September 2002
Just Relax
| "In all recorded history there has not been one economist who has had to worry about where the next meal would come from. " |
| -- Peter Drucker |
EMEMBER THOSE GOOFY CHARLES SCHWAB commercials where Chuck encourages antsy investors to, "Just relax"? Well that advice may not be a lame as you think, especially in light of late summer's developments.
As gut-wrenching as it was, July's selloff isn't the main source of investors' concern. Many market strategists had predicted a climactic blow-off to remove all sellers and end the bear market. Following the selloff, stocks ended July with a weeklong rally suggesting a bounce from the oversold bottom.
Those who stayed invested took solace in the fact that trading patterns responded as predicted. It was also comforting that second quarter earnings -- with the notable exception of tech -- were generally on target.
But just as the stock market began to regain its footing, July's economic numbers took an unexpected dive. Durable goods orders actually fell 4.5% in June, productivity showed its smallest increase since the second quarter 2001, manufacturing was down and GDP showed an anemic increase, fully 1% below predictions. In addition, WorldCom found another $3.3 billion in fraud and consumer sentiment understandably fell.
Ever since the first quarter of 2002, pundits puzzled over the divergence between surprisingly strong economic figures and the weak equity market. Typically stock performance is a leading indicator for the economy, but it just wasn't happening this time. Now it's starting to look like the market had it right and the economy was just giving a head fake.
Suddenly the focus has shifted to "false bottoms", a possible "credit crunch", and prospects for a "double-dip recession". Were all the positive signals from the early part of the year just another false start in an ongoing downturn?
Well, just relax.
Higher Interest in Lower Rates
The knee-jerk reaction following the market decline and weak economic figures was to call for the Fed to cut rates yet again. Prior to this time, strategists had expected the next move to be up, but in early August the consensus swung the other way. Goldman Sachs went so far as to predict an additional 3/4% cut by year-end, which would leave the Federal Funds Rate at a miniscule 1%.The FOMC held their little meeting in mid-August, but took no action. And why should they have? The previous eleven cuts still haven't made their way all the way through the economy. Why should an additional move now be expected to help immediately?
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 Source: Baseline Since the beginning of this easing cycle, the Fed has dramatically cut the Federal Funds Rate to historic lows. The 10-year Treasury Bond has responded by falling to 40-year lows. Still the economy remains sluggish. With the Fed Funds rate at 1-3/4%, the Fed is about out of ammunition. |
Those calling for a rate cut cite fears of an impending "credit crunch". This occurs when -- regardless of rates -- lenders are reluctant to make loans in a poor economy. If lenders hold onto available funds, monetary policy will be ineffective in stimulating the sluggish economy.
But just relax, while it's true that lenders are being more selective, this itself doesn't mean we're in a credit crunch. Lenders need to be more vigilant in a slow economy. Indeed, many have had to set aside additional reserves against defaults.
More importantly, as Japan so clearly demonstrates, low interest rates are not sufficient to stimulate an economy out of recession. The first few cuts have the greatest impact, but as they mount, successive cuts lose their effectiveness.
The way we see it, interest rate cuts are a lot like cold beers on a hot day. Often just the thought of that first thirst-quenching brew can make you feel better. When you finally get it, it's just about the most wonderful thing in the world.
The same is true for the first interest rate cut. When money is too tight, just the anticipation of a cut can help the market. When it finally comes, the reaction is usually swift and sharp. The second and third cuts are also quickly appreciated, too, just like a second or third cold beer.
But by the time you've had the eleventh cold beer, the twelfth probably won't taste as great. Indeed, it may actually do more harm than good, both today and tomorrow. The same is true for the twelfth interest rate cut: It probably won't have much of a positive impact now, but will have the potential to exacerbate inflationary pressures when the economy does pick back up.
And that's what's really needed to get things turned around -- a pickup in economic activity. If low interest rates could turn things around, it would have happened in Japan long ago.
But the U.S. isn't Japan. Here
- Productivity is still high
- Unemployment has stabilized at a relatively moderate 5.9%
- The weaker dollar will actually boost exports and U.S. multinational's profits in the short-run
- Inventories are at levels where new production will be required.
Yes, consumer sentiment and durable goods orders have fallen in the past two months, but who would have thought otherwise? The two are tied together and with all the negative
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 Source: Baseline Investors and economists alike were surprised by June's sharp drop in durable goods orders. They were equally taken aback by July's steep increase. Despite the magnitude of June's drop, the level only fell back to the year-long trend. July's pickup may actually signal a breakout. We'd suggest that each month's figure overshoots the actual trend and that investors should focus on the long-term pattern rather than month-to-month fluctuations. |
The fact of the matter is these are short-term factors that don't necessarily signal long-term trends. Most of July's selloff was retraced by the end of August. June's surprising 4.5% decline in durable goods orders was more than made up by July's equally surprising 8.7% increase. Consumer sentiment follows along.
These are volatile numbers that shouldn't be taken alone. Instead, we'd suggest looking at the 3, 6, or even 12-month moving average to get a better perspective. Thank goodness the Fed is aware of this and doesn't fall prey to the knee-jerk recommendations of the so-called "experts". Just relax.
Counting the Dips
The fears of a "double-dip" recession are equally overstated. A double-dip recession is said to occur when the economy stumbles into another recession before recovering from the first.The most recent concerns stem from the surprisingly weak GDP figures for the second quarter. Economists had anticipated growth of 2.1% but the first estimate came in at 1.1% sparking fears that the economy was sliding into the dreaded double-dip.
Before hunkering down for the second dip, consider a little perspective. First of all, recessions rarely end with a growth blastoff, yet that's what everyone seems to expect this
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 Source: Baseline The past twenty years have seen some major swings in quarterly real GDP -- both up and down. Throughout that period there have been three recessions, but only the 1981-82 one was a "double-dip". Indeed, it was the only one in the 20th Century. |
So the second quarter was back to 1.1%, is that really a tragedy? We'd suggest not, especially since the first quarter may have robbed a little growth from the second.
In addition, remember low growth is still growth. A recession -- and presumably a "double-dip" recession -- is defined as three consecutive quarterly declines in GDP. None in a row is not a trend. Just relax.
Contrary to what CNBC's talking heads may imply, double-dip recessions are really quite rare. In the past century, there was only one -- 1981-1982. Perhaps today's economists think this phenomenon is more common since they actually experienced that one. Whatever.
Anyway, don't lose sight of the fact that the economy -- like the various series that allow us to measure economic performance -- rarely moves in a straight line. Short-term fluctuations are to be expected yet it's the long-term trend that's most important. Over the past four quarters it's still on a definite uptrend.
Bottom Fishing in Fishy Bottoms
Given all the dire economic gibberish investors have had to hear, it isn't surprising they're on edge. When you add in mid-July's sharp selloff and August's rapid recovery, indecision seems like the logical response.From where we sit, there's still too much effort being dedicated to "calling the bottom". Some strategists argue July established the necessary low while others contend a "retest" will be necessary to truly establish the bottom. When all's said and done, despite late summer's volatility, stocks are still moving in the same downward trading pattern established at the market peak in early 2000.
We've never believed a final "capitulation" was essential but by the same token, volatility is likely to remain high as long as investors obsess over calling the bottom.
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 Source: Baseline Despite all the volatility over the past two years, the S&P 500 is still locked in the downward trading pattern established at the market peak in 2000. |
More importantly, regardless of the prospect of additional capitulation selling, it will take time for conditions to stabilize and stocks to resume a consistent move forward. Just as the economy doesn't turn on a dime, the equity market doesn't either.
Over the short-term, we'd expect more negative influences than positives. The month of September will be marked by third quarter earnings warnings. They actually started earlier than usual in late August, with Intel, Nortel, Footstar, Roadway, Novellus, and Sun Microsystems either issuing warnings or reducing their guidance for the quarter. We'd look for more announcements, especially from tech companies.
We'd also expect the market to struggle into mid-October when it may finally be buoyed by some upside earnings surprises from companies in the more defensive sectors.
Also, as long as the posturing for an invasion of Iraq continues, stocks will have difficulty making any lasting headway. As much as the market dislikes the terrorist threat of Iraq, it fears war even more.
Investors riding it out are best advised to maintain a defensive posture, diversifying across sectors with greater earnings consistency such as Healthcare, Consumer Staples, and 
traditional utilities. With tensions running high in the Middle East and winter just around the corner, Energy stocks may offer opportunity for a short-term trade.
If you take a longer view -- and you should if you're really an investor and not just a trader -- things look a lot better. Aside from Tech, third quarter earnings will have their share of upside surprises.
As we enter the fourth quarter, analysts will turn their attention to the coming year rather than the coming quarter. While their annual predictions are usually overly optimistic, 2003 will be better than 2002 and investors will start to act accordingly.
As signs begin to build of economic and earnings improvement, cyclical sectors such as Financials and Consumer Cyclicals will assume their traditional leadership positions. Telecom and Tech -- while they'll have periodic sharp rallies -- will be the last to truly recover.
As the past two years have demonstrated time and again, trying to call the market bottom is a loser's game. In essence, it's impossible to apply a logical trading strategy in an illogical market.
Wise investors use periodic selloffs to establish diversified positions in quality, fairly valued stocks. They realize there may still be short-term losses ahead before the market finally makes a definitive turn upward. Even so, core positions established now will form the basis for long-term profits ahead.
Most importantly though, just relax.
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