Note: Prof. Fleckenstein provides his regular commentary every Wednesday evening for educational purposes - his insights are not intended as investment advice. As a special feature, we get a double dose of the Fleck Rap this week! Please visit his website if you would like to read his missives daily.
'America, Like New York in the 1970s, But Worse'
There's lots to talk about today, which I'll again cover in a slightly different format as I describe the crosscurrents and potential opportunities being created. (More about today's headline toward the end.) At the outset, I must note that with all the motion occurring in so many markets, it's very easy to misinterpret what might be occurring. That said, here goes:
The only thing worth noting about the overnight action is that Japan was down 2.5%. This decline may or may not turn out to be noise, but I thought it was interesting. Our equity futures were doing little of anything, which was odd, in that so many companies won at the game of beat-the-number. Likewise, the market preopening seemed to shrug off an unexpected burst higher in initial-jobless claims (to 360,000 vs. last week's 328,000 and expectations of 335,000).
The Meaning of 'Going Down on Good News'
Once the market opened, we had a little attempt to the upside, and then selling set in. A couple of hours into the day, the S&P and Dow were about flat, but the Nasdaq was down almost 0.75%, paced by the Sox, which was getting pasted to the tune of about 3%. Why was the Sox getting hit after so many companies reported good news? That is the subject of today's discussion, which I think is a very important topic.
Anyone who's been paying attention has noticed that many tech companies have not really hunted on the upside, even though they've announced beat-the-number news. (Of course, there have been a few modest disappointments, like Intel.) That is something we haven't seen, for the most part, in quite some time. What I think is dawning on holders of tech stocks is that there's not enough (or no) growth in revenues, and/or there's not enough ( or no) earnings leverage, or some combination of these problems. Further, there are early signs of inventory building. (In addition to what Intel showed us, we saw the same thing last night from Texas Instruments. These are also perhaps an early-stage example of an excess of available parts, as more capacity shifts to 300-millimeter production.)
Last night, Fairchild Semiconductor (FCS) reported 17 cents pro forma and 10 cents GAAP. It said it was out of capacity and "guided" to 5% revenue growth. Well, you decide what you think the company's annualized earnings rate is, whether 50 cents, 70 cents, or 80 cents. But with a $24 stock price (meaning that you're paying 30 to 50 times earnings), the appearance of very little leverage and very little growth is a problem. That's why Fairchild was down almost 10% on news that was good.
Likewise, high-flier Sandisk (SNDK) reported spectacular numbers, but had an explosion of inventories despite the fact that end demand at the retail level has been firm. Given the amount of double- and triple-ordering that I'm sure has occurred (across many other chip categories), and given the capacity likely to come on stream, this problem won't go away soon, and will pressure prices. Also, Cypress Semiconductor (CY) and Linear Technology (LLTC) dropped in price. In semiconductor-equipment land, a beat-the-number performance recently by Novellus (NVLS) and last night by Lam Research (LRCX) did not prevent those stocks from going down.
Rethinking Rich Multiples for Rickety Fundamentals
What this says to me is that folks have figured out that we potentially have a budding inventory problem at a time when that shouldn't be happening. In addition, many of these companies don't have enough growth or earnings leverage to justify their huge multiples. (Away from tech, we have also seen companies fail to go up on good news. Just look at those much-loved financials, Citigroup, Merrill Lynch and Goldman Sachs, which are all lower in spite of reporting great numbers.)
It gets back to the old problem folks have ignored for about the past five or 10 years, and that is valuation. Today's investors seem not to understand the old adage that the difference between a great company and a great investment is the price one pays for it. To repeat, I believe it's dawning on people that these stock prices are too high, given that their earnings expectations for later this year and next are indeed a bridge too far.
I think that's what's creating the undertow in the tape. Demand is going to weaken, in my opinion, now that we have seen the end of the stimulus, and -- to put an exclamation point on this -- now that mortgage rates have started to rise. That will only worsen the problem.
Many of today's investors focus just on whatever the particular concept is regarding a particular stock they love, paying no attention to what its reasonable valuation might be, given reasonable assumptions about margins, growth rates, barriers to entry, etc. In short, too many people are players and very few are investors. That has worked for a long time (years, now), but we might be coming to the end of that as a successful (if inherently risky) investment strategy.
Turning back to today's action, I believe that we are experiencing (or have experienced) a failing rally, and am acting accordingly. Whether or not that turns out to be the case, we'll just have to see. In any case, after basically sliding all day, the market touched its lows with a couple of hours to go. Those levels were about 2% lower for the Nasdaq and 0.5%-plus for the Dow and S&P. Then, similar to yesterday, we had a spirited rally that brought us back near the highs of the day, at least for the Dow and S&P, which managed to close modestly green.
Thursday's Action Leaves Sox in Traction
In Nasdaq land, the rally was far less vigorous, as that index closed down about 0.5%. The Sox led the downside, down about 3%, though it had been down nearly 5% at one point. Away from the Sox, I didn't see any particular pressure to the downside, and pharmaceuticals were being chased to the upside. We'll see if tonight's bevy of earnings, combined with tomorrow's expiration, puts any excitement into the tape. But right now, things look pretty dicey.
Another Slice of Silver, Please
Away from stocks, fixed income was a touch lower. The currencies were higher, after being lower for most of the day. Precious metals were heavy early on, with silver down another 2% and gold down about 1%. Silver managed to turn green, closing up 1%. Gold ended 0.5% lower. I added fairly aggressively to my silver position today and will probably buy more tomorrow if it looks okay. I'll be the first to admit that silver can be a bit of a wild animal, so folks should take that into their risk-management considerations.
My conviction on the precious metals stems from my belief that the dollar is going to be in trouble, the economy is going to be in trouble, that we are going to experience inflation problems, and that we will ultimately run the risk of a train-wreck scenario, both in the economy and stock market. I believe that all those things will be bullish for the precious metals.
Rising Rates Don't Shut Metallic Gates
Up to this point, the metals have done well, with folks buying them as a currency play, a China play, or just because they were going up. I think we are now seeing a shakeout of the weak holders, who owned the precious metals for some of the reasons I suggested, but none of the reasons that I do. In other prejudiced words, the guys who owned metals for the "wrong reasons" are selling to those buying for the "right reasons," if that isn't too arrogant-sounding.
A lot of people worry about rising rates being bad for metals, about the dollar going up being bad for metals, or the stock market going down being bad for metals, because that's what happened in 1987. I don't share those concerns. I see 1987 as a pimple or rounding error, compared to where we're headed now.
I would especially like to make the point that rising rates in and of themselves do not make metals go down. A lot depends on why rates are rising. Rates can rise because folks think inflation is a problem, or the dollar's decline is a problem, or a Fed run amok is a problem. But though these factors can send rates higher, they will ultimately push up metals prices. A final caveat: Folks should recognize that I could be wrong, and make their own decisions on these subjects -- not just copy mine.
Felix Rohatyn Raps On
Lastly, to punctuate my claims regarding the prospective train wreck I've been warning about for years, in today's Financial Times, Felix Rohatyn penned an article (whose title headlines today's Rap) that, if I might add, reads like many columns I have written. As you will quickly see, you've read all this before. The difference is that he is Felix Rohatyn (he, not I, organized the bailout of New York City in 1975), and his views in the FT will get folks thinking. He writes:
"Indebtedness spinning out of control, fuelled by an unchecked increase in the deficit. An accounting system that indiscriminately mixes expenses with capital assets, ignores contingent liabilities, and makes Enron look conservative. A social structure sharply divided between 'haves' and 'have nots.' An administration locked into denial on the assumption that 'the markets will always be there for us.' A political system paralyzed as public finances careen toward catastrophe. That was New York City in the early 1970s; it could be America tomorrow. America's out-of-control federal budget deficit, rapidly growing domestic and foreign debt, and off-the-books social security and Medicare liabilities look eerily similar to the fiscal situation that faced New York nearly 30 years ago."
He then goes on to cite a couple of important elements that helped to resolve the crisis, in the spring of 1975: a willingness to pull together on the part of all involved, and some assistance from foreign leaders, since the U.S. government chose not to bail New York City out.
Next, he sets the stage for how we've been able to live so far beyond our means: "So far, the willingness of the central banks of China, southeast Asia, Japan, and Europe to finance U.S. deficits has allowed the administration of George W. Bush and the Federal Reserve to pursue a policy of cheap money, low taxes, large deficits, and reliance on a speculative stock market and property bubble to create economic growth. This may not last forever, and either the willingness of the foreign central banks to carry U.S. debt -- or their capacity to do so -- could be impaired.
"Some time before that moment is reached, the markets would begin to react: The dollar could fall further precipitously, interest rates would shoot up, and we would have to deal with a national crisis, which could develop into a global crisis." (He also notes that given the current political situation, we may not be able to count on foreigners in a moment of crisis.) Even though this path is quite possible, it doesn't mean that we will indeed have a crisis. However, folks need to be aware of the risks.
Continuing on, he rebuts Alan Greenspan's contentions that basically all is well, noting the rot I have vapored on about so often: "Alan Greenspan, chairman of the Federal Reserve, said recently that the huge rise in consumer debt in America posed no risk, as it had been matched by a rise in the value of property and stock portfolios. However, those are just the circumstances that brought about the speculative bubble of the late 1990s and the stock market collapse that followed. The U.S. at that time was in a much stronger financial condition than it is in today. America was running huge budget surpluses instead of the current deficits; its sovereign debt was declining instead of soaring; the currency was strengthening, not weakening."
This litany of concerns is why I own foreign currencies and precious metals, and am not willing to own stocks. We have a serious amount of trouble ahead. Trying to speculate our way to prosperity has only exacerbated the situation.
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