-->Decisive Indecision

The Daily Reckoning

Santa Fe, New Mexico

Thursday, August 05, 2004

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*** The Great Bust: The end of the beginning?

*** Stephen Roach...negative real interest rates...time to
sell bonds?

*** Santa Fe...St. John's College...An eighth-grade test
from 1895...and more!

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Consumers ran out of juice in June. Federal tax cuts played
themselves out...and spending fell. Spending on durables
took its biggest hit in 17 years.

What will get this consumer-led expansion back on track?
More tax cuts? Not likely. Another round of home
refinancing? Hmmm...hard to imagine.

Real wage growth is still negative - raises are averaging
less than inflation. Without any further sources of
available money, how will consumers continue to spend so
much?

Has the end of the beginning of the Great Bust finally
come? Maybe...

But no one cares anyway. It's the summer vacation season.
Along with millions of others, we are traveling around,
seeing the sights and hardly thinking about what happens in
the economy or on Wall Street.

Besides, the Dow has been over 10,000 for so long - and the
price of gold is once again under $400 - that few people
take our warnings seriously. Nothing can stop this great
economy, they say. And nothing does...until something
does...

More financial news from Tom...and then notes from a
strange city...

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Tom Dyson, just a stone's throw from the Washington
Monument...

- It's going to be a frenetic few days in the bond market.
On Friday, we get the reading for July's nonfarm payrolls.
Then on Tuesday, the market will be captivated by the
penultimate Federal Open Market Committee meeting before
the election.

-"I've never seen a Fed tightening cycle where someone
didn't go through the windshield." Stephen Roach was
scaring people on a recent conference call. We had dialed
into to the call at Morgan Stanley to learn something about
the unwinding of carry trades. What transpired was more
like a radio creep show.

- With the CPI at 3% and nominal interest rates at 1.4%,
Roach reminded us that we are currently living with a
negative real interest rate in the region of -1.6%. (Roach
uses the median year-over-year change in the CPI versus the
fed funds target rate.) We haven't seen real interest rates
at these levels since the late 1970s, he said, drawing a
direct connection to the extremely poor equity returns of
the period.

- Then in late 1993 and 1994, the last time the Fed raised
rates aggressively - from 3% to 6% in under 12 months - we
witnessed what Roach labeled"the worst performance ever by
the bond market." During the melee, real interest rates had
quickly climbed by nearly 5%.

- The stock market has, broadly speaking, been in a sweet
spot underpinned by the most"relaxed rates in history," he
argued."But as the potential for another 1994-style bond
meltdown gains momentum, this may be about to change."

- Here at The Daily Reckoning, as astute readers are
already aware, we, like Roach, argue that bonds have just
completed their first year in a secular bear market.
However, since reaching 4.90% on May 14, and the lowest
bond prices in two years, the 10-year Treasury bond has
rallied, clawing back nearly half of its initial decline.
Markets are wont to do this.

- There are technical and fundamental reasons for this
rebound. In May, bonds became extremely oversold after nine
straight weeks of losses. They were due for a bounce. At
about the same time, the news turned from being strong to
weak, sealing the new direction in prices.

- Again, last week, yields continued their decline on more
weak economic news. Yesterday, the 10-year bond closed at
4.43%, unchanged on the day, while 30-year bonds ended the
day at 5.17%. The market as a whole, in terms of price,
hovers just shy of a four-month high.

- Given that we are in a secular bond bear market, is it
the time to start shorting bonds again? Your editor is
already short bonds, but at only a cursory level; and for
what it's worth, we'd like to start ramping up our position
even more. However, for now, we will exercise caution and
urge readers to do the same.

- Overall sentiment towards bonds still seems very bearish.
The Commitments of Traders report corroborates
this...speculators are now more bearish on bonds than they
have ever been.

- And this from PIMCO, the managers of the world's largest
bond fund:"Much of the rate increase associated with
expectations of Fed tightening and higher inflation has
already occurred. Higher rates should cool the economy in
the near term, preventing the benchmark 10-year Treasury
yield from climbing much higher than 5%."

- Yesterday, the markets were largely unchanged. The Dow
closed at 10,126, gaining 6 points, while the S&P and
Nasdaq both fell marginally: The S&P closed 1 point lower,
at 1,099, and the Nasdaq lost 4 points, to 1,855.

- In the commodities pits, oil retreated from the prior
day's record, slipping $1.32, to $42.83 a barrel, while
gold dropped $1.90, to $391.95. The dollar hardly budged.

-"Investors seldom get what they expect, yet always get
what they deserve," observes the ubiquitous West Coast
correspondent Peter Schiff."Today's bond buyers, blindly
following Government and Wall Street propaganda, while
ignoring common sense, will similarly fail to achieve
anything near what they expect, but something much closer
to what they deserve."

-"At the end of the 1982-2000 super-bull market in stocks,
investor optimism on future earnings reached an extreme. At
the end of the 1981-2003 super-bull market in bonds, it
makes sense that expectations of benign inflation would
also be equally absurd."

- Expectations remain largely intact...for now. In the
meantime, we watch...we wait...and we wonder who's going
through the windshield this time. Freddie Mac? The dollar?
J.P. Morgan? George W. Bush?

- Buckle up...

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Bill Bonner, back in Santa Fe...

*** We have visited Santa Fe several times over the years.
You'd think we would have taken the city's measure by now.
But it is a city that won't stand still long enough for you
to stretch out a tape.

At one time or another Santa Fe has been a trading post, a
religious center, an administrative hub, an arts colony and
a western cow town. Now, it is a near-perfect place to have
a midlife crisis.

In Santa Fe you can create a new life for yourself. You can
get rid of your wife...grow a pony tail...put on some
turquoise ornaments...get a pickup truck...take an interest
in art...try transcendental meditation...live in a brown
house...learn about vigas and chili peppers...drink Dos
Equis beer...buy some Georgia O'Keefe pictures to
decorate...build piñon fires in the corner fireplace...get
a season pass to the opera...wear blue jeans every
day...and find a new girlfriend who wears hiking boots and
doesn't paint her fingernails.

"Santa Fe is a very pretty town," Elizabeth opined."The
houses on the hillsides are nearly invisible. There must be
strict building codes. All you see is the reflection of the
sun off the windows. Everything else is in adobe color -
the color of the ground. The style is very attractive. If
people put up the usual houses...you know, with vinyl
siding and gabled roofs, they would stick up all over the
place. The city would be hideous. Instead, it is
attractive, sophisticated...and very up-market. The other
thing that's nice about it is that it is small. You can get
anywhere you want in about 10 minutes."

Santa Fe is a rich town. It is a place where people come to
spend money. Where and how they make it...we don't know.

*** Our reason for coming to Santa Fe was so that Jules
could visit St. John's College, which has one campus here
and another in Annapolis, Maryland. St. John's is a curious
school that makes no pretense of preparing students for
careers. Nor does it seem particularly interested in the
typical admissions process. There are only 500 students at
the Santa Fe installation. There are no research labs.
There are no big-name professors. Nor is there a football
team; the only sport at which St. John's competes is
croquet.

"We do not really teach anything here at St. John's," our
guide explained."We merely read and discuss the great
ideas that have shaped our Western civilization. We begin
with the Bible and pre-Socratic philosophers...and work our
way forward, chronologically, in math, music, science and
literature, as well as philosophy and religion, until we
are discussing Max Planck and Ludwig Wittgenstein and other
more modern thinkers."

This appealed to Elizabeth. She saw a chance to turn over
the job of improving Jules to someone else.

But Jules was not sure.

If humans were simpler, more rational animals, his father
recalled, politics could be studied as though it were a
science...the Federal Reserve really could guide the
economy...and he could tell Jules what he really thought
about St. John's College. But if he spoke too favorably
about it, Jules might decide to go somewhere else - merely
to assert his independence. The old man kept quiet.

***"Would you like to help defeat George Bush?" asked
several DNC activists on the town square in Santa Fe.

"Yes," we replied. But before their faces had completed a
smile, we added:"And that humbug Kerry, too."

***"The average American college student..." we wrote two
days ago,"is about as well educated as a person with an
eighth grade education 100 years ago."

"Not so!" says a DR reader:

"Here is the eighth-grade graduation test given in Salina,
Kansas, in April 13, 1895:

*Grammar* (Time, one hour)

1. Give nine rules for the use of Capital Letters.

2. Name the Parts of Speech and define those that have no
modifications.

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The Daily Reckoning PRESENTS: The stock market just isn't
behaving itself these days. And no one's making any
money...at least that's what the pros say. But don't
despair! Here's the best way to play this market...

INDECISIVE DECISION
by Lynn Carpenter

Some say it's a roller coaster. Others like to call it a
yo-yo. But the most accurate thing to call the market today
is indecisive.

You've no doubt noticed it by now - any bit of news can
move the market up or down a few hundred points. Then it
suddenly heads in the other direction because of another
bit of news.

For normal investors, it's a nightmare. I don't believe the
same is true for value investors. The very definition of
value investing is tied up with value, not current price
movements. We know there's a lot of fear behind the impulse
buying and selling. That means unpredictability...and value
investing isn't about unpredictability. Even if the market
price is jumping around like a headless chicken, we are not
lost, because we buy on the basis of the company's value,
which does not fluctuate rapidly.

But even if you only buy undervalued companies, your
portfolio is still not bulletproof. Even good companies can
go soft. Their products can lose appeal; their production
and sales costs can go up while their ability to raise
prices doesn't. New technologies and new services erode old
favorites; once-lesser competitors revamp and start
stealing customers. CEOs change, commodity prices change...

Few people remember to get out when things change, and
sometimes they don't even notice. This is fatal. When you
buy a stock, surely you have a reason. I presume it's a
better one than,"My golf buddies say this is hot." So look
at your stocks and recall those reasons. Did you buy a
company because you expected it to continue increasing
sales 20% a year? And now it's only increasing sales 5%,
and it's been slowing down for the last four quarters? Man,
you shoulda been gone!

Value investors are realists. I find most of them are good
business people. So they understand that missing an
earnings forecast for a quarter may be reasonable. They get
it when a key commodity price cuts into margins
temporarily. You shouldn't overreact, but you should know
why you bought every stock in your portfolio. And if any of
them aren't still doing what you originally hoped, it's
time to reassess.

Of course, it always helps to stay out of bad markets. This
requires timing. Go away and come back when it's better, in
other words.

That would work if you could distinguish between the
rallies that are going to succeed and the duds. I can't,
can you?

Nobody does it well. I'm halfway respectable as a market
reader, and I don't try to time the market for investing. I
keep at it steadily.

There is something that is very close to timing that you
can do, however. Get there first. If you look for values
and exceptional companies, you tend to land in the right
places. The clue is when your list of good stocks to
consider seems to be heavy with clusters of stocks from the
same industry or sector.

For instance, last year, I added a series of small-cap
companies to the Fleet Street portfolio, because that was
what I was finding in my searches for strong values.

I didn't decide,"Hey! Small caps are it!" though it turned
out they were the flavor of the year. But I couldn't care
less what's popular, since I'd rather bank money than Miss
Congeniality statuettes. As a value investor, you don't
have to follow a trend...you can discover one.

Here's how the world really works: In searching for winning
companies last year - the sorts of companies with
particularly strong and predictable growth, leadership in
at least part of their industry and good profit margins - I
came across more small-cap companies than usual. In 1999,
it was a handful of transportation companies that passed
the test. In 2001, it was midcaps. In late 2002 and early
2003, it was dividend payers.

Essentially, we followed some basic principles. For
instance, brand-new companies tend to be riskier
investments, so we preferred companies with several years
of history to analyze. What we were looking for was a track
record that showed success in good and bad years, even when
things were difficult for the economy or a company's
industry. That way, we can expect that somebody there knows
how to manage well. And whatever this year and the next may
bring, the business is in the hands of can-do people.
Finding stocks that meet those tests also means you can
take time for the stock to work out.

When a company's operating history is short, I put more
emphasis on the business strategy and industry outlook when
making forecasts. Either way, you don't have to go the
high-risk route of buying stocks that have to move fast
before the hype wears off and there's nothing left.

We also looked at underlying fundamentals carefully. You
know what these are - things like sales growth, earnings
growth, debt level, return on equity and assets and value
ratios like P/E, price to sales, price-to-cash flow and
price to book.

Finally, we always forecast what we expect from each
company. Most conscientious investors have some method of
looking at the track record and fundamentals, though
usually much less detailed than ours. But then they go to
Money magazine, their brokers or Wall Street analysts for
whispers and guidance about what tomorrow will bring. And
all they get is a bunch of arrant nonsense:"Company X's
earnings will be 52 cents in Quarter 3." That's not an
outlook - that's baloney.

Those estimates are usually wrong. But even when they are
right, they're suspect because savvy companies that manage
their stock price a little too sharply play around with the
numbers in order to meet or barely beat expectations. Defer
a cost here, advance a project there and you have a perfect
rob-Peter-pay-Paul system for making the financials come
out where analysts expect - and of course, so-called
"earnings-guidance" announcements for companies to tell
analysts what to expect.

Our forecasts don't pretend to be as quantitative as they
are qualitative.

When weighing the future, I never predict 52 cents in
earnings. Instead, I look at the industry, the competition,
the economy, the profit margins and estimate reasonable
growth rates and the ability to increase or at least hold
on to market position.

So even if this petulant market frustrates you, don't go
hiding under the covers. Uncertain markets always have an
upside. You just might have to look a little harder. When
the other investors are being indecisive, you can be
decisive...make tough choices and find bargains.

Regards,


Lynn Carpenter
for The Daily Reckoning