Jeff Saut Presents: Slow, Muddle, or Reaccelerate - You Pick It
While the potential economic reacceleration thesis is driven by a number of conventional metrics, one of the more unconventional metrics is proffered by the out-of-the-box "thinkers" at the brilliant GaveKal organization
Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.
"We are mostly stock pickers, [but] I am surprised by the strength of the economy. As far as housing is concerned, the number of people who are employed and have jobs is more important. The consumer has the view that if he’s employed now, he’ll be employed next year. If the person next door to him has a job, he’ll continue to spend.
But a few elements in the economy are different. Where companies once used their cash flow to build plants, they are now outsourcing manufacturing to China and India. When demand turns down, instead of having layoffs in the U.S. and the cyclical elements Fred talked about, the cycles will become more muted. Companies will call their suppliers in Hong Kong and Mumbai and tell them to stop shipping. Because of this, cash flows at U.S companies are higher than historically, and will stay that way. The beneficiary is the consumer, who benefits from lower-priced imports. The economy this year will continue to muddle along. The stock market will have a correction, but not do much, net, on the year.”
--Oscar Schafer, Barron’s Roundtable
“Slow, Muddle, or Reaccelerate: You Pick It”... is the title of this report because, as repeatedly stated, “My firm can’t decide if the economy is going to slow or reaccelerate.” While this conundrum should be clarified over the next few months, my firm's mantra for the new year remains, “The fooler in 2007 might just be that the economy reaccelerates and the Fed, rather than lowering interest rates, either keeps them where they are or actually raises rates.” If interest rates are raised, the question then becomes, “Can earnings grow fast enough to offset the P/E multiple contraction that inevitably occurs under a higher interest rate environment?” This question is not unimportant, for by my firm's method of analyzing earnings, which includes deducting share repurchases and seasonally adjusting them, earnings momentum peaked in 4Q '05 at roughly a 20% growth rate and subsequently has slowed to 3Q '06s ramp rate of high single-digits (the 4Q '06 numbers aren't available yet).
While the potential economic reacceleration thesis is driven by a number of conventional metrics, one of the more unconventional metrics is proffered by the out-of-the-box “thinkers” at the brilliant GaveKal organization, which suggests the U.S. economy is morphing from an industrial-based economy to a knowledge-based economy. To wit:
“You have three functions that a company can perform – they can design, manufacture and/or distribute a product. More and more companies in the Western World are deciding that manufacturing that product is capital intensive. It’s labor intensive. It does not generate high returns [on invested capital]. And so they are focusing on the design and distribution – the knowledge portions of that activity. In the environment of the industrial world, economics is all about allocation of scarce resources – land, labor, and capital. In the information world, it’s all about the allocation of an abundant resource – knowledge. So platform companies are really knowledge companies. It’s not so much about the product or the service the company produces. It’s about the way that it goes about orchestrating the production and delivery of that product. Ultimately, the cost of capital for a platform company should go down, because they’re committing less capital to long-term assets.They’re generating higher productivity, which is the real key. The returns on intangible assets – returns on knowledge – are higher than returns on physical capital.”
Interestingly, as more and more companies morph into “platform companies,” there tends to be a build-up of cash on their corporate balance sheet because there is not the need to reinvest said cash in plants and equipment. And that, ladies and gentlemen, is one of the points made by Oscar Schafer in the opening quote and fleshed out by GaveKal. It also explains the boom in private equity as investment banking “types” look to buy out a company using the cash on its own balance sheet, re-leverage that balance sheet, and eventually “spit” the company back out in a public offering (IPO), but that is a discussion for another time.
So how does a company morph into a “platform company?” Hereto the good folks at GaveKal have an illustration using a company covered by a Raymond James analyst, namely 3.9%-yielding Furniture Brands (FBN). As stated by GaveKal:
“There are a couple of very characteristic signs that you can see when a company becomes a platform company. You can look through their financial statements and you can see the shedding of fixed manufacturing assets. And you can then see – hopefully – the productivity enhancements and superior returns that they’re gaining as a function of doing that. So when we look at Furniture Brands, we see a company that in 1998 had over $300 million in net property and plant equipment. Today, they have about $250 million. They’ve radically shed fixed assets. They shut down a lot of factories in North Carolina and [elsewhere in] the U.S., and moved a lot of production to Asia. In 1998 Furniture Brands generated $90 million of free cash flow. Last year , they generated $160 million of free cash flow. That’s largely because cap-ex [capital expenditures] was running at an annual rate of about $50 million in 1998 and now it’s running at an annual rate of about $30 million. So you see the movement and reconstitution of their assets. They’re investing money into intangible capital – investing in brands and in employee training.”
My firm believes in GaveKal’s “Platform Company” thesis and continue to look for companies playing to this theme. Regrettably, GaveKal (as of yet) does not have a U.S.-based product in which to invest. Hopefully that will change in the new year, for my firm would like to overweight portfolios along this “Platform Company” theme. However, for our international readers, I suggest exploring GaveKal and its themes.
While strategically my firm embraces GaveKal’s concepts, on a tactical basis we are not totally convinced the business cycle has yet been repealed. And maybe, just maybe, that is what the stock/bond market began worrying about late last week. Indeed, the downside surprise came last Thursday when, after Wednesday’s upside breakout above their recent reaction highs, the major market indices showed NO upside followthrough and actually closed below their aforementioned previous reaction highs. A good friend, Barry Ritholtz, termed last Thursday’s action as a “Bull Trap,” and by our definition of bull trap, that may be appropriate. Listen to this definition of a “Bull Trap” from the glossary of StockCharts.com:
“Bull Trap: A situation that occurs when prices break above a significant level and generate a buy signal, but suddenly reverse course and negate the buy signal, thus ‘trapping’ the bulls that acted on the signal with losses.”
Clearly, if the major market indices “fall away” from last week’s peak into a full-fledged correction (10%+), Barry’s “call” will prove prescient.
Unsurprisingly, concurrent with last week’s stock-swoon was an upside breakout in yields as the 10-year benchmark bond recorded a multi-month “yield yelp” high of 4.9%, causing one Wall Street wag to lament, “Is the fixed income complex telegraphing a re-acceleration for the economy?” As stated, while my firm is currently not sure about an economic reacceleration, we are sure that the next few months will clarify the situation. Still, the interest rate ratchet, when combined with the “buy signal” received in early December on the U.S. Dollar Index, “foots” with the stronger than expected economic figures my firm has seen year-to-date and gives credence to a potential economic reacceleration. Whether these figures are driven by the unseasonably warm weather remains to be seen, but I remain cautious and therefore are adhering to Warren Buffet’s two rules on investing, that being: rule number; (1) Don’t lose money; and, rule number (2) Don’t forget rule number 1!
The call for this week: Year-to-date, the DJIA has gained 24 points, which is not much upside progress for all the bullish banter expressed by the media. Verily, the S&P 500’s intraday high on 12/07/06 was 1418, while its intraday low last Friday was 1417. So despite all the huffing and puffing, the S&P has made very little progress over the past seven weeks. Consequently, it will be interesting, and probably important, to see if the Dow, and the S&P 500, closes up or down for the month of January, consistent with that old stock market axiom, “So goes the month of January, so goes the year.” Still, I pay more attention to the “December Low Indicator” that states, “If the December low is taken out to the downside during the first quarter of the new year – watch out!” For the record, the “December Low” closing price for the DJIA and S&P 500 are 12194.13 and 1396.13, respectively.
Also for the record, the Dow, and the S&P 500, have NOT closed below their 50-day moving averages since their July lows. Currently those 50-DMAs are at 12387.53 (DJIA) and 1413.56 (S&P 500). In conclusion, for participants wanting to hedge their portfolios on the downside, the QIDs (QID) make sense to us, since the NASDAQ is demonstratively weaker than the S&P 500. However, my firm prefers the idea of buying “call options” on the Volatility Index (VIX) as an alternative to buying the QIDs, despite the fact that “longing” the VIX has proved to be a losing strategy over the past few months.
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