Letter - June 2003

 

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Too Many Crosscurrents

There is an old saw on Wall Street, to the effect: "Sell in May and go away." Those who, this year, paid heed to that adage certainly must regret their allegiance to tradition as the past month turned out to be a real "barn burner." Another thirty-day period like May and investors will start calling up their brokers again, instead of their lawyers. The steady up-trend in stock prices since last year's October low has convinced many (possibly too many) that the three-year bear market is over. Bears will have to climb over a mountain of cash to make their point. Irving Berlin opined that "love makes the world go round," but from our experience it is money that does the trick. Federal Reserve Chairman Alan Greenspan, acting as financial cupid, has seen to it that there is plenty of money around.

The economy is literally drowning in liquidity. The Federal Reserve has cut interest rates to almost zero. The short end of the government market is under one percent. The money supply is growing at 8 percent a year, and recently enacted tax cuts are estimated to inject $31 billion into the economy this year and close to $90 billion in 2004. President Bush knows "it's the economy" if he is to be re-elected in 2004. Tight money (high interest rates) can abort a boom but cheap money (low interest rates) cannot always start one. So what happens when the supply of money goes up and the demand comes down? Money finds a home in speculative assets such as real estate and stocks. A return of one percent from a money fund will never fund a Palm Beach condo, but 100 shares of Intel could. Today's economic news doesn't count. Guessing, correctly, what tomorrow will bring is the key to successful investing. If you are wrong it doesn't matter, as long as you are the first to find out.

Today's investors are anticipating an upbeat second half to this year. Yet the current economic news does not justify 9,000-plus on the Dow Jones. Automobile sales are soft, unemployment is up, and durable goods orders are stagnant. However, compensating for this has been consumer spending and record low mortgage rates which have give homeowners an incentive to capitalize on the rise in house prices. On the other hand, business has not been receptive to cheap money. Its borrowings have been principally to refinance and strengthen balance sheets, rather than fund capital expenditures. Productivity and profit gains are the result of worker layoffs, rather than new machinery. Few CEOs, especially in the tech field, can yet see the light at the end of the tunnel. (Investors are perhaps more clairvoyant.)

All the above, however, could prove meaningless if on the foreign exchange markets the dollar continues to drop. The steady deterioration of our balance of payments over the years portends the possibility of a currency crisis, which never fails to upset equity and debt markets. The first casualty appears to be Europe, where the official currency, the euro, has shot up 20 percent versus the dollar. This is pushing the economies of the EU countries further into recession, and prolonging Japan's recession. A strong country does not have a weak currency, yet that is the position in which the United States finds itself. What if foreign capital, which has supported the dollar over the past decade, decides to depart? It won't, for where else can central banks safely park billions of dollars? Gold used to be the answer, but no more, since those same bankers discovered they could print money but not mint gold. If we don't buy the world's production, who will?

Just too many thoughts, too many crosscurrents. Even after listing my players on each side of the bull versus bear game, we're not ready to take sides. The bull leads the batting order with... 1. Record amounts of cash are sitting on the sidelines waiting for the "bell" to ring, "go get 'em." 2. A central bank that has shown no hesitancy in pumping up the money supply and cutting interest rates. 3. Consumer spending showing no signs of slackening in spite of the growth in unemployment. 4. Pension funds and income-oriented investors looking for returns no longer available in the fixed income market. 5. Stock market momentum, which shows no signs of tiring. However, the bulls are playing with corked bats, and they are hitting homers.

The bears see their strength in: 1. The bull misreading the headlines and betting on a strong (corporate profits) recovery starting in the second half of the year. Yes, the decline in economic indicators has slowed, but business is still not convinced. A surge in capital spending is expected to open up the box of goodies for investors, but most CEOs still don't see it that way. 2. P/E ratios are moving up, especially in the tech sector, defying the lessons of the late boom. 3. The insider selling/buying ratio has risen five to one, in favor of the sellers. The stock exchange volatility index (VIX) has given a sell signal. 4. The Fed can only further reduce interest rates by 1 percent. 5. North Korea and the Middle East. 6. The Federal deficit, etc...

At the end of each letter it has been our custom to list a half dozen stocks that we think are attractive for purchase. Today, we are going to beg off. We see little value and are not prepared to gamble on growth at 20 times earnings. To justify today's prices, investors are having to look for corporate profits past the second half of this year into 2004, and if that doesn't work, into 2005. The philosophy seems to be, if things are not getting worse, they must be getting better. Besides, the alternate investment, fixed income securities, is (in our opinion) a no-no. Saving is no longer an American tradition, but a couple of extra dollars in the bank and a few Krugerrands (once a gold bug, always a gold bug) under the mattress are conducive to a good night's sleep. It might be a good time to sit back and watch the crops grow rather than think about planting new seeds.

The market may well give back some of its recent gains over the summer. In September, the new business year begins. We will wait to see. Too much can happen in two months. Optimists may have already jumped the gun.

Philip Herzig


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