We have just had two days respite from a very tough year. That's been pretty much the pattern. It was the same pattern in 1994. We know that more money got vaporized in the last couple of months -- more than $50 billion alone at Schwab -- than got lost in all of 1994. But we have to draw the comparison because then, as now, it's the Fed that is behind the turmoil. Believe me, if the Fed weren't tightening, we would probably be at Nasdaq 6000, but we would also be setting ourselves up for Nasdaq 2000.
Again, all you have to do is recall what happens when there is no responsible Federal Reserve, as was the case in Japan in the 1980s. In Japan, there were so many years like the time between November of 1999 and March 10 of this year that everybody borrowed money to cash in. It was considered sinful if you didn't. They are now 10 years into a recession and they still have terrible consumer spending. Their industries are now being beaten by ours. Their growth is stunted. All because for five years they had what we had for five months. It's not worth it.
In 1994, we had a dozens of days where we got a weak number or two and felt we were out of the Fed's crosshairs. And then we would get a strong number and think, "What were we doing, dreaming? The economy is still way too strong." Now, of course, short rates are much higher now than they were then, but the Fed has always shown resolve in taming inflation and this time will be no different.
I penned this series about 1994 because I don't want you to be faked out the way I was faked out so often that year. I want you to learn from my mistakes. I want you to avoid the losses I racked up. And I still had a good year that year, so it is possible to figure this stuff out. I have received many thanks from people who started controlling their finances in the last five years and missed 1994. So I wanted to delve back this weekend to talk about the part of the series where I made most of my mistakes, where I got it wrong! What's my motive in knocking myself so you can learn? How about this: I want to be relevant and I want to be read. To do that I have to offer a value proposition. Here it is.
Let's get down and dirty. What didn't work in 1994? What killed you? What would occasionally rally and then just fail and cut your heart out? What was a good sale every time it rallied? (In markets like 1994, there are whole sections of the tape, which is slang for the market itself, that are just plain bear markets. That means they are headed down. It doesn't mean they go straight down. They're punctuated by vicious rallies up as the shorts try to take profits and the longs think the worst is over. That's what a bear market is all about. My job as a fund manager is to figure out which stocks can be bought on weakness and which stocks have to be left on strength. I find that technical analysis does absolutely nothing to help you in these kinds of markets because every breakout is false and every sign of relative strength is worthless. That's because everything in a bear market is done on light volume. I have joked about how Buzz and Batch will engineer false breakouts so they can get out of stocks. But believe me, it happens.)
First, remember the context of 1994. Then, as now, the Fed
had been too free with liquidity in the past. (Recall that after the savings and loan crisis, the Fed had to reliquefy the banking system. It chose to do so by allowing banks to borrow short-term and invest long-term and pick up the difference. If you are confused about that, think about it this way: Right now, if you were to take out a short-term loan, you would get a rate like that set by the federal funds, a rate set by the Fed. It would be over 6%. If you went and bought long-term treasuries, which also yield about 6%, with that money, you wouldn't make any money at all.
But at the beginning of the decade longer rates were much higher and short-term rates were much lower, so that you could make 300 basis points on this "spread" between short- and long-term rates. Many banks did this. They reliquefied very fast. Once the system was whole again, business caught on fire and the Fed had to rein it in. This time we are paying the price of the Fed's worries over Y2K -- they put a lot of money to work to be sure there would be no liquidity crisis. And we are paying the price for Nasdaq 5000 and its subsequent wealth effect.)
Then, as now, the Fed had to tighten aggressively in order to keep inflation under control. At the time the inflation in 1994 was mostly in commodities
. This time the inflation is commodity-based, but all stock-based
. (This was supposed to say also stock-based. In other words, there are two kinds of inflation roaring. Not just one.)
Remember, the Fed thinks the consumer is spending too hard because he has too much of a wealth effect
. (Periodically, I will read some story that says there is no wealth effect, or it's claimed that that effect is wildly exaggerated. Larry Kudlow might articulate this argument on CNBC. I want to believe it, but the macro numbers are way too strong for me to believe it.)
You may think the Fed doesn't know what it's doing, but when a company like Wal-Mart (WMT)
says what I'm hearing out of the mouths of Fed governors, I'm going with Wal-Mart. (Many of you emailed me to say that Wal-Mart is not representative of the economy, to which I respond: What rock are you living under? Wal-Mart is
the economy!) (Even after I wrote this people continued to tell me I don't know what I'm talking about. First, in case you were thinking of doing the same, I don't like it when someone says, "You don't know what you are talking about because you've never been to Wal-Mart or because you are too rich to shop at Wal-Mart." What kind of jerk do you take me for? I shopped only at Wal-Mart until they opened a Target (TGT) near me. I shop at Target because it is cheaper than Wal-Mart and I like it more. But to say I don't go there presumes you know an awful lot about me, which, in fact, you don't.
And now that that's off my chest, understand that I listen to every conference call I can, particularly every retail conference call because it's my job at Cramer Berkowitz
to develop a mosaic, a picture of the economy away from the data the government issues or the pastiche the research firms throw together. In other words, I listen to Wal-Mart to get the pulse of the economy. That company is so vast and so dominant that it represents a real slug of the economy. That conference call was the type of call that would make the Fed think, "So what if we got a weak producer price index number, Wal-Mart says there is inflation at the consumer level."
Many of you don't know how to play this game. It's not what you think that matters; it's what the Fed thinks that matters in 2000 because the Fed has a bias against higher prices right now. When the Fed is on your side, you don't have to worry about it. Right now the Fed is on the side of the bears. It's the bears that don't have to worry. If you are long stock, believe me, you have to worry.)
So, we have to keep in mind that what may have been the enemy in 1994 is not necessarily the enemy in 2000. But the tightenings are designed to cool off everything, so lots of things get hurt whether the Fed wants them to or not, because the economy is pervasive in our lives. (Here is that margin vs. fed fund rate argument. I continue to believe that if the pervasive inflationary portion of the economy is tied to the stock market, the Fed ought to use its power as a regulator of margin rates, to take them up near 100%. But the Fed seems to be worried about more than just stock prices and the wealth effect. It seems to be worried about all kinds of price inflation. So it's using the meat ax of fed funds rather than the Exacto-Knife of margin rates. I think that's wrong, but see the above paragraph: What I think doesn't matter beyond the parlor conversation I have at the office.)
Also, keep in mind the urgency of the Fed's position. It doesn't want to play a role in the 2000 elections, but it doesn't want a Japan circa 1989 on its hands (stocks keep going up, causing people to borrow money to buy stocks, causing stocks to go up causing ... until there's a crash). The Fed doesn't want a crash and it doesn't want inflation. It wants to finish its business before the election, but it probably can't. (People keep emailing me and saying that the Fed won't act in an election year. To which I say, I can't bet that way. I can bet only in a way that takes the Fed at face value. If the Fed says it's concerned about inflation, it's not going to sit around and do nothing and wait for Gore to win and then act, out of fear that Bush will be elected. That's a silly bet. The better bet is to ask yourself whether one more 50-basis-point hike won't be enough for now, and we could get a nice rally as the Fed takes the summer off to see what the 50-basis-point hike does to slow the housing, car and retail sale markets.)
With those caveats, here's what didn't work then. First of all, the financials. They were awful. Particularly the savings and loans. Those went down virtually every day while the tightening went on. I was heavily involved with the group at the time and a ton of them blew up, missed earnings and watched their stocks get cut in half almost overnight. (These institutions were horribly mismatched. They were lending out at the same price they had to pay to depositors to get funds. That's a recipe for disaster. At the time, the savings and loans were more heavily traded than they are today. There were many more of them. But this situation, the vicious Fed tightenings, caused so many of these institutions to drop in price that they were gobbled up by massive banks in the great wave of consolidation that was 1995-97. I used to speak to these savings and loan managers all of the time. They would warn me that another Fed hike would doom them. It was horrible. I tried to stick it out, but on the last Fed hike I puked out a lot of these at the bottom because if there had to be one more Fed hike, some of these institutions would have had to cut their dividends. It was a scary time.)
Banks fared terribly, too, as they could not adjust to the rapidity of the rate rises. As many of the banks at that time were borrowing short- to buy longer-term bonds and living off that spread or arbitrage
, this game ended almost immediately with the sharply rising rates. Everybody who was playing that game got scalded. Remember the Orange County
portfolio? Remember those knuckleheads who had all of those derivatives on? They were taking advantage of this trade and got whacked by the Fed's dramatic tightening. (The banks get hit in many ways, including the potential foreign losses. Remember, as we tighten it puts tremendous pressure on lesser-developed nations that are trying to attract capital because capital is always in search of a strong currency. Ours will be very strong if short rates go to 7%.)
Cyclicals do quite badly in this environment, as the short-rates ratchet up inventory costs. This time it could be even worse because the rates are taking the dollar up with it, making the possibility that the U.S. loses competitive advantage to those euro-denominated companies all the more likely.
Be careful here. The cyclicals already sell at low multiples so they are a tough short. They are too logical and many hedge funds
are short them already. But many of these companies will begin to miss earnings estimates
as the rates go up, and they'll disappoint. The companies levered to the housing industry will be very hard hit, as mortgage rates have gone up huge -- even as the long-term Treasuries
haven't. (I listened to a well-spoken gentleman on "Squawk" from Owens Corning talking about how his stock is being punished because people think it will do poorly with higher rates. He's right and the people are right. He will do poorly and the stock will trade lower. But when the Fed is done, you have to buy his stock hand-over-fist.)
Nine-percent mortgages put a real crimp on housing, especially in the context of the boom we have been seeing. (Refer here to story I told earlier in the week about the May 17, 1994 hike and how the market viewed that hike as the last one and spiked up all of the cyclicals. That turned out to be WRONG. The cyclicals go down on estimate cuts. You take rates up big from here, you're going to get estimate cuts. That's just the way it is. Take that as a given, please.)
Retail gets clubbed. You saw the downgrade by Goldman
whack the retailers. That "makes sense," judging by the way this group has acted before, notably in 1994. You didn't want to touch these stocks. I am betting
that a secular case, Target (TGT)
, can withstand the pressure, because it is opening many stores and is the ideal "trade down" in this environment. But it's not a bet that the odds favor, based on 1994. (Fittingly, Target rallied. Now let's talk about why Target may be able to withstand a turndown while a company like Kmart (KM) might not. Target is in growth mode, putting up stores; it also represents an attractive value proposition. Companies that can grow during this period do better than companies that have to rely on consumer spending to grow. They have what's known in the biz as "secular" growth. Sears has little secular growth and Kmart has none. That's why I would rather be in Target. Still, the odds don't favor making any money in retail during this period, so I'm swimming upstream with Target.)
Finally, the brokers, as mentioned above, just do awfully and simply can't be owned at all. Their customers get hit because of the higher borrowing rates (except short-sellers who get a higher rebate on the proceeds. When you sell stock short it generates proceeds) (Those proceeds can earn interest. Check with your broker to be sure you're earning that interest rebate on your shorts. You may not be. You should be if you're a good customer)
and that discourages margin buying, which lowers the amount of commissions. The new-issue market vanishes. (How important is this? With commissions as low as they are, the only way these companies' massive sales and trading operations can make money is through underwritings where the company pays the selling concessions. That's where the profit is. But how many deals have been done this quarter?)
We've seen that already this time. It's just dead. (As this period drags on, you'll see many estimate cuts in the group and it will be brought down even more in price. But every time we get soft numbers, you'll see a big spike up in these stocks as shorts scramble to lock in profits and accounts rush in to call the end of the bear market. The pleasure of the fall will be met by the total pain of the gain, as we saw Friday.)
Now, here is the big worry of 1994 vs. the big worry now, and why 2000 feels so bad when compared with 1994. In 1994, nobody other than the brokers cared about the new-issue market. (There weren't many new issues to speak of in 1994. We were in a different underwriting cycle. In fact, there was more net retirement of stock through takeovers and buybacks than net issuance. Now we've just finished a massive new issuance phase. We have too much stock chasing too few buyers. Deals that would have valued stocks at billions are now valuing them at hundreds of millions, if they can value them at all. The latter is the most likely event.)
In 2000, the new-issue market has been the lifeblood of technology. I have heard or seen dozens of companies that I now believe will not get funded, which would have been huge paying customers of the business-to-business and Web infrastructure companies. (Nobody really wants to talk about or admit to this stuff. It's kind of like a sick person who everyone wants to pretend is OK. Some people even say, "It's such a good thing that this is happening, so buyers can get these pieces of paper more cheaply. Hogwash. There were billions invested at what now look like some really bad levels both in the public and private markets. Many of these companies will never see the light of day.)
Numbers for these companies, while strong near-term, are probably all too high in next year because of the new-issue fiasco. (Here I'm talking about the Web infrastructure companies. A company like ARTG (ARTG), that has a publishing tool that is very useful, won't do as much business if there aren't more dot-coms. They're doing plenty of business today because they are still living off the deals that got through before the door closed, but they might not have a good pipeline next year. It's even tougher for the Scient (SCNT)/Viant (VIAN) crowd because many companies are doing the same thing, and they'll bid up the price for the talent pool and then have higher costs just when a max out in the amount of business to be done might occur. Every Web company that doesn't come public is a potential customer gone bad in this world.)
And the already-public companies that need financing won't get it. How much infrastructure equipment will Value America (VUSA)
or Fogdog (FOGD )
or drkoop.com (KOOP)
or eToys (ETYS)
be able to buy if the financing windows don't open again? (The answer is that they'll spend until they run out of money, or turn profitable, or get bought by others who perceive value in their brand names. Many, many companies came public with a sliver of equity and figured, what the heck, let the stock run up to a high price, then do a secondary to raise big money. This was the strategy for the first part of 1999 and it worked well.
But the companies that came public after April of last year for the most part never got to do a secondary. If they are burning through cash, they'll be hard pressed to get more financing. That means they can't spend as freely. I don't want to be too bearish. There are still plenty of companies out there with a value-added mission that will be able to raise money. But it will be much less money than before and it will be given only when there is a greater chance of profitability.
Where did all of the money go? I think it got vaporized. I think that a lot of the money that made the new issue market hot was margined money and now that that is gone, blown up, there isn't enough money around to generate the kind of demand that we had before March. It's very hard to remake the Old Economy when you have to play with your own money.)
That's why, even though tech did well in 1994, I am far more suspicious of it in 2000. I am not selling my favorite tech companies, but I am not doing much buying of them either, because of this new-issue decline. Its too dangerous for the out years. (Here's that concept of what you can buy on dips and what you can't. We are setting very strict limits on how much we will put into technology here, but very loose limits on how much we will put on consumer staples. We might by 25,000 Pfizer (PFE) on weakness but only 2500 LSI Logic (LSI) because we don't want to get trapped.)
So why do I stay long some Cisco (CSCO)
and some EMC (EM)
and some Texas Instruments (TXN )
? Because I have a big portfolio and I have room for these stocks. They are not my biggest positions by any means. They are positions. I can handle the pain and I work up short ideas against the ones I'm long to make the pain more tolerable. (Remember that I have the luxury of picking the sizes of my positions. I don't have any huge positions right now, but most of them are with fairly recognizable nontech companies. I switched to these because I like their risk-reward during a period of Fed tightening.)
Why don't I share those short ideas with you? Because shorting is a dangerous game
. Because I don't want to have to disclose which companies I am short, for fear our readers will gang-tackle me. Because I don't want to risk the wrath of companies that will demand that I be investigated because I am short them. I have already been investigated by the government for saying negative things about a company that I wasn't short. That's all I need: to be investigated for something that I am short!! No thanks. Life is too short! (Here it is again. I went on TV bashing Wavephore. It got knocked down. I must have known what I was talking about, as it went considerably lower in the interim. In the meantime, the company figured I had to be short it and complained to the Federal government. I wasn't short it so I was vindicated. But it taught me a valuable lesson. Don't speak openly about your shorts. The company involved might accuse you of doing something illegal and you will get investigated by the U.S. government. You don't want that.)
One other area of concern: foreign stocks of countries with weak currencies (i.e. Latin America). These act terribly when the Fed tightens. In fact, in the final installment of this series, on Friday, I will reveal what got us out of 1994 -- that is, foreign crisis -- and how it will probably do the same again. (These stocks would seem to be in the best shape for shorting if you think the Fed is going to raise rates big. But if you think that the rate hikes are almost done, you want to own Brazil and Argentina for big bangs for the buck.)