Saturday, April 21, 2007

Capital Equipment Recession And Earnings At Risk

Okay, first off this might be the last post for a week or two because I will be traveling. Hey, it's free! Now to the post.

It seems economists and Wall Street prognosticators have finally awoken to the capital equipment malaise. Six months ago nearly everyone was bullish on capex spending stocks. Ditto at the beginning of the year. The thought was that capex spending would save the economy and said earnings growth expectations were ratcheted up to unbelievable 25% for 2007. I warned at the time that those expecting capex spending to materialize would be sadly mistaken. I guess people simply don't understand what is happening and they expect capex to return to ridiculous levels just like they keep betting on Oracle, IBM, GE, EMC, Cisco, SAP and others.

There are very few on Wall Street or in the press who acknowledged the capex problems before the recent panic. The only two I have personally seen are Ed Keon at Prudential and Barry Ritholtz. Amazingly, they couldn't be more opposed in their views with Keon generally being uber bullish on equities and Ritholtz generally bearish. Capex investment is at levels not seen in modern times. That would be negative levels for those who are bullish. The few who have recognized this dilemma have given reasons such as short sightedness of American business and greed of American executives. Others who have come out recently said the capex weakness is unexpected and unexplainable. Well, they may not be able to explain it but that doesn't mean it isn't explainable. None of the reasons I've seen given are accurate. It is not because American companies are losing their competitive edge.

I'm surprised that no one has hit the nail on the head. It might require a little out of box thinking but it isn't that difficult. Maybe it is because I am uniquely positioned since I've spent the better part of my life pumping billions of dollars of capital equipment related goods and services into corporations. Since I prefer to stimulate thought rather than hand everyone all of the answers, all I'll say is ponder it a while and you might come up with some reasonable hypotheses.

A data point I watch quite closely involves capex expenditures. Because I tend to use data points not generally available, I haven't seen anyone talking about it. Fine with me. The bad news is that it had the largest decline since 1973 this past quarter. While I am too young to remember 1973, I'm very well aware of 1973 and the subsequent recession. It was the worst economic slow down since the Great Depression. Many called it a depression at the time. Interestingly enough, as I have written, the early 70s was surprisingly similar to today in many terms; a powerful global expansion, a housing boom, commodity inflation, Americans questioning their competitiveness, a barrage of imports from Asia, economic malaise, an unpopular war, strife in the Middle East, economic catastrophe for American auto companies, etc. That said, as I have written before, we are likely not reliving the 1970s but the 1930s as the "great experiment".

The problem that Wall Street doesn't typically understand is that major capital investment cycles are not tied to the liquidity cycle. That is why so many economists and money managers are caught off guard with their projections. The Fed and government policy can and does incent business investment but they are not primary drivers. So, Democrats praise the 1990s as supporting evidence of their policies and Republicans cite the 1980s. The fact is neither are responsible for the growth in the 1980s or 1990s. Their policies may have assisted in some way by mostly keeping government out of the way and letting free enterprise work its magic. That is why I have stated repeatedly the Fed will not save the economy and those expecting such will be sadly surprised.

So, let's take this capex discussion a little further. What are the other variables we might gain insight into by looking at weak capex? What impact has it created? Well, what's ironic is you need look no further than what the bulls are touting as supporting evidence of their posture. Weak capex spending has resulted in artificially inflated earnings. So, while the bulls tout fantastic earnings, a primary reason is there has been weak capital spending. How great is that? With below trend investment, how sustainable are earnings over the long term? Doh! Instead companies have been investing in stock buybacks which, again is cited by the bulls as supporting evidence of their position. Let's see. Capex or stock buybacks? Which one is most attractive to you as a long term investor? Investment in the future or finding nothing better to spend your money on other than artificially inflated stock prices? Next, if earnings are at cyclical peaks not seen in half a century, how cheap are stocks? Ain't nothing cheap about these markets. Finally, while it is very hard to measure accurately, I'm quite confident corporate research and development spending has been below trend as well. But, hey, with less investment comes a rosy earnings picture. An earnings picture which is so far outside of trend that it will not last. That is not a prediction. That is a fact. Then what?

All of this begs a question. Let's take this to its natural conclusion and talk about something you will never hear from Wall Street. If you are a C-level executive in a large corporation with strong financial controls, you likely have not only heard of it but it is likely part of your finance team's mission to model it. It's called earnings at risk. The topic is too complicated for this blog to go into the detailed analysis of such calculations. But, let's take a real world result we just recently experienced. How far might broad market earnings fall in a recession and what areas are most vulnerable? Let's answer the second question first. For various reasons, commodity stocks, utility stocks, consumer discretionary stocks and financial stocks amongst others. Commodity earnings as an example are many standard deviations above trend and given the disproportionate makeup of finance industry earnings in the markets, both have a high exposure of risk. What have I constantly harped about? Highly inflated commodity related stocks, small cap stocks, consumer discretionary stocks and financials. Given the minor recession on 2000, we saw earnings fall approximately 40% in the S&P. With this cycle's imbalances would earnings at risk be 50% across the board for equity markets? In other words, without going into lengthy analysis are market earnings of commodities, financials, etc at risk comparable or worse than technology in 2000? I don't believe that is unreasonable without grinding through calculations. If so, the S&P PE at risk is higher than 1929 and the small cap index PE at risk puts it higher than technology in 2000. What I'm saying is earnings at risk is a much better data point in this cycle than current price to earnings ratios or projected ratios which are simply trend following calculations any twelve year old could calculate.
posted by TimingLogic at 3:20 PM

Thursday, April 19, 2007

Is A Stock Market And Commodities Correction Coming?

Let's take a quick pulse of the markets. While we have had a positive bias over the past month, it has been weak by many measures. The oft watched market internals such as new highs and advance-decline line look reasonably okay but the NYSE internals have become very misleading anyway. Too many bond-like instruments, ETFs and international ETFs are now traded on the NYSE. In addition, the advance-decline line can be very misleading. If stocks have a larger daily range on up days versus down days, the advance-decline line can and does remain negative for years regardless of whether markets are rising or falling. Be that as it may, the market doesn't appear unhealthy looking at these data points.

Looking underneath the hood there are quite a few flags in the market. Regardless of what is being said in the press, I don't see an enormous appetite for risk. Traders are positioned very defensively. The only place I see insanely bullish action is in the uranium, steel and some grain markets. To look at the uranium market, I see a repeat of copper and oil mania into May of 2006. Is this a second major commodities top setting in for a correction? Are we about to see another leg down in oil? Uranium is definitely going to crater at some point. $7 to $125 a pound is simply stupidity. Or, if you are a trader who has been long that market, it is a thing of beauty. I'm not saying uranium isn't an interesting investment long term. But, at this price I guess those traders without a degree in nuclear physics don't realize there is something called economic substitution. Thorium is much more widely available, cheaper and substitutable should nuclear fuel technology continue to advance. In other words, this move in uranium is solely driven by traders anticipating future demand. It takes the better part of a decade to get approval and then build a nuclear power plant. While we may see substantial nuclear power growth in the future, is a move from $7 to $125 warranted?

The new data point of the day for the deliriously bullish is shipping rates. The global economy must be great because shipping rates are up. Maybe. But, what they fail to tell you is we have also seen shipping rates crater each time they have reached this level in this cycle. That was followed by stock market corrections. Hmm. I guess they forgot to tell you that small point.

So, with the market risk profile looking a little shaky at best, coincidentally parabolic moves in some commodities and China's re-established run of credit card investing, are we setting up for another May correction? Much of what I model tells me yes but that could change. I doubt it but we just have to see how the next two weeks play out.

Let's take a stab at another short term prediction and pick three possible market reversal dates: April 20th (lower odds with options expiration), April 21st and May 5th. Since the 21st is not a weekday, let's substitute the following Monday, April 23rd. If I were a betting man, and I'm not, I'd go with May 5th. Let's wait and see.
posted by TimingLogic at 11:25 AM

Tuesday, April 17, 2007

The Great (W)Mall of China

There is a story on which highlight imbalances in the Chinese economy I have been focused on for the past few years. Click here to read it.

The article highlights something I have said so often I feel as though I am going crazy by repeating it. Economic central planning by corrupt communist politicians playing favors is creating a mess like we have never seen in modern times. Again, as I've said, the world is focused on the U.S. real estate debacle but there is likely a mess just as ugly in everyone's own back yard. There certainly is in China.

Although, I guess I could argue the mess in China was also created in the U.S. It was created largely by American consumption of Chinese exports.
posted by TimingLogic at 7:47 PM

Monday, April 16, 2007

Is This An Exhaustion Run....Part Two

Back on March 23rd I posted a short term projection for the S&P 500 to retest its prior highs to the upside with a double bottom micro pattern. Today, nearly all of the indices accomplished that move. The Nasdaq 100 has yet to do so but it is so close I expect that to happen today or early this week. Two for two on short term projections over the last few months so maybe it is time for the markets to embarrass me. If one takes a look at the macro pattern on the daily chart, one could argue the S&P will retest its 2000 highs over the next few months. Patterns aside, this is the weakest rally in years so the bulls will have to earn their money from here. It is interesting to note that over the last year, as we've made higher highs in the major indices, we've had less and less participation from individual stocks and sectors. This is consistent with expectations of any bull market as speculative stocks typically peak before the last rally of any bull cycle. Penny and pink sheet stocks were off the charts with speculative fervor in early 2006. Since then, many leaders of this cycle including coal, oil, home builders, natural gas, mortgage related companies, specialty retailers, etc, have all failed to participate substantially for some time.

As I mentioned a few months ago on the precipitous drop in late February and early March, my intermediate model remained invested on the long side. So, we have a situation where my long term model is defensive or in cash and my intermediate term model is still invested on the long side. Does that seem a little odd? It should but let me explain. My long term model is based on the broad market. My intermediate term model is a trading model based on the S&P 500. So, it really does make sense. The rallies have narrowed considerably and the S&P is typically a strong late stage performer as money rotates into large capitalization investments. Where do we go from here? That's a good question. As I mentioned early this year, I would anticipate a "new" date for the end of this bull market to be September. Does that mean we rally into September? Maybe. Does that mean we start to correct from here and eventually rally into September? Maybe. No one knows exactly what will happen or I'd be picking the next winning lottery ticket. It is simply a guesstimate. But, as I mentioned in the earlier "Exhaustion" post and in this post, this has been a very weak rally and after filling these gaps created on the downward slide a few months ago, I would be very concerned about an ability to drive much higher without more participation.

Picking tops is like winning the lottery but attempting to understand cycles is a passion of mine. There is a time based component to making market projections and those are very difficult because no one clearly understands this dynamic. In other words, prices are a function of time and other esoteric factors in my estimation and have more to do with the mathematician Rene Descartes and less to do with economics. That is why economists and their projections are typically poor indicators of stock market returns.

posted by TimingLogic at 10:03 AM

Thursday, April 12, 2007

Goldman Sachs Is The Proxy For This Market

If ever there was a proxy for this bull market, it would be Goldman Sachs. Basically anything to do with a liquidity induced economic rebound is in Goldman's portfolio of capabilities. Goldman is a money making machine. Commodity trading; mergers & acquisitions; private equity; services to hedge funds, trading groups and mutual funds, etc. Buying into Goldman's stock gives someone access to all of the assets and sectors that are booming this cycle. Goldman's stock itself is almost the perfect asset allocation model for this cycle.

Let's take a look at Goldman's chart below. Before we do so, a little bit of history. There are three notable dates in Goldman's past. The first IPO in 1906 right before the market collapsed and fell 50% in 1907, the 1929 creation of Goldman Sachs Trading Corporation right before the stock market crash of 90% and the Great Depression and the second IPO in 1999 right before the tech fall of 80% in 2000.

Are there any parallels to Goldman Sachs Trading Corporation of 1929 and the proprietary trading Goldman has ramped up over this bull market? Goldman Sachs Trading's market value went from $500 million to $10 million after 1929. Is Goldman's management more savvy today? We tend to believe we are smarter than generations before us but that is simply inaccurate. Human intelligence has not progressed since 1929. Frankly, there is no evidence innate intelligence in humanity has ever increased. We saw just seven years ago that Wall Street isn't any smarter than they were in 1929. Is there any parallel to Blackstone's slated IPO this year and Goldman's IPO in 1999?

Remember, there is a little bit of luck, a huge amount of ego and a little bit of savvy in the corner offices of every corporation. Goldman is no different than any other company. Senior executives start to believe in their own invincibility and brilliance as we saw in the technology companies of the late 1990s. Society starts to believe these executives are brilliant as well. Some are. Most are not. Are the three historical dates cited above a sign of Goldman's savvy or egomaniacal mistakes made at the height of society's irrational exuberance? Were it not for Goldman Trading's decimation and ruinous effect on their reputation post 1929, I would say it was their savvy. But, given their debacle right before 1929, I lean towards ego and irrational exuberance. Is Goldman about to repeat history? What are the executives in the corner office at Goldman really thinking? We'll never know. I recently saw a comment that Goldman was levered to the hilt in markets and therefore we were not near any type of top because they are "smart money". Historically, that appears inaccurate. Time will tell if this time is different.

Let's look at the chart for some clues. Remember, charting is not a science but an art and chart patterns can and do resolve themselves differently than expected. So, my first rule of charting is never to be wedded to a particular view. The second is to use it as a decision support tool not a primary tool. I've drawn a few patterns on the chart. Since Goldman's IPO in 1999, the stock initially collapsed into a bullish falling wedge. That wedge was resolved to the upside in 2003 into a rising channel. Since then Goldman has been in a rising channel and performed quite handsomely. Recently, Goldman broke through the rising channel into what appears to be a potential false breakout to the upside. The Brave New World crowd is likely playing in the stock now. Encompassing both the falling wedge and rising channel patterns is a longer term bearish megaphone pattern. Longer term patterns trump shorter term patterns. So, unless Goldman resolves itself outside of these set ups, it may be headed for a very unpleasant future. The stock is facing formidable resistance at both the rising channel and megaphone trend lines. Over time the stock could ride these trend lines higher but I'd be very suspect of any sustainability beyond these trend lines. Stocks typically have an upward bias over the longer term but we are in a cycle where that is not a forgone conclusion. Just at the time when Goldman has achieved cult status, are they peaking?

Well, if my longer term thesis is accurate, investors in Goldman are in for a rough ride. One can imagine what that means for the assets and equity sectors that have performed so well this cycle.

posted by TimingLogic at 10:24 AM

Tuesday, April 10, 2007

The Yuan Dilemma: Hammers, Nails and Ridiculous Policy at the U.S. Treasury Department

"When the only tool you have is a hammer, you will see every problem as a nail."
--Abraham Maslow, Psychologist

The world, and most specifically the U.S., is pushing China for reform on many fronts. So far, China has resisted outside meddling as any country would. Will a global slow down speed up China's reforms as a matter of necessity or will we see the unthinkable happen at some point; that being a trade war? While that seems to be a low probability scenario today, the world dynamics are very imbalanced and will likely get worse.

This week I see where Brazil is the latest country to voice concerns about China's economic policies. Brazil's trade surplus with China has disappeared and enthusiasm for trade with China is turning to concern about China's mercantilist export practices. Many in Brazil are now supposing trade with China will continue along the lines of raw material exports exchanged for finished good imports. This is not what Brazil had envisioned. Similarly, the European Union has already taken an aggressive stance with China and the U.S. has finally slapped China with import tariffs after ridiculously attempting to negotiate intellectual property, economic, American business ownership, trade and Yuan reforms for years on end. The time for talk was before China was supported as a member of the WTO. It is obvious China understands nothing, if not action. Why so? China's internal problems including chronically weak domestic job growth is more important than accommodating the rest of the world through potentially destabilizing change. While the wheels of social consensus turn very slowly, I believe we are moving towards a scenario where China may become an pariah across liberal economies unless their own economic policies undergo significant liberalization. Policies which, ironically, would positively impact the Chinese and global imbalances but surely contribute to the demise of Chinese communism.

As I've written, the current account surplus in China shows many similarities to that of the U.S. industrialization pre-1929. It appears the U.S. was willing to fund exports at nearly any cost to drive domestic growth similar to that of China today. Eventually, the U.S. suffered disproportionately for such a policy. The Great Depression in the U.S. was substantially worse than much of the world. There is some reason to assume much of that was because of disproportionate export related industries. Sound familiar? In hind sight, central bankers blame such economic malaise on tight money policies of the Federal Reserve. They may be right. But, there is a part of me which believes central bankers are confusing a little bit of correlation with causation. In other words, historical revisioning is a dangerous and unreliable method of determining causation but remains a common practice of economists. Faulty science. To be fair, economics cannot be tested in the lab but rather is tested in the real world through fiddling and fudging with the world being its test environment. Feeble attempts to model human behavior with computational analytics is far from matter of fact and an example of murky science. Post 1929, when the Federal Reserve began stimulating through loose money and the government attempted to create jobs through social spending, the U.S. economy remained mired in a tremendous funk until World War II. Similarly, today, government spending and loose monetary policies have left the U.S. economy in a state of malaise post the 2000 stock market crash. Why would one consider the malaise of post 1929 to be any different when China's industrialization bubble breaks? To the contrary, as I've written, I would fully expect China to experience their own funk of some sorts as every major economy has at some point in their industrial development.

We really are in somewhat of chartered waters with such an enormous economy impacting the global economy. The last time the world was impacted similarly could be compared to the U.S. industrialization leading up to 1929. That was not a positive experience or positive outcome for anyone. Correlation or causation? We'll find out at some point.

The U.S. Treasury Department's response to trade imbalances is comparably ridiculous. Jaw boning about a Yuan revaluation or a free floating currency is like trying to kill an ant with a ton of dynamite. Or, when the only tool you have is a hammer..... In other words, Secretary Paulson would have more of an impact going on a fishing expedition with Chinese officials than being publicly shamed by said officials in the Yuan debacle. As the needs of China to add somewhere north of 8 million jobs a year to keep the unemployment rate from increasing, the need to drive more and more exports in order to maintain employment will become enormous comparative to global economics. That means China's imbalance with the world could grow significantly larger if unchecked. Without domestic reform required to consume much of this economic output, raise domestic wealth, increase demand and wages, the world and China are likely headed for a day of economic reckoning very few are talking about. Global leaders are already getting an ear full from a populace which has not generally benefited from globalization and the buzz has the potential to turn into a roar at some point. Why? Because the trend of the general populace suffering through globalization will not improve until emerging economic powers adopt serious reform or the world economies launch into a new period of business innovation. Which will come first? Reform or innovation? Yuan revaluation as a policy is using a hammer to drive the proverbial all encompassing nail.

Finally, I am very dubious of the theory associated with currency revaluation as it pertains to balance of payments and economic re-balancing. It requires an elasticity of imports and, more importantly, exports that I don't believe exists in the world today. This comes back to my supposition that the trade imbalances are partially a result of an unattractive export mix of products that has led to its creation. "Gross Imbalances" as I wrote about a few weeks ago. Since the dollar peaked seven years ago, the only thing the j-curve seems to stand for is "j=joke". Was the strong dollar and associated U.S. economic expansion and wealth of the 1990s some how inferior to the weak dollar stagnation and malaise of the last seven years? In other words, what has a substantially weaker dollar brought to the imbalances dilemma? Something is probably going to break at some point and there is likely nothing anyone can do to stop it. In the end I view that break as an opportunity but when and how it happens and the negative consequences will be felt by most everyone across the globe. Human nature is to ignore problems until they become crisis. Plug human nature into a computer and model its economic impact. Devaluing the dollar, in particular, or revaluing the Yuan, could actually exacerbate the imbalances by reducing the dollar value of American exports while doing nothing to stem the flow of what would be more expensive imports. Wouldn't that be nice?
posted by TimingLogic at 8:59 AM

Thursday, April 05, 2007

Sam Zell's Comments After Tribune Purchase

One more post before the holidays. Not what I expected to post but there is no lack of material just lack of time. I find Sam Zell's comments on Wednesday regarding the Tribune purchase to be very refreshing. Zell made three comments which yield clues as to the long term success of the wily real estate billionaire. One was that content is key to success with this purchase; two is that he isn't interested in cutting his way to properity; three is that his purchase is a long term investment.

In today's world of quarter-to-quarter Wall Street psychosis, we are reminded by Zell's comments that kowtowing to Wall Street's mentality ultimately results in failure. Failure for the obvious reasons. One, a short term focus typically results in lack of long term strategy and long term investment. ie, Win the battle, lose the war; two, content in any business is a function of intellectual capital. I don't care whether that is an auto company, a newspaper, a real estate company or an oil company. While oft quoted as cliche yet seldom truly understood by CEOs, employees actually are the most important asset of any business. While there are many times extenuating circumstances or failed policies of prior leadership or aggressive bets on new business gone awry, the reality is job cuts are one of the most easily measured indicators of a CEO's failed policy. It's nice to see there are still brilliant leaders out there who inherently understand this.

Much of success in life is based on calculated risk taking and being in the right place at the right time. I have no doubt Sam Zell has other great qualities separating him from his competitors. Frankly, this is likely the reason Zell's bid was accepted over more lucrative offers. The sellers likely wanted someone who was interested in building upon their successes rather than making a quick profit at the expense of building a long term franchise.
posted by TimingLogic at 9:59 AM

Monday, April 02, 2007

Sam Zell Buys............Tribune Or "Content"?

This may be my only post this week because of the holiday and travel. Maybe one more interesting post I have queued up if I can get to a PC later this week.

Sam Zell, the real estate billionaire, just bought the Tribune Company. While the Tribune is recognized as a newspaper company, they own other content franchises as well including television. This at a time when newspaper companies are considered dinosaurs by many including those who work in the industry. Newspaper stocks have been going down for years yet newspapers are still very large money makers. There was a very interesting article at The New York Times online in February about a Norwegian business newspaper that had successfully transformed its business model to include very significant success on the internet. The link to the article is here; While Others Struggle, Norwegian Newspaper Publisher Thrives on the Web. You have to sign up to read the article but doing so is free. It has been over a month since I read the article but as I recall the CEO brought in alot of fresh thinking from nontraditional sources including McKinsey. One must be willing to think outside of the box and newspaper editors and owners have been too rigid in their thinking. McKinsey, IBM, Booz Allen, Accenture, etc are companies who thrive by unleashing creative destruction. They live every day to turn client's business models on their head through transformational change. Newspaper minds aren't exactly experts at doing so or taking calculated risks. Eventually, all successful content providers are going to figure out how to make money on the internet. I can imagine a tremendous amount of opportunity for the New York Times that is not being exploited today. That includes video content and many new ways at exploiting their brand and advertising revenues. I'm not sure why it hasn't happened but it will.

The battle for net supremacy has not even begun. We are still in a stage of extremely crude development and applications. I wrote on here some time ago that the internet comparative to business network and intranet development is by some measures decades behind. And, that future development of the internet could, and likely would, follow some measure of technological development of the corporate world where technology is typically deployed first. In other words, very little of what is considered new technology when rolled to the consumer is new. Streaming content, distance learning, collaboration, social networking and search are five examples of very old technology yet all are just gaining traction on the net. Just a few examples of many.

So, to prematurely declare Google and Apple winners in this marathon race is very foolhardy. Neither own any content and provide low value-added capabilities. At some point, their business models too will require transformation to remain relevant. When content providers respond, the landscape of the net could be very different than what we see today. Google and Apple might be playing defense and find that teaming with content providers is required to survive. This is why I've long argued Google blew it when they hired a lab guy to run the company. It should have been Barry Diller who is one of the most brilliant content minds on earth. Marry that ability with the nerds who founded Google and you have one hell of a formidable force to build a long term business model around content.

Sam Zell's move may simply be an attempt to buy an undervalued asset, ie newspapers, or it may be that he and other investors see the true potential of a mispriced asset, that being content. Some may ask what a real estate developer knows about newspapers. Well, ironically alot. In Zell's world content is extremely analogous to the three keys of real estate success: location, location, location. You own the location and you are nearly guaranteed success. In the future, those who own content will nearly be guaranteed success. What's the difference between content and location? It's the same concept using different terminology. In the long run content will be king.
posted by TimingLogic at 10:06 AM