-->Creating Your Own Bull Market, 2003
The Daily Reckoning
Paris, France
Tuesday, 18 March 2003
--------------------
*** Adieu, Saddam...hello stock market rally?
*** Smarter than Buffett...is this really the time to buy
stocks?
*** Moving into venture capital...consumer confidence
falling...panaceas...and more!
-------------------
Well, Saddam has 48 hours to get out of his own town. Or
else.
Investors, like gamblers at a back-alley fistfight, are
betting on how long it takes the man to go down.
The smart money is probably still on the sidelines. But the
average investor seems to want a piece of the Saddam
bashing. The Dow rose sharply yesterday; buyers believed
that the Butcher of Baghdad will be felled quickly and
happily.
God bless 'em.
What impresses us about these people is not their optimism;
it's their unadulterated immodesty. Warren Buffett can't
seem to find decent values on the stock market, but they
think they can!
Stocks are far from cheap, says the Sage of Omaha. The P/E
for the S&P has run about 18, on average, for the last 50
years. Now, it's 29...and if you use 'core earnings' as a
measure (that is, earnings without a lot of financial
hankey-pankey in them), they're over 40.
Buffett points out that the stock market is a giant 'voting
machine' in the short run. It gives investors the outcomes
they choose, just as an election gives voters the sordid
louts they select.
But in the long run, Buffett explains, the stock market is
a 'weighing machine'. It measures out a kind of rough
justice...based on what stocks are really worth and what
investors really deserve.
Investors cannot guarantee success, of course. But at least
they can deserve it. Ben Graham, from whom Buffett learned
his trade, once described the kind of stocks that were
likely to reward deserving investors. They had to meet a
number of tests, he suggested, such as having 20 years of
uninterrupted dividend payments, a P/E no higher than 15
and a ratio of price to book value no higher than 1.5:1.
Thus can investors figure out if a stock market is
expensive or cheap: simply by looking at how many stocks
meet Graham's tests. In October of '74...when the Dow hit a
major bottom...85 of the S&P 500 would have qualified,
notes Grant's Interest Rate Observer. At the August '82
low, the number was 62.
What about the pre-war low of Feb. '03? Moms and Pops think
a major bottom is at hand. They're buying stocks as if they
were masking tape and plastic sheeting. But how many stocks
really deserve their money? Only two, according to Grant's
figures: Limited Brands and Scientific Atlanta.
We'll take a wild guess: investors gambling on the Saddam
bout are not buying either of these companies.
More from Eric...and then, more below...
-----------
Eric Fry back in the city...
- The long-anticipated"Invasion Rally" kicked into high
gear yesterday, as the Dow raced ahead 282 points to 8,142
and the Nasdaq sprinted nearly 4% to 1,392. As regular
readers may recall, the New York office of the Daily
Reckoning has issued a few fleetingly bullish musings of
late - emphasis on"fleetingly". Yesterday's spectacular
rally satisfied our bullish urges. We return now to our
habitual agnosticism-tinged-with-skepticism.
- The Invasion Rally seems a bit too pat and tidy to be the
beginning of a new bull market. More than likely, we are
witnessing nothing more than a textbook bear market rally -
swift, sharp and short-lived. Just like all the prior bear
market rallies that have punctuated the market's three-year
decline, the latest advance sprung to life from the mire of
pervasive bearish sentiment. The problem with these bear
market rallies is that they wither and fade back into the
mire as suddenly as they first appeared. This rally will
likely be no different...
- As noted in yesterday's Daily Reckoning, your co-editor
has been hanging out in the Bahamas for the past few days.
So he's much better prepared to discuss rum drinks than
Rumsfeld...or President Bush and his new 48-hour ultimatum.
But don't worry; your co-editor will re-acquaint himself
with the dismal headlines of the New York Times, well
before the shooting starts in Iraq...
- The Bahamas was the site of the latest meeting of the
Supper Club - a membership-only investment club dedicated
to examining venture capital opportunities."Venture
capital" is a scary term that conjures up images of self-
important MBAs throwing hundreds of millions of dollars at
preposterously high-risk technology companies. Certainly,
some of the deals presented to the Supper Club are plenty
scary, and there is ample opportunity to lose money. But
the Supper Club is a somewhat different breed of venture
capital. For one thing, the club examines a broad range of
opportunities that are far from the type your editor finds
around these parts [NYC]. Besides, it's a great time...and
worth a word or two of commentary.
- The Bahamas Supper Club meeting, for example, featured
opportunities to invest in ventures ranging from an L.A.-
based pizza chain to an innovative electric motor to a
Northern California commercial land development to a
special widget for securing wireless PC networks.
- After each of the venture companies pitches their story
to the members, the fun really begins. It is at that point
when the members begin to candidly - sometimes ruthlessly -
- assess the opportunities that have been presented to
them. This free and open exchange enables all of the
members to make a more informed assessment about whether to
invest in a given deal. The Supper Club - whose three-year
existence makes it a mere infant in"VC years" - cannot yet
point to any"10-baggers" or other eye-popping successes.
But a couple of deals appear to be close to producing some
measurable success. As the saying goes, however,"Close
only counts in horseshoes and hand grenades". So let's wait
for conclusive success before planting the victory flag.
- Of particular interest to this observer - as one who
keeps an eye out for intriguing macro-economic phenomenon -
is that the quality of the Supper Club opportunities seems
to be steadily improving, meeting by meeting. Apparently,
the lower the stock market falls, the more frightened the
traditional institutional VC investors become. Frightened
VC investors beget hungry entrepreneurs, which beget better
deals - and better investment terms on those deals - for
members to consider.
- If you look on the bright side of things, like we do here
at the Daily Reckoning, you might notice that this bear
market isn't all bad. Not only is it easier to get a
reservation in an expensive New York restaurant, but it's
also easier for investors with the right amount of capital
to locate more attractive - and more attractively priced -
venture capital deals...and potentially profitable
investment ideas - outside of the stock market.
- [Editor's note: If you're interested in learning more
about the deals being presented at the Supper Club, or
where the next meeting will be held, we encourage you to
send an e-mail to Vickie Beard, the club's coordinator:
VBeard@agora-inc.com]
-----------
Back in Paris...
***"There are two panaceas for a mismanaged government,"
Hemingway noticed."The first is inflation of the currency.
The second is war. Both bring temporary prosperity. Both
bring a more permanent ruin."
We are not Hemingway admirers. In our opinion, his whole
oeuvre could be condensed into a single line: 'Damn, I feel
awful; let's have a drink.' But if you write enough, you're
bound to say something that makes sense (oops, we have
given away our Daily Reckoning secret).
After mismanaging the economy into the biggest bubble in
history, the Greenspan Fed has been blowing as much
inflation into the currency as it could get away with. Fed
credit has been increasing at nearly 19% (annual rate) for
the last 3 months. The money supply, as measured by money
of zero maturity, rose nearly 12% - or about 5 times faster
than the economy, again in the most recent 3 months.
But inflation is not always the panacea that Hemingway
thought it would be. There are times when people are
reluctant to borrow and spend...and times when rising
capacity (in this case, from overseas) drives down consumer
prices. Despite heroic efforts from the Fed, the economy
still seems to be in a slump - 3 years after the stock
market peaked out.
Yesterday brought more evidence that the 'soft patch'
Greenspan described a few months ago is getting even
softer. The National Association of Home Builders, for
example, just reported the biggest drop in its index since
it was begun in 1985. Likewise, consumer sentiment is at a
10-year low, judging from recent poll results.
What can the Fed do? Most likely, it will continue to try
to inflate. Look for another rate cut.
But investors have lost confidence in rate cuts. Now,
they're pinning their hopes on war.
God bless 'em, we say again.
*** A reader wrote to complain about our approving quote
from George Soros. The reader is right; typically, we only
quote Soros to show what a fool he is. But that is the
trouble with fools like Hemingway and Soros, dear reader;
you can't count on them. Sometimes they say something you
agree with.
*** Another reader wrote to say the Daily Reckoning would
still be a good deal"at twice the price".
Other reader comments:
"I have appreciated the intelligent and restrained, cynical
approach to the coming war taken by the DR. Perhaps you let
J.C. Amberger's comments ["With Friends Like These..."
03/13/03] through just to give some time to the America,
right or wrong crowd. Yet, he didn't defend the war, just
attacked the critics' motives, not their arguments.
"As you have accurately dubbed Bush as a Napoleon, here is
a quote from Christian writer Alexander Campbell's 'Address
on War' in 1848.
"'Napoleon, on his death-bed, declared that he had never
engaged, during his whole career, in an aggressive war -
that all his wars were defensive. Yet all Europe regarded
him as the most aggressive warrior of any age.'
"And another quote, 'Kings cannot grow in America. But
under our free and liberal institutions, we can impart more
than kingly power under a less offensive name.'"
God Bless,
C.
"Sirs: The biggest problem in America the past 75 years has
been poor problem solving skills. It's the common
denominator to all our other problems. Today, for example,
we honestly mistake our personal opinions for actual fact.
"Sigh! And while Caesar's fascism was 'bad', our own
empirical manifest destiny still lives, and is somehow
'good'. Hail Caesar! So stick by your guns, boys...you are
right on target!
"For whatever its worth, I do suspect that:
1.) Bush's Mission is the democratization of Chaostan, and
the first Objective of that Mission is the ousting of
Saddam. Can you say"Armageddon"?
2.) We will uncover (literally) desert military stockpiles
of WMD, thereby justifying everything (in our eyes only).
3.) But don't worry about the dollar cost of this war...
with a U.S. governor - it will all be paid for by Russia
and China, and especially Germany, and most especially by
France...out of Iraqi oil perks, of course.
"'Don't give up the ship!'"
R.E.M.
"Dear DR,
"Don't pay attention to the fools who confuse patriotism
with loyalty to the current gang of politicos who currently
infest Wash. D.C.
"The tradition of our Constitutional Republic calls for
making money from foreigners - not bombing them.
"From a strictly economic perspective the fools who call
for pre-emptive war will wind up making a 'pre-emptive'
strike on our economic well being. Their military
adventures will accomplish nothing but huge future deficits
and a sickly dollar.
"I wonder how 'gung ho' the current crop of Baby Boomer
Bombers and aging chickenhawks will be when they discover
they are exchanging Social Security checks for rebuilding
Iraq's infrastructure and paying the salaries of Iraqi
civil servants salaries rather then funding Medicare...
"In the not-too-distant future, when the Gung Ho Geezers
wake up every 2 hours to pee because they are too poor to
buy prescription drugs since their pension funds have lost
90% of their value and Medicare is bankrupt.
"Waking up in the quiet solitude of night is a good time to
reminisce over the glories of Empire."
Regards,
F.L.W.
"Dear Daily Reckoning Editors,
"It makes sense that quite a few people would be sending
negative comment your way since people living within the
U.S. and accessing U.S. media exclusively are often
completely out of touch with the opinions and information
available in other countries. My Australian brother and I
see the world very differently from our brother and parents
that almost never leave the U.S. and are looked upon almost
as Martians when we share an opinion.
"I tend to agree with Le Carré that the U.S. has gone mad."
R. Germano
The Daily Reckoning PRESENTS: The close of the markets in
2002 marked the first time in 60 years when U.S. markets
declined for three consecutive years. This abysmal trend
has continued through the first three months of 2003. But,
suggests Jim Davidson, that shouldn't slow you down...
CREATING YOUR OWN BULL MARKET, 2003
By Jim Davidson
"Wealth is another word for change."
- Paul Romer,
New Growth Theorist
War with Iraq. Terrorism. Bankruptcies. Corporate Scandals.
Crisis in South America. Uncertainties about the economy.
Nuclear Brinkmanship by North Korea. Skyrocketing oil
prices. A faltering dollar. Developments during 2002 and
early 2003 have done little to satisfy hope for a sustained
rebound from three years of declining stock prices, much
less ignite a stampede to a new bull market.
The blue-chip S&P 500 lost 23% during 2002 (which closely
matched the drop experienced by the average mutual fund
investor, who was down 22%). This continued the painful
decline that began with a 10% S&P drop in 2000, followed by
a 13% decline in 2001. It was the first time since Hitler,
Mussolini and Tojo were on the march - 60 years ago - that
U.S. markets declined for three consecutive years. This
abysmal trend has continued through the first three months
of 2003.
Now, more than ever, one of the crucial mysteries for you
to decipher as an investor is,"What is the prospect for
economic growth in the months and years ahead?" And"How
can I prosper no matter whether an environment of growth or
retraction unfolds?"
Your editors at The Daily Reckoning, observers of the Old
School, think the prospects of economic expansion are
negligible because of heavy debt and a moral requirement
that investors be punished for the"excess returns" of the
1990s by a"regression towards the mean".
In other words, they think it is impossible for the returns
on investment to increase substantially over time. In
effect, they posit a kind of"steady state" of economic
potential, as if some law of physics with the potency of
gravity ordained that profits wear lead boots. But I know
of no such law of physics. To the contrary. The possible
rate of return on investment is clearly variable. It is a
function of the rate of economic growth.
In that respect, I am by no means persuaded that the
prospects are bleak."If the Information Revolution
increases the underlying rate of economic growth as much as
the Industrial Revolution did," I wrote over a year ago,
"the economy could grow by 18% per year. I don't expect
that. But the upsurge in the secular trend of growth could
surprise almost everyone. Part of that surprise could be a
much more rapid recovery from the downturn than would be
expected in a standard business cycle."
I am intrigued by the expansive views of MIT computer
scientist Ray Kurzweil. Kurzweil believes that the rate of
technological progress is ponderable. Due to the
exponential growth of computational power (up an
astonishing 40 billionfold over the past 40 years),
technological progress is also expanding on an exponential
curve. He calls this"the law of accelerating returns".
Kurzweil is not talking about investment returns, but his
argument amounts to the same thing. He believes that the
rate of technological innovation will double in every
decade of the 21st century, resulting in the equivalent of
20,000 years of technological progress before the year
2100.
Paul Romer, quoted above, is an economist, not a high-tech
genius. He makes no claims at all about his ability to
foresee technological change. But his analysis of the
dynamics of economic growth, for which he is touted to win
the Nobel Prize, points to a vastly greater potential for
growth in the Information Economy than ever existed in the
Old Economy of material objects. The crux of Romer's
argument is that the old, classical analysis of economic
growth, which viewed economic inputs as limited to"labor,
capital, and total factor productivity" (a vague proxy for
technological progress), was unduly pessimistic.
Although the older models acknowledged that technological
progress was an important long-run contributor to economic
growth, they were mum about exactly what was at work. Where
his predecessors were silent, Romer is articulate. He
believes that the so-called"classical growth theory"
overlooked the most potent source of economic growth -
ideas. By contrast, Romer's new model of economic growth
embraces technological progress, claiming that ideas,
rather than labor or capital, are the main drivers of
growth.
"Ideas are different. Ideas have special properties," Romer
says.
While things such as land, machinery and capital are
scarce, Romer argues that ideas and knowledge build on each
other and can be reproduced cheaply or at no cost at all.
In other words, ideas don't obey the law of diminishing
returns - where adding more inputs like labor, machinery or
money eventually results in the trailing away of additional
output.
An important confirmation of Romer's perspective has been
evident in the market for information technology over the
past quarter century, where rapidly falling prices have not
resulted in a falloff in demand. Skeptics may gripe that
most people buying computers have more computational
capacity than they know what do with. But new applications
are constantly being invented, creating markets that the
skeptics never imagined.
This has sweeping implications for investment. Because
ideas are limitless, the prospect for long-run growth at
accelerating rates are much better than proponents of the
old growth models would have you believe. They enshrined
the concept of diminishing marginal returns, which led them
to brood about"the limits to growth". The law of
diminishing returns states that as a firm uses more of a
variable input, with the quantity of fixed inputs constant,
its marginal product must eventually diminish.
Diminishing returns challenge the logic of the growth style
of investment, implying that growing firms cannot continue
to make profits indefinitely. However, as Kevin Kelly
points out,"this law only holds true when applied to
physical assets and traditional industry, not to the
digital economy, where intangible assets such as Wired
editor knowledge are so important. In fact, for certain key
components of the digital economy, such as technological
advancement and an emerging information society, the
opposite is true: increasing returns are commonplace. For
example, the costs of developing a new piece of software or
an operating system like Microsoft Windows are huge, but
once the first unit of the product has been sold, each
subsequent unit sold costs relatively little to produce. By
the same token, firms selling information-based products
also exhibit increasing returns: the costs of reproducing
an information-based product are practically nonexistent."
One of my objectives as an entrepreneur, investor and
investment analyst is to harness the power of increasing
returns in our portfolios. Software and biotechnology are
particularly well suited to increasing returns. These are
areas that stand to redefine an industry and spawn new
industries, and transform our way of living. If you can
identify and invest in technologies and businesses that
offer the potential of"transformational" change, you can
grow very wealthy. Cases in point are Bill Gates and Steve
Case. They did not found the Internet, the origins of which
date back to 1958, but they recognized the potential for
transformational change that the Internet could bring about
and began developing and investing in it early. Of course,
they became billionaires...and made thousands of other
investors into millionaires along the way.
In the somewhat depressing and uncertain climate I outlined
in the first paragraph of this article, it is easy (and
natural) for investors to be lured by the illusion of the
security of shifting their portfolios into well-known and
more liquid names. While eventually your blue-chip holdings
may rebound with the return of a bull market (whenever that
may occur), you don't want to wait that long. You can
create your own bull market by focusing your investment
resources on building wealth now rather than waiting for a
collective change of heart to confirm that investing in the
stock market is once again"the thing to do".
In even the worst market, there are always fortune-making
companies for sale while they are cheap. There are always
some sectors that enjoy special conditions, which can lead
to"bull" markets for them - even while better known
companies suffer.
Regards,
Jim Davidson,
for The Daily Reckoning
|