Minyan Mailbag - Marc Faber
A few weeks ago, I accidentally switched my television set over from MTV, which has a calming influence on my mood, to CNBC, which tends to irritate me. First, there was Elaine Gazarelli telling us that the stock market would go up further based on a strong economy and favorable corporate profits, and that, after a brief correction in the autumn, stocks would rise even further in 2005. Asked which sectors she favored, she replied that high-tech stocks were the most attractive. Then came a survey of CNBC watchers about which factors were the key drivers for the stock market. Seventy-seven percent responded that corporate profits were the single most important factor driving stock prices. Feeling enlightened by these deep insights, I then switched back to MTV.
Joe Granville, who became world-famous in the 1970s and whose book New Strategy of Daily Stock Market Timing for Maximum Profit (Prentice Hall, 1976) I highly recommend, had this to say about "news".
Traders and investors get into more trouble and make more expensive wrong decisions by following news than for any other reason. So heavily influenced by the news, the majority get lost in the maze, unable to see what the smart money is doing. News is also important to the smart money because they understand the role news plays in the market game, and they can usually act more effectively under the protective cover of news. They know that the news misleads the opposing game players into selling them when the smart money wishes to buy and into buying their stocks when the smart money decides that the time has arrived for distribution. As a market aid, news is of little or no value in playing the market game successfully. News is generally for suckers. It misleads more often than it guides. It creates mistimed fears which provoke selling at the wrong time and raises hopes which encourage the buying of stocks at the wrong time. The reason why news has very little relationship to what the market is going to do is simply because the market is moving on tomorrow's news, and thus the current news is a stale factor to the market; It is the out-of-step timing between news reporting and market action that enables the market game to be played so successfully by the smart money, preying on the public's overreliance on current news as a guide to what the market is going to do.
Therefore, if you hear daily on CNBC how strong the economy is and that the economic recovery will continue (even if it were true, which is another matter), it may not necessarily lead to higher stock prices, because stocks already went up over the last 18 months and until just recently on the expectation of the current favorable economic news. Granville devotes a paragraph to corporate earnings, entitled "Earnings - The Big Sucker Play". According to him,
probably no greater deception faces the average market follower than the general overemphasis on corporate earnings as a reliable guide to where the market price of a stock is headed. Yet 99% of all market followers are grounded in the belief that what a company earns is the very guts of what the stock market is all about. They couldn't be more wrong. When a company reports that it earned $4 a share in a given year, it is incontestable a fact, no argument about that. [As we know, the quality of earnings can vary significantly Ñ ed. note.] That fact, however, may be completely irrelevant to what the price of the stock is now going to do. The reason is simple and yet most people give it very little consideration. The fact that the company earned $4 a share is a statement of knowledge up to that moment. It provides no hint whatsoever what the company is going to earn in the future. Inasmuch as stock prices are on future expectations, what the price of the stock now does has little or no relationship whatsoever to the fact that the company just reported annual earnings of $4 per share. There lies the greatest deception, entrapping the majority to buy at the wrong time and sell at the wrong time, caught up in the cruelest hoax the market game can play on the innocent, those brought up upon the importance of corporate earnings. Bunk, pure bunk!
According to Granville, the key is to understand that price/earnings ratios are not constant but fluctuate widely.
The very fact that p/e ratios fluctuate points up the poor correlation between earnings and stock prices. A good correlation would be reflected by a near constant p/e ratio. In actual practice, however, we have seen the Dow sell at an overvalued 20 times earnings in the early 1960s which was far short of the Dow peak in early 1973 at 16.5 times earnings, and we have seen the sharply undervalued p/e reading for the Dow in the fall of 1974 at under 6. The actual figures force us to conclude that the market either overvalues stocks or undervalues stocks. That is no brilliant discovery, but it does underscore the fallacy of earnings. If a stock earns $3 per share and the earnings are increased to $4 a share, the increased earnings provide no clue whatsoever as to whether the market will overvalue or undervalue the improved earnings figure.
Probably the finest work I have ever seen which completely repudiates the importance of corporate earnings in timing stock purchase or sale was published by Arthur Merrill in late 1973. He presented a chart of the Dow Jones Industrial Average against the background of the constantly changing price/earnings ratios and that chart clearly revealed the rhythmical lag in corporate earnings behind the movement of the stock average. It showed the rise in earnings as the market fell out of bed in 1966, the drop in earnings as the market underwent a strong 1967 recovery, the rise in earnings as the market carved out the plateau 1968 top, the still rising earnings curve as the market plunged in 1969, the great market turn to the upside in 1970 as earnings continued to turn down, the upturn in earnings as the market went into a sharp 1971 correction, the sharper upturn in earnings as the market made the great plateau 1972 top, the still sharper rise in earnings as the market plunged in 1973 and 1974, and the great 1974 upturn in the market as earnings leveled off and started to decline.
(As an aside, Granville writes also that, "the media is the biggest enemy of the small investor, mostly headlining the wrong news at the wrong times, playing on his misguided reliance on fundamentals and his normal fears and greeds".)
I don't regard the writings of Joe Granville as the ultimate wisdom on stock market cycles, but his book contains many very interesting, yet simple, observations which investors should keep in mind when listening to the news that is broadcasted on CNBC and published in the media. Moreover, as usually, stocks have the strongest rallies during periods when corporate earnings decline or just begin to turn up. I might add that Bob Hoye (www.institutionaladvisors.com) recently published a table that also shows the frequent diverging performance between corporate earnings and the stock market (see Table below) with the note that, "while earnings themselves may not be inherently dangerous, they can be hazardous to the unwary".
In particular, I should like to attract our readers attention to the severe bear market years 1973/74 during which the stock market declined by 27% in 1973 and 35% in 1974, but when simultaneously earnings grew by 28% in 1973 and 15% in 1974!
So, while Elaine Gazarelli may be right in her prediction of a strong economy and rising corporate profits, this certainly doesn't necessarily imply higher stock prices, as, in a strong economy scenario, inflation could accelerate and bring about far higher interest rates. I am also very skeptical about her technology stock pick. First of all, the market action of high-tech stocks doesn't suggest that all is well in the land of extremely rich valuations. A day after Elaine's bullish call on high-tech stocks, contract manufacturers such as Jabil Circuit (JBL:NYSE) fell out of bed, and subsequently companies such as Intel (INTC: Nasdaq), Hewlett Packard (HPQ: NYSE), Cisco (CSCO: Nasdaq), Veritas Software (VRTS: Nasdaq) and IBM (IBM: NYSE) all failed to match investors' high expectations.
The problem for most high tech companies is that inventories and account receivables are soaring, while sales are slowing. In addition, it is evident that in 2005 huge new capacities for the production of semiconductors will come on stream in China.
Finally there is one more point that ought to be considered in relation to high-tech companies. In order to make it clear, let us compare a high-tech company with an oil company with large proven oil reserves. If a high-tech company does not invest almost all of, or even more than, its annual profits in R&D, and new technologies and equipment, its final products will be largely obsolete within two years. In short, most high-tech companies have either no, or only very little, free cash flow that can be distributed to shareholders. By comparison, an oil company with proven reserves (not an exploration company) can curtail its capital spending expenditures considerably and generate significant free cash flow. In fact, an oil company that took the view that oil prices will rise significantly in future should consider shutting down production entirely and keeping its oil in the ground, rather than selling it for US dollars whose purchasing power is bound to diminish over time. (I imagine that OPEC countries would have been much richer today had they sold half as much oil over the last 30 years or so, instead of selling oil for US dollars, which were then blown away either on poor investments or on expensive weapons purchases.) Now, just consider what would happen if a technology company were to shut down production for just one year and then start producing again. All of its products and equipment would be obsolete! As a result, I am somewhat puzzled by all the investors' hype and obsession with high-tech companies, as well as by the high valuations of high-tech companies, when one considers the obsolescence risk, the inevitable commoditization and resulting price erosion of successful products (cell phones, PCs, printers, etc), and high-tech companies' minuscule level of profits, which don't have to be reinvested in the businesses to ensure their very survival (just to keep up with the rapid technological progress) but are really available for distribution to shareholders. Therefore, while trading rallies in high-tech stocks are likely to occur from time to time (driven mostly by momentum players), new highs in the NASDAQ Index above the January highs are not very likely.
Still, we have to avoid being overly bearish and selling short stocks too aggressively right now for several reasons (just my humble opinion not advice). Near term the market is somewhat over-sold and the presidential cycle, which tends to produce a rally starting this August, may come into play. According to Bob Hoye (www.institutionaladvisors.com), Ned Davis Research Inc. has done some excellent work on seasonal, presidential, and decennial stock market patterns that are valuable when assessing the upside potential. Based upon data from 1900 through 2000, the best results occurred when the incumbent Republican Party won the election. The worst results were when the incumbent party lost. The lesson is to be cautious if it looks like a Democratic victory.
According to Bob Hoye, ¨the end of August is the optimum point from which the two patterns begin to deviate. Generally there is an interim high mid-August as the markets go through a period of hesitation leading up to Labor Day. Once the Republican National Convention (Aug 30th to Sept 2nd) is concluded, the market will likely cast its vote as to the outcome of the election. History has shown that you want to go with whichever trend becomes dominant following Labor Day". From the figure below (courtesy Bob Hoye), we can clearly see that in most election years, a rally got underway sometime in August and, therefore, given the current oversold position of the stock market the near term odds do not particularly favor to be heavily short the stock markets.
Source: Bob Hoye (www.institutionaladvisors.com)
Moreover, considering the likelihood that the economy will disappoint, I think that bonds may have begun a medium term bear market rally, which may carry long term bond prices up by another 5% or so.
Minyan Marc Faber
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at email@example.com.
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