MARKET CORRECTS EXCESSIVE
VALUATIONS NEXT MOVE
UP IS IMMINENT
Prepared by The Wall Street Digest, Inc.
The U.S. economy is as sound as the U.S. Dollar. Money continues to pour into the U.S. because of a strong stable U.S. currency, a strong stable U.S. economy and political stability. Prior to the Asian currency crisis, $80 billion per quarter, $320 billion annually was flowing into the U.S. from Asia (including Japan) and Europe. The rate of inflow has now reached $100 billion per quarter.
A sizable portion of this money is flowing into the U.S. stock and bond markets. The Asian currency crisis was the excuse that U.S. stock traders used to produce a correction in the U.S. markets.
The U.S. stock market was probably 15 to 20% overvalued prior to the correction. As we go to press, the market is approximately 5% overvalued. During the 1980s, the Southeast Asian countries (Hong Kong, Singapore, Malaysia, Thailand, Indonesia, Taiwan and the Philippines) pegged their currencies to the U.S. Dollar.
However, one by one each of these countries were forced to unlink from the U.S. Dollar and allow their currency to float in the free market.
This produced an orderly devaluation of Southeast Asian currencies, which was necessary because of excessive government spending and excessive credit creation to foster rapid economic growth. Hong Kong maintained the link to the U.S. Dollar at 7.8 Hong Kong dollars to one U.S. Dollar. Consequently, currency traders shorted the Hong Kong dollar, speculating that the Hong Kong government would devalue its currency to remain competitive.
When the Hong Kong government raised overnight interest rates by 300% to defend its currency, the Hong Kong stock market plunged by 10%.
This had the net effect of triggering an overnight plunge in the European stock markets, followed by a plunge in the U.S. stock market. The Hong Kong government, with strong backing from China, has successfully maintained the 7.8 peg to the U.S. Dollar. Some analysts feel Hong Kong will eventually be forced to devalue simply to stay price competitive.
However, Hong Kong is the banking and financial center for all of Southeast Asia. Very little is produced or manufactured in Hong Kong because wages and the cost of living are too high.
Consequently, many analysts say Hong Kong will be able to avoid devaluation and maintain stability and competitiveness. Only time will tell. The fear on Wall Street is fairly simple: U.S. companies are not as competitive in the region because of the devaluation of Southeast Asian currencies.
In a worse case scenario, if the U.S. were to cease all exports to Southeast Asia, our GDP would suffer by less than 2%.
Most economists are projecting a loss of only 0.5% in GDP growth over the next year. The final net result will probably be even less because productivity is soaring in the U.S. Most company CEOs say the real problem limiting faster business growth is the lack of skilled employees.
As a result, capital spending for automated equipment, computers, software and productivity enhancing expenditures increased by a stunning 18% last month.
Fed Chairman Greenspan has stated many times that inflation is not a current problem because productivity increases are greater than wage increases. Productivity is soaring. Wage increases are up, but not soaring. The best measure of inflation declined to an annual rate of 1.4% in the 3rd quarter. The 30-year bond yield has been falling as a result.
Last year we forecasted a 6% 30-year bond yield by year-end. As we go to press, the bond yield is 6.08%. Our sell signal for Japan in September was timely.
We also cautioned our subscribers about rushing into China and Southeast Asia in July. Inflation fears are fading because of productivity increases. The good news is that capital from all over the globe is flowing into the U.S. Some of the money is flight capital from Asia seeking a safe haven.
However, most of the money is flowing here because of a strong U.S. Dollar, attractive interest rates and stable economic growth.
The Fed is unlikely to destabilize the financial markets by raising interest rates in December. Sometime in the future mild deflation is possible, but it would not be the problem that most people on Wall Street fear. This country experienced its fastest rate of economic growth and expansion between 1870 and 1900, as the railroads, telegraph and other booming “new technologies” created jobs.
Prices fell because of technology advances. Between 1870 and 1900 prices fell 30%, an average of 1% per year, as economic growth exploded.
The same scenario is unfolding today as the computer-internet-information age boom drives prices down. In the U.S., a shortage of workers is slowing economic growth. However, the Asian mess and rising interest rates in Canada and Europe could slow growth in the U.S. over the next twelve months.
As a result, the technology sector is correcting. The U.S. economy is beginning to slow from the 3.5% pace in the third quarter.
Wall Street fears even slower U.S. growth because of: 1.) the stronger competitive position of the Southeast Asia countries after devaluation; 2.) rising interest rates in Europe to meet unification requirements in the face of the lowest inflation and highest unemployment since World War II; 3.) Japan's economy is in a depression and faces further problems including deflation and more bankruptcies in the banking system; and 4.) China is contributing to global deflation by aggressively cutting prices to capture market share from Southeast Asia.
The net result of the various forces described above will be: a.) a slow continuing decline of prices around the globe; b.) lower long-term U.S. interest rates; c.) the U.S. will emerge as an even stronger economic power; d.) more countries will unwisely use currency devaluation as a price competitive strategy; and e.) lower interest rates around the globe will be required to prevent deflation.
In view of these trends which are probably not reversible, we are adjusting our portfolio to a more defensive position. We are closing our position in Latin America.
The proceeds should be allocated to 30-year government bonds and zero coupon bonds. After gold and the precious metals mining shares traced out a firm technical head and shoulders bottom and began a sustained rise, the Swiss central bank announced its intention to sell one-half of its gold supply in the year 2000.
While the Swiss central bank may never sell its gold (and we do not think they will) the net affect of this announcement will keep gold prices from rising.
The possibility of even mild global deflation ahead will also keep the price of gold and the mining shares from rising. We are therefore closing our 5% gold position and will allocate the proceeds to 30- year long-term U.S. government bonds and zero coupon bonds. Our portfolio is now 65% U.S. stocks and mutual funds, and 35% 30-year U.S. government bonds and 30-year zero coupon bonds.
If U.S. economic growth and global economic growth continue to slow at a faster pace than we now perceive, we will reduce our allocation to U.S. stocks and increase our allocation to 30-year U.S. government bonds.
The single best investment for a growing U.S. economy will be small and mid cap stocks on the NASDAQ because they have less exposure to international problems. We do expect continued economic growth in the U.S. over the next 12 to 18 months. Historically, the stock market always bottoms in October or November.
But the November, December, January rally (the three strongest months of the year) historically begins no later than Friday after Thanksgiving.
Excellent retail sales for Halloween are forecasting an excellent Christmas for the retailers. The single best investment for declining inflation and mild deflation (if it does occur) would be 30-year U.S. government bonds and 30-year zero coupon bonds. Mild deflation would improve the standard of living for most Americans as it did between 1870 and 1900. We expect the stock market to be higher by year-end than it is on Thanksgiving Day. Dow 9000 in 1998 is still a reasonable target.
Market Produces Strong Buy Signal
We have always had the utmost respect for a technical indicator developed by a gentleman named Richard Arms. The indicator is named after him, and is relatively simply to construct. It compares the number of advances to declines on the New York Stock Exchange, and then divides that relationship by the volume traded on the advancing stocks compared to that of the declining stocks.
Put simply, it just measures how much energy (volume) is being used to push the market either up or down.
History has shown that when an inordinate amount of volume is being required, the advance or decline has extended all the energy that traditionally is available. In other words, the bullish (or bearish) vehicle is about to run out of gas. Since we are more involved with the bearish case in recent days, let's describe the necessary criteria to create the required buy signal.
Since its origination in 1962, on all occasions when the 10-day average of the above calculation has moved up to 1.5 or higher, it has never failed to call a tremendous buying juncture.
We have shown those previous occasions on the chart. It is obvious that these buy signals pinpointed the best buying opportunities of the last 37 years. Not one of the signals have failed to be correct. In fact, if you evaluate the signals even closer, you will see that in every case a new bull market started within two weeks of the signal. Wow! The last time this buy signal was flashed was on October 16, 1987.
Even though the next day was the sharpest decline of the previous 50 years, this signal created a phenomenal signal.
Obviously, the reason we are describing the phenomenal buy signal is because it was once again activated as of the sharp decline on October 27, 1997. The 10-day average of the Arms index moved up slightly above 2.0. So even though we recognize that the valuation of the stock market, as measured by the S&P 500, has been trading at one of the highest levels in history, we have to take notice of this heretofore “perfect” indicator.
It is telling us that this panic decline has certainly flushed out the weak holders and cleared the path for another very strong bullish move in the months ahead. Even with this signal, we are going to err on the side of caution. In 1987, when this indicator was flashed, it proved to be the low for the Dow, but the advance decline line and most other indices still had to endure three more excruciating months of volatile periods of weakness. So we are not ignoring the buy signal, but are going to cautiously keep watching for signs that we should ignore the excessive valuation.
We're Bullish On Oil Service Stocks
There's no question that technology stocks provide the best long-term investment returns. But as the market attempts to climb out of its October collapse, we're guessing that some of the hot money that got burnt in technology high-fliers will look for a less risky place to grow. The oil services industry is an attractive alternative.
Here is an industry that burst out of a decade-long slump early in 1996 and has been climbing like gangbusters ever since.
Sure, it's a cyclical industry. But the cycles tend to be long, so you can get many profitable years out of the top stocks. The reason these cycles are so long is that the industry is so capital intensive. It takes years to build new equipment, especially offshore drilling equipment like jack-up rigs and semi-submersibles. It takes years for the industry to become saturated with too much equipment.
When the number of rigs in service finally catches up to demand, contract drilling prices start to fall. Historically these declines have been long and punishing.
It then takes years for demand to again catch up to supply and for companies to recover the cash (and the guts) to begin building again. So you can see why the cycle has always been long. Of course there is a chance that the companies will be smarter (less greedy) this time. Maybe they'll add capacity less rapidly. Maybe they won't saturate the market with new equipment.
And maybe the global demand for energy will continue to grow at such a pace that demand will continue to exceed supply for many years. It's possible–and if it happens, we're ready for it!
Remember, these are not oil companies. They don't need rising oil prices to reap windfall profits. They benefit solely because the oil companies have increased both drilling and exploration activity. And they benefit from new, cost-effective drilling techniques like 3-D and 4-D seismic surveys (the fourth dimension is time) and horizontal/directional drilling.
They're also reaping profits because the last decade's slump put many competitors out of business–the current consolidated industry includes fewer players than just a decade ago.
Add it all up, and you understand why we're bullish on energy services.
The Bull Market Isn't Over
No bull market ever dies of old age. Bull markets usually end when the Fed decides it's time to put the brakes on an economy that is heating up inflation-wise by sending interest rates too high. Bull markets are occasionally brought down by currency weakness, but this also goes hand in hand with higher interest rates.
If we've gained anything from this recent debacle, we should have learned that we can still be brought down by forces from abroad.
Should we still be in stocks? By all means, yes! The pros are leaving most of the equity stocks, but they are not leaving the stock market. Many are still buying undervalued small caps. (WSD Editor's Comment: The Fed's monetary policy is very accommodative for continuing economic growth and higher stock prices. Liquidity at $4 trillion+ is at a record high and rising.)
The Fed Is Flooding The Market With Money
“The Fed is flooding the market with money,” Donald Sazdanoff, editor of The Soverign Advisor newsletter in Columbus, Ohio, told DTN. “The Fed hopes to offset or counteract deflationary forces from overseas,” Sazdanoff said. “M2 has been growing at greater than a 5% annual rate, and the more telling `non-M1' M2 has been growing at better than 8%,” Sazdanoff said.
The M1 measure of money supply consists of currency in circulation, commercial bank demand deposits, NOW accounts, credit union share drafts, mutual savings bank demand deposits, and travelers checks.
M2 includes M1, plus overnight repurchase agreements issued by commercial banks, overnight Eurodollars, savings accounts, time deposits under $100,000, and money market mutual fund shares. .“M1 fluctuates more, making it hard to pin down the short-term trend,” Sazdanoff said, explaining his reliance on `non-M1' M2.
“The money supply is growing faster than gross domestic product, which has been growing at about a 3½% annual rate,.” Sazdanoff said.
“That has created the potential for inflation.” “We haven't seen inflation because the excess dollars have flowed into financial assets, not hard assets,” he said. “Japan tried to do the same thing, but the excess money went overseas, taking advantage of interest rate spreads because rates were so low in Japan,” Sazdanoff said.
Sixth Annual List Of Stocks To Double In Price
It's that time of the year again–the most favorable period for buying stocks. Seasonal trends don't always work, but this is the most reliable such pattern. November, December and January have been the three best months for the market. Often the strength persists until spring–so that in most years, the great bulk of the market's gains have occurred from November through April.
What's more, there is often a dip (particularly in secondary and out-of-favor stocks) just before the annual bash. This typically happens in November but it often continues into December. Portfolio readjustments and tax selling are the reasons.
Money managers don't want to show losers in their year-end portfolios and individuals decide their mistakes are at least valuable for tax write-offs. So undervalued stocks can get more undervalued. The market's current volatility could disturb the usual pattern but it may also create even greater bargains.
In any case, we have selected some stocks that are thoroughly depressed right now and should recover whatever happens to the market. If the usual seasonal forces come into play, that will merely accelerate what we expect. Five years ago, partly to underscore the merits of year-end bargain hunting, we picked a short list of stocks we thought had the potential to double during the coming year.
Average Gains Of Previous Doublers
At Their Highs
1993 Stocks (4)................................up 196.5% 1994 Stocks (4)................................up 217.2% 1995 Stocks (4)................................up 111.8% 1996 Stocks a (4)..............................up 198.5% 1996 Stocks b (4)..............................up 132.8% 1997 Stocks (4)................................up 106.3%
In fact, the stocks nearly tripled on average (at their subsequent highs). Naturally, we repeated this experiment the next year, and that list better than tripled on average. So our doublers list became an annual tradition. Each roster has at least doubled, including the two separate lists in 1996. (The first group doubled so fast that we picked another.)
This year's list has been the worst performing so far–it only did a bit better than double, and then the stocks came back.
That was because of the market's emphasis on large-cap stocks (which has since changed somewhat) and a sharp decline in mining issues, which were emphasized in the portfolio. It has all made mining stocks huge bargains, so we have a couple on the new list. Still, we are spreading the risk.
One of these is an industrial minerals play and the other has interests in both copper and gold. Our other candidates for 1998 are in biotechnology and oil and gas–altogether a diversified roster.
What they have in common is big upside potential along with relatively low risk, because of their depressed prices and the value of their assets and projects. These are all very low-cap stocks and they may be thinly traded at times. We prefer to buy on dips, using limit orders. Also, we are bearish on gold and gold mining shares.
Do Not Worry About Inflation
Inflation is not the problem. But something I've not seen in my lifetime is zero inflation/potential deflation and the inability to raise prices. I project inflation at 0 to -2% within five years. I know that's not what you're reading and hearing in the financial media, but I believe it's true. If I'm right, it will dramatically affect the way you need to invest to make the biggest money during the next five to 10 years.
Am I still super bullish about America's prospects and making money in stocks? You bet, but in a much different way than before.
One difference is I now believe long- term Treasury bonds have a much wider place in portfolios of investors of all ages and needs. Another is that many companies will fall by the wayside in this new environment. Profitable investing can't occur in a vacuum. If you don't understand where you're going, you will leave thousands, if not hundreds of thousands, of dollars on the table.
Inflation is defined as the “persistent increase in the level of consumer prices, or a persistent decline in the purchasing power of money.” Most of the western world accepts it as normal and natural that prices go only one way–up.
Most of the western world is ignorant of economic history. They don't realize that for the past 800+ years, there were lengthy periods of flat-to-falling prices following extremely long waves of inflation. According to Brandeis University history professor David Hackett Fischer, the end of these long inflationary waves brings prices back to “equilibrium” (a flat to declining trend), accompanied by crisis.
Professor Fischer opines that the conditions causing the current fourth long wave of inflation are quickly coming to a conclusion.
These include: 1.) slowing domestic and world population growth, 2.) an end to the cold war and subsequent major decline in worldwide military spending, 3.) the disintegration of Communism, 4.) the rapid spread of competition through capitalism, and 5.) public assets transferring into private hands.
Intense competition–plus an end-of-the-millennium burst of technological innovation with rampant increases in productivity–keeps prices flat and sometimes pushes them down.
Computers are an excellent example. A can of tennis balls is another. Some deflationary trends already in place are fairly widely known. One, Japan's economy is contracting at an annual rate of 12%. The Land of the Rising Sun is in a depression.
Two, unemployment is at outrageous levels in many countries–22% in Spain, 13% in France, and 12% in Germany and Italy. Three, credit- market debt in the U.S. totals a whopping $20+ trillion compared with a GDP approximating $8 trillion, a ratio of 2.6 to 1.
Less than 17 years ago the ratio was just 1.6. In the 1950s the ratio was 1.3. Heavy debt is deflationary. Throughout the 60s and 70s, long-term interest rates were below the growth of GDP, and that condition was inflationary.
In the early 80s, interest rates skyrocketed above the GDP-growth rate and remain there. This is deflationary. Interest rates peaked in 1981 and have been falling ever since.
They're still in a long-term downtrend (short-term moves aside) that shouldn't trough until at least 2008-12. This trend alone tells us–inflation is not going to be a worry. Four, there is abundance or excess of almost any good or service you can name ranging from a record amount of retail/office space per person in the U.S. to worldwide surpluses of automobiles and the capacity to produce them, steel, aircraft, computer assembly lines, financial institutions, and lodging rooms.
Warren Buffett is widely suspected to have bought at least $10 billion face amount of zero-coupon government bonds. He is betting on a big drop in interest rates and soon.
Because zeros pay no interest, investors get the most bang for their buck when rates move down. Treasury bonds are the most liquid, safest security on the planet. The current yield is 6.1% for the 30-year T-bond. But what if interest rates fall to 5% within five years and to 4% within 10? In that case the outcome is something to get very excited about.
Long- term bonds offer very strong competition–and superior defensive characteristics.
The environment seems ripe to start accumulating long-term Treasury bonds and also the GMAC zero-coupon bonds maturing in 2015 and traded on the New York Stock Exchange at 300.
Sell The Large Caps–Buy The Small Caps
The average pension fund in the U.S. is over-allocated in large cap stocks and is planning to trim their allocations in large caps in favor of allocating more funds towards small-to-mid capitalization stocks. Since the pension community moves relatively slow, we expect that more money will be allocated towards small-to-mid capitalization stocks for at least the next several months as more pension funds increase the percent they allocate towards small-to-mid cap issues.
Computer Sales And Productivity Are Soaring
At year-end 1996 there were 305 million computers in use worldwide, up from 259 million in 1995. The top 25 list consists mostly of the largest industrialized countries. The U.S. is the clear leader with over 108 million computers in use. Japan is second with an installed base exceeding 23 million computers. These 25 countries account for nearly 80% of the total computers in use. Over 95% of the computers in use are personal computers.
Worldwide yearly shipments of computers will surpass 80 million units in 1997, but only 50% plus will add to the installed base as nearly half will be replacing existing computers. By year-end 2000 the computers in use will approach 600 million units.
(WSD Editor's Comment: Company CEOs know that raising prices is no longer a solution to rising wage costs.)
In the global market, price competition is ferocious. Raise prices and you lose market share. As a result, U.S. companies have no choice but to purchase the very latest software updates as soon as they are released, the newest and fastest computers and other automated productivity enhancing equipment.
In a tight labor market, wages are rising, but not as fast as productivity, which is soaring. Productivity was up 1.4% in the first quarter of 1997, up 2.7% in the second quarter, and up 4.5% in the third quarter.
Soaring U.S. productivity is the reason that U.S. companies are the most competitive in the market place. After a trip to Southeast Asia, House Speaker Newt Gingrich asked Fed Chairman Greenspan, “How do we achieve faster economic growth without inflation?” Greenspan replied, “As long as productivity increases are greater than wage increases, inflation will not be a problem.”
The Greenspan Fed, which dates back to 1987, has never allowed economic growth to exceed 2.5% without raising interest rates.
Soaring productivity is the only reason the Fed is allowing economic growth of 4.9% in the first quarter of 1997, 3.3% in the second quarter and 3.5% in the third quarter without raising interest rates. The U.S. has 65 computers per 100 workers, Japan has only 17. The rest of the world is racing to purchase computers and software to catch up with Japan. After the current technology correction is over, you can safely bet that computer, semiconductor and software stocks will lead the market again.
The U.S. produces the only products that will improve productivity. Foreign companies must purchase these products or die in the global free market. The technology sector will keep U.S. economic growth very positive well into the next century.
December 1997 The Wall Street Digest, Inc.
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