Bull or Bear?

John Mauldin | Thoughts from the Frontline
January 12, 2001

The Millennium Wave Sector Model has switched into the Rydex Energy Services fund (RYVIX)

First, I can count to five. I know last issue I said the four most dangerous words are "This time it is different" -- is five words. But I meant to write "This time it's different." I promise you if you look at the punch ballot, you can see the dimpled chad which clearly indicates I meant to use the contraction. And besides, there was a crowd outside my office, etc. I hate it when I make mistakes so publicly. I guess it comes with the territory. Now, on to the markets......

The Millennium Wave Investor Sentiment Index is 81.2, trending up
The Millennium Wave Sentiment Momentum Index is 49, trending up
The Millennium Wave Sentiment percentage Uptrends is 20.72, trending up

Recession? What Recession? I know I keep repeating that I do not believe the NYSE stocks will experience a bear market until enough investors believe there will be a recession or at least a serious slowdown. Our Investor Sentiment data just keeps confirming this. In light of the fact that I think there is a 50% chance we will see a recession, let me make the cases for both a continued rise and a drop from here. As I do so, I am going to use this forum to answer a lot of questions that I have been receiving.

What about my tech stocks?

First, let me say that I think the NASDAQ/tech/internet/telecom world is still in a bear market. The latest rally should be viewed as an opportunity to lighten up and/or rotate into other models.

Look at these numbers (% down numbers are rounded off)

StockPrice/EarningsRatioPerformance ----------------------------------- Dell30.42Down60% Compaq21Down45% Intel22Down55% IBM22Down30% Cisco99Down50% Microsoft32Down55% Gateway14Down85% JDSUniphase70Down65% AmazonEarnings?Down85% AdvancedMicro7Down70% Maytag10Down20% Whirlpool8Down30% NASDAQ100100Down45% NYSE Down5%

I could make the list go on for pages: Ariba, Worldcom, Verizon, Sun, Oracle, etc.

None of the above companies are dot.com losers. All of them are good companies, even Amazon. I would like to own shares in all of them, but not at these prices.

Notice I put in Maytag and Whirlpool. What do these stodgy old companies do? They make boxes in a highly competitive market. What do Compaq, Dell and Gateway do? They make boxes in a highly competitive market. Their respective industries grew about the same last year. Yahoo's earnings only grew at 18% they told us a few days ago.

Let's examine everybody's favorite, Cisco System. (The following is all data I gleaned this morning from http://www.bigcharts.com and www.thestreet.com for free.) Just a few months ago, Cisco's P/E was off the charts, in the hundreds, if I remember. They have grown an exciting 28% per year for the last five years. At today's price and earnings, the company will need 99 years to make enough money to equal their stock price, and no one is even talking about dividends.

But they are growing, albeit they have told us they are going to grow slower. Let's be VERY generous and assume 24% growth for the next 6 years, which is in line with the optimistic analysts of the world. That mean earnings will double and double again. But the P/E ratio at today's stock price will still be roughly 25, less all the new shares they issue to employees for stock options.

But, if you take out their recent extra-ordinary items (stock sales and one time deals) and fully dilute the shares, it appears their earnings per share is only $.36, or half of the stated earnings per share, which would make their P/E almost 200.

Can Cisco quadruple revenue and profits in six years? Maybe, but it would make them one of the largest revenue companies in the world at an annual $80 billion per year. That would be 2/3 of monster General Electric today. It took GE decades to grow from $20 billion to $80 billion. If Cisco continues to buy other companies and add to growth that way, they might. But often they use stock to buy companies which dilutes earnings per share.

Their markets are very competitive. This stock is still priced for perfection. They make boxes, albeit very powerful and high margin ones. Do Cisco investors really think this stock will grow at 25% a year? Do they really think the market will let them stay at a P/E of 99? At some point, they will have grown so much that other huge billion dollar growth numbers will be extremely hard. It is one thing to grow 25% and have that growth be a few billion. It is another to grow sales $10-20 billion in one year as a 24% growth would require in just a few years. It won't be done unless they buy another huge company and thus dilute shareholders. This is still a bubble stock.

At some point, the market will wake up and notice the emperor is naked. Investors in Cisco today are betting on the greater fool theory.

Look at Amazon. They have no profits. They have huge debts. They will file for bankruptcy sometime in the future. They do not make enough to make their debt payments. I read somewhere their debt is selling for 50% on the dollar. What will happen is the bond-holders will end up owning the company, re-negotiating the debt down to a level they can pay, and Amazon will become just another book-seller, or Barnes and Noble or Borders will buy them from the bond-holders.

Amazon is a good company. I buy books from them. They were the single biggest seller of my last book. I want them to succeed. But their current business plan will have to change drastically for them to do so. Reality in the form of their bond-holders and bank debt will force them to do so.

What is my point? Look at the chart below. It is from chart maven Kevin Klombies, who writes a daily analysis letter for $40 per month filled with charts and ideas. Write him for a sample at krk@krk-imra.com.

The chart shows the comparative value of growth stocks versus value stocks. Look how it got way out of line beginning in 1998. It is almost back down to where it started. The chart shows that value stocks have been gaining relative to growth stocks since April. Not coincidentally, that is when our sentiment data showed a clear shift to old economy value stocks, as I wrote back then. When it gets back to where it was in 1997, will that signal a bottom? Maybe, but it is also possible it over reacts and goes down further than it should.

Investors, one by one, are coming to the realization that Warren Buffet is right.

Notice the NYSE index is only down about 5%. The only reason the S&P 500 is down is tech and telecom. Yardeni tells us the non-tech and telecom portion on the S&P 500 is up 8% for the year. If it were not for the NASDAQ high tech world, no one would be talking about a bear market. The NASDAQ was not a bull market. It was an irrational bubble. It was fun to have your stocks go up, but now the party is over.

Some of the stocks above are getting close to being value plays. Gateway? Intel?

The NASDAQ is going down from here as more and more stocks get brought back to realistic value levels. When Intel is selling at a P/E ratio that equals its supportable 5 year growth rate, I want to buy it. Advanced Micro Devices (AMD) may be there now. AMD makes a good chip, and even though it is losing money now, it could turn around quickly.

If we have a hard landing, the NASDAQ could easily drop another 40% from here before it gets to P/E ratio sanity. Staying in NASDAQ stocks with large P/E ratios is a big risk, in my humble opinion. I know there will be some exceptions. There always are, but you need to know why you believe the stock you are in love with is going to grow and prosper in a slowing economy.

The big play in the next few years is going to be value stocks. When we can feel comfortable about the economy (more below), we will want to jump into value stocks with both feet.

Investor Sentiment

You ask: "If everything is so bad, why are stocks going back up?"

My point is that things are not that bad. We are dealing with the aftermath of a bubble. Investor Sentiment is quite high, as we measure it. The mutual fund portion of the sentiment index is smoking. My guess is that we will see some very nice in-flows into mutual funds for January, as they are certainly putting money to work. Even the schizophrenic institutions are beginning to show some consistent positive numbers.

Sentiment Momentum is up as well. But what I want to focus on is the Percentage Uptrends Index. This is the percentage of stocks hitting on all eight cylinders. It is starting to rise. Before there can be any major move in the markets, this indicator will start to rise, and if we see a sustained move, it will continue to rise. If this rally is for real, this index needs to move up. We will pay special attention to it.

My mentor on investor sentiment, David Levin, constantly tells me the market will do whatever it needs to do to humble the most investors possible. He specifically includes me in that list. He talks as if the market is a person, and to him it possibly is. As we talked the other day, I expressed amazement at the high sentiment numbers and the market seeming to want to rally after the drop from Greenspan's cut jumped the market so fast. He pointed out that most people expect the market to go down or sideways, so it is very possible the market will go up. That is what our current sentiment data tells us could happen.

One of two things is happening: either investors still don't believe in a recession or any possibility of a serious slowdown, or they want to get in position before the Fed rate cuts stimulate the economy and are buying the stocks they think will do well in that new environment. Remember, sentiment drives the market.

If the recession that the yield curve is predicting arrives, it won't be before the third quarter. I think investors are thinking that if there is a recession, it will start this quarter. Since it does not look like there is a recession, they are hoping the steep rate cuts now will prevent a recession. We will see, but the first quarter should not be a negative growth quarter, unless we are in really deep kimchee.

I continue to counsel caution for now. If we get a recession or a hard landing, caution will rule the day.

What About Bonds?

My favorite bond fund, Target 2025 (BTTRX) is getting hammered (http://www.americancentury.com). Last year it was up 31%. It should be down about 6% or more for the month after today, as 30 year rates are back up to 5.62 on my screen. So what is happening?

First, the yield curve is trying to get back to a normal situation. This will make the markets volatile. Secondly, various Fed officials and commentators are telling us they don't think the economy is in danger of a recession and will grow at 2% or more this year, so maybe we won't see a deep 150-200 basis point cut. Retail sales numbers came out today stronger than expected (even though they were negative), and my source in the trading room at Bear Stearns says investors are selling bonds to buy stocks. Plus, I am sure there is some short-covering.

If you have bonds, keep them. If you are thinking about getting into the Target 2025 fund, now might be a good time to do so if you believe like I do that long-term rates will go down in a slowdown/recession. If you do not think we will see a slowdown, I would not invest in this fund.

For new readers, the American Century Target 2025 fund is a US government zero-coupon bond fund. You invest in zero-coupon bonds for capital gains, not yield. If rates go down, zero-coupon bonds go up faster than regular bonds. But when interest rates go up, they go down faster. This fund lost 16% or so in 1999 as rates went up. A less volatile and safer way to play lower interest rates is any good long term US bond fund.

Sector Rotation Model Switches

The Millennium Wave Sector Model will switch into the Rydex Energy Services (RYVIX) fund at the close of the markets on Friday. You can go to the web site at http://www.2000wave.com to see the latest rankings, but I will give you some thoughts. It is interesting to see last years darlings, biotech and utilities at the bottom of the ladder, and tech stocks and telecom actually moving up from the floor.

This has been a particularly volatile period for sector rotation models. If there is a trade next week while I am out of town, you will get a brief note from my assistant, but I still urge you not to actually make these trades until we see where the economy is going. Right now, we are just learning and watching.

Euros?

I promised to research a fund that specialized in Euro's. I spent a few hours the other day at Morningstar's web-site trying to find a mutual fund that specialized in Euros. Every international bond fund I looked at, when you looked at what they were really invested in, showed a lot of Asian or other odd-lot bonds. Funds which call themselves global bond funds have heavy investments in US corporate bonds for the most part.

If anyone knows of a pure Euro only no-load mutual fund, I would like to know about it. But there is a way to buy Euros and Eurobonds. You can call John Kaupisch of Investec at 800-548-6193 and buy Euro bonds directly. They handle accounts as small as $10,000. Investec is a huge outfit, and I find their free newsletter interesting if you are interested in international investing.

Inaugural Ball

Yes, I will be traveling next week to DC for the Inauguration. I got my tickets (finally) for the Texas Ball. If you are in DC, and would like to meet on Sunday afternoon/evening for an informal Q and A, email me or call me at 800-829-7273. If any of my money management clients (or potential clients) will be there, I will make myself available for more in-depth meetings.

Also, I would like to scotch the rumors I will going to the Bush administration. I must confess I have hired a few illegal immigrants over the last few decades, and evidently that disqualifies me and just about every other Texan I know.

Income Program

I know I promised information about our new income model, but I am checking some things out with legal counsel to make sure I can say what I want to say, so I will get to that as soon as possible. But it is high on my priority list.

As always, I enjoy your comments and questions. It helps focus my writing.

Your getting ready to party with George W. analyst,

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