14 Dec 2001 ‘Tis the Tax Selling Season

To the casual observer, this week’s markets seem overly concerned with news that should have been expected and already priced into stocks.  We know, for instance, that a recession means higher unemployment numbers, declining payrolls, and weaker retail sales.  So why did it seem like investors ran for the exits this week after the buying spree of the week before?  The answer lies somewhere between human nature and the tax code.  Last week saw a market poised shake off months of pessimism in favor of the possibility that the economy would be turning soon.  Stocks rallied as investors and portfolio managers bought to avoid being left behind in case a new bull market was emerging.  Another common characteristic of investors is their tendency to hold positions with losses as long as possible hoping that time will reduce their losses.  As the year comes to a close, investors must sell their losses to recognize them for tax purposes.  Some years the process is orderly.  This year’s tax selling season will likely be more erratic because of the significant losses sustained by investors in 2001, generally bad economic news, and disappointing quarterly corporate earnings reports.  Sellers may panic into ‘selling at any price’ on market decline days, forcing some stocks to decline further than they would in more normal markets. 

As the stock market undergoes its year-end volatility, many investors will watch from the sidelines until the furor settles down.  Others who wish to get back into the stocks they sold this year must wait 31 days to satisfy IRS rules for realizing the losses on their tax returns.  Both groups of investors will likely return to the markets in January, buying as fast as they can, causing what is known as the “January effect.”  Add to those stock buyers, the holders of the six trillion dollars in cash and money markets who will see the markets rising and fear being left behind, and you have the possibility of a very strong equity market in the coming months.

Much of the economic data released this week confirmed the fact that the economy is weak, but there were no major bad surprises.  The consumer continues to participate in the economy, but his rate of buying fell off this month, as expected.  The record-setting pace of auto sales of October could not be maintained.  The zero percent financing in autos and other large ticket industries cannibalized November and December’s sales as consumers accelerated their buying decisions to get the attractive financing.  It is now evident that consumers slowed spending in lesser-priced goods too as retail sales fell 3.7%, the largest decline in 10 years.  Non-auto sales fell .5% compared to October’s increase of .8%.  Consumer confidence, announced on Tuesday, was higher than expected.  Consumers are not as shaken as was earlier feared.

The manufacturing sector continues to suffer, but there are signs of improvement.  Inventories continue to be worked down, but must be replenished if the consumer remains engaged, as he has so far.  Semiconductor sales may have seen their worst and could turn soon.  These products are a good leading indicator, as semiconductors are an integral part of so many manufactured goods.  Economists are looking for gross domestic product to increase in the first quarter of next year, effectively ending the recession of 2001.  The Federal Reserve further reduced the discount rate by another ¼ percent to 1.75%, as was expected.  The cut was viewed by fed watchers as largely cosmetic because rates are already low enough to have a simulative effect on the economy.   In fact, review of the November FOMC meeting minutes revealed that the vote to cut rates by a half a point was a close call as some of the nine voters felt they had done enough and argued for a lesser cut.  A quarter point cut can be taken as a message that the fed remains concerned about the economy and will do what is necessary to continue to add stimulus.  A larger ½ point cut is more substantive in its effectiveness.  The policy makers were also concerned that the markets might build into their expectations the hope of even greater fiscal stimulus.  It is more likely at this point that the cuts are at or nearing an end.  That of course does not mean that rates will be going up anytime soon.  The fed will wait to see real signs that the economy has turned before notching rates up a bit.

The economy is likely in a basing mode, meaning the worst is behind us and a turn may be coming soon.  While terrorist threats or acts will disrupt the markets for brief periods, investors have learned that terrorist events are essentially local in nature.  As such, they will not likely have serious impact on the broad economy.  The airline and travel industries are obviously significantly damaged by the events of 9/11 and the fear of future events, but the general economy is not as damaged.  The broader economy has experienced a ripple effect caused by the declines in these two very important industries, but again, the general economy plods on.

As we look ahead there are several investment areas we think will outperform the general market as the economy improves.  They include:

• Healthcare: generally favorable demographics and pricing trends
• Technology:  Semiconductors showing improvement, software that increases productivity  or lowers costs is doing well
• Telecom:    Reduced travel increases the use of telecommunications, increase of  corporate virtual private networks, growth in wireless communications as      new services, such as web access are rolled out
• Consumer Cyclicals:     Well-positioned retailers, particularly discount, are doing quite well in this low inflationary period

A few words are necessary regarding Calpine and its continued decline.  Almost since purchase, this investment has eroded on one piece of bad news after another. I bought the stock on the strength of the company’s operations and management team and because of its very attractive valuation.  The stock had fallen from a high of $58.04 to our purchase price of $45.00.   Calpine, based in California, builds and operates electric generating plants all over the country.  Their facilities are among the lowest cost generators in the country and their able management has been growing the company at over 40% per year for the past several years.  On numerous occasions since our purchase, Calpine management has assured investors and analysts that their growth goals were still achievable.  Brokerage houses such as Goldman Sachs, Merrill Lynch, Lehman Brothers, Legg Mason, and Banc of America have had and maintained “strong buys” on the stock while investor confidence and share price have continued to fall.  The stocks price slide started for us when the Senate went to Democratic control as a result of Jack Jeffords declaring himself an Independent.  Investors worried that government policy would swing away from deregulation of the power industry and back toward price controls which would limit producers’ profitability.  California continued to make noise that it wanted to renegotiate its contracts with power generators, implying lower profitability for generators.  Management continued to assert that they could maintain their growth and profitability targets.

Finally, the Enron fiasco has clouded the entire industry with doubt and concern.  Calpine declined to $10.00 under selling pressure on Wednesday only to rise 60% when S&P said the company’s credit rating would remain the same.  Today, the stock is down 17% on news that Moody’s, another bond rating service, might reduce the company’s bond rating on liquidity issues stemming from uncertainty in the industry caused by Enron.  At this point Calpine has been reduced to 40% of a normal position in the portfolio and, as a result, has little performance impact on the portfolio at this point.  Management and analysts maintain confidence in the company’s ability to perform, so I am inclined to believe them until such time the fact prove them wrong.  If the company can find the financing they require to fuel their growth and they can grow at, let’s say half of their target rate of 40%, the stock is incredibly cheap at a P/E of 7.  Time will tell.