The Tony Dorsett Economy

John Mauldin | Thoughts from the Frontline
March 16, 2001

Since I wrote the last e-letter about my belief that we are now in a total bear market, the Dow has collapsed another 8%. The NASDAQ is down more. In this issue I want to follow up on some questions, review some previous important predictions and offer some advice. Also, we are going to follow up on high yield bonds and our sector models. I will make an effort to be brief with so much in our hopper.

First, let me make myself very clear. It is my belief that up until a few weeks ago, the "bear market" was largely limited to tech, internet and telecom stocks. The "Old Economy" was holding up well, or even showing gains. The large institutional buyers we watch in our data appeared to be shifting from "growth" to "value", and that shift had been going on for some time. They were not shrinking from the market, just going to new locations.

Two weeks ago, the share of the market that the institutions normally occupy began to shrink. That, coupled with mutual fund share shrinking, is what made me become bearish about the market as a whole. Further, coupled with the problem that the institutions are not buying as much is the fact that their sentiment index is basically neutral. There are days where they are decidedly gloomy. Yesterday, with the market holding up, institutional market share was down 25%!

I believe this is because they think we are headed for recession, and it is not going to be over this quarter. Stocks lose an average 43% in recessions. If the broad markets lose anywhere close to that, we will see the Dow below 8,000 and the S&P below 1,000. I think the NASDAQ is headed to 1500 no matter what.

The Tony Dorsett Economy

A few months ago, I talked about junk bonds. We track junk bonds daily in an investment model we use to manage client money. Junk bonds can be very good investment or they can be nuclear waste. The good news is they tend to trend very well and very slowly, so you can use them in a trend-following portfolio, as many money managers do. We have our own system, of course, just as every manager does.

I noted that junk bonds tend to move up prior to or at the bottom of an economic recovery, as they did in 1991. When I wrote that piece, junk bonds had moved above the moving average system we use into positive territory. That was curious to me, as the yield curve which I have often written about says the recession should not start until the third quarter. But maybe, I thought, Greenspan was right: in the New Era of Information, time gets compressed, and economies react faster. But I worried, as long time readers know I often do about many things, about the junk bonds giving us a head fake, like Tony Dorsett of the Dallas Cowboys used to do to linebackers. My question then: Is the economy going to power through to a quick recovery like Earl Campbell or give us a head fake like Tony Dorsett, teasing us with false hopes, just as Dorsett used to tease linebackers with his "now you see me, now you don't" running style.

Today, junk bonds moved below their averages again. They appear to be in a real down-trend, and we exited junk bonds to the safety of money markets with a 2% loss. If any of you are in junk bonds, I would exit them today or at your first opportunity. I think we got the Tony Dorsett head fake. For junk bond timers, that means we will have another opportunity and the rubber band will possibly be stretched tighter at a later date, and hopefully we will get back in with even more opportunity.

But the real importance is that it means investors are losing faith in the economy and the ability of companies to meet their payments. That is not good. It is another bad sign, like the disappearance of the institutional investors.

The Yield Curve

Some of you asked me how the Yield Curve is doing. It is now becoming normal. But remember I told you it would. It always normalizes long before the recession starts, so the yield curve becoming normal is not anything to give us hope, other than the more negative the curve gets and the longer it stays negative would not be a good omen for a quick recovery.

So now, we sit and wait and see if Time truly does get compressed in the New Era and the recession ends before the Yield Curve says it should be starting, or if we are going to see a longer recession than the one we experienced in 1991.

Oil Gives Us Some Good News

Once again, Greg Weldon finds some great tidbits hidden away in his vast information network. As OPEC meets today, the members of OPEC are cheating to the tune of 200,000 barrels of oil per day over their agreed upon production. At the risk of saying I told you so, I distinctly remember telling you they would.

How did I know? What secret pipeline do I have into OPEC meetings? Do I have an OPEC Deep Throat?

No, nothing so fun. I simply have watched a pattern of greed overtake these mostly dictatorial countries making them cheat on their agreements when prices are high. It is only when they have the price wolf at their door do they agree to once again cooperate.

10,000 barrels a day extra is $10,000,000 per month, give or take a few dollars. The Saudis are raking in an extra $60,000,000 per month! If the Saudis are going to cheat, what about the rest of OPEC? They are going to cheat. Now at their current meeting, they talk of cutting production 1,000,000 barrels a day. But from what level? The real levels or the fake ones?

The Lords of Nigeria and Libya are made of greed. Venezuela desperately needs cash. Do you think Iraq or Iran will show restraint? Angola is desperate and has new production coming into play. The list goes on. Only one country was not cheating: Indonesia. But that country is in political turmoil and I will bet you a dollar against a donut they are trying their best to cheat but simply cannot get the production up in the midst of crisis.

World demand for oil and everything else is slipping as the rest of the world starts to catch cold as the American consumer sneezes. Japan had a negative trade deficit last month. So did Taiwan and a few other Asian countries. I think oil prices will slip some more, helping lower inflation. Do NOT be surprised if we show a month or so this year when we actually have the Consumer Price Index show a negative number.

Has Elvis Left the Building?

The American consumer is getting nervous. Last month, we saw the highest level of unemployment checks for two years. As Weldon points out, people tend to spend unemployment checks differently than a regular paycheck. I repeat, consumer confidence has nothing to do with the view of Joe Lunchbucket about the economy, but only whether he feels secure in his job. Watching growing lay-offs, he is getting worried.

Last year, for the first time in 45 years, the average net worth of the American family dropped. Not even in 1974 did net worth decline. That is because back then, not many people were in the stock market. Now everyone is.

Do you think $4 trillion of lost stock market value would not dent our wealth? And this month, we might be losing another trillion as the broad market declines. I talk to prospective clients every day who definitely are not as wealthy as they were a year ago. Some have very sad stories. I truly feel terrible when I talk to retirees who have lost a great deal of their funds because they were told to hold onto their tech stocks.

From Morningstar: "To understand the bust, it's well worth looking at the boom--and the boom just ended was stranger than most. Even though the broad market appeared to soar in the late 1990s, a tiny number of stocks did the vast majority of the soaring. Just 11 stocks were responsible for half of the market's $5.5 trillion gain in value (as measured by the Wilshire 5000) between the end of 1997 and the market's peak on March 24, 2000. The same 11, in turn, account for half of the market's $4 trillion loss since then. Cisco Systems alone created a staggering $487 billion gain, only to give $413 billion of it back. The loss alone is enough money to buy every living American a brand-new, well-equipped PC. You can bet that Dell ($89 billion erased) would've appreciated the business."

How many of the tech investors got into Cisco prior to 1997? How many got in late in 1999 or 2000? And yet, the NASDAQ 100 still has a P/E ratio of 44. As more and more tech companies lower their earnings, that ratio will either get worse, or the stocks will drop further, or both. My bet is the NASDAQ 100 stocks drop another 25% AT LEAST.

Let me tell you straight: it is not too late to sell. Stop listening to Abby Cohen when she says we are at a bottom. Her announcement on Friday of last week as the latest "bottom" now seems ludicrous after this week's monster losses. But in few days she will go on TV again and tell us the bottom is here and "today" is a buying opportunity. Analysts are cheerleaders. They try to be nice to companies so their firms will get juicy investment banking fees. Less than1 to 2% of their recommendations are sell recommendations. They are notoriously optimistic and wrong with their earnings predictions. Ignore them. They are dangerous to your financial health. If an analyst actually gives a sell call in his market, he usually gets fired. My Dad had less polite terms for people who get paid to give the customers what they want.

You are not the customer. The customers are the companies the analysts follow, and the huge investment banking fees they pay to the brokerage firms who hire the analysts who tell you to buy.

I repeat my rule of thumb: a companies P/E ratio should not be more than its annual earnings growth for the next three years. I will bet my entire life savings and everything I can borrow that the NASDAQ 100 earnings will not grow at 44% for the next three years. Any takers? Then why should you listen to analysts who tell you such crappola, if you will excuse my French. Sorry, but I just talked to another investor who lost a lot of money listening to these cheerleaders. I will calm down in a minute.

If you are long these tech stocks, you are betting YOUR savings that they will grow 40% plus.

When to get out? I would wait till Greenspan announces his rate cut next Tueday. If it is only 50 basis points, get out as soon as you can. The markets will not like that, I think. If he cuts 100 basis points, then play the rally but still get out. It remains to be seen what they will do if he cuts 75 basis points. Maybe it rallies, and maybe it doesn't.

Are We Near a Bottom?

Investor Sentiment is still high, though dropping. Sentiment Momentum is dropping as is Sentiment Percentage Uptrends. I will not explain these again now, other than to say every one of our indicators dropping is not good. I do not see a lot of positive trends in the dozens of sentiment indicators we look at in our daily runs. The smaller traders and individuals are still trying to buy the dips. They are not yet convinced.

The bottoms of bear markets are usually marked by our sentiment indicators going below 50. There are still too many investors out there listening to the talking heads telling them to keep buying. They call it dollar cost averaging. I call it losing money.

One of two things will have to happen in my indicators to signal a bottom. We will either need to see the Big Boys come back to the table, or we will need to see sentiment go bearish across the board. The Wall Street types call it capitulation. We are nowhere near any numbers that looks like capitulation.

Deflation Watch

Gold is going back below $260. The dollar is rising against the Euro, which I find odd. I am not looking for a dollar collapse, but I thought we would see parity. Most currencies around the world are dropping against the dollar. But the rest of the world is having its problems. The dollar rising makes OPEC more likely to cheat. They want all the cash they can get to protect them against a real downturn in the world economy. They reason it is better to get the dollar one can get now rather than the hope of a dollar in the future.

Commodity prices are down and the dollar is up. This is nothing but bullish for government bonds. But it also means more room for the Fed to ease up. They are growing the money supply at huge rates. If that is any signal, then it means they intend to cut rates a full 100 basis points, but who can discern the mind of that Great Magician Greenspan?

Quoting Greg Weldon again: "LESS companies expect to hire new employees. Indeed, the Fed Survey concludes ...... "demand for labor continues to be weak." Moreover, the Survey results for "Number of New Employees" ... and "Average Workweek" ... were BOTH pegged in negative territory for the FIFTH consecutive month.

"For their part ... the Fed is acting like any good 'pit-crew' would, trying to find the right combination of downforce and torque to get the car moving smoothly along the track. As reported by the Fed last night, the M-2 money supply aggregate expanded by a whopping $25.4 billion in the latest week. That is a HUGE number, and despite the fact that the Fed has been buku-easy with money growth ... it is still MORE than TWICE the 4-week and 13-week average gains ($11.7 and $11.8 billion respectively).

Two weeks ago we highlighted the fact that FINALLY the FLOOD of liquidity boosting M-2 and M-3 for the past two months was visibly trickling down into M-1. As of last night's report, the 3-month ROC of M-1 has jumped to 4.6%, up HUGE from last week's 1.8% rate.

As for M-3 ... well it takes the cake ... with the 3-month ROC spiking to a nose-bleed inducing 14.0%, up from last week's already blood-stained 11.7% 3-month rate.

It would seem that even the US Federal Reserve is racing ... speedily boosting money supply to support a diminished US consumer.

I quote that above, and know that some of you will have your eyes glaze over at technical numbers. But I don't want you to not grasp the real impact. My take on all this: Greenspan is worried about a real recession, and he is pumping the money supply like crazy. That means he is no longer worried about inflation. I have been saying that for months. Oil being down, commodities being down, factory utilization below 80, employment growth being weak, the world in problems, and Japan getting to be a real basket case gives him plenty of room and incentive to cut. He should cut more than50 basis points. He could go for a 100. If he does, sell your stocks and mutual funds after the rise. Reality will set in within a few weeks or even days, and then look out below.

Sector Model

We have traded out of Rydex Basic Services into Rydex Electronics. Curiously, Basic Services was still #1 on our list. We made a little in this last trade, but got stopped out on our 6% trailing stop loss. Therefore we went to the next highest sector on the list, which was Electronics. I bet this trade loses some. It is not time to be sector trading. It will not be for some months.

One Sad Note:

For those of us with Irish in our blood and bloodlines, I note that last month the government of Ireland has lifted its price freeze on the price of alcohol, subsequently lifting that nation's Consumer Price Index to the highest in Europe. Let us raise a flagon of Guinness to the Motherland as we lament the trials of our ancestral climes. (How much Guinness and Irish whiskey do they have to drink to jump the CPI by 12%? Or how low did the prices have to be? It is a good thing the Irish economy is in great shape, otherwise there would be rioting in the streets!)

I am sorry about writing such a doom and gloom letter, but long time readers know that I really do try to call it like I see it. I look forward to calling the bottom, but I don't think it will be soon.

Your Irish in His Blood (and needing a bit of wine after this dismal report) Analyst,

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