Are We Happy, Yet?

In the past couple of weeks, a number of long-time clients have called to ask, in essence: “You must be happy, now?”  Generally, they were referring to the dramatic deflation of the mindless tech and pseudo-tech stock market bubble. I am anything but a Luddite and, in fact, incessantly marvel at the opportunities opened by the computing, communications and Internet revolutions. What drives me crazy is the combination of ignorance and greed that accompanies the “new era” markets we seem to experience every twenty years or so.

But, with the Nasdaq Index down more than 60% from a year ago and many individual “flop.coms” down anywhere between 90% and 100%, yes, I am relatively happy on that count.

Some callers also referred to my predilection for declining markets, and my growing discomfort during the late, speculative phases of bull markets. This reflects my value bias, which thrives when the prices of good companies’ shares collapse, but struggles in euphoric markets. But, again, I do not share the perpetual bearishness that seems to be the lot of overly intellectual investors – witness my current bullish stance on “hopeless” Japan.

As concerns the US stock market, my optimism has been building over the last couple of weeks:

·        The 60%+ decline in the more speculative segment of the market, with more than 80% losses for many day-traders’ favorites, seems in line with my observations of prior burst bubbles.

·        The S&P 500’s 25% drop from its high is also in the range of my earlier expectations (25% to 35% from the top), and its 12-month rate of change (also 25%) is now in the range where prior bear markets were close to bottoming out.

·        Only the Dow Jones Industrial Average has failed to register a full-scale, bear-market loss. But it had gained less than the other indexes during the bubble. Also, it has been catching up on the downside in the last few days, as the market decline has become more indiscriminate.

·        In any case, I take heart from the fact that $4.4 trillion (30%) has been erased from the total stock market capitalization, as reflected in the Wilshire 5000 index, over the last twelve months. This is roughly 40% of GDP and more than four times what was lost in 1987, when GDP was somewhat less than half of today’s. So, we can assume that, even though no one seems to be bragging, it has felt like a bear market for some investors.

That’s the contrarian case for being bullish. But how plausible is the bullish scenario?

So far, the great surprise of the economic downturn has been inventories. It had been widely assumed that in the New Economy, everything was so smooth, integrated and “just-in-time” that the inventory cycle – responsible for much of the economy’s volatility in the past – had been all but eradicated. Now, not only are we having a beauty of an inventory cycle, but it is most severe in, of all places, the New Economy sectors. (In fact, inventory liquidation in old-economy sectors is likely to be minor as there had been little build-up.)

This being said, the reaction has been prompt and drastic: it looks as if excess inventories will be liquidated or written off quickly – including those that may have been hidden by the debatable accounting tricks of many of the stock market’s “tech” idols. Chances are that excess inventories will have been liquidated by the fall, which would not make a stock market bottom in the spring unthinkable.

I share the concern of many economists about the consumer being financially overextended. However, it seems that the rashest excesses have taken place at one or the other end of the wealth spectrum. At the high end, a rising stock market boosted luxury consumption in relation to incomes – even if some of these gains were too recent to have been considered as permanent wealth increases. At the bottom, it appears that many low-income families succumbed to the heaviest promotion of credit-card loans by bankers in years. These two extremities will now have to reduce their spending. In the broad middle, however, there is little indication of pervasive or unmanageable excesses. This is also the segment of the population that may still benefit from refinancing mortgages at the present lower rates, thus reducing monthly payments. Unless there is a sudden collapse in residential real estate prices, which I do not foresee immediately, the broad middle of the consumer population should hold up relatively well for now.

One additional concern is that there has been massive over-investment into technology by US corporations, which is seen as a prelude to very subdued capital spending for the next several years. There is ample indication that overly easy financing for dot.coms and telecommunication companies has facilitated heavy investments that would not have otherwise been made. But, again, many industries where capacity has been ample and the rate of innovation more normal only made the investments necessary to improve efficiency and productivity. There are few reasons for these industries to cut back on such expenditures, especially at a time when the Internet revolution begins to do what it was meant to do all along: benefit mostly the user.

Aggressive monetary easing by the Federal Reserve and the tax cuts being planned by Congress and the White House should be sufficient to prevent the current recessionary tendencies from gaining momentum – not only here, but also abroad, with a modicum of cooperation from European and Japanese policymakers.

Perhaps the reason why I am not quite as euphoric as I often have been at past market bottoms is that I do not sense around me the feeling of despair that should have accompanied the losses of the past year. Of course, CNBC and their followers appropriately lament the demise of the stocks they used to push (while unabashedly blaming the losses on others, from analysts, to company managements and even Mr. Greenspan). But they have been quick to turn bullish again at every rally attempt. Meanwhile, individual investors have only now begun to liquidate stock mutual funds, and not too aggressively at that.

Furthermore, many quality companies, while much cheaper than last year, are far from selling at distressed prices, whereas we may have another two or even three quarters of disappointing profits ahead. Finally, there’s the wild card of the overvalued dollar and the record current account deficits: a sudden reversal of this unsustainable situation could prove highly destabilizing for the world economies and financial markets.

It is entirely possible that these overhanging questions will be resolved over time, without much lower stock prices. For example, I would not be surprised if the stock market bottom took a “W” shape, over several months. Nevertheless, with significant stock market declines already behind us, this is no time to fight the Fed, and the Fed is busy pumping liquidity into the financial markets.

My moralistic side believes that not enough pain has been endured to fully cleanse the bad attitudes of the “wealth-tech” economy. My practical side reminds me that, in a bottom area for the stock market, one should not be too cute with the macro-analyses: if you find values, buy them. That’s what we have been doing.

François Sicart

^© Tocqueville Asset Management L.P.
March 26, 2001