17 Aug 2001 The Bear

Bear markets turn investor strengths into liabilities and this insidious beast is no exception.  The aftershocks of the ‘Internet Bubble’ make this crash all the more difficult.  What we held as strengths before the collapse in confidence have become liabilities.  During Bull markets, long-term investors are rewarded for holding good companies in spite of brief stock pullbacks that occur when short-term investors are frightened off by negative news.  Investors with longer views snap up the bargains left behind, believing that the news has limited or no long-term relevance.  Alternatively, bear markets lack clarity or visibility of the future, making it difficult or impossible to know whether the effect of negative news is short lived or has longer implications. 

During bear markets, stocks of good companies are at the mercy of gremlins that rarely hold any power over them during good markets, such as short sellers, short-term traders, and they feel the effects of bad news of companies only weakly associated with them.  Stocks can be punished excessively without the quick snapbacks experienced in bull markets.  A good example is SkillSoft, an e-learning company we added to our aggressive model about a month ago.  The stock traded to about a 25% premium from our purchase of $28 until it reported earnings two days ago.  The report was exemplary on every point, including an earnings increase of 161% over the past year, and an industry-leading gross margin of 94% – not bad in this economy huh?  The stock traded down as much as 30% the next day.  The reason? – traders were in the stock only for a quick flip on the earnings news.  They were willing to take a 10-20% short-term gain and pay half of that in gains taxes.  In other words, they were more interested in a 5-10% after-tax return than in a possible multi-year return of 40-50% (expected growth rate of earnings).  SkillSoft is coming back, but slower than it dropped.

Another time-honored bull market strategy is buying beaten down or out-of-favor stocks.  But during bear markets the strategy tests the patience and conviction of investors.  If the rules of value investing were ignored during the recent period of ‘excessive exuberance,’ it can be argued that the rules are being ignored all over again during this period of excessive pessimism.  Microsoft, Intel, Coca Cola, and Walt Disney all carry the same price-earnings ratios of 30, yet the long-term growth prospects of Microsoft and Intel are 70% or 80% greater than those of Coke or Disney.  Clearly the market assigns little credence to Microsoft’s and Intel’s long-term prospects.  Stocks are valued by their expected future earnings growth.  When the Microsofts and Intels of the world can convince investors that they can achieve the faster rates of growth well into the future their stock values rise in accordance with those future expectations.

When will it end?

Bear markets end when investors are convinced in sufficient numbers that future earnings announcements by companies are more likely to surprise on the upside than on the downside.  Bear markets end when the bull’s life-blood – optimism – is squeezed out.  A seemingly incessant series of failed rallies discourages even the most ardent bulls until the last finally succumb to the pressures and sell.  Capitulation is the term I hope we will be hearing soon as investors sell in a panic to get out.  The final bulls surrender.  Valuations in out-of-favor industries fall to levels that can’t be rationalized.

Many are trying to call the bottom of the market and the end of the bear.  Most prognosticators point to the end of this year for recovery.  Others say there are months more to go.  One thing is sure, markets are notoriously bad script readers.

Economic Releases

With 93% of S&P 500 companies reporting, profits should fall 16.2% according to Thomson Financial/First Call.  Analysts had expected earnings in the quarter to fall 6.3% as of April and 17.3% as of July.

For the year analysts expect earnings to fall 9.3% compared with expectations for an 8.9% rise in January.

The employment index stopped falling in May and July was better than June.

The Inventory index of NAPM is at  an eighteen year-low, a full 25% below its year ago level. The work-down of inventories is the single biggest factor driving down profits.  When the restocking begins, it should improve visibility and generate profit growth again.

The PPI fell by 0.9% in July, three times the consensus (-0.3%).  Lower energy prices (mainly gasoline) dragged the PPI down, the largest monthly decline in eight years.  The fall in gasoline was so large it took six tenths off the headline number. The core finished goods index surprised on the upside, rising by 0.2% (vs. 0.1% consensus).

U.S. retail sales excluding automobiles rose in July as business increased at electronics, furniture and department stores, a sign Americans may be buying enough to keep the economy growing.  Sales excluding autos rose 0.2% to $220.2 billion after a 0.2% decline in June, the Commerce Department said.   Total retail sales were unchanged, stronger than the 0.2% decrease analysts expected, for a second straight month.

Businesses continued to reduce their inventories in June as the level of stockpiling fell 0.4% for the month to a seasonally adjusted level of $1.190 trillion, the Commerce Department said Wednesday.  The decline follows a revised 0.2% decline in May. May’s inventory performance was originally reported as unchanged.

Sales plunged 1.4% in June to $829.2 billion, following a 0.9% gain in May.  The June decline was the largest monthly sales drop since sales fell 1.5% in August 1992.

Industrial production fell for the 10th straight month in July.

Federal Reserve said that production at factories, utilities and mines fell 0.1% last month.  Capacity utilization continued to hover around 18-year lows, coming in at 77%, following a revised 77.2% in June.  Economists had expected a 0.3% drop in production and capacity use of 76.7%.

Housing starts jumped 2.8% to a seasonally adjusted annual rate of 1.67 million units in July, the Commerce Department said Wednesday. The report surprised economists, who expected housing starts to fall to 1.63 million, according to a survey by Thomson Global Markets. The housing sector remains one of the few pockets of strength amid the slowdown.

The Labor Department reported that the number of U.S. workers filing first-time applications for unemployment benefits fell by 8,000 to 380,000 claims for the week ended Saturday.  Economists expected claims to rise to 395,000 claims.

U.S. July Consumer Prices fell 0.3%, the second decline in the past 15 years, as costs of gasoline, clothing and computers fell.  April 1986 was the last decline.

Portfolio Strategy

Conditions:

• Fed Funds rate 3.75%, will likely cut another .25% August 21st meeting to support consumer spending
• Commodity prices declining
  • Energy prices declining
  • Excessive government interference and tight monetary policies that exacerbated the slowdown not reversing
  • Interest rate cuts not having the desired effect on the investment sector of economy.
  • The information technology and communications industries in a depression
  • Manufacturing in recession
  • Growing concern of deflation
  • Consumer debt growth is slowing – will spending follow?
  • Corporations are reducing their interest costs by re-financing at lower rates.

Likely outcome:

• Extended slowdown, possibly another year.  The economy must pull itself up, capital investment will be slow to return.
• The old economy will respond first – consumer cyclicals, consumer durables, and basic materials will be early winners
• Company consolidation will increase at some point as industry leaders seek to gain market share and improve efficiency by buying their less-efficient competitors.
• Market volume will continue to be relatively low and volatility will be high.

Action Plan

• Maintain long-term focus on economy, industry, and companies
• Own top leading companies in major economic trends
• Add to under-valued companies while pruning over-valued assets
  • Entertainment companies should do better as people travel less and go to the movies or watch cable more.
  • Health-related companies will likely be the best performing economic sector for next 5 yrs. as population ages and as major new discoveries enhance investment opportunities.

Major Economic Trends

• Outsourcing (just in time inventory etc. – we have learned that the info. economy can reach  overcapacity quickly)
• Diagnostic testing will grow w/ medical advances
• Storage of information
• Providing offices and homes with fast connections to the Internet
• Wireless data
• Fuel economy
• Competitive advantage concentrated in people, ideas, and networks