Investment Strategy
by Jeffrey Saut
“A New Queen Bee!?”
“By the time a queen bee is five she is old and no longer reproduces, leaving her army of honeybees torn between loyalty and survival. Since the hive cannot survive without a productive queen, the beekeeper reached into the hive with a long-gloved hand and squashes the enfeebled queen. With the entire hive as witness, all know the queen is dead. Absent the scent of their leader, the honeybees panic.
But the beekeeper is prepared, having ordered a new queen from a bee breeder. Arriving in a two-inch-long wooden box with a screen at the top and bottom, the queen is accompanied by a court of six to eight escort bees who care for her every whim, cleaning and feeding her, removing her waste. At one end of the box a tiny piece of hard candy blocks access to the queen. When the box is inserted into the hive, the first instinct of the worker bees, who immediately know she has the wrong scent, is to kill the new queen. The workers struggle to reach her, but are blocked by the candy. Soon they become diverted by the sweet, and over the two or three days it takes to eat through it they succumb to the enticement. Their fealty is won. All hail the new queen bee.”
. . . “Three Blind Mice,” Ken Auletta
Something similar to that “queen bee” sequence could be happening currently. The “old queen” has been interest rates. The “new queen” may be “money” as the Federal Reserve added $36 billion to the nation’s money supply (M2) last week. This is not an unimportant point, for under the guise of “tight money,” fostered by higher interest rates, the Fed has recently been increasing the money supply. Unfortunately, Greenspan & Co. did away with the broader-based M3 money supply figures, so it is difficult to calculate the leverage the Fed is introducing into the economic system. Suffice it to say, if M2 increased by $36 billion M3 should have increased by a greater amount. Whether this liquidity injection is in response to the worrisome real estate environment is unknowable, but our real estate research team is clearly worried, as suggested in their recent note. To wit:
“We continue to be troubled by the weakness in the housing sector and the risk it represents for the economy and the equity markets. The housing data continues to get worse, with inventory levels increasing again, for the most recently available data which was July. We expect more of the same for August as the data rolls out over the next two weeks. We aren’t ignoring the fact that economic growth continues to be relatively sound, or the likelihood that the Fed is near the end of the tightening cycle, which lends some support for the equities market. But investors should be aware that historically housing cycles have been predictive of general economic health and currently the housing cycle is decelerating at a much greater rate than we anticipated. Inventories of homes for sale in numerous markets around the U.S. are soaring as new and existing home sales continue to slip. On this backdrop we are recommending a more defensive investment posture and recommending a decrease in the allocation to equities.
(Further) we have been surprised by the reversal of fortunes in the bond market over the past two months as the ten-year yield peaked at about 5.25% in late June and has now fallen to the 4.75% level. We note that over this period yields for corporate and junk bonds have fallen while spreads have generally widened. With yields widening, we believe this is more of an indication of a market retreat to safer ground, vis-à-vis equities, than a market breathing a sigh of relief that the interest rate pressure from the Fed may be subsiding. Said another way, we believe the bond market is also sending very cautionary signals, at this juncture, with regard to the outlook for the economy. We would be making adjustments in fixed income at this juncture as well, modestly adding to fixed income positions.”
Cleary, the battle lines have been drawn on the “street of dreams” between the bulls, bears, and boars (we are a boar), a point excellently reprised by the insightful folks at Tocqueville Asset Management (
www.tocqueville.com) in an article titled “Moralist or Visionary?” Tocqueville points out that the Moralists believe the economic resilience has been built on an increasing mountain of debt, creating unsustainable imbalances. Simply stated, they think the U.S., as well as the global, economies have stolen growth from the future so that a period of sub-par growth, or recession, is inevitable. They also note, “what we have today is ‘biflation:’ the price of what China buys goes up and the price of what they sell goes down. Meanwhile, ‘average’ inflation, as reflected in the popular indices, seems to go nowhere.” To the Moralists, the credit bubble that has been created, and found its way into financial assets and housing, cannot last so there is no escaping the day of reckoning.
The Visionaries, who have had a tendency to identify future trends, believe that the revolutions in communication, computing, and other technologies, when combined with accelerated globalization, have ushered in a “Brave New World.” Nearly three billion new workers added to the world’s labor force, from previously “closed” economies (China, India, Russia, etc.), suggests that Schumpeter’s “creative destruction” will give birth to new industries while destroying older industries. This process has been accelerated, they note, by the ubiquitous technology revolution that multiplies man’s intellectual strength, just like the industrial revolution multiplied man’s physical strength. Such convergences bring jobs, boost incomes, and create more consumers as the increased demand, not just for oil, etc., but for new technologies and consumer goods, “pulls” the world economy forward.
Tocqueville concludes by suggesting that the views of the Moralists and Visionaries are not necessarily irreconcilable, but rather a question of time horizon.
“The global economy may have changed long-term course (for the better) as a result of globalization and recent technological revolutions, but that does not mean that traditional cyclical influences and patterns have been eradicated. . . . In our global environment of unprecedented leverage, there is no lack of candidates to precipitate the next financial crisis and, in a weakening economy, very possibly a recession. But, as Warren Buffet reportedly said: ‘you don’t know who’s swimming naked until the tide goes out.’ We may actually have entered a ‘Brave New World,’ but it is a safe bet that it will still have tides. For the moment, (we) would rather stay onshore and full dressed.”
The Tocqueville article was by far the best read we encountered during last week’s “dullsville” environment, not just because it concurs with our “boarish” market stance, but because the author (Francois Sicart) lays out both sides of the bull/bear argument, consistent with our view that it is a mistake to be overly bullish, nor especially bearish. As for the best chart of last week, it has to be from our friends at Credit Suisse who wrote:
“Currently, growth stocks are trading at a discount to value according to a key valuation measure, price-to-cash flow, for the only time in the past 30 years (as can be seen in the nearby chart). Large-cap growth stocks are currently priced at 12.8 times cash flow, in-line with the historic average. The present price-to-cash flow multiple for growth stocks is actually lower than the 13.6 multiple awarded to value stocks, notwithstanding the historical premium typically afforded to growth. Many other ratios tell a similar story, including P/B, P/E, DY, and Price to sales.”
Click here to enlarge
Hereto, this is consistent with our view that “growth” is cheap and that large-caps, not mega-caps, should be favored.
The call for this week: Mark Twain once said, “October: This is a peculiarly dangerous month to speculate in stocks. The others are July, January, September, April, November, etc.” While cute, Twain’s notion is questionable since September is statistically the most dangerous month for stocks. Nevertheless, last week’s “liquidity injection” found it way into stocks, leaving the DJIA above its July and August reaction highs. We have suggested this might occur and even proffered that the Dow could make a new all-time high (above 11722) totally unconfirmed by the D-J Transportation Average, or various other averages. Moreover, while we got a short-term buy-signal from a number of our indicators last week, we also got a sell-signal from our volatility indicators as the environment becomes curiouser and curiouser. Consequently, it will be interesting to see what happens this week when the “pros” return from the Hamptons. In the investment account we continue to over-weight non-economically sensitive themes like education and large-cap technology growth (like RFID, homeland security, GPS, teleconferencing, healthcare, water, entertainment, etc.) as we ponder the question is this just a mid-economic slowdown, or something more?!
September 4, 2006
