short-term deviations from the normal long-term rate of return, if extended, usually create bubbles that eventually crash. The pendulum then tends to swing the other way, with overly depressed prices, until the normal long-term rate of return and S&D comes back into equilibrium. This is usually true for stocks, bonds, real-estate or any type of quality long-term investment.
Just like it seemed obvious in 1999 and early 2000 to get out of tech stocks, it should have been obvious by 2004 to start exiting real-estate. Maybe you could have waited another year, reasonably speculating the government would make sure the applecart wasn't upset during an election year. But you should have realized that property values were extended compared to long-term trends, and that it was only greed that kept mainly other flippers overbidding homes. Don't be the last one holding the hot potato!
Easy credit actually continued to flow until summer 2007, expanding the magnitude of the housing bubble's inevitable pop into a near financial industry collapse. And the worst of it may be yet to come!
Deregulated debt markets with cheap and easy money created the housing bubble. Government policy made this mess as their short-term recession-preventing lack of focus failed to realize the long-term implications. In the buy-now pay-later society we live in today, short-term pain for long-term gain is almost always reversed. The result, just print more money to ease the pain, and we'll deal with curing the disease later.
Government continues to choose more and more debt, without a plan to avoid its inevitable future wealth consequences of catastrophic inflation, high taxes and interest rates, plummeting currency and asset values, and economic depression, some say. Most people believe that inflation simply means higher prices, but this is only one symptom.
I'm worried about hyperinflation if the world loses confidence in the value of the dollar, produced by decades of out of control debt growth. Money is manufactured out of thin air and is no longer backed by hard assets. The last 8-years may have caused this new money bubble to stretch beyond the point of no return. If foreign lenders simply threaten to turn off the debt taps, or price commodities such as oil in another currency, or replace dollars as their reserve currency, any one of these dollar S&D factors, or others, could pop this $ bubble overnight. Watch gold prices if the US ever loses its AAA sovereign credit rating!
Has long-term real-return value been enhanced, or lost; and has the inflation effect simply made it seem that values always go up over time? Yes, I agree prices tend to go higher over time, but does this usually translate into more, the same, or even less buying power than when you started?
Are we really better off today than our parents? Not that long ago, a typical family had one breadwinner. Today the norm is both parents working, just to keep up. But we have bigger homes, two cars, multiple TV's, i-everythings and we eat out more. True, but we also have 10 credit cards charged up to more than we earn in a year, and we can only pay our loan shark, err I mean banker, the minimum balance each month. We borrow or lease to buy everything, and hope that we can pay it off before it rusts or falls apart.
Back then our home was our castle and paying it off within 20 years was a reasonable goal. Today, for a $300,000 5% mortgage, many prefer a 40-year amortization instead of 30-years; because the lower payment represents an extra $164 per month in extra spending now, even though you have to pay $1,447 per month for an extra 120 months, including an extra $115,000 in interest. Reverse mortgages didn't exist back then, as they would have begged the question "what's the difference with renting?"
Over 70% of the US economy is consumer spending, and is it any surprise that personal savings rates remain at historic lows, while debt continues to build from the individual, the family and to every level of government. Most of what we buy is imported, as we prefer to do finance and marketing over old-fashioned work like industrial production or manufacturing. My point is that all this stuff we buy doesn't build wealth.
So we borrow like drunken sailors to buy depreciating consumer products, mostly made and imported from somewhere else, and we believe we are entitled to this standard of living beyond our means, and that it can go on forever. We are deaf to the piper and don't worry about nor intend to pay him, as this is a problem for our children to figure out.
The US economy has been ravaged by over 3 million foreclosures and many believe the worst is now over. Some reply to the severe selloff in stocks with a shrug, because we can magically pull a rabbit from the hat again to save our economy from its current doldrums.
So what say you about the 9,000,000 US option ARM mortgages that get very little airplay, that are supposed to reset or recast starting in 2010? These aren't the same toxic mortgages for those who could never afford a mortgage in the first place, but rather middle class mortgages for those who probably never missed a debt payment before now.
Keep in mind the unemployment rate has gone from near full employment at the end of the 1990's, to now 8% that some predict may eclipse 10% this year. The estimate for both unemployed and underemployed is over 15%. Many have simply lost their job and can no longer afford to own a house under any scenario.
For the vast majority of these mortgages it is the unknown that is most daunting. Many are liar loans now subject to an income test that will not pass go next time. Interest rates are as low as they can get, with the Fed funds rate at 0.0% to 0.25% and people still can't pay. What happens to property values and defaults if rates go up just 1%? The Fed doesn't control this - watch the yield on long-term bonds!
Home values have plummeted and over half of these mortgages are now underwater. Some predict housing prices in 20 major US cities to decline 20-25% further this year. Even if you can get a mortgage, how many will choose to, or will they just walk away?
I could draw similar horrific debt bomb scenarios for commercial loans, auto loans, credit cards, social security, Medicare, and all levels of government debt. But what's the point when even our leaders have a hard time keeping track of whether they meant to say millions, billions or trillions!
Any one of these scenarios could be the perfect storm that may make our current mortgage tidal wave seem like a fart in the bathtub. The interest on all this debt comes from taxes and goes to the privately owned Federal Reserve. Tricky debt and the wiping out of Middle American equity is the real problem, and the Fed is now being held out as the obvious systemic risk protector. Talk about conflict of interest!
One thing seems absolutely clear. If we are to get out of this mess, prices must somehow go higher, for a long enough period to absorb the bad debt on everyone's balance sheets, to build equity again and discover new growth industries. I believe higher prices will come, but for only the short-term as the long-term fundamentals will not have changed.
The long-term fundamentals I believe we need to embrace are higher savings and lower debt levels, and new technologies. We don't want to do real labour and there's a limit to how many cokes a person can drink, so we will need to start discovering the medical, robotics, and energy breakthroughs the world needs - to have something to sell again.
The US has always fostered an entrepreneurial spirit, but the will to succeed today is not enough unless supported by the highest educational standards. Outsourcing engineers and scientists is not an option in building real wealth at home, from the future's newest technologies, quality products, innovations and efficiencies.
Maintaining the lead is what protects market share and gross profit margins, and attracts experienced management, liquidity, access to capital and healthy balance sheets. Done right the results are more long-term sales, earnings and dividends. Done wrong the results are losses, more debt and financial ruin. Only time will tell!
Many more terms are applicable, but no matter how they are expressed they all boil down to one word - Growth! But what happens to stock prices if there is no more growth? Absurd you say; there will always be growth.
But hasn't our growth always been based on two continuing assumptions - population expansion and low cost energy? More population has simply meant more consumers. Low cost energy has meant prices could remain low, and profit margins high, because the cost of energy to produce, manufacture and ship remained low.
Perhaps we can have the best of both worlds, again supplying and servicing growing demand in China, India and other emerging economies. At the same time we can rationalize and return our legacy costs of social security, health care and debt costs to a low percentage of GDP/GNP without relying on domestic consumption. It's ironic how these statements compare to GM's current troubles - I wonder how that will turn out?
However, these hurdles are not even close to within our sights and I believe there will be significant inflation in any event. I believe this to be true whether the dollar, stock markets and oil prices, debt and savings levels, go up or even down. Since we left the gold standard the puppet masters parade has always led to more inflation, and I see no reason why it should be different this time. Start asking why they don't publish the M3 money supply anymore?
But one thing that has changed is the magnitude and velocity of change itself. Debt and stock markets move faster than ever and can pull the rug from under any stock, currency or commodity in minutes on just a rumour - thanks to global markets and round the clock computer trading. Did you notice last year how some banks that were proclaimed safe on a Thursday, were gone that weekend?
If you believe things will get much worse, you may need to position quickly. For most this means to pay off high cost debt and lock-in low mortgage rates while you still can. For investors this may mean gold related assets, as a hedge at least. You can even argue certain quality stocks with high-cash and low-debt levels may benefit, even if interest rates take off to dampen high inflation and to support the dollar's value. Simple buy and hold does seem to need to be replaced by more nimble trading, for at least the near term.
In conclusion, I do believe the markets are due for a nice run higher for at least the next year, to possibly the next four years. The past eight years has reinforced my belief that the presidential cycle and government policies can have a major impact on investment values. In this regard I'm really just saying that government should stay out of the way of businesses - that are best at creating sustainable long-term jobs, and private citizens - who are best at allocating their own wealth.
My point is that government usually doesn't have to help in this regard, but they can surely mess things up. Significant fixes are now needed, as the Bush administration left several gargantuan flaming bags of poop on Obama's doorstep.
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