Jubak's Journal
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Say goodbye to easy money
After a long run, the cheap-money cycle has hit the wall. Bulls and bears differ on what's next, but I've got two strategies that should help in either scenario.
By Jim Jubak
The cycle of cheap money that has fueled the booming financial markets of the last 20 to 25 years is coming to an end.
Are you and your portfolio ready?
From January 1980 to January 2005, M1, the Federal Reserve's most conservative measure of the money supply in the United States, grew by 252%. M3, a measure that captures some of the money created by Wall Street's institutions, grew 420%. At the same time as the money supply was growing, the cost of tapping into that river of cash was falling: The Fed funds rate, the cost for a bank to borrow overnight from the Federal Reserve, fell from 13.8% in January 1980 to 1% in January 2004.
No wonder that with money so easy to borrow (thanks to that jump in supply) and so cheap (thanks to low interest rates) that the price of assets such as stocks and bonds that you could buy with borrowed money soared. From January 1980 to January 2005, the Dow Jones Industrial Average ($INDU) returned 1,098% and the Nasdaq Composite Index ($COMPX) returned 1,175%.
But now, that cheap-money cycle is over. After hitting a low of just 1% in the first half of 2004, the Fed has hiked its target for the Fed Funds rate to 2.75%. Reading between the lines of the Fed's press releases, I think it likely intends to take its target up to 4% to 4.5% by year end. That's the level economists see as "neutral," meaning interest rates are neither so low that they stimulate the economy nor so high they put the brakes on growth.
And growth in the money supply has started to taper off, too. After growing by 11% from 2001 to 2002, growth in M3 dropped to 7% in 2002, and then to 4% in 2003, before kicking up again slightly to 6% in 2004. For the three months from November 2004 to February 2005, the annualized rate of growth has dropped further to 4.2%. That's a level near the growth rate for the economy during the last quarter of 2004 (and therefore roughly "neutral," since the growth in the amount of money in the economy is approximately equal to the growth in the size of the economy as a whole).
What next? Two scenarios
So what happens now?
The bulls believe the Fed will be able to engineer a gentle transition from the cheap-money economy to a "neutral"-money economy. In this scenario, short-term interest rates will rise gently -- just enough to keep inflation under control -- to somewhere around 5.5% in 2006. The economy will grow at 3% to 3.5%, a level some economists call its natural rate of growth based on U.S. population growth and U.S. productivity improvements. Corporate earnings will climb 7% to 10% a year, thanks to improved cost controls in the new, leaner U.S. corporations. And all that combined will keep the stock market chugging along with annual returns in the neighborhood of 8%, give or take two percentage points or so.
The bears believe the bulls are hallucinating. You can't grow the money supply at rates like these -- 77% growth in M3 for 1980-1985, for example, as the Fed tried to boost the economy out of the dumps -- without creating serious structural problems in the economy and financial markets. Cheap money has inflated the value of assets -- stocks, bonds and houses -- and the end of cheap money will result in the collapse of those prices. At the same time, all that money chasing a limited supply of goods and services must result in inflation, they argue. The Fed, they believe, has seriously miscalculated by waiting too long to begin to raise interest rates and then compounded that error by raising rates too slowly.
Splitting the difference
My view lies somewhere in between the bullish and bearish positions.
Yes, the bulls are right in emphasizing the strength of the U.S. economy -- short of an energy-supply crisis -- and 3% projected growth does seem reasonable. But the bulls are underestimating the inflationary consequences of the monetary and fiscal policies of the last decades. The Fed flagged the rising possibility of higher inflation in the March 22 statement from the Federal Open Market Committee: "Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident."
On March 31, the Commerce Department reported that its core Personal-Consumption Expenditure (PCE) price index, a favorite inflation gauge of Fed Chairman Alan Greenspan, rose 0.2% in February on top of a 0.3% jump in January.
As a consequence, I believe the bulls are overestimating the annual performance of the stock market as a whole, as measured by broad market indexes such as the S&P 500 ($INX), for the rest of the decade.
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And, yes, the bears are right to emphasize the danger of a blowup as traders and speculators -- a category that includes some of the biggest industrial corporations and largest financial institutions in the economy -- unwind positions purchased with borrowed cheap money. At the least, investors can expect a constant series of negative surprises like that which has wiped an estimated $11 billion in earnings off the books at Fannie Mae (FNM, news, msgs) recently. The bears are also correct in pointing out that in the cheap-money economy, negative surprises have a way of creating ripples of ugly consequences.
For example, the earnings restatement at Fannie Mae has led the company to cut back on its purchases of mortgages, shrinking its loan portfolio by 1.8% in February. With Fannie Mae buying fewer mortgages for its portfolio, mortgage money gets a little tighter. That, in turn, puts pressure on housing prices, if so far only slightly. But the bears are underestimating the huge excesses of supply in goods and services created by the entry of China and India into the global economy. That will certainly create inflation in the prices of some raw materials such as oil and iron ore, but it will damp inflation in vast categories of finished goods and, increasingly, in services, too.
Two strategies to stay out of trouble
Frankly, I don't know how rapidly either the bear or bull scenario will unfold (and neither do they) and I certainly don't know how long this period will last. But I do have a pretty good sense of the kind of stocks I want to avoid and the kind I want to own during these years.
Avoid the stocks of companies built on leverage. During the cheap-money decades, U.S. industrial giants such as General Motors (GM, news, msgs) and General Electric (GE, news, msgs) have turned themselves into finance companies to take advantage of a river of cheap money. About 50% of General Electric's revenue in 2004 and about 40% of its profit came from the financial businesses of GE Capital Services. The revenues and, more importantly, the profits from financial services aren't in danger as long as General Electric can maintain the high-quality credit rating that assures its ability to raise funds in the capital markets, which it then lends to businesses and consumers. As long as GE can maintain the spread between its cost of money and what it can charge consumers, rising interest rates won't be especially damaging to its profits.
But a company built on financial leverage can see its entire profit structure collapse if it loses its access to money at the cheapest rates. In 2004 all -- and I mean ALL -- of General Motors' $2.8 billion in income came from its financing and insurance business. The company's auto-making operations lost a total of $89 million in 2004 on $162 billion in revenue. In contrast, GM's financial businesses showed net income of $2.9 billion on $32 billion in revenue. Unfortunately, GM's ability to make money in the mortgage and insurance businesses it runs (as well from loans on cars) is at risk because the parent company's credit rating is approaching junk-bond territory. That raises General Motor's cost of capital and, because the company is in competition with companies that can raise money more cheaply, puts the margins in the company's financial business at risk. If those margins start to fall, the financial markets will react by raising the cost of capital to GM even more.
Buy the stocks of companies with a below-market cost of capital. Companies that can generate huge cash flows internally have two distinct advantages in the post-cheap money period. First, the cost of that internal capital can be substantially below the cost of borrowing money in the capital markets. Analysts estimate that the cost of capital at Warren Buffett's Berkshire Hathaway (BRK.A, news, msgs) is close to or below 0%. All things considered, Berkshire Hathaway should be able to generate greater returns than companies that must raise cash in the capital markets. And that's not an insignificant plus when you're sitting on $42 billion in cash, as Berkshire Hathaway was at the end of 2004. Second, companies that generate huge internal cash flows can borrow money in the capital markets at the best available rates. Johnson & Johnson (JNJ, news, msgs), for example, generated $5 billion in free cash flow in 2004. That -- plus a balance sheet with $13 billion in cash and just $3 billion in debt -- earns the company a AAA credit rating, enabling it to borrow money at a lower rate than all but a handful of U.S. industrial corporations.
I think if you avoid the leveraged and buy the capital-advantaged stocks in the market of the next few years, your portfolio will outperform the broad market averages.
Two columns from now I'll give you a screen for finding companies with the right financial advantage and I'll include the names of 10 stocks that fit the bill. But first, I want to devote my next column to looking at what the end of the cheap-money cycle means for the rest of the globe -- and global stock markets.
New developments on past columns
First-quarter 2005 performance for Jubaks Picks
Its time for the end-of-quarter and longer-term performance numbers on Jubaks Picks. The portfolio finished the first quarter of 2005 solidly ahead of all the indexes with a return of 5.4% for the period. For the quarter the Dow Jones Industrial Average lost 3%, the Standard & Poor's 500 lost 3% and the Nasdaq Composite lost 8%. The 5.4% return on Jubak's Picks for the March quarter of 2005 compares to a 6.8% return for the first quarter of 2004. For the trailing 12 months, Jubak's Picks returned 27.8%. That was ahead of the 1%, 5% and 0% returns for the Dow, S&P and NASDAQ indexes, respectively.
But returns for the quarter would have been better if I hadn't tried to be so smart. I added financial stocks MBNA (KRB, news, msgs), Hartford Financial Services (HIG, news, msgs) and U.S. Bancorp (USB, news, msgs) in the quarter in an attempt to outguess the market on interest rates. The stocks sank 9.4%, 3.6% and 7.1% from the date they were added to Jubak's Picks to the end of the quarter. My attempt in the last half of 2004 to time a rally in technology and biotechnology stocks continued to haunt the portfolio too as investors fled from volatile stocks into safer names when the stock market stalled in January. The smartest move I made in this area wasn't holding onto EMC (EMC, news, msgs), Micron Technology (MU, news, msgs) and Cell Genesys (CEGE, news, msgs), but selling Texas Instruments (TXN, news, msgs) and Biotech HOLDRs (BBH, news, msgs). In the quarter what paid off were the bread-and-butter plays in energy, real estate, railroads and food. I expect a short-term rally in some of the more beaten down names in out-of-favor sectors as we enter earnings season in early April, but I'll be surprised if the bread-and-butter sectors don't wind up leading the market again for the quarter that ends in June. Heres how I did against the major indexes:
| Jubaks Picks vs. major averages | | Index | First quarter 2005 | Trailing 12-month | | Jubak's Picks | 5.4% | 27.8% | | Nasdaq Composite | -8% | 0% | | Standard & Poor's 500 | -3% | 5% | | Dow Jones Industrial Average | -3% | 1% |
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Here are longer-term performance numbers for three years, five years (a period that this quarter begins at the peak of the bull market in 2000 and includes the bear-market collapse from that peak) and since the inception of the portfolio:
| Jubak's Picks vs. the indexes -- the long-run picture | | Index | 3-year return* | 5-year return** | From inception*** | | Jubak's Picks | +59% | -20.4% | +163% | | Nasdaq Composite | +9% | -56% | +50% | | Standard & Poor's 500 | +3% | -21% | +43% | | Dow Jones Industrial Average | +1% | -3% | +46% |
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*Close on March 31, 2002, through close on March 31, 2005.
**March 31, 2000 through March 31, 2005.
***May 7, 1997, through March 31, 2005. All returns for Jubaks Picks deduct costs of commissions.
As is my practice, I will update these performance numbers at the end of the next quarter in June 2005.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Cell Genesys, EMC and Micron Technology. He does not own short positions in any stock mentioned in this column.
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