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Posted 12/9/2002
Contrarian Chronicles
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Contrarian Chronicles
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| | Contrarian Chronicles
Is a cleaner Street around the corner?
There's still a lot of cleaning up to do from the collapse of the tech bubble. Too many stocks remain overpriced. But at least a few analysts are finally mending their ways.
By Bill Fleckenstein
Can't wait to see Wall Street cleaned up? Well, join me for a ride on the Contrarian Chronicles' own (pro forma) sanitation truck. There's a heap of trash to be picked up, and we won't have to look far to find it. Here, a bunch of rusted PC-replacement cycles. There, a gathering of speculative juices. Just around the corner, as usual, that mound of bottom-sightings. Yes, yes, I know everybody's getting tired, but let's pull together and make room in the truck for the biggest haul of all, that mile-high pile of overpriced tech stocks.
Florence Nightingale, Wall Streetwalker
A host of downgrades in technology land last week suggests that a new phenomenon may be emerging. It seems that the big dead-fish houses have realized that in order to turn a profit prospectively, they'll have to try to help people make money. When I entered the business in the late 1970s and early 1980s, the brokerage business was maybe about 75% to 80% oriented toward attempting to help the customer make money. The "prostituting" part -- pushing bad investments on unsuspecting investors to boost investment banking profits -- was perhaps only 20% to 25% of the business. (That is not to demean the oldest profession.)
By the time the mania-led bull market ended in late 2000 (and, I would say, until very recently), the part about trying to help the customer was approximately 1%, and the prostituting part was about 99%. Looking ahead, if the corporate finance business is not going to be what it once was (and it won't be), brokerage firms will have to rely on commissions to drive their profits. They will need to get serious about earning those commissions by actually helping people.
The pitter-patter of the price-wise
Getting paid for doing that is, I think, a reasonable business. I believe this is starting to dawn on the dead-fish community, and that is why we have begun to see the handful of downgrades based on valuation -- something that people had not worried about for the past seven or eight years.
As I have said again and again until turning blue in the face, valuation (or my shorthand way of saying it, i.e., price) is the critical component of your prospective rate of return. There is a big difference between a great company and a great investment, and that difference happens to be price. Over time, as that difference comes to matter to the people who earn a living by helping others to make money, I expect we will see healthy numbers of live fish born, while the dead fish wash up on the beach and rot.
Oh Danny boy, the pipe dreams are calling
Meanwhile, a prominent dead fish whose name rhymes with "denial" demonstrated last week why he is one of the leaders of the dead-fish community when he upgraded Intel (INTC, news, msgs) to "overweight." Apparently, despite evidence to the contrary, he "continues to see signs of a PC replacement cycle," centering on 180 million PCs that are four years old. Dead fish are always reaching for the notion of a mass corporate-upgrade cycle, but they fail to mention the fact that in the last two years, 300 million PCs have been sold, some of them even to corporate users.
When one hears what IT managers say, and what the people who actually sell PCs have to say, there are no signs of this fabled replacement cycle occurring, or even of any hints that it will occur. (For a flavor of that, see last weeks column.) So if Mr. Denial was listening to the recent comments by Hewlett-Packard (HPQ, news, msgs) and Tech Data (TECD, news, msgs), it may have been with a banana sticking out of each ear. In any case, reality does not stop those engaged in the sport of chasing stocks from doing just that. People continue to extrapolate any minor statistic into a long-term trend, even if there is more evidence refuting it than corroborating it.
Growth engine hauls excess baggage
Behind all the fantasy remains a problem that no amount of arm-waving can change: As a consequence of the biggest bubble in the history of the world, we had a dramatic misallocation of capital, which resulted in tremendous excess capacity in virtually every industry, which in turn caused the well-documented collapse in corporate spending. The consumer, on the other hand, continued to spend in the last couple of years, thanks to the refinance boom that precipitated a bubble in housing. (But other than some last-minute chasers, that is now history, as rates are higher since the last rate cut.)
Now, however, on the back of a spending spree, the consumer is basically sated, sort of like when everyone gets sated at Thanksgiving dinner and stops eating afterward. On top of that, the consumer has plenty of debt, together with concerns about his or her job. So, given the consumers state of mind and corporate Americas state of mind, I do not see a big engine for growth to overcome the massive excess capacity that exists. That would leave only government spending (which will assuredly go up) or exports (which seem unlikely to improve) as a big impetus for the economy.
Of stocks and paradox
I realize that when a true bottom is seen, bad news seems impossible to overcome. But the opposite does not necessarily hold -- that if things look bad, it must be the bottom, because things can't worsen. Since they can, that analysis doesn't work in reverse. People are fond of saying that a rising stock market can solve lots of problems, as we saw in 1990 and 1991. But a lot of our troubles then were a function of credit not being administered properly within the financial system, as bad loans caused many difficulties.
Overdosing on sugar-daddy debt
In this case, our problem is not a lack of credit, unless you are a completely collapsed entity such as a Lucent Technologies (LU, news, msgs) or a WorldCom (WCOEQ, news, msgs) or an Enron (ENRNQ, news, msgs). In fact, the problems are a function of just the opposite: Credit was handed out on the up-cycle until people choked on it. So, the circumstances that we find ourselves in do not lend themselves to ready remediation by easy credit.
For the economy to turn around, we need to work off all this excess capacity and debt. To do that requires lots and lots of time. In a nutshell, that's why I believe the economy will not make much progress over the next year, and as soon as the little flight of fancy in the stock market is over, things are going to worsen again. To repeat, I don't say this because I want it to happen. It just seems so clear that this is what we face prospectively.
Downy-lined bull case
Most people who are bullish about the stock market these days are driven by some variation on the following themes:- Well, it's gone down far enough.
- It's gone down long enough.
- It's not so expensive (as long as one tortures the statistics).
But markets are markets. They don't have to trade at any particular price. They can go from one crazy price to another crazy price. (More about that in a minute.) Obviously, we saw that for the last several years of the millennium.
People tend to forget that part of what occurred in the mania was that the euphemistic "everybody" took their exposure in equities from practically zero to the functional equivalent of 100%. Yes, a few participants have taken some money out. But basically, people still own them. That pig went through the python, and there's not going to be any big replacement in its wake. It's silly to think that some new wave of greater fools will come along to carry the market to even higher prices.
Paying up for eking out a nickel
While in lofty-valuation land, let's do some math by comparing two stocks that recently traded for almost the same price (around $20): Inco (N, news, msgs) and Texas Instruments (TXN, news, msgs). Lets start with Inco, which I have owned in the past. This company is the world's second-largest producer of nickel, and it produces other metals, including cobalt, gold, copper and silver.
In 2000, its best year in the last seven, Inco earned $1.67 per share. So, at its current price, it trades at roughly 13 times what has been its best earnings in quite some time. In my opinion, that's too much to pay for a cyclical stock. I want to buy a cyclical stock when it's losing money, or when it's making pennies, and people are down on this particular commodity. I don't see any advantage in buying a cyclical stock at a P/E like Inco's, on what are not too far away from the best numbers it tends to see. (Somewhere between $10 and $14 would be my price, depending on circumstances.)
In about half of Inco's quarters over the last five years, it has either lost money or made less than 10 cents per share, plus or minus. When things are going well, the company makes 30 or 40 cents per share per quarter. This year, it's on track to maybe make over a buck. So, Inco is an example of a mundane cyclical stock that I don't find particularly cheap. Nevertheless, in the last seven quarters since 2000, the company has managed to make $1.18.
Pricey fact behind pretty face
Texas Instruments has been a stock that people love to love because, after all, it's technology. In those same last seven quarters, since Texas Instruments' peak year of $1.22 per share, it has made 28 cents per share. Compare that to what Inco has done. In the period from 1995 through 1998, Texas Instruments never made more than 50 cents per share. In 1999, it made about 90 cents. In a good year, it's likely to make 40 or 50 cents. So, Texas Instruments is trading at about 50 times a reasonable estimate of peak earnings, and at about 20 times the best numbers it's ever made (which it's not likely to see again, since I don't think the phenomenon of 1999 and 2000 will be repeated).
To me, Texas Instruments seems absurdly expensive, a point that is underscored when you compare it to a mundane stock like Inco. If TIs earnings pattern is worse than Inco's, why pay the big price for less earnings power? And that is the purpose of this little exercise, to illuminate the ridiculous valuations that people seem willing to pay for technology stocks. Of course, as you can see with Inco, people overpay for mundane companies, too. I know two stocks don't make a market, but they demonstrate the problem with the market, and that's price.
This is not to say there aren't a handful of cheap stocks out there, as I'm sure there are (though en masse, this is not the case), or that stocks can't trade higher (they can). But in essence, joining the party right now means ignoring the fact that stocks still aren't cheap and that there's lots of risk out there, in favor of placing blind faith in the spurious rationales I mentioned earlier. It's a tactic that may work for some people, but for the average person to take a huge chunk of his hard-earned money and make that bet is just plain crazy, in my opinion.
Growl your way to growth
Lastly, I should note that ignorance can be found in high places as well. In a recent Op-Ed piece in The Wall Street Journal, editor Robert Bartley enjoined corporate America to let out its animal spirits to help the economy: "The recovery has been lackluster so far because businessmen have lacked animal spirits. To join the consumer in boosting the economy, businessmen need to take prudent risks." So basically, if corporate chieftains would just act crazy, no matter what the facts are, we'd all be OK. Bartley's advice is sort of like Dallas Fed head Robert McTeers telling people in 2001 to go out and buy an SUV, and then the economy would be fine.
If you had to single out the most clueless comment in Bartleys piece, it would be: "The stock market may (the emphasis is mine) have gotten ahead of itself at the turn of the millennium, but the information revolution proceeds apace." Now, this fellow is the editor of the Journal, and he says may have gotten ahead of itself? Just possibly? Kind of sort of? Well, what do you expect from the publication that capitalized the letters n and e in "new economy."
To challenge corporate America to go out and spend on that analysis is the height of lunacy. What Bartley describes as the market getting "ahead of itself" was the biggest mania ever. As for the information revolution, it has been proceeding apace since the printing press was invented. So, when an individual at the editorial desk of one of our nation's top business papers demonstrates such a lack of understanding, it's no wonder that the stock market is home to the kind of behavior that we see on a day-to-day basis. Before this bear market is ended, that kind of nonsense will no longer be written.
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 held a short position in Intel. 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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