For part one of the Streetside Chat, click here.
: So we come back to the wealth effect. The real wealth effect came from the Fed excessively easing monetary policy; we had an excessive boom in spending. And then, of course, they had to cut back on the money and they raised the interest rates. But, still, point to point from the beginning of '97 to the beginning of the year 2000, we still see a higher trend in retailing. And I don't believe that has anything to do with the stock market. That has to do with the maturation of the baby boomers and therein is another long idea, but it's one that's going to be very important to the bull market over the next seven or eight years.
Baby Boomers' Consumption
The boom in babies in this country occurred between 1952 and 1964. We had 4.5 million babies every year or more. Those babies are today 35 to 47 years of age. Fact No. 2: The American consumer spends the maximum money when the head of the household is in his or her late 40s, approximately 46, 47 years of age. All of these statistics are borne out by the consumption expenditures surveys of 1998. Every year, you can see that the boom in spending in the 45 to 54 age bracket.
So as the American consumer moves into the maximum spending bracket over the next decade, we will see a consumption boom. It just started. Think of it this way: If you add 46, 47 years to 1952, the beginning of the baby boom, we should begin to see a big surge in spending at that time. If you add 46, 47 years to 1964, the end of the baby boom, that should be the end of the spending surge.
You should see the biggest boom in American consumption between the years of 1998 and 2010 and it should peak in 2007 and 2008. It has nothing to do with the stock market. It's people sending kids to college, paying for room and board, buying the big house, buying the big car, helping mom and dad with retirement. This is lifestyle stuff, it has nothing to do with the Federal Reserve or the
average. It is something else again. And to tighten monetary policy because you think there's excessive speculation, which is in itself false, doesn't make much sense.
I say there's not excessive speculation, because most of the market did nothing for two years. And it was only the Nasdaq, but the market took care of that one.
: In that context, what do you think of the action yesterday, which was somewhat of a surprise in most markets?
: Hey, you know, you're down 35% from the top, so if you go up 6% ... I don't think ... the economy didn't change last week and it didn't change this Monday. We're going to have this kind of volatility for two, three, four months possibly.
: What about the overvalued tech stocks? You point out how quickly they rose.
: Well, this is another interesting thing. We're splitting up the Nasdaq into those companies that have earnings and those that do not. And I was shocked that those that have earnings are trading at an 18 P/E less than the S&P.
People say you have a very high P/E for the Nasdaq. We don't even know that, because a lot of those with negative earnings don't have projections for earnings -- nobody follows these stocks. But for the stocks that we follow, the P/E has really come down. The secondary stocks are down 40%. So you come down to 18 times earnings. I don't think that's a problem.
: Is that a median?
: That's a cap-weighted average that followed Nasdaq. I have to be careful here, because
is still doing these numbers. But he needed to have analysts, at least one or two analysts, following a stock and a forward earnings estimate. You don't do trailed earnings, because you get really high numbers. But if you do forward earnings estimates -- that's the way we do P/E -- so he gets 18 cap weighted.
: Just on the Nasdaq?
: Yeah, on the secondary names. The blue-chip technology stocks in the S&P have a 45 or 46 P/E as of last Friday. The growth rate of these stocks is 22 to 23. What is the right P/E-to-growth ratio? First of all, there is no such thing; it changes all the time. It depends on interest rates, inflation and the growth rate of earnings itself. It can go from less than 1 to more than 2. At this moment, given the low inflation rate, I think the right P/E-to-growth is about 1.9 to 2.0.
: How do you make that calculation?
: You take two different valuation models and you try to explain the P/E or the earnings price. It's a function of inflation, No. 1, real bond yields, No. 2, and the growth rate of earnings, No. 3. That's in terms of statistical significance.
That's the numerator. And then the denominator is just the growth rate of the earnings. That's for the market. You can show that over time the P/E-GE rate, the justified P/E-GE ratio, assuming the fair value of the market, goes up and down.
Right now, it's 1.9 to 2.0 and the P/E GE ratio of the tech sector in the S&P is 2.07. So you're 4% to 9% overvalued. That's not a big deal for tech. Just wait about three months and the earnings will catch up and the P/Es will go down and you're fairly valued. That's why these tech corrections don't last a long time.
is overvalued, it's got a 40 P/E and an 8% growth rate. I mean, 8, forget about 8 -- it's going to take five years for the earnings to catch up with the P/E. But these tech stocks have been growing earnings at 35% a year last year, 35% this year. Just wait three, four, five months and your valuation problem disappears.
I won't make the same statement for the secondary names. Some of these guys don't even have earnings, so it is a little more confusing. And, arguably, there's more over valuation in the dot-com area, where they don't even have a business that's viable. There are some speculative problems, no question about that.
Primarily I focus on the S&P and I think overall the market's undervalued, moderately. The techs are only slightly overvalued. So it may take some time, but eventually we're going to go higher.
: So this is the Dow 36,000 argument.
: Well, it depends on productivity. We've had amazing productivity numbers. We were 1% or so in the early 1990s and in the last four years, we've had close to 3%. We hit 5% in the summer and 6.4% in the fourth quarter. These are just mind-boggling numbers.
The Productivity Possibility
The question is, will this productivity continue? If the answer is yes, you don't worry about inflation, No. 1. The P/Es remain high, No. 2, and the bull market has a lot longer to go. So will the productivity continue? This is the ultimate question.
When we looked at our productivity trends over the past century, we realized one thing -- the typical trend in the United States is up about 2.25% to 2.5%. And we're back to the typical trend. This is not a new paradigm, this is the old paradigm. The odd man out was the period of the '70s and the '80s, when it went sideways. To me, that's the question. What happened in the '70s and '80s and could it happen again? And if the answer is yes ...
: Too much bad music.
: Bad music was certainly a part of it, but another one is bad government policy and the collapse of business confidence and no investment. It's easy to remember, we have tax rates going to the moon -- they were 93% in the early '70s. People were spending more time working on tax shelters than working on work. We had a lot of regulation after the
years. We had massive antitrust activity. They attacked
, they attacked -- they broke up
. All large mergers were subject to review.
And the Fed, God knows what they were doing, they were too easy in election years, too tight afterwards. Business had no idea what the bond was going to be in a year or two. And so people did not invest. And the growth rate of real investment went from 8% in the '60s, 6.5% in the '70s, 4.25% in the '80s. Apart from the PC boom, there was really very little growth in business investment and productivity was flat. We had a bear market.
The good news is that tax rates have been cut here and in the U.K. and in Japan. Japan keeps promising to cut them. Germany keeps promising to cut them. Someday, when they do, maybe the euro will go up, but they haven't figured it out yet. But, otherwise, globally, tax rates have calmed down.
Japan's tax rates are now lower than Germany's. They've gone from 63% to 47%. That's still way too high, but Germany's in the mid-50s.
Deregulation is another global trend. We've deregulated transport, telecom, utilities right now and with
gone, we'll be deregulating financial services in the next few years. And there'll be an M&A boom in banking, that's the reason I like banks right now.
Third, I think the mergers and acquisitions and restructurings are also going global. Europe is doing it. It's starting in the Far East. Actually, I'm a little more worried about the United States. You know, the attack on
, the attack on the health care industry. These are signs that maybe government is going to be less friendly to business. Although I think that even with Mr. Gore as president -- I can't see the United States going backwards if the rest of the world is moving in the right direction. And with a President Bush, I don't even have to worry about this.
The Fed -- what do they say? Now they're more transparent. They tell you what they're talking about, they tell you why they did it, they even hint at what they're going to do. So the markets anticipate and when the Fed does it, we actually rally nowadays.
So it's better for business confidence and investor confidence. But the real key is the productivity payoff of all the technology investment. Because technology is now 50% of all the business investment in the United States.
The problem, the so-called productivity paradox is a lot of this investment did not lead to productivity for many, many years. And there's a lot of people that are still very skeptical about this whole thing.
The Dot-Com Effect
: So what is the effect of the failing dot-coms on this -- when these businesses do go belly up and these people that have left traditional companies go out looking for jobs? What happens then?
: There's an interesting story in
The Wall Street Journal
today telling us that things aren't quite as bad as we think they are; some of these companies actually make money, which is a shocker.
But I think the point is, it's more than just e-retailers here. There's a broad range of companies that we call the New Economy, and this really all began in the '80s. My thesis is that even when you don't see the immediate productivity payoff, in conjunction with other innovations and investment and other technologies, eventually you get a powerful acceleration in productivity. And we reached that point in the middle of 1999.
I'll give you some examples. In our historical look at the four-year microprocessor cycle, we had a big boom in spending on 286 chip equipment. That's the PC boom. But the PC was not a productivity machine. It was basically an electric typewriter. And you had to hire a bunch of people to fix the damn thing and so it was a minus for productivity.
The 386 came along in '87, it was a little more reliable, but you couldn't connect one machine to the other. You didn't have the Local Area Network until the 486 in 1991 and then you had cheaper machines, more reliable machines. You could buy them and take them home and you had cell phones. By '94, you had the search engine, the outranet becomes the Internet. Now everybody can know where the address is to anything.
The Pentium I, Windows 95, laptop. Now you can work on the airplane, that's a productivity ... I sleep on airplanes, but you have the option. Then you have B2C in '97, B2B began in '98. The
merger advanced the onset of broadband. With broadband, we will see the characteristic innovation of our time, which is Web-based, digital video teleconferencing. You have digital video teleconferencing -- it stinks. The picture, you move your head, the shadow follows, the sound is off and up and down. It's $10 a minute.
So it's not terribly useful. But with broadband, you have digital quality video, high fidelity sound. The phone is on the Web for 10 cents a minute. The broadscreen comes down from $18,000 to $8,500 today. And it will get cheaper, it's Moore's Law.
You already have everything you need for the highest quality digital video teleconferencing -- at 10 cents a minute, not 10 dollars. You start thinking about the combination of B2B and digital video teleconferencing and you have something that's the equal of the laptop or the PC or the TV or the telephone or the jet plane. That is yet to come.
And the reason I'm bullish on technology is because we ain't seen nothin' yet. Many of these companies will not be around in three years, but that doesn't mean that these innovations will pale. They're on the way. We can see them now. We reached that recognition point in the middle of last year. And that's why we had this explosion of New Economy vs. Old Economy. It went too far and we're correcting that now. But I am very bullish about technology. I just have to figure out which ones to buy and which ones to avoid.
: OK, which ones should you buy?
: You need to have earnings. Or contracts from companies that have earnings. I think B2C is very hard to figure out. E-finance -- that's probably tough also. But infrastructure, B2B, services, these things that don't rely on any one line of business succeeding. You don't care who wins. As long as somebody wins, they keep buying the services.
But I'm not recommending any Internet companies at the moment. I think we're in a period of consolidation. I think blue-chip tech stocks will rotate first, that's what we saw in the market yesterday. But even they will run into a little selling when we get halfway back up.
In the meantime, I think there's some opportunities in the Old Economy. I mean, what is all this wonderful stuff for? It's for the Old Economy companies. And it's going to improve their margins and the earnings gap is going to close. It'll never fully close, but it will close a little bit over the next two, three, four years, as the Old Economy adopts these innovations.
S&P tells you that earnings growth has been 8% in the past five years. But if you look at the companies in the S&P as it exists today, earnings growth in the past five years has been about 11.25%.
Now, that reflects two things. It reflects the restructuring of the old companies getting more efficient. It also reflects the S&P selection process. Because of mergers and changes, they're forced to drop less profitable companies and add more profitable companies. Or companies with higher sales per share growth. Out goes a
, in comes an AOL, you understand that process. Over 30% of the capitalization of the S&P has been replaced in the past five years by S&P. So what's happening is that the S&P is reflecting the modernization of business and the greater efficiencies of business. But it's also a higher tech component, so that also pushes up the growth rate. But even nontech earnings have been growing faster than the historical trend.
It's all over. Even boring industries are partaking of the New Economy.