Refiguring Relative Prices

Speculation is not the only reason for the wild valuations of the tech sector relative to the rest of the market.
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Editor's note: Beginning next week, Jim Griffin's column will be published on Sunday instead of Monday.

I had been watching the odometer carefully as my secondhand

Volvo

approached 100,000 miles, and I pulled over to the side of the road when the great moment came. My wife, however, was not impressed. "What are we going to do?" she asked. "Stay here?"

And so it is with

Dow

10,000. Duly noted. Drive on.

The market's level is mildly interesting, but its breadth is fascinating. The Dow Jones Industrial Average may have scaled a historic peak at 10,006 last week, but it has been exactly one full year since the

NYSE

cumulative advance/decline line made a new high. It has been 10 months now since the diffusion of market success was positive, in the sense that more stocks traded above their own 200-day moving averages than below them. Less than one-third of NYSE issues now have positive performance to show for nearly a year's worth of trading, as represented by 200 days, and the current condition is a fair snapshot of the way it's been since last spring. The new-low list has tended to be longer than the new-high list, for both listed and over-the-counter issues, since last May.

Narrow breadth, and especially extremely narrow breadth, has a whiff of technical disaster about it. Is it reasonable to deduce that the great pyramid of Giza has lasted so long because the ancient Egyptians did not build it point down? A broad base is reassuringly stable. Wider is better, if

Pontiac's

current slogan can be taken as gospel. You have probably been bombarded with empirically ambiguous tales of the results of the Nifty Fifty condition in the early 1970s: "You deserved what you got if you were so undiversified." "No, you would have been fine if you'd just held on for 20 years."

Technical studies indicate that a narrowing of the market's advance typically precedes a downturn, so the fact that bad breadth is having a birthday is a matter worth noting. It is a matter of concern, but it is not necessarily a matter for high anxiety.

Here's how I have tried to explain it to myself:

Imagine a simplified economy of two sectors, one that produces the food necessary to sustain life and one that produces frivolities. No doubt about which is more important, but we can't yet determine which sector may produce the better returns for investors. In hard times, when food production is low and prices are high, there will be little left in the household budget for frivolities. But presuming a secular trend of productivity enhancements in agriculture, necessities will take a smaller share of the budget and more will be available for frivolities. The returns to investment in frivolities should tend to vary directly with the trend of productivity in the production of necessities. What is a rising standard of living, after all, but the ability to buy more stuff that you don't need?

The topic here, of course, is relative prices. Why are farmers, arguably the most important people on the planet, doing so badly, while couturiers are doing so well? (My slip may not be showing, but my bias surely is.) Because agricultural productivity is so high that the relative price of food is low. How many bushels of good Maine spuds does it take to buy one

Prada

handbag? Low relative prices of goods produced will have a tendency to generate low relative returns to the capital that produces them.

Don't get me wrong. This is not a bad thing. We no longer scratch the ground with pointed sticks to earn our daily bread, so we have time to surf the Internet. The millennial transformation now being brought about by fast processors, fat pipes and smart code is clearly still in its early days. The networked world is moving so fast that even early adapters are having trouble keeping up. Most of the rest of us are hopelessly behind, and we therefore constitute a constantly expanding market for the new products and services being conceived in the imaginations of nerdy gearheads.

Back to a two-sector economy model. Imagine a world of Net and not-Net. As productivity increases in not-Net and its prices tend to fall relative to Net prices, capital will be attracted to Net in order to benefit from its potentially higher relative returns. The secular growth prospects for Net are tied, at least loosely, to the productivity trends in not-Net. Taken to an extreme, highly productive invested capital in not-Net might actually produce negative returns, like overcapacity, to new investment -- and thereby drive new capital to Net. If it is not redundant to say this within a two-sector model, you could have a very narrow market.

Commodity prices have been in secular decline in relative terms as technical progress has proceeded. That's a 20th century fact. The narrowness of the current U.S. equity market, with its tech sector leadership, may be a reflection of this fact -- and therefore not necessarily a predictor of an impending market decline.

Cyclical business conditions will tend to exacerbate the divergence between Net and not-Net. The commodity-like nature of not-Net means its prices, and the returns to its invested capital, will tend to vary directly with cyclical demand conditions. That same effect may be true for Net as well; recession will depress the new as well as the old. But with the powerful secular growth vector that drives it, cyclical drag may be a minor inconvenience to Net, so small relative to the secular growth trend that it goes virtually unobserved.

Given the abysmal cyclical demand conditions of the global economy in the 1990s, it is not difficult to see now, after the fact, that commodities and commodity-like products and services would generate relatively low returns to invested capital. And capital markets would tend to allocate new capital away from these disappointing returns and toward more hopeful prospects.

Recovery in global demand conditions should tend to benefit both Net and not-Net, but it will work to the

relative

advantage of not-Net. Not-Net relative prices should improve: You might be able to get the Prada handbag for, say, 25% off in terms of bushels of potatoes. The farm economy should do somewhat better

relative

to the wired world, and ditto for energy, metals, chemicals and other so-called cyclicals.

In short, the ominous technical condition of the U.S. equity market -- its extremely narrow breadth -- is a function of the cyclical depression of 1990s global economic demand conditions. It may also be a function of bubble-like speculative enthusiasm for the new technologies of the wired world. But speculation, it says here, is not the sole possible explanatory factor for the wild valuations of the tech sector

relative

to the rest of the market.

When global cyclical demand conditions improve, wider portfolios might indeed turn out to be better

relative

to the narrowly focused winners of the past year. But stronger global demand conditions are hardly a negative for the true growth stories to be found within the Net sector.

Jim Griffin is the chief strategist at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Griffin cannot provide investment advice or recommendations, he invites you to comment on his column at

GriffinJ@aeltus.com.