Mid-Year Investment Outlook
By Michael E. Lewitt Harch Capital Management Inc., Boca Raton, FL
The U.S. economy and financial markets are in a decline. Corporate earnings and stock prices are tumbling. There are still too many "dip buyers" attempting to trade through the market’s ferocious volatility.
Financial markets always veer between extremes of optimism and pessimism. The truth always lies in the middle. It is an investor’s job to identify that middle and take advantage of the opportunities it offers. One thing is certain: risk still overshadows reward.
The U.S. economy and financial markets are under serious strain. The Nasdaq has declined by more than 60 percent between March 2000 and March 2001, a steeper decline than the Dow’s 1929-31 decline of 89 percent in 34 months and the Nikkei’s 1990 decline of 50 percent in one year. Global stock market declines have destroyed more than $10 billion of paper wealth. The stock market is selling the future at a discount. Whether the discount is steep enough is a question we will address below.
The credit markets are even more depressed than the equity markets. Corporate bond defaults reached a record $31.8 billion in the first quarter of 2001. Moody’s projects the corporate default rate to reach 9.9 percent in the first quarter of 2002; it could reach as much as 12 percent and establish a dubious high water mark for corporate failure. More troubling, perhaps, is the sharply lower recovery rates realized on defaulted bonds. Investors are discovering what high yield bond skeptics have known all along: high yield bonds offer the upside of bonds (par, or par plus a modest call premium) but the downside of equities (zero).
By the end of March, high yield bonds had surrendered much of their gains from the short-lived January rally. Particularly hard hit was the telecom sector, which has crashed as many large issuers defaulted and others threatened to do so if conditions do not improve. The latter group of issuers, who are effectively engaging in repudiation of their debt obligations, have caused prices on even the strongest telecom company bonds to plunge. Adding insult to injury, the corporate bond markets have been deluged with falling angels, as the debt of corporate giants such as Motorola, Lucent, Owens-Illinois, Nortel, Hasbro has been downgraded to non-investment grade status. Increasingly leveraged European and American telecommunications giants such as AT&T, Deutsche Telekom, France Telecom and British Telecommunications are likely to follow these companies into the valley of the downgraded. The high yield bond universe is starting to look like the base camp at Everest during a blizzard.
Corporate earnings are plunging faster than the Mir Space Station as years of overproduction fed by an excess of available capital are coming home to roost. California’s economy, a main engine of U.S. economic growth, is being hammered by the collapse in technology spending and an unsolved energy crisis. The U.S. economy has been the engine of global economic growth throughout the 1990s, providing support during difficult times such as the 1994 Mexican crisis and the 1998 Russian default/Long Term Capital Management meltdown. This engine has run out of gas. The economic slowdown is unlikely to be limited to the United States. For the first time since 1974, the world is facing sharp economic slowdowns in its two biggest economies, the United States and Japan. Accounting for 46 percent of world output, U.S. and Japanese economic weakness is likely to leak into Europe, non-Japan Asia, Canada, Mexico and South America. Already countries as geographically diverse as Argentina and Indonesia are experiencing severe economic problems that could adversely impact global financial markets.
The strength of the U.S. dollar in the face of these negative factors is noteworthy. In view of the huge U.S. current account deficit, the U.S. equity bear market, higher U.S. money supply growth than in Europe and Japan, and the falling real rate of return on dollar-denominated assets, the dollar should be weakening. It appears, however, that the dollar remains the ultimate safe haven in a turbulent world. Despite its flaws, the U.S. economy appears preferable to the available alternatives.
While most observers are obsessing over the Fed’s actions on interest rates, they are missing the story that is far more likely to have an immediate impact on financial markets. According to data provided by the St. Louis Federal Reserve, money of zero maturity (MZM) has grown at an annualized rate of 21.4 percent over the last three months. This constitutes an enormous infusion of liquidity into the financial system. That said, the system is being highly selective in doling out this liquidity, cutting off weaker borrowers from access to the commercial paper and high yield bond markets.
Investors also need to remember that the Federal Reserve only began to lower interest rates on January 3. It followed an initial 50-basis-point cut with three additional 50-basis-point cuts by the end of April. It is clear that the Federal Reserve is determined to do everything in its power to pull the economy out of its slowdown. While these sharp interest rate cuts are likely to speed the economy’s exit from the downturn that began in the third quarter of 2000, they will also justifiably revive arguments that Fed policy is creating a "moral hazard" by convincing the markets that the Fed will always come to the rescue. The long term dangers of such a policy orientation are severe. In the short run, however, these interest rate cuts should positively impact the economy with a lag time of 6-9 months, meaning that the second and third quarters of 2001 are likely to be the trough of economic growth as well as the zenith of pessimism. By the beginning of the fourth quarter of 2001, we are likely to begin to see the benefits of lower interest rates in the economy.
Investors should understand, however, that lower interest rates are not a panacea for what ails key sectors of the economy, particularly telecommunications and technology. The difficulties facing these industries are more structural than cyclical in nature. The enormous overcapacity in these industries was attributable to the availability of cheap capital in both the equity and debt markets. Much of this money was spent ahead of development of appropriate levels of demand. It is difficult to see how lower interest rates will solve this problem with sufficient dispatch to bail out the stakeholders of many of these companies. A sure-fire way to lose money is to invest in beaten-down stocks on the basis that they are "cheap." Technology stocks are still not "cheap" and analysts are likely still too optimistic about their prospects. The only difference is that today they are overpriced based on a significantly worse earnings outlook than before. The price/earnings ratio of the Nasdaq was still a whopping 168 when the index was trading at 1900 in mid-April 2001. As of the beginning of April, analysts were still projecting that by year-end the Nasdaq Index would increase by 89 percent. We hope they are right, but we think they are wrong. Stocks and bonds of companies in the telecom and technology sectors should be avoided by all but the most experienced investors with an unhealthy appetite for risk.
Cyclical industries, such as manufacturing and housing, are more likely to benefit from lower interest rates. Clouding this outlook, however, is that no one can quantify what, if any, the likely "wealth effect" (better understood as a "lack-of-wealth effect") will be from the evaporation of trillions of dollars of stock market wealth and mounting corporate layoffs. Money that was previously available, either psychologically or otherwise, to purchase cars, appliances, houses and other consumer goods no longer exists. Lower interest rates may make financing these purchases easier, but funds to repay these borrowings or make down payments may have disappeared into thin air. In view of this uncertainty, only non-technology stocks bearing low price-earnings ratios (8 and under) are worth considering in such an environment. Such stocks could trade lower; stocks of cyclicals can trade at price/earnings ratios as low as 2 or 3 at the bottom of the cycle. But investors who are hell-bent on owning equities, patient, and who avoid companies with large debt burdens can do well over the long term by investing in stocks with low price/earnings ratios.
We have been in a bear market since March 2000. To quote Richard Russell, author of The Dow Theory Letter, "in a bear market, he who loses the least wins." Trying to pick a market "bottom" is both an impossible task and a recipe for disaster. A "bottom" will not be reached until the last seller has been flushed. With many stocks still being valued at high multiples, sellers still remain. There are still too many corporate insiders holding stock with a cost basis of pennies that can still be sold for huge profits. There are still too many "dip buyers" attempting to trade through the market’s ferocious volatility. John Maynard Keynes wrote that the market can stay irrational longer than investors can remain solvent. If you are an individual investor and feel compelled to have some stock market exposure, you should only invest with the assistance of a professional money manager through a mutual fund. Sometimes, however, the best thing to do is nothing. My advice is to maintain high cash levels and limit stock exposure as much as possible. I will be more than happy to take the blame if you miss the "bottom."us
This article was adapted from The HCM Market Letter, which is published monthly and is available by subscription only. For information, please contact Michael E. Lewitt at
Harch Capital Management, Inc.,
One Park Place,
621 NW 53rd Street,
Boca Raton, FL 33487
or William Villafranco at
577 Chestnut Ridge Road,
Woodcliff Lake, N.J. 07675-1209,