Review and Outlook
My Clients, Friends & Observers:
January 9th, 2002
is waste and worthless, till
the wise selecting will,
out of slime and chaos, Wit,
the threads of fair and fit.
investors of 2001. We’ve graduated, under budget and on time.
We called the bottom on September 29 and immediately discounted the
recovery of ’02. We did more trading (buying) in the ensuing
three weeks than we did in the prior five months combined.
On the equity
side we screened about a hundred companies not already in our composite,
passed twelve, and positioned four – all midcaps, low P/E’s,
strong earnings, significant dividends. We repositioned many equities
in our composite at fairly discounted prices. Our equity theme emphasizes
total return, capital appreciation and dividend growth.
On the fixed
income side we have waded in from the money markets, primarily to
corporates, weighing portfolios to an average maturity of seven years,
with at least 20% of portfolios maturing in three years. Without sacrificing
much in yield that will protect against rising rates in longer maturities
from a falling dollar, ebullient money supply, fiscal and monetary
stimulus, and potentially rising oil prices. We want cash flow.
In Peace, 1981 - 2001
I did not foresee
a year ago that a Fed which had so mercilessly raised rates would
atone with eleven consecutive cuts. There is only a 50% chance of
another Fed rate cut in January but nil probability of any rate increases
this year. The great bull market in bonds is exhausted. Herewith our
obituary. It was conceived during the Carter administration, under
the Fed Chairmanship of G. William Miller, whose Board started to
take seriously the ideas of Milton Friedman (and others) to control
money supply and the velocity of money to control inflation. It was
born in 1981 during the Reagan administration, Paul Volcker presiding
at the Fed. Volcker’s Board refined policy further to emphasize
the goal of price stability. That’s continued to date under
Alan Greenspan. Of all the social, political and scientific ferment
the last twenty years the economic liberation was Prometheus unchained.
More people than ever before became "Free to Choose" (a book by Milton
and Rose Friedman). The human condition is improved because we have
learned and acted accordingly –a shining example of good public
-like him or not, a genius -created junk bonds and leveraged companies
that refinanced with equity. Over at Salomon Brothers two other geniuses,
Bill Simon and Louis Ranieri, were creating a mortgage backed securities
market that seeded whole crops of new financial instruments. Shell-shocked
by the prior 10 years of economic wreckage, who could have predicted
that the creative chaos underway in the ‘80’s would lead
to unemployment of 3.9%, budget surpluses, Dow 10,000, interest rates
of 1.75% and more concern over deflation than inflation? The invisible
hand was made visible, electronically and instantaneously. The financial
globe was an unstaked gold field and new prospectors rushed in relentlessly
with new tools. Real wealth, a better standard of living, was created.
One has to be grateful to be alive in this age and place and be optimistic
for the future. It was the bond market bull that laid the foundation
for recovery and the phenomenal, secular bull market in stocks.
That too ended,
in year 2000, along with the "peace dividend" in 2001, which contribution
cannot be underestimated. What we are left with are financial assets
generally overvalued relative to likely near-term growth rates. We
are also left with far more tools than we had 20 years ago to monitor,
evaluate, and control to a greater extent our economic fortunes. If
we use the standard definition of recession as two consecutive quarters
of negative GDP then this one will be ending by the time it’s
defined. And there is a fair probability that we won’t have
two consecutive negative quarters.
Housing has remained
strong, the result of low mortgage rates and compelling demographics.
Ed Yardeni, chief economist for Deutsche Bank Alex Brown, makes the
point that Baby Boom II’s need for housing will not come from
the existing stock of Baby Boom I, who will live longer than any other
generation in history. Many commercial REITs liquidated during the
year however, after posting the best asset class gains the year before.
That suggests that the best money has already been made in that class.
The auto industry
has had two extraordinary years of sales, replenishing the auto fleet,
but at low prices and low profits. They’re in for a rough couple
sectors will have to work out their obesity. I’m afraid that
we may never see many promising technologies realized. George Gilder,
the writer, thinker and leading technology guru complained in an op-ed
piece in the Wall Street Journal last August that federal government
policies were aborting many nascent technologies. He indicts OPEC,
internet taxation, arbitrary antitrust enforcement, deflationary monetary
policy, and plainly socialistic telecommunications regulations. With
the exception of deflationary money policy which the Fed has corrected
I would agree with him on all counts. By its policies the government
is pruning out all potential profitability from huge capital investments
and stifling the realization of complete, interactive, accessible,
cheap telecom and internet connectivity. Add up an average household’s
minimum monthly expenditures for TV @ $30 (33% commercials), cell
phones @ $40 (over and above regular home phone service) and Internet
access @ $30 (the world’s greatest free library). That’s
an extra $1,200 a year that wasn’t being spent a few years ago
going mostly to companies that are predominantly old tech in their
industry. The "last mile" of connectivity to the house is restrained
by the political clout of the old phone companies. I don’t think
this is what Judge Green had in mind when he split up AT&T. Those
household costs would be far lower and service far better if the government
would get out of the way.
You can lead
a horse to water but you can’t make him drink. Government monetary
and fiscal policies can encourage or invite investor participation
but they can’t force it. Regulatory actions have the power to
destroy. There are $2.3 trillion in money market funds looking for
a place to work. The function of managerial finance is to identify
and enhance profitability, cut costs, gain share, raise prices. Looking
around, competition is relentless and brutal, pricing power is generally
weak, labor costs are rising. For a company with a 5% operating margin,
giving a 2% price discount requires a 67% increase in volume to recover
the lost profit, to stay even. Increasing productivity is essential
to a strong recovery and we need technology to do that.
The most visible
growth in a tech sector is in storage, demand for which is growing
exponentially, and which simply cannot be delayed. It is too essential.
OPEC has got
to go. The compounds that can be derived from oil are so vast in number
and scope that it is a tragedy that we waste it by burning it into
the atmosphere. Why do we risk American lives for it? Gasoline could
be replaced. The markets will do the rest in controlling crude oil
prices. The Germans have had a fleet of BMWs successfully beta testing
in LA for three years now burning hydrogen. Hydrocarbon emissions:
zero. It would take a Kennedy-esque national declaration of independence
from foreign oil by the end of the decade. It is an ambition worthy
utilization fell to 74.7% in November. The NAPM Price Index fell to
34.7 in December, down from its peak of 78.5 in March 2000.
through November ’01 increased year to year 6.5% for M1, 10.5%
for M2, 14% for M3, and was accelerating the last three months. Clearly
inflationary and that’s OK.
Oil closed the
year at $19.84. Gold at $278.70. Commodities, basic materials, in
the DJ-AIG Commodity Index closed at 89 (1991 = 100). This index appears
to have bottomed and bears scrutiny. Nominal inflation in November
enhanced its version of Social Security by giving participants some
discretionary investment authority. Russia completely replaced its
regressive, unwieldy, complicated tax system with a simplified flat
tax resulting in a boom of compliance and revenues. The Russian economy
is finally rebounding, strongly.
The agency that
collects analysts consensus, First Call, predicts S&P 500 earnings
2001 and +16% in 2002.
The rate of obesity
in American children increased 50% in the 1990’s. (MSNBC)
Targets for 12/31/02:
DJIA 11,542; S&P 500 1,274; NASDAQ Composite 2594. On the yield
curve we forecast a 1.5% Fed Funds Rate, a 5% five year note and a
6.5% ten year note. Positive indicators of stable growth.
slaves fulfilled the poet’s dream,
wire, strong-shouldered steam.
docks were built, and crops were stored,
ingots added to the hoard.
though light-headed man forget,
Matter pays her debt:
through her motes and masses, draw
thrills and ties of Law,
bind the strengths of Nature wild
the conscience of a child.
The poem is "Wealth"
from the book Conduct Of Life by Ralph Waldo Emerson, 1860