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Posted 5/3/2004
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Investors finally may be waking up
The harsh reality of how overvalued stocks really are -- and how the Feds overvalued reputation has led them astray -- is setting in at last.
By Bill Fleckenstein
Stocks were dropping last week, and one reason may be something rarely seen in the past five years: dot-connecting. Perhaps folks are starting to realize that some companies can't grow fast enough or expand margins sufficiently from current levels (or some combination of the two) to justify valuations.
The appearance of that thinking is suggested by the heavy action in chip land, where recent quarterly reports from five of six contract manufacturers indicate a not-insignificant buildup of inventory. (A handful of chip companies such as Intel (INTC, news, msgs) and Texas Instruments (TXN, news, msgs) have also admitted to growing chip inventories.) If the industry-wide buildup is exacerbated by a diminution in end demand (which thus far has not happened), many of these chip stocks are in for some pretty serious air pockets in the second half.
A portfolio manager wields pom-poms . . .
However, even as folks at home begin to confront reality, "professional" money managers still exhibit delusional psychology. Exhibit A: The intimate testimony from a longtime reader of my "Market Rap," who wrote:I work as a financial adviser for a large financial services firm. Recently, we had a portfolio manager speak to us as part of a regional conference. This person manages billions of dollars for a mutual fund within a well-known money management firm. . . . His outlook was completely positive and bullish, to say the least. Phrases such as "long and strong," "productivity gains," "don't fight the Fed," "Internet economy," and "the only risk is not being fully invested" were mentioned over and over.
He opined that valuations were currently quite undervalued, and that the mighty Fed "would continue to be diligent and effective in leading the U.S. economy forward." He said the firm is currently taking large positions in Internet companies like Yahoo! (YHOO, news, msgs), Amazon (AMZN, news, msgs) and eBay (EBAY, news, msgs). Its rationale? The Internet would leverage these companies' earnings, and they'd certainly grow into their current valuations. In fact, he said they were beginning to shy away from old-line "Old Economy" stocks, believing that any rise in interest rates would severely limit the growth of companies like Alcoa (AA, news, msgs), Wells Fargo (WFC, news, msgs) and Wal-Mart (WMT, news, msgs). The "New Economy" was where the action was now, and going forward.
. . . and whisks away the risk
He went on to write:Suffice to say, I was stunned. There was no mention whatsoever of any potential problems, disappointments or flies in the ointment. I turned to my colleague and quipped: "Talk about deja vu. I've always wanted to go back to 1999 and remember what the lunacy was all about." When someone had the actual nerve to inquire about any (remote) possibility of something going wrong, the portfolio manager responded that a Sept. 11 event could cause a "minor setback," though that, in his firm's opinion, would simply create an even better buying opportunity. . . .
Adding to my anxiety was something that had happened earlier in the day. I'd met with a client who had the same mutual fund this portfolio manager oversaw. I know, what a coincidence. I had recently inherited the account and came to find out that this client had invested in the particular mutual fund beginning in early 1998.
Approximately six years later, and after reinvesting dividends, the client was still currently down over 40% on the investment. Heaven only knows where they stood a year ago, before the "rally" commenced. If that's what they mean by "long and strong," then I'll be happy to sit on the sidelines and watch the train wreck from a safe distance.
Jim Grant on inflation vs. deflation
Now to share some thoughts on Where we came In," a truly brilliant essay by my good friend Jim Grant, from the current issue of Grant's Interest Rate Observer. The essay takes up nearly the entire issue and is essentially a review of monetary policy, with fiscal policy and macro variables mixed in, during "modern" times (i.e., mostly my own lifetime). Beginning in the 1960s, it chronicles the tail-end of the dollar-gold standard (contrasted to where we are today -- on the Trust Al Greenspan standard), the rise of Japan and the rise of China.
I have read many articles that try to put the forces of inflation and/or deflation into perspective. I have read many books on financial history. But Jim's discussion is the best one I've ever seen on this subject, and I plan to reread it several times. (I highly recommend that anyone with an interest in financial markets read this issue, which can be purchased for $50 on Grant's Web site.)
Since I couldn't possibly do justice to Jim's comments by paraphrasing them, I'd just like to reprise a couple of points that I especially like:
- Create too much money and bad things will happen -- somewhere. When the Fed embarks on a policy of excess liquidity creation, it's not possible to know exactly where that liquidity will go. I like to picture a tube of toothpaste with its top screwed on and with holes in various places. If you squeeze it, you cant predict from which holes the toothpaste will squirt. Jim, however, says it much more eloquently:
"By definition, there's no predicting through which set of channels the surplus money will enter the economic bloodstream. The point of contact might be consumer prices, asset prices or . . . taxicab medallion prices."
- The Fed is trying to manage too many things.
Jim puts into perspective how the Fed sees its role: "Emboldened by its experiments in interest-rate fixing and crisis management, the Fed is trying to manage the unemployment rate, the inflation rate and the GDP growth rate all at the same time."
Of course, we all know what happened to centrally planned economies, but somehow, folks seem to believe that Easy Al, with his liquidity jets, knows how to handle all matters economic and financial. Folks even listen to him opine on natural gas and other such subjects, of which he knows nothing.
- More inflation lies ahead.
After reviewing the past 40 years of financial history, Grant concludes that more inflation lies in our future. (I'm sure he would not disagree that after inflation is tried, if it fails and the system breaks -- i.e., if down the road, stock prices collapse, real estate collapses, and the currency collapses -- then maybe we could see deflation.) But anyone having read this article would be hard-pressed to conclude that we're headed for deflation imminently.
I always get lathered up whenever some group of items goes down in price and folks in the deflation camp say, See? There we have it. That's the signal deflation is about to commence.
Nothing could be further from the truth. At any moment in time, any asset class or any group of asset classes may go down in price. That does not signal deflation. Deflation is when the dollar appreciates against a basket of goods and services. Or, to put it another way, in deflation, your dollar goes further -- a lot further.
Easy money deflects deflation
We have not experienced deflation in this country since the 1930s. At the time, we were on the gold standard. Were this system in place now, deflation would be a likelier event, in that dollar bills could not be dropped from Fed Governor Ben Bernanke's helicopter. Further, from the government's perspective, it's the fear of deflation -- witness what the Fed boys spewed about an inflation rate deemed too low -- that drives us toward inflation.
As I said, I am fully cognizant of the possibility that we might eventually experience deflation -- if debt accumulation, asset-price declines, and a dollar decline become severe enough to force the Fed to abandon its easy-money standards. But to repeat, that does not look like the imminent outcome.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com site. 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. At the time of publication, Bill Fleckenstein was short Intel (INTC, news, msgs) and long Intel puts. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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