July 2003
Put Up or Shut Up
| "True luck consists not in holding the best of the cards at the table; luckiest is he who knows just when to rise and go home. " |
| -- John Hay |
HERE COMES A TIME IN EVERY POKER game when the betting is over and the cards are revealed. Winning hands are shown and bluffs are either exposed or proven successful.
That time has now arrived for the economy. For three years we've been hearing that things will be better in the second half. Now the second half is here and it's time to, as the gambler says, put up or shut up.
We've been there before. Back in the spring of 2001, the slowing economy fell into recession but economists still felt things would improve in the second half. Then 9/11 caused a misdeal and all bets were off.
The next year again started slowly but many investors were willing to bet on a better second half. Stock rallies in March, August, and November all ended in deep sell offs, calling the economy's bluff.
The betting is heavier this year as stocks have rallied from mid-March through June. Many investors who were ready to fold back in early March have doubled their bets as share prices climbed.
Now the second half of the year is here and all bets have been called. Do equity investors have the winning hand this time or have they again fallen prey to an economic bluff?
Pair of Deuces at Best
The economy is showing its cards in a manner not unlike seven card stud. Each week one or two indicators are reported, but there's no clear trend. At best, signals are mixed, nothing better than a pair of deuces.On the negative side, the press (and some politicians) have made a big deal out of the so-called "jobless recovery". Unemployment has been climbing for the past two years and currently stands at levels last seen in late 1994. This recovery -- if it is a recovery -- isn't creating jobs.
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and Raise Your Jobless Claims |
 Source: Baseline Unemployment has headed up since 2001. Even so, this indicator isn't very predictive given that it's historically risen for months following the end of a recession. |
But this is reading far too much into the unemployment numbers. The unemployment rate that the government reports is a backward looking number. Historically, unemployment has continued to climb months after the economy emerges from recession as more and more discouraged workers reenter the workforce and resume for jobs.
Weekly jobless claims provide more current data, but they too, are subject to substantial seasonal swings. In the past, a four-week moving average above 350,000 has signified a recession, but this figure has exceeded 400,000 for the past five months even though the most bearish economist wouldn't say we've been in a recession.
More forward looking series haven't offered much insight, either. The Index of Leading Indicators has been essentially flat for the year. Productivity has shown modest increases while durable goods orders have slowly declined.
Through the end of June, the CRB commodities index is virtually unchanged. Oil and natural gas had a considerable run up prior to the Iraq conflict, but now are actually down slightly for the year. Farm commodities and gold are up only modestly.
The inflation card is more interesting. Both the Consumer Price Index (CPI) and Producer Price Index (PPI) increased in the first three months of the year only to fall in April and May. Both are on track for relatively low annual increases of 2-2.5%.
Low inflation is usually good for the economy, but in this case, it may be too much of a good thing. Alan Greenspan and his friends at the Fed are 
now more concerned about deflation than inflation. Although he describes the possibility as "remote", Sir Cutsalot is willing to continue lowering interest rates in an effort to head off deflation.
The Fed is also willing to take other action to jump start the moribund economy. One possibility would be the open market purchase of Treasury Securities at the longer end of the yield curve. (When the Fed purchases Treasuries, they pay cash for the securities, thus injecting liquidity into the system.) Actually the Fed hasn't done this yet, but bond traders are acting like they have, sending long-term prices higher and yields lower
And that's the beauty of this strategy: So far the Fed hasn't done much of anything other than talk about what they'd do, but that's been enough to get the bond market to react as they'd hoped. Maybe they really aren't that concerned about deflation, they just wanted it to appear that way.
Heavy Bettors
Bond investors are making heavy bets, whether based on the Fed's rhetoric or on their own forecasts of ongoing sluggishness. Most market observers (us included) thought the bond rally was over when the 10-year Treasury yield fell to 3.5%. But that level was breeched in mid-June when Mr. Greenspan's statements and tepid economic numbers convinced investors further rate cuts were in the offing. One June 13th, the 10-year yield hit a half-century low of 3.11%.That's a pretty negative bet, even for traditionally bearish bond investors. It boils down to the belief that thirteen rate cuts still aren't sufficient to inject enough liquidity into the economy to effect a turnaround.
Such a sluggish environment is good for bonds, in fact at these levels, it's about the best bond investors can hope for. In their statement following the June FOMC meeting, the Fed indicated a willingness to keep rates at present levels for a prolonged period of time. If that's the case, bond investors won't enjoy additional capital gains, but at least they won't suffer losses while collecting their coupons.
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 Data Source: Baseline Over the past three months, the lower the company quality, the greater the return (green bars). In addition, the smaller the company, the greater the return (red dots). This suggests there's already a lot of speculation in the current market, something that doesn't normally happen until rallies near their conclusions. |
Curiously, the stock market has also rallied. You wouldn't think the prospect of a stagnant economy would have investors betting on stocks, but they sure are.
And they, too, were heavy bettors. From March 11 - June 17 the S&P 500 jumped 26.3% while the Nasdaq climbed 31.1%. The second half may be better, but the run up in share prices makes it look like it's a sure thing.
The riskiness of the bet wasn't just in the share prices, it was in the types of stocks being purchased. Not surprisingly, cyclical stocks took the lead with Tech, Consumer Cyclicals, and Industrials at the forefront. These sectors typically outperform in an expanding economy. If you're betting on a recovery, these are the sectors you seek.
But what you might not look for are small, low-quality companies. Oddly enough, those are the very issues that propelled the spring rally.
This is illustrated on the nearby chart where we've divided the S&P 1500 Super Composite by S&P's Quality Rankings. Standard and Poor's rates companies on a scale ranging from A+ (Highest) to C (Lowest) with B+ being average. The green bars in the chart clearly show that the lower the quality, the greater the gains in the three months ending June 17th.
The red dots on the chart represent the average market capitalization of the various quality ranks. Again it's clear that the smaller companies were the ones with the greater performance.
After such a long, grueling bear market, it's hard to believe investors would seek out the smallest riskiest companies, but that's exactly what happened. Speculation of this sort isn't how bull markets normally begin, but rather how they end.
Dealer's Choice
So if you've been counting cards, here's what you can take away from the situation: First, it's pretty clear that bonds have little if any appreciation ahead of them. Yields could stay at the present levels for months, but the ultimate trend has to be up. That also means the ultimate direction for prices will have to be down.Following the Fed's June rate cut, money market funds and other cash investments yield well under 1%. Aside from real estate or other, less liquid investments, stocks are the only real alternative.
We can thank the Fed for that. Low interest rates have not only made stocks more appealing relative to fixed income investments, they've also pumped liquidity into the financial markets. All that cash has to go somewhere and last quarter it went into stocks.
It's not unusual for stocks to rally sharply when a bear market finally comes to an end. At that point, stocks are usually beaten down and oversold.
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 Source: Ibbotson Associates After bottoming in September 1974, the S&P 500 jumped 55% in nine months. Over the next 33 months it only managed an 8% gain. The current March-June rally may represent a similar bounce from bear lows, but as in the 1970s, a prolonged period of consolidation may lie ahead. |
That's exactly what happened in 1974 at the end of the last long-running bear market. After hitting their lows in September 1974, stocks were off to the races for the next nine months. By mid-1975 they were up 55% from the bottom. The March-June rally was roughly half of that.
If the future's like the past, stocks could have further to go. But that's only a short-term bet; longer term things are a little more cloudy.
Again looking back at the '70s, stocks stalled for almost three years after the initial bear-ending rally faded. Over that period, stocks returned an annualized 2.8% which, at the time, was below the annual inflation rate.
This was the period of "stagflation" when the economy was dormant and inflation was high. After the '74-'75 rally, stocks were no longer dirt cheap and prospects were muted. Share prices essentially tread water until the economic outlook improved.
Could that be where we are today? Inflation certainly isn't the problem it was in the 1970's. Indeed, the Fed is now worried more about deflation rather than inflation.
To be sure, both conditions are troublesome. As we've argued before, both corporate earnings and share prices grow fastest when there's price stability. So maybe there is something of a parallel here.
In addition, at the end of June stocks are certainly no longer undervalued. With the S&P at 20x forward earnings and the Nasdaq at 37.5x, a little consolidation may be in order. You'd have to be a gambler to bid up share prices from these levels.
Which brings us back to the second half recovery: A continuing equity rally is a bet that it's finally here. Share prices have risen but earnings haven't kept pace. If further gains are in the offing, both profits and the economy must improve.
With the Fed Funds rate at 1%, the Fed has just about all the monetary chips on the table. Starting this summer, this year's tax cut will increase workers' paychecks and sweeten the pot. The weakening dollar will help import additional cash to the table.
There's not much monetary or fiscal policy left to raise the ante. The betting's been going on for three years now and the time really has come for the economy to put up or shut up.
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