November 2000
The Soap Market
| "If you have to be in a soap opera try not to get the worst role." |
| -- Boy George |
ALL STREET IS OFTEN PORTRAYED AS A PLACE WHERE high-powered deals are made and fortunes are won or lost on a daily basis. But despite the macho swagger, this year the daytime soaps are a more appropriate comparison. Just consider the common characteristics:
- Each day brings a new crisis and ends with a cliffhanger.
- Unbelievable plot twists are the norm.
- Despite a high degree of melodrama, very little really occurs.
- The acting's bad and the plots are weak, yet thousands tune in everyday.
- No matter how they're dressed up, there are really just a few recurring themes.
Perhaps armed with this knowledge, we can better deal with the market's gyrations. At any rate, let's give it a try.
All My Indexes
Volatility has certainly been up this year. Significant daily movements -- both up and down -- have been on the increase. Nevertheless, through October, most major indexes are quite close to the levels at which they began the year. Even the Nasdaq (up as much as 24.07% and down as much as 24.44%) is still within striking distance of its year-opening value.|
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 Source: Baseline Tech stocks led the Nasdaq to a sizzling start this year. But when they faded, so did the index. The Dow, while still down for the year, plodded along at a much steadier pace, ending October solidly ahead of the Nasdaq. |
Unfortunately, this hasn't been the case for a number of individual issues. Hardest hit have been last year's tech darlings, but the pain hasn't just been confined there. Consider for example, WorldCom (down 55.2%), Wal-Mart (down 34.4%), Procter & Gamble (down 34.8%), AT&T (down 54.4%), and Circuit City (down 70.6%).
As the year's worn on, value has taken the lead over growth. When overvalued growth issues came back to earth, proceeds flowed into neglected value stocks. The Dow's "old economy" stocks were the beneficiaries while the Nasdaq's growth oriented ones suffered. Treasury securities also benefited in the flight to quality.
Corporate bonds were left behind as spreads widened with Treasuries. The slowing economy called into question companies' ability to service their debt. Should the decline continue, defaults -- at least for lower quality issues -- may become a legitimate concern.
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 Source: Baseline Despite all the recent inflationary fears, the CRB index has fallen back to its 200-day moving average. As October ended, it was testing support at the 220 level. If commodity prices continue to fall, inflationary pressures should ease. |
Confirmation of the economic slowdown continues to grow. Third quarter GDP fell to 2.7%, less than half of the previous quarter's torrid pace. Many of the earnings warnings that recently rocked the stock market were attributed to falling orders for finished products. This decreased demand will inevitably make its way through all levels of the supply chain.
The budgetary wrangling in Congress has also contributed to the current slowdown. As the 2000 fiscal year came to a close and the 2001 budget remained unsigned, spending on federal programs has diminished. Not only has this helped brake the economy, it's also reigned in the biggest cause of inflation, government spending.
Despite September's elevated CPI, inflation shows little sign of heating up. Oil prices continue to fluctuate, yet most believe prices will fall next year, returning to more favorable levels. Until they do, higher petroleum prices actually restrain inflationary pressures by acting as a tax on spending. Every extra dollar spent at the gas pump is one more dollar that can't be spent on other items. Extra funds required to heat consumers' homes must come from a reduction in discretionary spending.
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 Source: Baseline All year the euro has weakened while the price of crude oil has risen. Both were blamed for U.S. companies' third quarter earnings disappointments. One might wonder why there was such a big impact in the third quarter when the trends were developing for months. |
The weak euro (and correspondingly strong dollar) also curbs domestic inflationary threats. This makes it easier for foreign countries to export their goods to the U.S. making it more difficult for domestic firms to raise prices. As long as the dollar retains its relative strength, inflation will have a hard time getting established.
At this point, recession would seem more of a threat than inflation. The Fed doesn't really have a very good track record when it comes to tinkering with rates to achieve a soft landing. We continue to be concerned that the most recent round of rate increases may have overshot the mark, making a recession a real possibility.
The Young and the Profitless
Other investors seem to share this fear. The volatility and corrections that have dogged the stock market are related to these concerns. Coming into 2000, many stocks were priced for perfection. P/Es had swollen to the point that companies had to execute flawlessly and economic conditions had to remain stable in order to justify current stock prices. When the economy slowed, oil prices rose, and earnings were a cent or so short of projections, skittish investors ran for the hills, driving down the offenders' stocks by 25-30% in just one day.This "revaluation" started with the profitless (and pointless) dot.coms and quickly spread to all industries in the tech sector. Given that relatively low interest rates kept bonds from offering a viable alternative, proceeds taken from the tech sector flowed into traditional value sectors such as consumer staples and basic materials. While they may not have the greatest growth potential, they were certainly not overvalued, having less to lose. In the volatile equity markets, this was relative safety.
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 Source: Baseline Through August, growth and value stocks took turns in the spotlight. But in September, when the economy showed tangible signs of slowing, value took command. |
But as the tech carnage spread from industry to industry, it also started to infect other sectors as well. Financial issues fell prey to rising interest rates. Consumer cyclicals succumbed to slowing consumer spending. Basic materials felt the negative effects of slowing demand both here and abroad.
As autumn arrived, mutual fund tax-loss selling added to the downdraft. It may actually have been worse this year, as many funds had sold appreciated holdings to lock in profits. These gains must now be passed out to shareholders, even though many funds were showing negative year to date returns. In an effort to offset gains with losses prior to the October fiscal year end, many managers were selling their losing positions. As a result, stocks that had already suffered endured an additional pummeling.
Guiding Light
But now that tax-loss selling season is over and every corner of the tech sector has corrected, the equity market may be poised for the traditional fourth quarter rally. Just as the earlier run-up in prices was an overreaction, the recent sell-offs were equally exaggerated.Why would investors return to domestic equities? Quite simply, they still remain the only game in town. Bonds have rallied about as far as they can without an easing of monetary policy. Indeed, the currently inverted yield curve already appears to factor in at least one such move. When it will occur is anyone's guess, but probably not before late first quarter of 2001.
Foreign equities don't have a lot to offer, either. European economies are struggling with the weak euro and the Japanese economy still can't find a sound footing. The U.S. economy is still showing greater growth. As is always the case, growth is the true determinant of performance.
This holds for individual stocks as well. Earnings growth is their guiding light. If our sense about this is correct, the path for investors is fairly obvious.
With a slowing economy, companies that can still grow earnings with be the best performers. In this scenario which would you prefer, Alcoa or Intel? General Motors or Johnson & Johnson, Duke Energy or Solectron? In each case we'd take the second alternative, not because they're cheaper -- they aren't -- but because each alternative is more capable of growing earnings in a slowing economy.
The same holds for sectors. At this point we'd suggest focusing on technology, healthcare, selected cap goods, and growth utilities. Integrated oils in the energy sector may still have one or two good quarters 
ahead of them, too. We'd avoid cyclicals, especially retailers, basic materials, and transports. Selected consumer staples may do well in the short-term although their long-term prospects are mediocre at best.
Looking ahead into 2001, financials may come around, especially if the Fed cuts rates. Communication services stocks may also see increased interest since they're already trading off their recent lows and consolidation sweeps the industry.
Waylays of Our Lives
In such a volatile -- and often irrational -- market, it's often hard to remain focused on the long-term. Short-term gyrations are frequently quite irrational, punishing the reasonable investor. As in the soaps, the unbelievable is to be expected.
No one can come out ahead by attempting to predict the next outlandish development. At best we can hope to apply logic and reason, tested by the past. Aside from short-sellers, few benefit from volatile markets. The best you can do is stick with a reasoned approach.
Hopefully Santa's just around the corner with a nice, orderly rally. Odds are it won't have the same magnitude as last year's amazing run-up, but it should leave the equity market at a higher level on December 31 than it was on November 1.
At best, most indexes may only finish flat to slightly up for the year. There's not a lot of fireworks and surprises in that, but still, it's better than where we were at the bottom. Unlike TV's soap operas, every investing story doesn't necessarily have a neat and tidy ending.
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