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THE BLUE MONEY REPORT.
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The Blue Money Report
"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning. "
~ Henry Ford
Welcome to the Blue Money Report
Today's Commentary: 11.04.02 There is a point, according to the late Dr. Per Bak, when you can do no more, where the existence of a power law becomes a surprise. In mathematics, a science that attempts to predict what will happen next, the state of criticality, the point when things can change, be it imperceptibly or catastrophically, becomes the most difficult to determine.
The economy, the markets, and the politics surrounding us, are all at critical impasse. We have reached a moment in time, so singular, that the next movement could mean nothing, or everything.
I took one of my wife's Halloween decorations before she could store it away and attempted to determine what will happen next. What this glass object told me was nothing short of equal to what the economy, the markets, and the politicos in Washington have been doing.
The Economy
Let's talk about the top player, the most recognizable name, Mr. Greenspan. I have wondered in past columns if he has any economic wizardry left in his magic bag. He seems to be looking at the same information that is generally available to all of us, and seeing something we have missed. He believes that the economy is pushed forward through productivity. This idea was initially thought and proved by those folks that back his words with facts, that technology, mainly information systems has improved what the average worker can produce. Of late, this increase in worker output, has come at the hands of less workers doing more work. Capital spending within companies hasn't responded to monetary policy leaving me to draw one conclusion. Increases at the expense of decreases are a form of cancellation. If it took two workers eight hours to produce a hundred units, and now, with cost cutting by companies reducing the labor force to one, and that one now produces 60 units in eight hours, his output is up 20%. But the company has not increased production with this maneuver, it has decreased total production by 40%.
Perhaps not the best of analogies, but one that is not lost on the lone worker, or the one who was displaced. I hesitate to use the terminology unemployed because often, these employees are lost through attrition, or relocation, and some to the unemployment lines. The figures on unemployment continue to stay below 6%, which is seen as not that bad. Unless of course you are unemployed.
Back to Mr. Greenspan. His case for technological advancements aiding in workplace production came with the continued business reliance on the computer, the internet, and e-mail. The focus on output and productivity simply skirted the issues facing many businesses today. The stagnant environment most industries find themselves in shows that the current liquidity and the low interest rates have done little to bolster anyone's spirits.
This is a cause and effect of deflation. It has been pointed out here, and at length elsewhere, that the power to price a product at its worth and to produce a profit is under severe stress. That stress is deflationary. Rate cuts in all likelihood will not get companies back into the mood to spend. They still see demand for those sixty units produced by one worker, and purchased by consumers who want to pay as little as possible, as an unprofitable way to conduct any operation. With the labor savings, they are finding themsleves closer to profitability. Granted, the deflation is mild by historic standards, but it is still there.
Just ask the consumer. I hesitate to point to the Consumer Price Index as the tell all of what the consumer is thinking. Go to the mall and you will find the consumer out there in droves. There are bargains to be had and when that happens, customers will come into your store and purchase. Or are they falling into a deflationary mentality? Could it be that shopping has become a wait and pounce activity operating under the belief that whatever it is they are looking for, in all probability might be cheaper tomorrow?
Are those at the end of a company's purse strings expected to act differently? No Mr. Greenspan, they are not. They have found a state of criticality within their businesses, and for the consumer, within their pocketbook. One more purchase could send the current state of tenuous balance off kilter, creating an imperceptible movement or an economic avalanche.
The GDP number and the latest unemployment figures were released on the last day of the month and as expected the economy is growing, as long as interest free cars are available, which is a little like borrowing from Peter to pay Paul. Reign in those numbers as car companies did in October, and sales will drop dramatically. Unemployment moved in the wrong direction based on expected guesses.
But don't count on the Treasury Secretary Paul O'Neill to spin this as anything but good news. He has gotten into a real rhythm when it come to commenting on the state of economic affairs. This man has consistently seen something in the economy that the aforementioned Mr. Greenspan, the nations chief economist, has failed to observe. The indicators that he is interpreting as he speaks across the country point towards trouble, unless interpreted by Mr. O'Neill.
Our Prediction: The economy will continue to grow... slowly. It is on good footing despite efforts by the administration to trip it up. The Fed will lower rates once again and this will not have any real effect. We will experience more deflationary pressure while companies keep inventories low, learn to live without much more than a skeleton of a workforce, and increase capital spending only to replace machinery and equipment that has become obsolete. This last item will be misread by many people as a return to spending by companies. I doubt it. The customer just isn't there, even though the price is probably right. Mr. Greenspan will cut rates to 1.25% even as he increases the money supply to record levels.
The Investment Market
Most of the markets have been cooperative with bullish sentiment. The stock market has seen a lot of pension fund managers buying into what they perceive as a market bottom. Mutual fund managers are sitting on an awful lot of cash, some as much as 3-5% of their portfolios. Making their money do some work is part of the reason that we have bounced off the lows and finished October with strength.
Asset allocation from many of these big institutional investors will increase significantly over the next six months. This influx of cash will do nothing but good for the look of the market indexes. But will their be any underlying difference in the stocks they are buying? Not really.
Profits will continue to sour, but only slightly, before picking up next year. Beating pathetic numbers is always easier. As long as growth comes at the expense of the worker and not because of any fundamental change in the business cycle, the illusion of efficiency will increase as many investors will be left wondering if they missed the jump in point.
Consistent and even investment will serve as the best method over the next six months. The stock market will be roiled by our entry in to the Middle East and will not recover significantly for six months after any conclusive outcome. Should the outcome be less than conclusive, the distraction will keep investors out of the markets. Low volume will equate into volatility. Does this mean you should move out of the markets? Not at all. If you are invested at least in the 65 to 68% range, with the remainder of your investment divided evenly in fixed income and cash, you will and should be all right. In fact, you probably will come out of this smelling like a rose.
The bond bubble is real and has been heading for exactly this point in time for twenty years. If you are not in fixed income, you should probably stay away. The top has been reached and now is the most attractive moment for investors. There is just too much risk in junk and too little return in Treasuries.
The housing bubble although, is not real in the same sense. Homes will continue to sell although not at 2002 levels, but the market for shelter will still be strong. But REITs are another matter altogether. The number of vacancies is climbing.
When most investors think of REITs and real estate, they think locally in terms of their own homes. But the companies involved in real estate trusts are more likely to have invested in commercial properties. When business is hurting, it is the properties that take the hit. First the market deteriorates followed by the amount of money landlords can charge for rental space. This has been going on for the last several years.
But when these trusts start to pull back on the amount of payable dividend, then the trouble is more evident. There is however, a break even point, which is getting closer and is becoming more worrisome.
REITs are exempt from corporate income taxes and as result pay larger dividends. When a company sees a drop in occupancy, it determines the point at which it will effect its dividend payments. For the first nine months of this year, that dividend has averaged around 7% according to the National Association of Real Estate Investment Trusts. Compare this to the dividends paid by the companies in the S&P 500, which pay just shy of 2%, and you can see why investors have suddenly taken notice.
When the market bottoms out on REITs, investors are just as panicky, if not more so than with equities.
Companies within funds that hold REITs have only three options when their cash flow is hampered by diminishing cash flow: cancel dividend payments, sell properties or borrow money to pay them. In each of these scenarios, the investor feels the short fall first. Canceling dividends eliminates investor trust. Selling properties in an already depressed market means earning shortfalls and possibly charges taken in the following quarter. Borrowing is similar to creating debt to pay off debt in the Peter to Paul method.
If you own REITs because they have been good performers, you probably have gotten everything from them that they have to offer. If you are familiar with the companies within your fund (and owning them through a fund is the only way to go because many are small companies with limited exposure) explore the percentage of occupancy. Many of these companies will start seeing trouble when their rates of occupancy falls close to or below 90%.
Some things to look for when buying a REIT fund include: Excellent longer-term returns. This can help a fund weather sudden downturns which might be on the horizon. A talented, experienced management team is a must and the costs should be reasonably low with small investment minimums and reasonable expenses. Some funds in this category tend to be risky and the reason for this is their method of investing. Watch out for funds with concentrated portfolios that can lead to day-to-day volatility.
Our Prediction: A 70% exposure to stocks, with large caps making up the lion's share should be a healthy way to greet the new year. The big companies have been battered pretty good of late and their recovery is a safe bet. The biggest growth will come from big caps that have found themselves trading as near mid caps. Once the top companies have recovered, these middle sized companies will be seen as inexpensive investments and expansion vehicles for those with solid stocks for trade. Small caps have seen their day, which is a good sign that the bears may be looking to hibernate. But politics will make most of your investments seem like bottom fishing. Washington will continue to seize the stage, making investing very difficult indeed.
The recent rallies are not necessarily a welcome mat for the bull, but rather a rug that the bear can sleep on while the bad news works its way through the system. This would not be a good time to lump sum invest with cash sitting on the sidelines, but rather use the trickle method, or dollar cost averaging to better involve yourself. There will be plenty of bottom from here as the current rally peters itself out at around Dow 9000.
The Politics
There will be no change in the tax policy, one of the two policies President Bush fully embraces. The economic effects of this follow through will be devastating to the next administration in 2004 but by then, Mr. Bush will have blazed a successful transitional path into the role of ex-President, private citizen, and friend to all those who have stood beside him and behind him monetarily.
His vendetta against Iraq and his posturing on the world stage as a mob boss whose is hell bent on taking the ruler who placed a "hit" on his father is being underplayed. The real threat of weapons of mass destruction is the primary reason and this go it alone stance will see us at war in the next twelve months. That may not seem to be much of a prediction, but I really believe that we will still be at war when I update this next November. The only difficulty is with whom, as additional leaders will vent their distaste for American aggression on behalf of the world's safety.
The bad economic news will continue to drift from those agencies that monitor these pulse points and the appointed secretaries will trot out their optimistic spin on these numbers. Phrases like: "showing signs, real growth, optimistically favorable, and positive outlook" will permeate many a speech given from the administration concerning the economy. Mr. Greenspan says productivity and the whole of Washington points towards this as the beacon of full recovery.
I do realize that unemployment will lag behind as the recovery progresses, but to steal from football, these will only be one yard gains. By mid year, we will be wondering why we are going for the first down on fourth and long yardage.
Mr. Pitt, whose head we called for numerous times immediately after his appointment as chairman of the Security and Exchange Commission, and who Mr. Bush points out so eloquently to Congressional leaders recently: "you all voted unanimously", will still be Wall Street's top cop in twelve months. Provided, of course, that he can keep his mouth shut and finish that crash course in spin that he just hasn't had time to concentrate on in light of the breakneck pace of chaos that his office has become. Mr. Pitt can only hope that war will provide adequate distraction.
The state of criticality has reached the White House and the change will not be imperceptible. It will not go unnoticed by Wall Street, and the economy will need to brace for more than the simple displacement of the current trend. When I first heard about this theorem of criticality, it was described as the sand pile that forms at the bottom of an hour glass. According to Dr. Bak, this pile will continue to grow and grow until the next grain of sand causes a landslide.
We are almost there.
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