War Drums

Since reaching a five-year low on October 9th caused in large part by the threat of war with Iraq, the Dow has rallied almost 22% from those lows.  The NASDAQ has risen 32% as investors and short-coverers have snapped up depressed technology stocks.  What has changed?  The threat of war seems as great now as it did on early October?  Have stocks risen too far too fast?  The short answer is, quite possibly, but maybe just for the near-term. 

The market is THE best leading indicator of economic trends and it is likely forecasting a recovery.  But we cannot remove emotions as a large contributor to the recent run up.  Stocks, particularly tech stocks, have been depressed for so long that any sustained positive movement is taken as a sign that their troubles may be over.  Investors still remember the exciting times the techs provided in the late 90’s and they do not want to be left behind if another such rally is near.

History tells us that the market sectors involved in a bubble usually significantly lag the recovery that follows it.  If history repeats, then communications particularly, and information technology, generally, may have to take a back seat while other industries lead us out of this slowdown.  Indeed, economists have predicted for months that the telecommunications industry will likely not see recovery until mid or late 2003.  Worse still, the telecommunications industry is dramatically impeded by misplaced Government regulations that were originally intended to stimulate competition.  In the last few years, the result has been to stifle capital investment by those companies that have (or had) the ability to do so.  It is our hope that President Bush and the Congress will include in the fiscal stimulus package we feel confident is coming, the elimination of this hurdle to further development of our communications networks (the Internet).

The larger story though, is that recovery IS taking place at the corporate level.  Carly Fiorina surprised the investing world when she announced that Hewlett-Packard’s profit had increased four-fold and sales outstripped forecasts.  The stock had its biggest gain in three years.  It seemed that the merger, maligned by many, was indeed working.  Cost savings in the first six-month since the deal were 30% greater than even the company had estimated.  Other computer related companies, such as Microsoft, increased on the news.

Amazon, a survivor of the dot com era, with its unique cost structure and near-zero cost advertising, is slowly, but surely gaining the confidence of investors.  The company has not reached profitability as fast as investors hoped, but television and radio took much longer to reach profitability than earlier thought too.  Other survivors such as eBay and Yahoo continue to surprise the skeptics as well.

Investors were also reassured Wednesday night when General Electric Chief Executive Jeff Immelt made some disclosures for the company.  He started with the bad news that the company would fall short of expectations due to $1.4 billion in costs necessary to boost reserves in their reinsurance business.  He said he “hated” giving the bad news, almost implying that he did not expect to do it again in the future.  Once the bad news was out of the way, he confidently stated the company’s 2003 projections for earnings.  He sounded so confident that investors greeted the news by driving the shares up by over 7% the following day.

Many companies remain in the cost-cutting and consolidation stage of the recovery cycle.  Government numbers tell us that layoffs are declining, but they are still happening.  Companies are cutting costs wherever they can to maintain profitability.  We are also seeing numerous asset sales as companies spin off less profitable businesses.  It is widely expected that GE will eventually sell their lighting and appliance divisions.  These are sentimental favorites of the company, but if holding them doesn’t make good business sense, then the company will be that much stronger afterwards.  Many others are getting back to their core businesses, producing those goods or services where they maintain and will likely continue to maintain a strong competitive advantage.  This process makes surviving businesses leaner and more competitive for the coming recovery.

But business cannot go indefinitely cost cutting and spinning-off less profitable divisions.  Eventually it must invest capital to improve the utility of its products and to expand into new markets.  Economic recovery in the business sector begins with companies investing in their future.  We are beginning to see some of that investment.  In July of this year Bill Gates of Microsoft announced that the company would increase its research and development budget by $900 million this year and add 5,000 jobs.  The company spends in excess of 15% of its sales on developing new products and services, which are designed to improve productivity at many levels.  Gates said then that the future of technology was brighter than ever.

While technology has provided the spark for the latest market rally, it is not likely to sustain it.  The consumer remains the linchpin.  There have been some signs of slowing in spending, but Christmas is practically upon us.  It doesn’t have to be a record Christmas for the associated spending to stimulate to the economy.  Indeed many factors weigh against a record Christmas.  The west coast dock slowdown is already causing inventory shortages in key retail areas.  The containers that remain on the docks and the ships waiting to unload have not been able to return for the last critical shipment before the holiday spending rush.  The looming war with Iraq and the daily reports of terrorist acts have a psychological impact on the consumer, but we have little idea at this point how it will impact spending.

The lid on this market remains UNCERTAINTY and its biggest cause is the possible war with Iraq.  Mr. Greenspan refers to the war as “geopolitical risk.”  The administration says it is not coming soon, but it is busy aligning international support.  NATO does not speak directly to military action, yet they are preparing measures for humanitarian aid in the wake of war.  The NATO inspectors express dissatisfaction with the amount of disclosure they are getting from the Iraqi government.  The signs, the rhetoric, and the upcoming favorable climactic conditions argue for a war in Iraq, sooner rather than later.

The market has precedence for this war, so it is reasonable to expect it is already discounted in prices.  In our view, investors are looking beyond the war, expecting that it will be relatively short-lived and executed satisfactorily, as it was in the early 90’s.  But still, the uncertainty of terrorist activities linked to it and its potential effect on oil prices keep a lid on excessive market optimism.

So, once again the market is restrained by uncertainty.  But the last three years of excessive uncertainty have steeled the will of investors to patiently search for survivors of the slowdown and winners of the next expansion.  The market is less emotional than it has been in past months.  Individual companies still get trounced over relatively small disappointments, but the general market seems more resilient to bad news.  A more stable market is a more hospitable market.  Investors will respond by coming back to stocks gradually, as daily volume indicates.  We expect the market to trade in a relatively narrow range in the coming weeks until we see fiscal stimulus measures proposed and enacted by the Administration and the Congress and until the war with Iraq is concluded or disarmament is accomplished.

Sam Bass
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