Good Riddance to the Bubble and to 2000!
Help from the Fed and Other Catalysts for 2001
Asked to recall the single most important financial event of last year, most investors would be likely to say: “It was the year the technology bubble burst.” Really? Texas Instruments, as imbued with technology as a semiconductor manufacturer can be, was down just 2% last year and Corning, with its optics technology now in high demand because of the worldwide migration to broadband, was up a very respectable 23%. Did these two companies simply escape the puncture of the technology bubble?
We don’t mean to be disingenuous. But for experienced investors, the annual ritual of pretending that the world stops with the closing bell at year end has always been singularly unsatisfying and seldom more so than in the year just closed. So it was that, on December 29, 2000, the Standard and Poors 500 saw its first down year in a decade (down over 9%) and the technology-laden NASDAQ Index, having declined 54% from its high on March 10, 2000, fell 39% for the full year.
The carnage in stock prices in 2000, however, cannot be conveniently dismissed by the characterization that the so-called technology “bubble” simply burst. A bubble did, in fact, exist and did burst but it was confined to a narrow segment of technology, the Internet industry. However, the largest disasters occurred in the B to C (Business to Consumer) e-commerce part of the Internet. One of the most dramatic examples pertains to the fate of priceline.com, a company with well over $1 billion in revenue (but no earnings) for 2000. Eighteen months ago the stock, riding a wave of e-commerce euphoria, sold at $165 per share. Today the shares sell for just under $2 per share, a decline of 99% in a year and a half.
EToys Inc., one of the top ten most visited retail websites during the holiday season in 2000, is selling at around 20 cents per share, down from its $86 per share peak in October 1999, a 99.8% decline in 15 short months. The list of fallen dot com darlings is huge and is likely to keep growing until and unless the industry figures out how to gain access to additional capital and give Wall Street the profitability it is demanding.
If the majority of the technology and telecommunications industries is not directly linked to the B to C debacle, what caused the dramatic reversal of fortune in the tech sector in 2000? In a word, the Fed. Fear of inflation, including a disastrous increase in oil prices from $10 per barrel in the fourth quarter of 1999 to a peak of $36 per barrel in September 2000, not to mention an exceedingly strong economy, caused the Fed to tighten interest rates six times in the twelve months ending June 2000. This caused economic growth rates to come crashing down. These economic skids have simultaneously collapsed short term growth rates, especially for technology stocks, creating a huge contraction in earnings multiples. The average forward earnings multiple for the technology sector of the S&P 500 was over 50 times estimated 2000 earnings last March. Today, the group is selling at 26 times forward twelve month earnings.
However, the precipitous decline in the market, a rapidly slowing economy, emerging concern over a credit crisis and the current absence of meaningful inflation caused the Fed to reverse its restrictive position at its meeting in December. At that time, the Fed moved to an easing bias in order to shore up an economy that was deemed to be slowing too markedly and too fast.
On the second trading day of 2001 the Fed made good on its December reversal of bias and, in an unusual between-meetings decision, lowered the Fed funds target rate by 50 basis points (from 6.5% to 6.0%) and lowered the discount rate by 25 basis points (from 6.0% to 5.75%). The stock market rally triggered by that unexpected move saw a 5% increase in the S&P 500 and a 14.2% increase in the NASDAQ Composite in a single day. However, when the Fed lowered the discount rate an additional 25 basis points two days later, the market had re-focused its attention to disappointing fourth quarter earnings pre-announcements. The net result was that the full week saw major market averages in decline.
The tough stock market we’ve endured has resulted in securities valuations becoming as reasonable as they have been at any time since the trough of the Asian credit crisis two years ago. Oil prices have reversed and are trending downward. We expect that oil prices will be lower at the end of 2001 than they are now. There is real potential for meaningful tax reduction this year. Finally and most dramatically, the Fed is easing. Average gains in the S&P 500 after the Fed first begins to ease have been approximately 19% six months later and about 23% after one year, including all sustained periods of easing since the 1973-74 recession. What has been true in the past, of course, may not apply for this round of ease.
Why then aren’t we pounding the table and loading up on common stocks? The simple reason is that global growth is slowing and slowing rather dramatically. And more than a few economists are concerned that the U.S. economy’s soft landing could quickly descend into recession.
We at Oakwood do not hold with that view. Central to our expectations is the presumption that the Fed has been successful at engineering a soft landing for the U.S. economy. This would entail growth slowing to around 2.5% - 3.5% from the breakneck pace of the first half of 2000, which operated at a run rate around 5%. At present, however, it looks as if the second half of 2000 will be reported in at around 2%. This is much softer growth than the Fed would like to see.
Despite the easing moves by the Fed, we continue to expect that fourth quarter 2000 economic reports will be weak with Gross Domestic Product (“GDP”) probably up less than 2%. In its zeal to halt inflation and slow the economy, the Fed also appears to have engineered quite a credit crunch. While high quality companies still have access to the capital markets, bank credit has tightened rapidly. In fact, lending standards are tighter now than at any time since 1991 and fourth quarter bank loans to business were flat for the first time since late 1998. Further exacerbating the situation is the fact that the junk bond market has completely shut down as that market absorbs the fading promise of B to C and the widening of spreads attendant to a generally weak stock market. Factory production fell 0.5% in November and capacity utilization is around 80%, the lowest level since 1992.
Retail sales were down 0.4% in November and retail inventory buildup is likely to seriously depress fourth quarter retailing earnings. However, there is no shortage of consumer credit and we expect that consumer spending, which is two-thirds of GDP, will come in at 3% for the fourth quarter.
These lackluster results are likely to continue into the first and perhaps the second quarters of 2001 as well. However, the second half of the year, spurred by Fed action now, should begin to show improvement. For 2001 we expect that consumer spending will be in the 2.5 – 3.5% range, well below the 5% levels that prevailed in previous years. We are estimating that capital spending will be up 10% in 2001, substantially slower than the up 16% rate that probably occurred in 2000, and will be almost entirely comprised of technology spending. Thus, we reiterate our full year GDP growth expectation for 2001 of 2.5% - 3.0%.
Inflation pressure is clearly on the wane as the Producer Price Index (“PPI”) has barely budged during the last couple of months. We estimate that inflation, as measured by the Consumer Price Index (“CPI”) was up 2.9% and, aided by declining oil prices, will approximate 2.5% in 2001.
Critically important to all our market expectations is that the U.S. avoids a recession, that Fed rate cuts continue and that they exert a positive effect on the economy. Key risks to this outlook include further downside to the market itself which, in an environment where much larger portions of household wealth now reside in common stocks, could substantially increase the chance of a recession. Similarly vulnerable is the outlook for capital spending, dependent as it is on spending in the technology area. We come out on the side of a soft landing (that is, no recession) and are making investment decisions on that basis.
The NASDAQ Composite’s decline of 54% from its peak in March is matched only by the decline of 60% from its peak in the 1973 - 74 bear market. Yet, the macroeconomic environment today is in much better shape. Arguably, therefore, the decline in the NASDAQ may be overdone. Going back to 1973 – 74 and on average, the NASDAQ Composite has increased approximately 27% in six months and around 37% in one year after the Fed first reverses its previous posture and begins to cut interest rates.
The degree to which returns for 2001 will see the upper end of that range is dependent upon whether or not growth rates, earnings estimates and price/earnings multiples have stopped declining and can again expand. The importance of increasing estimates is that it refocuses investors on the longer term. One of the major causes of this downturn in stocks has been the substantially foreshortened time horizons investors suddenly develop when growth rates get called into question.
Long term growth rates have not been reduced much from a year ago but P/E ratios have declined by roughly 25%. This has occurred because investors have become focused on lower growth rates occurring in this year, and probably next. Hence, the relevant investment horizon has grown very short and is depressing stock prices. In retrospect, it appears that the market was anticipating earnings six or eight years out for many tech stocks last March and is now only willing to look a quarter or two ahead. Both points of view are extreme and are not likely to last. Investors will begin to bid stocks up again when they begin to believe that earnings estimates will be met or exceeded and when estimates themselves are subject to increases rather than decreases.
Declining price/earnings multiples are evident in the S&P 500 index. Today, the S&P 500 sells at 20.6 times earnings with half the companies in the index selling at P/E ratios less than 15 times. Over the last decade, the low P/E ratio was 15.8 times, attained in the first quarter of 1995.
Stock market strategy this year, however, may be a veritable minefield. We believe that, selectively, investors need to continue to adequately weight technology and telecommunications stocks in their portfolios. Not only are industry fundamentals better than they were at the times at which these companies sold at their most deeply cyclical discounts but their growth rates also continue to be among the highest in the S&P 500. At Oakwood the overall technology sector is split between “communications,” which includes the telephone companies, and “technology,” which includes the computer, semiconductor and software companies. We are, at present, only market weighted (around 20%) in technology and are slightly overweighted (by 15%) in communications. Thus, Oakwood portfolios are exposed to the extent of one-third of their market value in technology-based companies, only slightly overweighted versus the S&P 500.
We are paying special attention to sub-sector selection within these groups, however. Within the telecommunications sector, we emphasize companies which are part of the move to optical and wireless communications rather than companies locked into yesterday’s technology (such as wireline), or companies which are dependent upon expanding infrastructure budgets. Furthermore, we seek companies which will dominate segments of the transition to digital. There is a growing need for faster logic, communications and memory chips, for storage and servers and a continued trend toward outsourcing by original equipment manufacturers. In the software business, we strongly favor a licensing business model over a model of outright sale.
This year we also like the beneficiaries of lower interest rates, such as many financials and selected retailers. We are overweighted in financials, especially banks, as they are extraordinarily cheap, reflecting credit concerns and overall economic malaise. Retailers have experienced dramatic pullbacks in the wake of concern about the consumer slowdown.
We have moved to an underweighted position in energy. Although that group has performed admirably earnings will be flat this year as oil prices decline. We have also recently moved to an underweighted position in health care, reflecting the fact that this group, among the best performing of 2000, will find it tougher to excel this year, in view of slowing worldwide economic activity.
Earnings for the S&P 500 for 2001 are estimated to be in the $63 range. This estimate represents an 8% increase or so, depending on where 2000 comes in. We anticipate a tough fourth quarter earnings reporting season, which is already underway. No fewer than 30 earnings warnings were issued a few days ago within the first few hours of trading and they did not emanate from the technology sector. Companies from Delta Airlines to Honeywell are throwing cold water on investor expectations as fourth quarter results accumulate. Although expectations are not as high as they were three months ago, it is clear that earnings in many industries continue to be quite volatile.
All bear markets, such as the one we’ve recently experienced, conclude with such climactic events as large selloffs, high mutual fund redemptions, higher cash positions on the part of professional managers and high levels of pessimism. We’ve seen evidence of all these potentially climatic events in recent weeks. Such conditions are perversely positive as they presage an end to the bear market and set the stage for the next rally.
We will exercise caution and extreme care as the events of the year unfold in the stock market. Judicious changes to the portfolios will continue to be made as we identify opportunities upon which we can capitalize for the benefit of our clients.
