COMMENTS WEEK OF 1/03/00-1/07/00
game of musical chairs, the lamenting of the death of the illusion of
perfection, and waiting for the big one dominated yesterday's trading.
The game of musical chairs, or sector
rotation out of the techs and into the cyclicals, is one we've seen
before, and is largely a product of the continued belief that one must
stay 100% invested or lose out on the "only game in town". While
this week's move into the cyclicals is a reaffirmation of the public's
belief that the current bull market will stretch into infinity, the
wholesale buying of cyclicals is likely to bring little but heartache as
the Fed ratchets up rates this year in an effort to slow the
Among the cyclicals, the aluminum
stocks, chemicals, and papers are frothy and their valuations already
fully discount peak cycle earnings. While the cyclicals will benefit
from the recent uptick in global growth, the current hostile interest rate
environments in the U.S., Canada, and Europe, and a Fed bent on slowing
the domestic economy, limit the appeal of these stocks. We look for
cyclical stocks in the frothier industry groups to get hit hard as rates
rise this year.
Coexisting with the move into cyclicals
this week has been the rapid death of the public's belief that all that
wears the technology moniker is golden. A string of high profile earnings
warnings, combined with a realization that momentum can travel in two
directions, has dealt a body blow to tech sector euphoria.
Despite this week's selloff, the sector, and
the NASDAQ Composite, still remain dangerously overextended. The
possibility of further steep declines exists as earnings season
unfolds. While Lucent's post-bell warning is a Lucent specific
problem, the stock's after hours massacre illustrates that many stocks in
the sector are held aloft only by a fragile pocket of air that can rapidly
deflate at the first sign that perfection will not be met.
The earnings warnings by BMC Software
and Gateway this week, however, are indicative of problems that cut a wide
swathe through the tech sector this earnings season. As we said a
month ago, the problems of component shortages and Y2K related revenue
shortfalls will put a damper on the earnings of many companies in the
sector. Although tech earnings as a whole will be strong this
quarter, a fact which is already fully discounted in the prices of tech
and Internet stocks, it is unlikely that we have seen the last of the
pre-season warning announcements by major tech sector players.
The sharp runup in stock prices during
the final two months of last year has left the market in a similar
situation to that seen last July: everyone who wanted to buy already has,
and there is nothing left to do but sell on the news.
With the February FOMC meeting rapidly
approaching, this earnings season will play a second fiddle to Fed
Fear. While we continue to expect the Fed to lift rates in February,
the stock market is likely to be lulled into complacency at the slightest
hint of the benign, with today's December employment report the first of a
string of economic reports the first test.
The market's focus in today's data will
be on the unemployment rate, with average hourly earnings playing a close
fiddle. While a dip in the unemployment rate would send traders
running for the hills, the combination of a steady jobless rate and below
forecast wage growth would quickly send the major averages back to their
old highs, complacent in the belief that only minimal action will be
required by the Fed--a complacent attitude that will be quickly put to
rest as the Fed begins its task of slowing demand.
you remember the day euphoria came to town and there were smiles all
around? Do you remember the days when the unstoppable bull market made
winners of us all? Do you remember when we were on top of the world and
thought the good times would last forever? Do you remember our New Era? Do
you remember when the clock struck midnight and ushered in a new decade--
a decade we thought would be paved with gold? ....
Do you remembered the days that followed
our bliss, the dark days when dreams were trampled under foot, when
illusions of grandeur were dealt a mortal blow by a harsh dose of
reality? Do you remember the death of the seemingly invincible
one-way ticket to riches when the parabolic equity train derailed?
Do you remember when our New Era died and someone else's was born?
Do you remember 10 years later when the clock struck midnight and ushered
in yet another new decade and all we had to show for the previous decade
was a 50% loss in our portfolios? ...
...We remember all too well.... and as
the new millennium dawns the industrialized world is once again faced with
the dangerous spectacle of a dominant economic power teetering on the
verge of a lost decade as it attempts to alleviate the economic imbalances
that euphoric public sentiment and an ignorance of the past have bred.
Last January, we said that unless both
the Fed and the financial community acted swiftly and responsibly to nip
euphoria in the bud and "take some of the froth out of the
market", the U.S. would enter the next decade doomed to repeat the
painful post-euphoria history of 1990's Japan.
The Fed realized the need to act, but
its actions, accompanied by market hand holding, were too little and too
late to prevent euphoria from reaching a fever pitch from which there is
no turning back.
While the majority of the financial
community have acted responsibly and have sought to quell the growing
euphoria of their clients, we have also seen an alarming increase in the
numbers of firms and individuals who are not acting in the best long term
interests of the retail investor, but rather are seeking to maximize their
profits regardless of the cost that ultimately will be exacted on the
We have seen an alarming surge in the
number of upstart brokers who encourage their clients to overtrade,
offering enticements such as free airline tickets or a free month of
commissions for signing up, glamorizing the stock market but failing to
adequately inform their clients of the risks involved.
Perhaps even more alarming are the often
media hungry brokerage firm analysts who seek to outdo each other in
pleasing potential investment banking clients by setting attention
grabbing target prices on highflying stocks and issuing "research
reports" that are little more than promotional puff pieces, all the
while doing so at the expense of retail investors who hang on their
This irresponsibility shown by a vocal
few in the financial industry helped to greatly magnify the degree of
froth already in the market last year, and this year it is likely that a
price will have to be paid by the average investor as that froth is forced
out of the market.
The sharp stock market selloff during
the first two trading days of the year did little to dissipate the rampant
complacency and euphoria that infect the U.S. stock market, as evidenced
by the market's rally on the year's third trading day despite a sharp jump
in bond yields.
This complacency is setting the U.S.
stock market up for a fall during the first half of the year as it comes
face to face with a Fed attempting against the odds to bring the economy
in for a soft landing without popping a bubble in the process.
The degree to which euphoria has been
allowed to build, and the resulting parabolic rise of many stocks during
last year's final two months, makes it highly unlikely that the Fed will
succeed in its attempts to slowly let the air out of the bubble and reigning
the wealth effect. The other side of euphoria is never a soft
As we have said before, the inability of
the Fed's actions to date to slow consumer spending means that the Fed
will be forced to raise rates far higher than many expect before the
effects of rising rates outweigh the effects of the wealth effect.
We continue to look for the Fed Funds rate to rise to 6.5% before the
latest rate hike cycle is over, with yields on the long bond approaching
7.25%-7.50%--levels which the stock market will be unable to ignore.
The majority of this rise in rates will
occur during the first half of the year as the Fed attempts to avoid any
second half market moving actions during a Presidential election year.
We look for the anticipated rise in
rates, along with the Fed's reversal of its pre-Y2K pumping of liquidity
into the system, to push the major averages back down towards their levels
of October 1999, or lower, with the Dow Industrials falling to 10,000 or
lower, and the NASDAQ Composite dropping to 2800 or lower as it gets hit
the hardest by a reversal of euphoric momentum.
These levels would still leave the major
averages significantly overvalued by historical standards, and given the parabolic
nature of the market's rise during last year's final two months, we
wouldn't be surprised if the market significantly overshoots our
projections to the downside.
While a favorable employment report this
Friday could push the major averages back to their old highs in the short
term, an unfavorable interest rate environment, multiple contraction, the
inevitable unwinding of euphoric sentiment, and excessive valuation levels
will make 2000 a year to forget...
...and we wouldn't be surprised to see
the multiple contraction stretch beyond this year....don't be surprised if
the Dow is trading at its current levels in 2005.
For this year, cash is looking
increasingly like the best investment, and given the weakness in the
dollar that we expect, we'll take our cash in euros.
Tomorrow: The Outlook for Europe in
has dawned and the world remains in one piece, from emerging market to
industrialized nation the lights remain on, the factories continue to hum,
and the markets have opened for the first trading day of the new
...in short, its business as usual,
relief rallies are the order of the day, and the sustainability of the
post Y2K dash to new record highs remains the only question to be
As the New Year begins and Y2K fears
subside, many emerging markets are likely to see today's post-Y2K relief
rally turn into a sustainable year long advance. Initially, we would
expect to see a sharp increase of inflows into emerging markets as
investors who had stayed on the sidelines riddled with fears of a Y2K
related emerging markets meltdown return. Continued strong economic
growth, coupled with reasonable valuation levels, will keep the rally
going as the year progresses.
In Asia, Indonesia, where valuation
levels remain low, remains the best bet for continued gains as the
Indonesian and Asian economies continue their recovery.
Singapore and Malaysia also remain attractive for further gains.
Further gains are likely in store for markets in the Philippines and South
Korea, but both markets are approaching fair value and the South Korean
market is vulnerable to any uptick in inflation. Thailand is
attractively priced, but an uneven economic recovery diminished the allure
of its markets. Strife torn Pakistan and Sri Lanka hold promise, but
that promise is unlikely to be fulfilled this year.
Although the Hong Kong stock market
continues to surge, the market holds few attractions: valuations are
stretched, and the market remains vulnerable to any acceleration of the
slowing Chinese economy's decline into a deflationary spiral. The
Hong Kong market is also the Asian market that is likely to be hit the
hardest by any reversal of fortune by the U.S. stock market.
Among Asian ADRs, we continue to like
Indonesian telecoms Indosat (NYSE: IIT)
and Telecomunikasi Indonesia (NYSE: TLK).
In South Korea, steelmaker Pohang Iron & Steel (NYSE: PKX)
and utility Korea Electric Power (NYSE: KEP)
remain attractive plays on South Korea's recovery, but both stocks are
approaching fair value. Cellular operator SK Telecom's (NYSE: SKM)
recent runup has left the stock overvalued and vulnerable to any market
declines. In Malaysia, conglomerate Sime Darby (OTC: SIDBY), is
attractive, as are the Philippines' Philippine Long Distance Telephone
and Singapore's Asia Pulp & Paper (NYSE:
South American emerging markets hold the
greatest promise as this year begins: valuations are historically
low, and the region is beginning to recover from the meltdown of
1998. While South America's economic growth will lag that of the
Asian emerging markets, we would expect Latin American stock markets to
outperform their Asian counterparts this year.
The Argentinean and Brazilian markets
remain attractively priced, and the markets are likely to continue their
late year rally. The recession wracked markets of Colombia, Peru,
and Venezuela hold the greatest prospects for gains in the region.
Among South American ADRs, the baby
'bras, the companies formed from the breakup of Brazil's Telebras, remain
significantly undervalued in comparison to other global telecom
plays. Among the baby 'bras, the most attractive are Telesp
Telesp Celular (NYSE: TCP),
Tele Sudeste Celular (NYSE: TSD),
Tele Norte Leste (NYSE: TNE),
Tele Norte Celular (NYSE: TCN),
and Tele Celular Sul (NYSE: TSU).
Other attractive Brazilian plays include electric utility plays Companhia
Paranaense (NYSE: ELP)
and CEMIG (OTC, CEMCY), retailer Companhia Brasileira de Distribuicao
and banking group Unibanco (NYSE: UBB).
Elsewhere in the region, other
attractive plays can be found in Argentina's Banco de Galicia (NASDAQ: BGALY),
Chilean telecom CTC (NYSE: CTC)
and utility Chilectra (OTC: CLRAY), Colombian banking group BanColombia
Peru's Telefonica del Peru (NYSE: TDP),
and Venezuelan telecom CANTV (NYSE:
VNT) and food producer Mavesa (NYSE:
In Eastern Europe, Russia outperformed
NASDAQ last year, and Yeltsin's abrupt New Year's Eve resignation has set
the pieces in place for continued outperformance by the Russian market in
the runup to this year's election. Telecom giant Rostelecom
remains undervalued despite gaining 300% in 1999.
Outside of Russia, many other regional
markets, including Poland and the Czech Republic are approaching fair
value and need to correct before they once again become attractive.
In Africa and the Middle East, Egypt and
commodity play South Africa stand out, although the recent runup in both
markets leaves both markets vulnerable to a correction.
While we expect the emerging markets to
outperform the markets of industrialized nations this year, the markets
remain vulnerable to any sudden sharp reversal by the highly valued U.S.
stock market. Although we would expect emerging market stocks to
fall in sympathy with a meltdown in U.S. equities, we believe many of the
emerging market stocks would quickly recover and decouple from the
performance of the U.S. markets.
Finally, for those in search of great
promise and unafraid of a complete lack of liquidity and a nonexistent
market regulatory body, there is Lebanon and the fledgling 13 company Beirut
Stock Exchange, dominated by banking and construction companies. While
we expect the Lebanese market to eventually be a great winner as the
country recovers from two decades of civil war, the lack of liquidity and
regulation is keeping us away. Time will tell whether we missed out
on the opportunity to get in on the ground floor.
Tomorrow: the prospects for the U.S. and
European markets in 2000.