10 May 2002 A Tale of Two Markets
“It was the best of times, its was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us . . .” Charles Dickens – A Tale of Two Cities
The best of times seems like a distant memory in so many ways, particularly as we focus on all the bad news out there and ignore the good that peeks through occasionally. There’s plenty of ‘darkness’ adding to our confusion, but there are hints of light too. On Tuesday, Cisco’s Chairman John Chambers spoke of improving business. His comments and his company’s results sent the markets soaring, as short-sellers covered their bets against optimism and buyers bet that the pessimism might be waning. If only for a day, optimism was openly discussed and celebrated and the negative took a brief respite.
Two markets now exist, the ‘Bear’ championed so well in today’s headlines and the ‘Bull’, quietly gaining strength beneath the news. The numerous sources of fuel for the Bear are so well known that further discussion here is unnecessary and even counter-productive. The Bull, not so well covered, is doing pretty well. Traditional havens for defensive investors, like consumer staples and healthcare stocks are remain market leaders. But there is more to the story than these over-valued defensive and value stocks.
Since early March, more than 70% of New York Stock Exchange stocks have traded above their 200-day moving average. That’s a lot more than consumer and medical stocks. With few exceptions, the number of stocks making new highs on a daily basis outweighs those making new lows. Many are defensive, but there are some real growth opportunities here. A higher percentage of corporations delivered better earnings numbers than analysts predicted this quarter than they have in a long time.
The stocks leading the charge are small-cap and medium-cap companies. They are not terribly complicated financial structures; so accounting scandals are not likely to be a problem. They are generally below the radar screens of the large broker/investment banks, so the limited research done on them is not fraught with the conflict-of-interest issues we see the SEC investigating today. And because their outstanding shares are generally too few for the large brokers to recommend to their large numbers of clients, their stock prices are not subject to the volatility caused by analysts’ sometimes-whimsical buy and sell recommendations.
The large-cap companies are the household names we all know and ‘trust.’ But for the past few months our confidence in some of them has been shaken. Accounting irregularities, debt problems, and valuation issues have all piled on these Dow Jones, S&P 500, and NASDAQ index leaders, sending their share prices and the indexes they comprise lower by the day. IBM and GE have broken down and could be headed considerably lower, both on their own issues and by virtue of being major components of the large indexes. The US markets are lagging the world markets in performance. The dollar is declining and may go lower. As it does, foreigners’ appetite for American stocks (Dow Jones and S&P 500 indices) will wane, sending those averages down and the stocks they contain, with them. Middle and small-cap stocks are largely isolated from these forces.
Finally, there is great fear among investors now; so their appetite for owning stocks is down – but not gone. Smaller stocks require far fewer buyers to move their prices higher. Unfortunately, the reverse is also true, so due diligence is more important than ever. We use diversified exchange traded funds for some of our exposure to small-caps and mid-caps, but we have also made some recent purchases of companies, such as Fastenal, Chico’s Fashions, Charlotte Russe, and Bed Bath & Beyond, that have very strong fundamentals and management. The expected (and historically reliable) average rate of earnings growth for these companies is well over 20% annually. We will continue to search for and own companies of this sort until they begin to reach valuations that are unsustainable.
The general economy also continues to be a tale of two cities. The consumer continues to do his part to sustain his two-thirds of the economy. The latest retail figures were softer than expected, but still higher than recent months.
Productivity was the big economic story of the week. On Tuesday the government surprised the markets with a first quarter preliminary productivity number of 8.6%, well above the expected 7% and dwarfing the 5.2% achieved during the fourth quarter of 2001. Productivity is the energy that sustains an economy. Increases suggest that more goods can be produced without additional labor. It generally rises during economic recoveries as managers demand more of their employees and are reluctant to hire additional workers until sufficient and sustained demand requires it.
We know too that technology investment generally precedes further hiring because the paybacks are greater and come faster. The old economy represents 80% of technology companies’ customers. When technology spending begins ramping up, we will know we are progressing well into the recovery. Unemployment numbers will be among the last statistics to confirm the recovery.