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Posted 8/11/2003
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Disillusionment: ticket to lower stock prices
Share prices are too rich, and economic policy can't solve what a speculation bubble created. When people finally realize this, watch out.
By Bill Fleckenstein
One day, folks will regard stocks not as lottery tickets but as fractional (mini) stakes in businesses. When that psychology shift occurs, theyll start asking questions.
How well is the business actually doing? What sort of future lies ahead? What are its barriers to entry? Are the shares overvalued for those prospects?
This thought process can only result in lower prices, as rigorous analysis cannot justify today's prices under any realistic assumptions.
Last Tuesday Costco (COST, news, msgs), one of the countrys better-managed companies, was forced to reduce expectations because of "lower-than-planned gross margins, continuing escalation of costs associated with employee health care and workers' compensation expenses, and increased initiatives to improve customer service. . . . " So, here is a business where millions of people love to shop and a very successful enterprise; yet management is forecasting next year's sales and earnings growth in a range of just "8% to 10%."
Selling in bulk
That the news dropped the stock 22% over Tuesday and Wednesday illuminates a couple of problems. In fact, Costcos problem is a microcosm of the problems that I see in the equity market. Paying 20 times earnings was obviously deemed too high for that growth rate, though 20 times earnings would sound quite low to folks in tech land. If Costco can't eke out a more meaningful growth rate despite its success, and, if 20 times is too much to pay for a well-run operation that folks love, how can the S&P (aka the Standard and Poors 500 ($INX)) trade for 30 times earnings, and tech stocks for even more monstrous multiples?
This is not exactly a rhetorical question, because we know the answer. It's because folks have expectations that some wonderment or miracle will occur and launch us back into the mania. That's not going to happen.
And thats the crux of my belief in a problematic second half of 2003 for stocks. Even when I was constructive on the market earlier this year, I anticipated that, some time into the second half, it would be clear that expectations had risen too high, both for the stock market and the economy.
Greenspan has no magic wand
Once that realization sets in, folks will have to ask themselves why they've been disappointed. Theyll realize that Alan Greenspan has no magic wand to fix the problems that were caused by the biggest speculation bubble in the history of the world. The consequences of that were delayed by a bubble in bonds and a huge refinancing/housing boom that appears to have run its course. And folks will lose confidence. That will have negative ramifications for stocks, bonds and the dollar and positive ramifications for gold.
This has been my view since February. I laid out as much in an April 26 speech and posted here on MSN Money. Back then, this point of view was rare, but its incipient acceptance -- which I would describe as the first stage of the process that leads to the market's undoing -- was illuminated last Tuesday in a front-page New York Times story headlined "Surge in Rates May Hurt Pillar of the Economy."
To share a couple of quotes from the story: "It remains to be seen whether last week's surge in longer-term interest rates is just a blip or the start of a trend. Either way, however, it is remarkable as a demonstration of the limits of the Fed and its chairman, Alan Greenspan, to force the hand of the nation's financial markets. (The emphasis is mine).
One can see how that quote fits into my scenario, as frequently described in these pages.
The emperor has no clothes?
The story offered this comment about Greenspan from Wells Fargo's chief economist, Sung Won Sohn: "It looks to some people now as if the emperor has no clothes." Further, the story stated this obvious but important point: "The astonishing divergence of Fed policy and the reaction of the financial markets poses a challenge to Mr. Greenspan, who has until now enjoyed a nearly mythical reputation for his power to make the enormous American economy move to his tune."
Amazingly, his reputation has thus far stayed pretty much intact, even though his halo has slipped a bit. It's as though he and the Fed can continue to receive a free pass for the bubble they created (in the 1990s), so long as their gambit to drive down rates could successfully buoy the housing market. Now, however, as folks are beginning to have second thoughts (as I pointed out during his recent Fool on the Hill testimony), Greenspan's credibility is starting to suffer.
Admission ticket to the downside
So, where does this all leave us? If Im right and the economy and the stock market are set to sputter, people will start asking themselves why. They will stop believing in the Fed's continual promises of a recovery. They will come to see that the Sept. 11 terrorist attacks and the Iraq war were just excuses, and that the Fed has now run clean out of them. They will be forced to realize that the Fed can't deliver us to the promised land.
If that happens, the shift in psychology will force stocks to trade as investments in businesses rather than lottery tickets. That will result in much lower stock prices and the problems in the market and the economy will be self-reinforcing to the downside. That there has been so much hope and hype only makes the potential adjustment in the form of some sort of a crashlike event that much more likely, though always a low-probability event from a statistical point of view.
From the 'say what?' department
To end on a lighter note, get your hands on Bull! 144 Stupid Statements From the Market's Fallen Prophets, a new book written by Greg Eckler and L. M. Mac Donald. (This is available through Amazon, Barnes & Noble, and others. For those who need to know, the publisher is Andrews McMeel.) Greg is a longtime reader of my daily column, but thats not the basis for my enthusiasm. Rather, this is one of those rare finds that's not too long, right on point, hilarious and well written.
It's an easy-to-read history of quotes from many of the mania's pundits, complete with follow-up comments by Eckler and Mac Donald that at times had me laughing so hard I literally cried. I promise you, whatever the effort to obtain this book will be well worth it. Meanwhile, I leave you with a little nugget: "This correction will run its course until the middle of the year. Then things will turn up again, because not even Greenspan can stop the Internet economy." That was from Larry Kudlow, in The New York Post, Feb. 25, 2000. The authors' follow-up comment: "The Internet economy has passed on, but Kudlow remains omnipresent."
Finally, be sure to check out our Web site, where we are currently running a small survey, in addition to our usual posting of questions and answers.
Bill Fleckenstein is 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 the time of publication, he held no positions in securities mentioned in this article. His investment 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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