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Posted 8/26/2002
Contrarian Chronicles
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A rally to fear, not to cheer
The only good thing about the recent return to outlandish valuations is that it offers a better exit position for those who wise up. If we believe this rally, we've learned nothing.
By Bill Fleckenstein
From this week's observation deck, the Wall Street landscape won't win any beauty awards. It's a scene of speculation, high prices and a nasty riptide of mutual-fund redemptions. Fittingly, the aerial comes with an audio -- the sound of market-darling Dell Computer (DELL, news, msgs) trumpeting its recent results. And as always, folks strain the deck rails, the better to cry "bottom."
The rally that began July 24 continues, but more than trace amounts of speculation have followed in its wake. Considering the size of the celebration that day, which saw higher stock prices cheered -- and risk turned away at the door -- I thought a couple of comments might be in order. Let's begin with the idea that staying an arm's length from the punchbowl exposes the peril behind the party. To wit, the prices of some of these securities have now returned to levels that are truly stunning, given the underlying fundamentals. Once again, rising prices and deteriorating fundamentals only increase the risk to equity holders, not vice-versa. Many people apparently believe that stock prices going up means they're less risky, because they are basically extrapolating the recent past. So, the higher they go, the more these people drop their guard -- with the most extreme case in point being what happened during the mania.
But people who are overextended ought not to look this gift horse in the mouth. Sometime in the next couple of weeks, they should use the opportunity to lighten up, if they have more exposure to the stock market than they were comfortable with during July. That the public has now learned it can lose money in stocks was noted recently in The Wall Street Journal, which said that Fidelity's Magellan fund (FMAGX) had its largest outflow ever in July. The next time the market starts down for real, I believe we'll see a wholesale liquidation in the stock market that will make what happened on the 24th of last month look just like a tune-up.
A visit to the incremental health clinic
Turning for a moment to market darling Dell Computer, I'd like to share some thoughts about its much-anticipated and recently released results. On the surface, the numbers were pretty good. However, beneath the surface, they may not be as sustainable as the bulls would like. Sequentially, their revenues grew just under $400 million, and their net income was up a little over $40 million, meaning that the profit margin on that additional growth was north of 10% after taxes. Yet, the profit margin on their entire base of revenues was only about 5.9%. So, this incremental piece of business was unusually profitable. Also, the receivables were up just under $300 million on the same previously mentioned $400 million in revenues. That is a decent chunk of growth going right into receivables.
As to the cause, the company offered some comments that I couldn't quite follow. Perhaps there is a completely innocent explanation for all of this. But I find the superior performance somewhat confusing, and at a minimum, I would not expect it to be repeatable on the same level of revenues. Therefore, I find Dell's raised guidance for earnings-per-share next quarter of 20 cents to 21 cents to be a bit of a stretch, and likely to result in disappointment. But we shall have to see.
Spendthrift institution
My biggest concern with Dell is the balance sheet, because what they make on the income statement from their PC business, they lose in the stock-buyback business. (Meaning that management should stick to its knitting --selling PCs and taking market share in what is essentially a no-growth business -- rather than dabbling heavily in stock speculation.) The company is always talking about how wonderful their buyback program has been, yet they have managed to obliterate their retained earnings in doing so.
This is not readily apparent, because when they buy stock back now, they count it as treasury stock, and therefore, it hasnt wiped out retained earnings, as it does when the two are netted. However, when one looks at the equity figure, it is accurate. Furthermore, a couple of rather large items on the balance sheet dont make sense to me. At this point, I can come up with a couple of explanations, one being totally innocent and one slightly less so. But Ill endeavor to get to the bottom of this as I dig more into the numbers, and if I can, Ill be sure to pass along whatever I find.
All aboard the viewliner
Now I would like to respond in these pages to a very thoughtful e-mail I received from a reader, since others may be interested. He asked me, in essence, why I felt so certain that the market had not bottomed, why I have held that view so consistently, and why other people who may have been bearish before now turned bullish? He wanted to know what the difference is between our views, why I have been correct and they have been incorrect, and doesn't that possibly suggest my view is now about to be wrong.
First of all, let me say that I could turn out to be wrong about this. I have been wrong many, many times in my career. In fact, every lesson that I've learned has its roots in my prior mistakes. That's the way it is in the investment business, at least for me. You get better by making mistakes. The trick is to not make the same mistakes more than once, and to use those lessons to engineer yourself into a position whereby any mistakes you do make don't leave you hurting badly. That's why experience counts for so much in this business, and why the nave thought that was sort of promoted in the mania, about buying stocks and waking up rich, was never going to work. It simply isn't that easy.
My view has been, and continues to be, that we had the biggest bubble in the history of the world. Many people pay lip service to this, but they do not appear to understand what it means. To me, it means that the problems we are facing, that we have faced, and that we will continue to face were more or less preordained. We cannot solve the problems that ensue from the bubble. Perhaps they can be ameliorated, but more likely, they will be made worse. That, to me, is the lesson of studying prior bubbles, i.e., ours in the 1920s, and Tokyo's in the 1990s.
The ferocity of the reciprocity
The difference between my view and the view of others who had been bearish concerns what the aftermath must look like. Just as the mania on the upside had to run to exhaustion, the aftermath has to run to exhaustion. I don't believe this will occur until people have truly given up, and I also believe that stocks have to be cheap. Neither of those two things has happened.
While certain individual stocks or sectors may be cheap, stocks are not cheap en masse. People who try to make the argument that stocks are cheap need to resort to some distorted statistics, like: Let's compare valuation to prior periods of low inflation, or it's cheap if you normalize earnings, or various other rationalizations. To me, after the biggest mania in the history of the world, stocks ought to be unbelievably, obviously cheap. And, people brave enough to own them will have to make the argument: Hey, these things are dirt-cheap, and then lose money before it can end. That's what ought to happen after the biggest mania in the history of the world, based on my reading of the prior two examples that we have.
Keeping up with the Dow Joneses
Setting aside stock manias for a look at the housing variety, I would just point out the implications of a recent story in The Wall Street Journal called "Come On, My House Is Worth More Than That." This is a potentially frightening look at the extent to which people are pressuring their appraisers so they can maximize the money borrowed against the value of their home. One appraiser said a prospective client warned, "If you're not going to come up with the number I want, I'm not going to pay you." These threats are becoming increasingly more common. As if to put an exclamation point the kinds of things that are taking place, the story winds up with the following quote from a Des Moines appraiser, who received a call from an unhappy homeowner: "With my appraisal, the bank wouldn't give him sufficient money to buy the boat he wanted. I said, 'Buy a smaller boat.' He didn't like that answer."
Now, not being in the mortgage business, I don't know how prevalent these stories are. But I continue to hear such accounts of how people are using this money to continue to fund a good life that's beyond their means, rather than to lower interest costs. If the bulk of these refinancings are being undertaken by the former, that will be a huge problem down the road, guaranteed. When the housing bubble bursts, all these people that are leveraged up will find themselves in a tremendous amount of trouble.
Departing Golden State, arriving Golden Council
Segueing, finally, from speculation to store of value, gold bulls might take note that this past week, the World Gold Council announced the appointment of James Burton, formerly the chief executive of the California Public Employees Retirement System, as its new president. It's a very interesting development, and a possible first step in linking the gold market to investment demand. Should this occur, it would certainly cause prices to move dramatically higher.
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At time of publication, William Fleckenstein owned none of the equities mentioned in this column. Positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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