09 Nov 2001 Money Goes Where It’s Treated Best
Over long periods of time the stock market outperforms bonds by a substantial margin. But, it should come as no surprise that bonds were the winners over the past two years. In fact, bonds have outperformed the S&P 500 by a 60% premium, the strongest difference in seventy years (1931 and 1932). Tom Galvin of Credit Suisse First Boston notes that the year following the strong bond performance, stocks posted a 54% return in 1933 as the cycle reversed. A similar story of good treasury returns during two consecutive bad years for equities came during 1973 and 1974. That period was followed by greater than 60% returns in 1975-76. The left-hand graph below reveals just how significant the signs are that we are at a critical turning point for stock and bond investors. If the cycle repeats, the next twelve months could bring strong returns to stock investors.
The events of September 11th sent huge numbers of stock investors running for cash. The month represented the largest one-month dollar total on record. According to the Investment Company Institute, equity flows inclusive of monthly allocations to 401K retirement funds are down over 95% from last year. Bond funds have enjoyed more inflows than equity funds for the first time since 1991. And money market fund flows have grown by roughly 330% this year or an unprecedented 20-fold increase over equity funds. Today, over 8 billion dollars rests in cash. That’s over 20% of total equity investment in this country. Not since the Great Depression has that ratio been so high. The right-hand graph above shows how extreme the current cycle into cash has been compared to flows of the last sixteen years.
On Tuesday, the Fed eased rates by another ½ %, bringing the funds rate down to 2.0%. The FOMC has now lowered the funds rate a cumulative 4 ½% during this easing cycle, which started in January. It is likely they will continue to cut rates in the next two meetings. As short-term rates fall close to zero, long rates also continue to fall. The Treasury’s announcement that it would end of the 30-year treasury has caused an unprecedented drop in that bond’s yield, and a commensurate reduction in long-term rates in general. As rates (price of money) come down, we see people and corporations taking advantage of them. The surge in October auto sales proves that consumers are favorably impacted by lower rates. It also shows that their expectations about the future of the economy are not so dire, if they are willing to plunk down 30 or 40 thousand for a new car, zero percent financing, notwithstanding. On the long end, mortgages continue to come down. As more people re-finance their mortgages, consumer-spending power rises. The lower rates allow for larger mortgages (cash out) and smaller payments.
What about those investors who own the money markets, bonds and mortgages? How long will they be content with yields of 1.5% and four or five percent respectively? At some point, when the economy shows signs of improving, inflation concerns will creep back into the equation. Inflation drives bond prices down. In other words, bond investors have had a good ride, but their growing returns are likely nearing the end of their cycle. As indicated above, after prolonged periods of bond outperformance, stocks are poised to have exceptional returns.
I do not look for the market to go straight up from here, but it has shown significant strength in the face of some ugly economic numbers last week. One can sense a sea change in the orientation of investors. The bearish analysts do not seem to get the same credence they did a few months ago. Their comments fail to damage stock prices as much as prior earnings periods. Investors now listen to signs from management that their businesses are improving. John Chambers was very upbeat during his earnings briefing last week. Since Chambers’ rather bullish comments, his stock is up 6.6%, compared to 1.4% for the S&P 500. Trust is everything though, as investors of Enron have learned. As evidence that management could not be trusted come to the public eye, Enron shares have fallen over 70%. The company and its management were heralded just a year ago in Fortune as one of America’s finest and most benevolent corporations. We too suffered a management letdown when Qwest Communications surprised the shareholders by badly missing their earnings targets. Why they failed to pre-announce their shortfall along with everyone else in late September is beyond me. When it was learned that they were basically halting their network upgrade programs and that earnings would be flat to down until 2003, we sold the shares. The company had been the favorite regional Bell of top analysts of Goldman Sachs, CSFB, and Prudential.
As we look to 2002 and the opportunities it likely brings, where are the best opportunities? The general answer to the question is that technology and medicine will be major investment themes in the next decade. Some of the sub-themes as we see them include:
- Outsourcing (just in time inventory, new processes, and productivity, etc.) Companies will transfer the inventory and capacity risk to more able companies. Companies we own or are watching include Celistica, Jabil, and Flextronics, EDS
- Energy requirements will grow as the information economy grows: Calpine, Haliburton
- Diagnostic testing will grow w/ medical advances: Johnson & Johnson, Cardinal Healthcare, LabCorp of America
- Growth in semiconductors will be in the network rather than the PC: Applied Micro Circuits, Texas Instruments, RF MicroDevices, Broadcom
- Providing offices and homes with fast connections to the Internet: Cisco, Corvis, Broadcom, AOL
- Wireless data will become a way of life: Nokia, Sprint PCS, RFMD (the chips in handsets), Amdocs (wireless billing services)
- Software will become more functional and more transparent: Microsoft, Intuit, Symantec, Seibel Systems
- With less travel people will look for more entertainment at home: AOL, THQ (gaming software), Best Buy (inexpensive electronics)
- Medical advances will dwarf any time in history as the human genome mapping progresses: JNJ, IBB (Biotechnology iShares) GE
Corporate competitive advantage will be concentrated in people, ideas, and networks in the future, not in plants and equipment as in the past. The business cycle and profits will still matter, but the greatest value creation will come from companies focused on information and productivity. The markets’ ability to recognize the intangibles of people and ideas and translate them into value will improve with time and experience. There will be some bumps along the way, but the investment future now looks brighter than ever.
Portfolio Changes
Quality Model
Bought Haliburton. Haliburton provides energy services and engineering and construction services, as well as manufacturing products to the energy industry. The company offers discrete services and products and integrated solutions to customers in the exploration, development, and production of oil and natural gas. Our timing for purchase was influenced by its exceptional valuation relative to an expected 25% annual growth in earnings.
