The world looks alright to Peter Canelo, managing director at Morgan Stanley Dean Witter, except for that whole Federal Reserve thing. But despite what he believes is the Fed's strange tendency to correlate stock market gains with the wealth effect, he's not worried about the Fed. He believes Alan Greenspan & Co. are nearing the end of their recent bout of tightening interest rates. What's currently happening in the stock market is a full-blown valuation reversal, he believes, due to the recent technology correction. Sectors he thinks will benefit include banks, insurance stocks, retailers, health care, capital goods and oil services stocks. Canelo, a managing director in the U.S. strategy group, joined Dean Witter in June 1996 as senior vice president and chief investment strategist. He formerly held that position at NatWest Securities and Bear Stearns, and was monetary economist at Merrill Lynch. Canelo spoke with several TSC staffers, including Executive Editor Jonathan Krim, Managing Editor Geoff Lewis, Associate Editors Justin Lahart and Dan Colarusso, Chief Markets Writer Brett Fromson, Markets Writer David A. Gaffen and Markets Reporters Kristen French and Diane Gross.
: Peter has been one of the real consistently good strategists of the past few years, particularly as the market has become more volatile. A lot of strategists don't like to do any kind of market timing, mostly because they're so bad at it. As the markets become more volatile, for a lot of investors it's important to know when the good entry points are and when things change. And I think Peter's been better at that than most people. Which isn't to say that he hasn't made some mistakes.
A couple of weeks ago Peter was saying that technology was probably going to flatline here and we're going to see rotation into other areas of the market. Arguably we've seen rotation into other areas of the market, but technology has not flatlined.
To start things off, I wonder what you think has happened to the market?
: By the way, when you say that technology's going sideways, that doesn't mean that it gets boring. We have had three major technology corrections in the past five years and, at the extremes, they've been down 14% to 24%. That's based on the
tech sector. So that's definitely not flatline.
And at the extreme, last Friday, we were down about 20% since the
topped out on March 10. So that's in the range of the corrections of technology, at least for the big blue-chip technologies that we've seen in the past. So that doesn't surprise me. I wouldn't call it flatlining, but I think the key here is that we can rally on good earnings. We did that a year ago in March and April after the initial decline in February. And then you die. The tech market basically went back down. And it didn't regroup until the middle of June. The whole correction lasted four and a half months. Most of the damage was done in the first month, but the whole process took time.
And this time, the secondary stocks were much more overpriced. So it would be very surprising if this process didn't stretch out through the middle of the year. That's what I mean by "sideways doesn't mean boring." It's never boring in technology.
Now, while these technology corrections go on, the market has typically rotated into something else. Last year, the people bought retailers in the first quarter, they bought cyclical stocks in the spring and they moved into the auto service and energy area into the summer.
This year, the news is actually better. We have seen a much broader rotation. 48 of the S&P groups -- this was as of Friday April 14 -- 48 of the S&P groups were up 10% or more since March 10. That's amazing. There's about 105 S&P groups. 65 of them were up 5% or more. There were only 13 that were down. Now, you know which 13 they were, they were all the tech and telecom, cellular phone, telecom equipment and all of the technology group. Since they are a big chunk of the market weight, it has dragged down the S&P.
Now the only risk to the Old Economy stocks is that there really is an inflation problem and I think that is a key issue. Basically, you're unwinding the unbelievable divergence of the past year. And just to give you some perspective, from the beginning of 1998 to about a month ago, the technology sector in the S&P tripled. Whereas everything else in the S&P did zero, literally, exactly, zero. And the divergence was even more extreme from the middle of July until a month ago. We had the S&P tech sector up 46% and the Old Economy stocks actually down 20%. That's considered a bear market, especially when you have 79% of the stocks under the 200-day moving average. And that's what we had.
Sectors and the Three Markets
It was a real bear market, and valuation for the Old Economy stocks reached more than minus 20% below fair value. So not only did you have a technical bottom of great importance at 1330 on the S&P, you had a great valuation reversal. That's why we're seeing such breadth in so many groups. But the ones that are leading, I believe, are banks, insurance, retailers, health care, some of the capital goods -- and at some point I think we will see the oil services join in, as soon as we see that oil isn't going to go down a lot more. Possibly a few other groups.
But I think it's a broader rotation in this tech correction and so I think you have to be very careful when you talk about
market. There are still two markets. And there are actually three markets, because if you look at the secondary technology, that's another thing all unto itself.
I'll give you some examples of just how bad things have been in the past month. While the S&P tech sector has only been down 20 -- I say
20 -- the
(the Nasdaq 100) fell 30. And the rest of the Nasdaq Composite was down 40. The B2C stocks were down 45 and the B2B stocks were down 55. And the biotechs were down about 49%. Well, they had a slightly earlier peak in March, but basically they went down 50%, too.
And there is the problem. While I think investors can handle 20% -- that's a correction, that's not a bear market ... technology, especially after you go up 80%, that's not a bear market. But 50?
a bear market. And from bear markets, you do not come back quickly. You have a lot of people on margin who aren't coming back for a long time. They've been escorted out.
You have a lot of people who are still playing the game, but they're mad as hell and as soon as the stocks get back to where they bought 'em, they'll be happy to get out even. That creates an overhang supply. That's why the tech sector corrections of the past five years have all been expanded, at least in terms of time. You just have a lot of base building and testing and that process takes time.
So that's what I call going sideways. You can call it flatlining -- I call it going sideways, but it isn't boring. It is highly volatile and I think the real risk for investors is to think that, OK, it's all over, all clear, let's go back to the races. It's not that easy. This time you've had a much broader speculative frenzy in the secondary names and in the Internet names.
: You're fairly bullish on tech.
: Yeah, I am. I'm even bullish on some of the secondary areas. I think once this corrective process is completed, and it's going to take time ...
: How long do you think it will take?
: I'd say mid-year. Then I think we will begin a broad rally, with tech and other parts of the market -- something we haven't seen for two years. Usually, this is a very favorable time for the market, going into the presidential election. The
is usually out of the picture in the second half of the year. There was actually only one time they ever raised rates in an election year. They did it twice, '84 and '88.
: And this year.
: And this year. I mean, before this, there was only two periods, but only one time they ever did it in the second half of the presidential year. That was '88. That was partly because they'd lowered them a lot during the crash and so they had to come back to where they were.
Now, they lowered them a lot in the panic of '98, but they're already back to where they were -- they're higher than where they were and so the issue, I think, will be, one: Is there is an inflation problem? And two: Is the strength of the economy a problem in and of itself, in the context of the wealth effect? And three: Are there significant other imbalances that would force the Fed to be more aggressive?
These are important issues, especially for the Old Economy stocks, but generally for the entire financial market. Maybe I could go at these one at a time.
Last Friday, everybody got all worried about inflation, and the CPI certainly was out of line. However, nobody paid any attention to the PPI the day before, which showed absolutely nothing. And now, if you look at the six-month rate of inflation in core finished goods in the PPI, that was 2.1% a year ago on a six-month basis. Six months ago, it was running 1.5%. And in the past six months, it's running 1%.
: So what is Greenspan talking about?
: Wealth effect. Let me just nail this argument that there's an inflation problem. Second, the unit labor costs have collapsed. They were running 3% 15 months ago. In the past 12 months, they are running less than 1%.
Commodities, ex-oil, topped out around year-end into the Y2K inventory building, and they're down. Industrial materials prices are down about 7% since the year-end period. And then oil took a little longer to top out, but it's also topped out. And the dollar on a trade-weighted basis keeps going higher. That doesn't show any big panic or inflation fear. And the bond yields are down from over 100 basis points from their high point in January.
Now, it's not just because they're not making any more bonds. There's definitely a perception in the bond market that the Fed isn't going to do as much as people fear, but you look at the T-bills -- the fixed-month T-bills are only about 15 basis points higher than the 3-month T-bill. So there's a 30 basis-point hike built into the market. That's maybe one hike, in May.
And I don't think that's unreasonable, because I think as we go through the next few months, the oil is already down and it's going to really bring these numbers down and people will calm down.
So we come to your question. What is the Fed all worried about here? Well, they have made this astonishing argument that productivity somehow causes inflation. I think this is right up there with the world is flat.
: Normally it worked the other way.
: Yeah, productivity means there's more product. If there's more product, you have a lower price.
: I think that's the great thing about entering the New Economy and finding productivity was the new god and was making everything magical, you could have lower unemployment ...
: You didn't read the second half of those speeches. He's had two speechwriters and the guy that starts off is the model is productivity guy. And then the guy that finishes his speeches says the speed limit, the non-inflationary growth.
But here's the argument, in essence: The productivity creates a lot of profits. Well, that's true, nobody can argue with that. And the profits create higher stock prices; that's self-evident.
But then there's this crazy idea that the higher stock prices are creating a stronger economy, which I believe is a logical fallacy. And then there's this further idea that a strong economy creates inflation, which is just absurd, because there's no evidence of that. Every major period of strong growth in the United States have correlated with the lowest inflation.
For example, in the last four years, we've had 4% real GDP and 2.25% inflation. Now, people worry, how long can this last? Well, if you go back to the '50s and '60s, we have 4% inflation in a 21-year period. Four percent real growth in a 21-year period and 2% inflation.
From 1908 to 1929, we had 3.6% real growth and, apart from the World War I period, 1% inflation.
: What about housing costs?
: They're rising in New York and not much more elsewhere.
: Silicon Valley?
: Well, that's one of the other places.
: But Seattle, Los Angeles?
: Your premise is that there are things that cause inflation, like houses and wages and things like that. We've had wages rising six out of the last eight years, and inflation has been falling for 10 years. We've had house prices rising in Silicon Valley at least since 1992, that I know of. And periodically they rise in the financial centers when you have good markets. But that doesn't mean that inflation has been rising, it's been falling.
And it's productivity. Let's get this straight. We are in the third major boom in productivity of the last 100 years, perhaps the fifth or sixth in U.S. economic history. These numbers -- 2.5%, 2.25% -- don't look like a lot, but they are a lot. It's the difference between 2% inflation and 4.25%, 4.5% inflation. It's the difference between an 8% mortgage yield and a 10.25% mortgage yield, 10.5%. You know that's a lot.
And all of these periods have been periods of disinflation. All of these periods have been periods of high P/E ratios and all of these periods have been major boom markets. And the productivity has never been a problem.
: Can you go back to Greenspan's argument?
: The problem is that we had a nice 5% trend in retail sales until 1997 and then, since then, the trend has been faster. Maybe close to 7%. That's a significant acceleration, because it's lasted for over two years.
This has been blamed on the stock market, the wealth effect. There are a few problems with this, not the least of which is that we've had a bull market for more than 10 years. How come we just have this wealth effect in the last two years? That's interesting.
There's a logical fallacy here. I think one of you wrote about it when Mr. Greenspan gave his last speech. If I sell my stock, I have more money to spend. But if I sell them to you, you have less money to spend. This is Canelo's law. The money is always there, only the pockets change. The stock market does not create new money.
Let's say I don't sell my stocks and I borrow. Then it seems like I have my cake and I can eat it, too, because I have my stocks and they're going to go to the moon, and I can go spend. The problem with this argument is my broker has to borrow from the bank, the bank has to borrow from you. So somebody has less money. Only the pockets change.
: Well, that's not true for stock options, though.
: Why not? Here's the problem: If everybody wants to monetize a financial asset at the same time, what is that called? It's called a bear market. Now, everybody feels happier and richer when the market goes up. Because on paper, everybody's richer. I'm not quibbling with that.
But the only way that everybody can monetize the increment of paper money well is if the Fed increases the supply of money and credit. Now we have a classic example here in 1998 and '99. So we can see if there really is a wealth effect. We had a bear market in the second half of 1998. It was a significant bad market. If there is a wealth effect, you would expect a negative effect when the stock market goes down. You can't have a wealth effect that only works in one direction.
: But he's often linked the spending surge also to housing and to lower mortgage rates, which is one thing that transpired at the end of 1998?
: Well, what he didn't say is that the reason you have the housing boom is because they lowered the interest rates in 1998. And here you have a classic example. Lower interest rates, through the effect of housing and other interest-sensitive sectors, stimulate the economy. And if you look at what happened to retail spending from the middle of 1998 through the middle of 1999, they were up 10%. So where's your wealth effect? It certainly wasn't the stock market going down. It was the interest rate, the easing ...
: Right, and also they pumped all the money into the economy at the end of '99 to get to the Y2K problem.
: OK, but they took that out. I'm saying the real pump occurred in '98 and early '99.
Three years ago, before we ever heard of Thailand, we had about 8% growth in money supply, which is the broadest measure of all the checking accounts. By the end of 1998, in the heat of the crashes, we got to 15% growth in the money supply. Now we are back to 8%.
But who created the boom in retailing from the middle of '98 to the middle of '99? It was Mr. Greenspan. It is just like government to blame what they do upon somebody else. It's just like government always says, there's too many people working, there's too many jobs, it's causing inflation. That's just nonsense. It's government policies that create inflation. But they like to blame things on other people.
: Could I ask one other thing about the wealth effect? Another aspect that people built up these financial assets, including the rise in the value of their housing. That enabled them to feel that they didn't have to put as much money aside and the savings rate declined, declined, declined, partly because people felt that they could spend more money because these assets had built up so that their future for education and for retirement had been built up.
: I look at the data. And the sum of money market mutual funds and savings deposits is $1.8 trillion. This is a giant amount of savings. I have no idea how the government calculates the savings rate.
I mean, I had a guy paint my garage about six weeks ago. And he said, well, if you give me a check, it'll be $1,500, but if you give me the green stuff, it'll be $1,200. What did I do?
I mean, it's not my responsibility to pay the taxes here, I paid him $1,200 in cash. So next week, he came back, he had a new truck. He did a good job. I was happy, he was happy. But the government records the consumption of the truck, but there's no income. Right? Nobody recorded any income.
So the savings rate goes down, but that's not really what happened. We can record consumption quite accurately. Income we don't record very well, because sometimes waiters and waitresses keep it off the books and other people, too.
Now, I have a research assistant, took her 15 minutes to figure out that savings have been rising sharply -- she added them up. It would have taken her five minutes, but she had to go get coffee.
All these other economists at the government, they've been revising all these savings numbers. I think it's amusing. Savings were growing last year at a 9% rate. I'm an agnostic about a lot of these government statistics.
You also believe that there is a massive trade deficit problem. You know, if I buy a
, my savings go down and our trade deficit gets bigger. So there's two ways of measuring the deficit, the external deficit. You can either believe the statistics the government is giving you or you can look at what they call gross domestic savings, changes in gross domestic savings, which include the government surplus or deficit, the corporations' retained earnings minus investment and the personal savings -- which we know are understated anyway.
But if you add up the savings changes, our deficit is less than $100 billion. If you add up the trade numbers that the government gives you, you'd think there's close to $300 billion.
These numbers are supposed to be identical, so they have this thing called the statistical discrepancy, which is now over $180 billion. That's the GDP of New Jersey. How do you lose something as big as New Jersey?
For my money, I don't pay any attention to the trade numbers, because we don't really record our exports. In many cases, we use the import statistics of our trading partners. There's no record of our rice going into Japan, because it would make the farmers upset, so they don't record it. So if our trading partners aren't recording imports, then we're not recording our exports.
The point is, we do have another way of measuring this stuff and it's much more accurate; if anything, it's understated. So the problem is not as big as the papers report.
That's why the dollar hasn't been going down for five years, because we don't have such a big problem. So all of these economics problems may not be as big as we think. All these imbalances.
For Part 2 of the Streetside Chat, go here.