Does Santa Still Deliver?

These last few workdays before the Market goes holiday-somnolent find us puzzling over what seems like a departure from normal year-end Market action, and, not surprisingly, wondering about what the New Year will bring for investors. As is fitting for such a way-too-interesting year, the home stretch of 2009 seems to be disregarding the normal, seasonal cue cards. That would be a wave of abnormal selling pressure as yearend approaches, attributable in the main to the need or desire of many investors to generate losses for tax purposes. The eventual abatement of this tends to be followed by a decent rally in the indices, which has been called the “Santa Claus Rally” or more prosaically, the January effect. This has gone on for many decades, though in recent years the “January-ness” of it has diminished. As more investors, no doubt trying to get a jump on others, have done their tax loss selling in November if not October, the rally which follows has shifted into December.

Last year, the Panic which started in earnest in September marked out a bottom of sorts on November 21 and pretty much did away with the need for anyone to deliberately generate a tax loss for the purpose of offsetting gains (not that 2008 had been rife with opportunities to book gains in the first place). The unpleasantness that dominated the early months of 2009 has blotted out the memory of a DJIA that rose some 24% from its 11/21 nadir to its intraday high on 1/6/09. This time around, the effect of tax loss selling seems hardly to have registered. Most of us can find the answer to why this is by reviewing our accounts. If there is not a lot of tax loss selling going on, it is because most investors have enough of those cussed things already, booked early in the year if not carried over from last year. To the extent they also have gains, they are probably still of a short-term variety, and probably only a few months before they go long term. This dearth of what is normally seasonal selling pressure is in my estimation being met with unusually strong demand from money managers who underestimated the power of the post 3/9/09 recovery (We all underestimated it, but some of us at least recognized the turn in the tide and found the courage to act). This “better late than never” buying is no doubt motivated by the fear of being taken to task for missing out on what has come to feel like the rally of a lifetime. We should not be surprised if once 2009 is passed, this upward pressure abates, and so allows the Market to sell off to a degree that would be considered a meaningful correction.

In reviewing the tape, so to speak, of that way too interesting time that was the last leg of that historic Bear Market, I could not help but notice that for many stocks, 11/21 really was the Bottom. There were lots of stocks you could have bought 100+ days ahead of what we all hope is the Generational Low of 3/9/09 and you did alright, certainly better than if you had waited until March and then been so balled up full of dread that you did nothing (a real possibility considering just how scary it was as we stumbled along what felt like the edge of an abyss). November was the bottom for many of the stocks that had fallen from favor clear back when the Market got its first whiff of impending recession. That last leg down after 1/6/09 was much tougher on the stuff that investors thought was somehow immune, as if the Market was making a point about “no place to hide”. There might have been more bargains on 3/9 than on 11/21, and there were no doubt some even more extreme bargains, but my point is that while an investor who went “all in” 100 days too early would have paid a great price in terms of visceral wear and tear over the next three months (unless they had the good sense to go on a sabbatical in Patagonia or something like that), a year later he still would been sitting pretty indeed. It’s not about timing the Market, but it is a lot about being there when it hurts.

So what should we expect in 2010? Viewed through the lens of that bag of tools that is securities analysis, the Market is by any measure ahead of itself and poised for some kind of meaningful correction. In terms of what I call Commercial reality, I get a very bifurcated view. If the business is based on truly global demand (e.g., components for electronic devices that facilitate connectedness on one’s own terms, aviation equipment) growth and/or cyclical improvement if not downright excitement is clearly in the picture for 2010. If it is strictly domestic and at all discretionary (e.g., housing related), the road ahead looks steep and slippery for as far as the eye can see. It is going to be trickier to make money in the Market in 2010 than most of 2009 turned out to be. I would expect to be a net seller over the course of the year until a convincing correction (15% decline in major indices) manages to take place. My sense is that while there will certainly be numerous days when the Market swoons, such a meaningful and sustained pullback is far from inevitable. Absent the sort of development that registers in the history books, we are looking at a Price Reality that probably keeps the Market on an upward skew for most of the year ahead. This is because equities, especially US equities, seem to be setting up to become the proverbial, albeit short-lived, “only game in town”.

Such momentary madness (where residential real estate was just a few years ago) generally happens by default. Money is restless, and sometimes flocks to the least ugliest candidate in the beauty contest. The world is awash with capital looking to earn a return. Where can it go? As I survey the options, and consider the degree to which so many investors cannot or will not accept mere nominal returns, it is hard not to see a net flow into equities. Money rates are practically nil. Bonds (a.k.a., certificates of confiscation) have just done the seemingly impossible, outperforming equities over the course of a full decade. A year ago, there were once in a generation opportunities in corporate and municipal bonds, but that cow has since been milked. Look for a regression to normal and then some. Commodities, especially gold, have just gone through that classic, 10 +/- years procession from dead money to a near-mandatory category of asset allocation. As with any other asset whose price has gone hyperbolic over the course of a decade, gold could easily double again, or already have started a multi-decade slump back into sterile oblivion. (You pay’s your money, you take your chances.) Real estate abounds with opportunity, distressed priced assets in the hands of those who did not intend to be owners, but only for the truly astute who can afford to be patient. (The demise of the popular notion that it is the rule rather than the exception that home ownership will be a primary generator of, as opposed to a mere store of, personal net worth, will be the subject of a Musings in the not too distant future.) And however important it is to have a global orientation to one’s investments (i.e., exposure to companies that are not strictly domestic), Dubai World and now the sovereign state of Greece are reminding us that there are risks and uncertainties of a whole different order when one ventures beyond our shores. Indeed, investors are likely taking heart from the recent political developments here in the U.S., where the system has proven remarkably resilient against what earlier this year looked like an unstoppable takeover of productive assets by the non-productive. Damage is indeed being done, but nowhere near as badly as we were tempted to expect only six months ago, and the ugliness of the struggle seems to be setting the stage for a vintage 1980-like revival.

The debate among analysts as to what stocks are worth can (and does) go on ad nauseum. The reason Bull Markets of every sort last longer than those of us who “know better” can make sense of is that a big popular market is one place where wishing really can make it so, if only for a season. The data of valuation is inherently debatable and ambiguous at best. What seems to tip the balance in a direction accommodative to price appreciation most of the time (i.e., except during periodic Bear Markets, when all this accrued unreality gets flushed out and then some) is a heartfelt need on the part of investors at the margin to be able to earn “acceptable” returns. “Acceptable” got up around 20% during the late Nineties. It is not that high now, but it is a lot higher than fixed income can presently deliver. Marginal investors and their enablers will see the data in a light that will continue to bid up stock prices. A resumption of M&A activity will produce “metrics” which confirm bullish valuations.

This will to believe in the “everything’s going to be alright” that comes with plump 401ks that don’t need a lot in the way of cash contributions is why the Bull can be durable and powerful beyond all we can make sense of. So as we approach 2010, I remain “constructively fully invested”, which is to say with a modest amount of “dry powder” in the event we hit an air pocket early on in the New Year. Barring a downturn at least as spirited and durable as what marked June of this past year, though, I would look to be much more a seller than a buyer as the year goes by, making sure I have the flexibility to take advantage of any kind of “bump in the road” as well as whatever other needs for cash might come along. If you can’t afford (i.e., are yield dependent) to keep upwards of 20% of your investable net worth “at the ready” (in cash) a good deal of the time, you will be operating at a significant disadvantage to those who can.

Systemic Inscrutability Reaction Syndrome

This week’s research workload saw us more engaged than usual with inscrutably complex systems and the tendency of experts to bluster past their mysterious aspects. No, I am not referring to the oh, so, au courant question of Climate Change, though it is a mystery indeed how when all those generators of hot air and bad gas congregate in the Nordic regions, so much of North America is visited by record breaking cold. (Could it be a somehow endothermic extinguishment of the celebrity star power of a certain professional golfer/lothario?) This week has been very much about trying to get to the bottom of what drives demand for a promising new medical device that has been developed by one of my companies, which has meant trying to learn all I can about how the body responds to trauma. It is truly amazing how, via what is called the sympathetic nervous system, our bodies somehow “know” to respond to threats. We understand this in terms of “stress”, which triggers responses (adrenaline, endorphins, faster pulse, being “in the zone”, etc.) that facilitate fighting back and otherwise coping (“eustress”), but past a certain threshold render us less effective (muscle tension, excessive perspiration, “choking”). When the body experiences trauma that it somehow deems life threatening, this same sub-system starts down a pathway that is initially manifested by what we call shock. This mechanism seems to start out as a way of enhancing survival. For example, blood is restricted from the extremities so that it might concentrate on the brain and heart, which are most susceptible to damage in the event of oxygen deficit. However, if this chain of events persists long enough, it cascades into things like S.I.R.S (systemic inflammatory response syndrome), sepsis (S.I.R.S + a pathogen) and multiple organ dysfunction syndrome (MODS), hallmarks all of what despite all of our progress remains pretty much a path of no return. I cannot help but wonder, when I consider the lot of that vast sweep of humanity that did not exist on this apex of technologically-rendered ease and comfort that we think of as normal, if perhaps this is a system seemingly designed to hasten death and make it less difficult (akin to how shock can shut down the pain response to the sudden loss of a limb) once a certain point has been passed.

In the process of learning not only about this marvelous system and how our understanding of it has evolved in recent years, but also how clinicians and other practitioners respond to evolving knowledge, I could not help but see the similarities that arise in any field of inquiry where there is complexity shrouded in mystery. (Perhaps we should define mystery as a way of describing that part of a field of study for which our tools of inquiry remain inadequate, or perhaps do not exist at all.) The ways we go about trying to understand the system that is human physiology are not unlike how we address similarly complex and mysterious systems like climate, the economy, or the enterprises which comprise the productive portion of an economy (or the government entities which comprise the non-productive portions). In any case, we have lots of data derived from observable phenomena and subject to timely verification, but much of what we like and need to know is shrouded in mystery. In these cases, we rely on indicators where the connection between the observed phenomena and the functioning of the organism is plausible but not assured. Sometimes we find indicators that seem to have predictive value (“leading”). More typically, we get lagging indicators, which obviously are not much help in dealing with contemporaneous threats to the system, but do help us learn and so be better prepared for the future.

With this in mind, the old joke about the drunk looking for his keys under the lamp post (“because the light is better”) comes to mind. This joke is a classic because it connects with something very real in the human condition. We go where the light is, with the indicators we have and are used to. The passage of time invariably brings up new ways of looking at things, but the uptake is way slower than an idealized understanding of ‘the pursuit of knowledge” would expect. Medical practitioners understand the mysteries of physiology which they face each day with the accepted wisdom they “grew up with”. Experts in all fields find themselves similarly stuck. To the degree that reputations, academic sinecures and other forms of financial security are tied to a certain interpretation of a field of inquiry whose understanding is hindered (if not foreclosed) by mystery, resistance to reinterpretation is all the more likely to occur.

I would like to think that my experiences as an investor have provided something of an antidote to this. It is, after all, about acting on the courage of one’s convictions with respect to an ultimately inscrutable future. The Market is pretty good at instilling humility, at teaching us, if we are willing to absorb the lesson, the consequences of being dogmatic about mere data, especially when we have confected some elegant hypothesis that ends up almost but not quite bullet-proof. Spare me the pride of authorship if it psychologically locks me into an eventual capital loss! (In the aftermath of that avalanche of humility that was the Market a year ago, it was a real treat to read Mr. Buffett’s interview with the WSJ about his experience, to be reminded that we weren’t the only ones experiencing stress bordering on shock!)

Such humility seems to be lacking in fields where there is nothing like the Market doling out its corrective feedback. Indeed, any subject that relies heavily on indirect measures of what happened before there was anyone measuring is probably going to end up overrun by reckless speculation. I suspect this is a problem in any number of disciplines (paleontology, cosmology, etc.) but is especially in play in what we call climate sciences. Here, with the Climategate scandal, we have been treated to an illustration of exactly why “appeal to authority” is one of the classic logical fallacies. Scientists are human (though not all “scientists” are really scientists in the sense that they actually use that methodological set of tools that is science as classically understood). We should not be surprised to learn that there are scientists (even in the real sense) who are pretentiously and yet falsely “objective” in much the same manner that we find clergy whose facade of “holiness” turns out to be an instrument of deceit. (For some reason, something in us tends to want to hold the clergyman to a higher standard. Mysterious, no?)

Back to where my research goes on, the path that took me into the mysteries of physiology is pointing in the direction of what just could be, from the perspective of picking stocks, my biggest winner ever. The device in question appears likely to be able to replace lagging and difficult-to-do indicators of shock with something of a leading indicator (i.e., hypoperfusion of oxygen in the microcirculation as opposed to arterial or venous) of shock, or at least early enough to prompt a more timely intervention aimed at keeping the patient’s system from starting down the aforementioned path of no return. It has also been found to be useful in cutting down the likelihood of over-resuscitation, which is both expensive and damaging. In a venue where each hour of delay in recognizing the onset of sepsis (the #2 killer of the elderly) increases the likelihood of mortality by 7%, a simple to operate, noninvasive early warning would seem to be a real game changer. The financial implications of this are staggering, and will be the subject of much work by High Road Value Research in the year ahead. Stay tuned.

Put Another Log on the Fire

This week finds us wondering about something we thought we had gotten away from when we exited Upstate New York: the prospect of running out of firewood!  An early start to winter way down here at Latitude 30.32 has our wood stove working a lot harder than recent experience had led us to expect. A blast of snow and hard frost has it is starting to look like our not inconsiderable wood pile might not get us through winter. Now the consequences of this are not as bad as in one of our “favorite” memories of life in the Taconic Hills (i.e., stumbling around in the snowdrifts looking for deadwood that might be burnable) but it certainly helps to set my frame of mind as I consider the scandal that has engulfed the “science” of anthropogenic global warming (AGW). 

This recent uproar, wherein a coterie of scientists got caught red-handed perpetrating an array of dirty tricks in order to protect their carefully orchestrated “consensus”, does not offer much as to the substance of the debate over AGW. To argue that it somehow settles the matter as to whether the “A” belongs next to the observable phenomenon that is “GW” would be to stoop to the same tainted logic that its promoters have used in imploring that “the discussion is over”. A wobbly case just got a whole lot more so, but it is the authority upon which so much of it rested that took the real hit. At issue is a matter even larger than what the Gasbag from Tennessee or that weird man who is in line to be the next King of England have told us is at stake. Our worst suspicions about collaboration between corrupt journalism and corrupt science have been confirmed. Like the proverbial pair of sticks, portions of those two institutions were rubbed together under a pretense of producing illumination, but after years of generating nothing but blinding smoke have suddenly burst into a pyre that threatens to immolate both of them.  

Now to say that an enabling if not morbidly incurious Establishment media has lost yet another shard of credibility is not unlike describing the Titanic settling a bit deeper into the sea bottom as “sinking”. Corruption in the press has been with us for about as long as there has been printing, though the fatalism that has accompanied the technology driven splintering of media seems to have hastened the rate of putrification. The true heart of the matter is what this scandal has to say about the enterprise that calls itself Science. We should not be surprised that people who choose this path are any less corruptible than those who choose others. The proportion who succumb to, say, greed might not be as high as what we observe on Wall Street, but that does not mean that at least a few “scientists” will not sell out for money. The temptation to celebrity,  to prideful repute as a top “expert”, or that urge to be a part of some “inner circle”, and of course the impulse to exert control over others; has not Science grown to be a sufficiently capacious tent to provide cover for legions who are susceptible to these? Thoughtful observers will not be surprised to find that Big Science has its bad apples, too. But as others have already observed, AGW has over the past few decades become the face of Science as popularly understood. It has not helped that like so many other words, “science” has gotten so squishy, to degree that what we once called the “hard” sciences have been buried under all kinds of activities that employ a lot of “scientists” in what amounts to mere speculative (i.e., not subject to that empirical verification that once defined the heart of science) activity. With AGW having hogged the spotlight for so long and now having been rendered suspect by the exceedingly unscientific actions of its perpetrators, we have to wonder how much damage will be done to the credibility of science as a whole. 

This is not an altogether worrisome development. One wonders how hard anyone anywhere thinks about the science underlying the technology which enmeshed so much of their lives. How awful would it be if it got harder for charlatans to wrap themselves in that mantle of authority that so many people ascribe to science? I am thinking of someone I once did a bit of business with whose arguments are riddled with condescension rooted in his status as a “scientist”. The man rescues squirrels and cats for a living (okay, endangered snow leopards.), a kind of globe trotting dog-catcher if you will. A bunch of biology courses 25 years ago somehow makes him more of an authority on any matter encompassed by “science” than the rest of us. Not surprisingly, a lot of people fall for this. It has been said that Nathan’s of NY hot dog fame got its first leg up by hiring earnest looking young men wearing white lab jackets to hang around eating at their stand. It created the impression that if doctors ate there, it must be good for you. The bull case here, if you will, is that spurious “science” might lose some of its ability to bamboozle, that it will become harder for charlatans to extract money, political power or influence by invoking the priest caste that so much of the “scientific community” has become. 

I think we can expect this scandal to slow the advance of Green Tech and forestall some of its more damaging aspects, but there are good reasons to expect the body politic to proceed with some kind of Energy bill. The need for some kind of driver of economic growth will trump the shoddiness of the science. Recovery from a recession requires some kind of economic locomotive. Last time it was housing, the time before that, the emergence of the Internet economy. Neither of these look powerful enough to move the needle on 10% unemployment. A re-tooling of energy production and distribution, worldwide, certainly has that potential. Just because the issue of what the energy sector will look like in the future has been co-opted by jackasses does not mean that there are not bona fide investments to be made in safer, cleaner more efficient power. For example, the US seems to be dragging its feet while the rest of the world, down to the likes of Viet Nam and Bulgaria, are jumping on the nuclear power band wagon. Opponents have been reduced to making insinuations about “cost”, but considering our lack of focus here for the last 35 years, what do we know about what the actual costs might be? It is specious to say that its too expensive because we haven’t really treated it with the kind of priority that in the past have  yielded surprisingly good results. It is an engineering problem, the kind Americans are unusually good at. Make it a priority like the Space Race, and we just might surprise ourselves with just how cost effective a solution our engineers come up with.  

There are also ways that our electrical grid can be made a lot smarter, at least if politics can be kept at bay. There are certainly more places where siting wind turbines makes sense, though probably not as many as the industry’s advocates would have us believe. Likewise, if there really is a path forward for solar cell efficiency akin to what was done with previous nano-structures like microprocessors and LCDs (I suspect we will eventually find out why Moore’s Law is less applicable here than purported, but am willing to go along until more evidence is in.) moderate subsidies might prove to be a good policy investment. All this would be easier to implement if AGW was a credible, palpable threat its perpetrators have labored to trump it up to, but less so now that the credibility of Big Science has gone up in smoke. Expect a lot of Wizard-of-Oz-like “pay no attention to that man behind the curtain” from the political class and their enablers, a greatly diminished likelihood of severe damage-by-legislation, but also a continuation of investment that improves the lives of millions, though perhaps with not quite the financial returns that a few friends-of-Al have been dreaming about. In the mean time, I’ve got to go and put another log on the fire. 

Thank The Designer

The week of Thanksgiving Holiday, 2009, finds us in a thankful frame of mind indeed. What started out as a year to just get through: the Financial Panic of a lifetime doing a not-atypical number on our retirement nest egg, the loss of a job   at the very nadir of that crisis, a regime change at the seat of federal power that promised Change in the direction of profligate collectivism, and by some measures the worst drought ever here in South Central Texas. It ended being an opportunity to stand among those investors who were financially and emotionally prepared to make the proverbial bet against the end of the world and profit accordingly. Financial independence is within reach, if not quite firmly grasped. A semblance of gainful employment has, in fits and starts, started to take shape. The once ominous HopeNChange Express barely made it out of the garage before the engine started smoking and sputtering, the wheels started coming off and the pit crew started making like to slit each others’ throats. The drought has recently given way to a series of rainstorms which in turn unleashed a torrent of photosynthesis and concomitant vegetative activity. So gratitude towards whoever or whatever might be keeping things from collapsing into a cosmic scrap heap, that wellspring of Love that seemingly countervails ubiquitous Entropy, comes easily to mind.

With this in mind, it should not be surprising that this week’s meditation came to be. I had been working on a new investment idea. It is a company that holds the high ground with respect to the technology of controlling heat, pressure and so ultimately rates of flow for large scale processes like oil refining. This company designs and manufactures highly engineered equipment, which is to say that while there may be a certainly simplicity to the designs, each system has to be attuned to local conditions in order to achieve consistent and optimal performance. What struck me was that it is also designed to operate for upwards of twenty years, not unlike the aviation equipment that has been such a focus over so much of my working life. In both instances, a very large installed base has been put in place, to the degree that the need to replace equipment reaching the end of its economic life is a big part of what drives prospective demand. As I pondered what that might look like over the next few years and started putting dates to things, it occurred to me that this “replacement demand” will be driven by the retirement of equipment that was being installed or even designed early in my working life. Indeed, I can remember when the aircraft whose looming retirement is expected to drive demand for “next generation” models like the Boeing 787 was the “next generation”. Now, part of this apparent obsolescence is due to design advances. We also know the outliers as to how long well-engineered equipment can be kept running, but we also know that it takes a great deal of special, and often expensive, care and attention to do so. We see some evidence to the contrary, but they tend to be relatively simple, though still marvelously engineered, piles of stone, like pyramids and aqueducts. Even a modicum of complexity in a pile of stone will eventuate in the need for a great deal of expensive attention to  keep it from falling down, such as the cathedral we were able to visit in Cologne early this year. Equipment might be made with the most durable of materials, but however well designed it is, operating in any but the most hermetically benign environment, it still eventually wears out. And it does so at a rate which does not compare favorably with human beings.

Here I am at the midpoint of my sixth decade, certainly not made of the most durable of materials and fully aware that in another 55+ years my frame will be dust. In at least a few respects, this seemingly highly engineered system is not operating at that peak efficiency denoted by youth, but compared to the aforementioned examples which are at the apex of humanity’s best efforts, it is doing quite well. The idea of clocking an unbroken string of sub-6- minute miles is certainly a thing of the distant past (Hell, just having to run a mile is not something I want even think about), but I can still from time to time get to a tennis ball that everyone else on the court thought was gone. My eyes certainly need a lot of help, but can still make out amazing things when they know what to look for, like that whiteness on the inside of the mouth of a feeding trout that is otherwise marvelously well camouflaged. The list of things that still work but not quite like they used to could go on, but let’s not go there! What is amazing, if you stop and think about it, is that we were designed to operate as well as we do for as long as so many of us have. 

It is miraculous that we are as self-repairing as we are. Many of us enjoy seeing antique equipment, planes, cars, locomotives, etc. being operated. In many cases, even with antiques houses, these remarkable testaments to craftsmanship are very nearly devoid of their original material. With us, a similar process takes place without our even thinking about. Wound repair, immune systems that continue to provide scientists with more questions than answers, memory and especially that prosaic miracle we call sleep, all designed into a system to keep it running even longer than a KC-135 (which certainly doesn’t repair itself!) This is not to say that a disregard, willful or imposed by circumstance, for basic preventative maintenance (i.e., calories consumed should approximate calories burned, sleep when needed) or any number of manifestations of evil will not preclude an expectation that which attributed to Moses over 3000 years ago: “The length of our days is seventy years, or eighty if we have the strength.” (Psalm 90:10). It should, however, remind us that we are fearfully and wonderfully made. 

This ancient observation bespeaks yet another layer to the beneficence of Providence in our day. Not only do we seem to be designed for 50+ years of relatively low maintenance functionality, we have also been blessed with an unlocking of knowledge which is pushing the envelope on that Psalmist’s observation. For example, the pain management provided by opiates and variously rendered ethanol concoctions was only supplanted about 100 years ago by mass produced salicylic acid (a.k.a, aspirin), which has in turn been supplanted by a host of successor compounds. But more to the point, the technology to provide “repair” against all manner of upsets, even as our designed=in repair sub-systems wear down, has exploded in our lifetimes. Case in point, the immediate progenitors of the fearfully and wonderfully made system that has been the object of this meditation, i.e., my parents. Both of them are nearing the end of their ninth decade, and both have been in for repairs. But one still drives all over the country to look at birds through eyes that had cataracts several years ago, helped along by a remarkably unobtrusive hearing aid. The other maintains airplanes and flies one of them almost every week, when he is not busy growing grapes to make outstanding (i.e., Best of Show at the Western Washington State Fair more than once) wine. This workload is easier to bear than it was a decade ago, thanks to a pair of titanium knee-joints. What a blessing to live in a time when access to such life extending technology is scarcely remarked (although the prospect of placing more of the dead hand of government on this body of innovation is deservedly being remarked upon!). 

2009 was a year of great suffering and setback. The Psalmist goes on, “ ...yet their span is but trouble and sorrow, for they quickly pass, and we fly away.” Trouble and sorrow have been more in evidence of late than many of us have been accustomed. Yet there is so much to ameliorate that, so much to be grateful for. A look at History, just about anywhere you choose to peek behind its curtain and into what troubled our ancestors, should make you thankful for the troubles we have as opposed to the troubles we could be having. Happy Thanksgiving! 

And the Walls Came Tumbling Down

This week finds us observing the anniversaries of when two walls came tumbling down. Twenty years ago, the wall purportedly erected to protect the socialist revolution in East Berlin was torn asunder. Ten years later, on November 12, 1999 , that "wall" that had for two generations divided commercial from investment banking was dissolved by the repeal of the Glass-Steagall Act. The former was perhaps only the most emblematic of a whole series of actions which brought an end to the Cold War era, when something called Communism loomed menacingly against what in more self-confident times was called Western Civilization. For a decade or so (two months shy of 12 years, to be exact), it became fashionable to presume an "end of history", that titanic struggles between disparate worldviews had been rendered a thing of the unseemly past. The dissolution of that other wall came at a moment when faith in markets had been inflated by widespread animal spirits to what was arguably an all-time high (NAZ was going to see to it that we all retired early and rich!) 

A decade or two later, I am struck by what the passage of time has done to enervate moral clarity and its concomitant courage to decide and then act. We have been reminded in the run-up to the Berlin Wall anniversary of Ronald Reagan's resolve in this matter. The Wall was but one element of the whole "evil empire" that he found so repugnant. However timely its seems in retrospect, his "Tear down this wall!" demand was delivered over the strenuous objections of the State Department and members of its staff. He set his sights on freeing millions of oppressed people and ending the doctrine of mutually assured destruction. Did any of us not think of these as farfetched aspirations at the time? But by golly it happened, peacefully and in a few short years, thanks to the unwavering moral insight of a few leaders. 

That this end to the Cold War did not mark the end of history really should be no surprise. For a thousand years, attempts to spread Islam at the point of a sword ranged as far west as the Pyrenees and Vienna (1683), simmering down just as its Western nemesis was being transformed by ideas from the likes of Newton, Calvin, Jefferson and Smith. For three centuries following Ottoman failure outside Vienna, the West enjoyed an energizing transformation which made it rich and powerful, while the Islamic world devolved into sclerotic impotence, a radical departure from the preceding ten centuries. How surprising should it be then that when a perverse ideology like Marxism came along that it would seem like public enemy number one, civilization-wise? Contrary to what seemed so obvious when we were growing up, it turned out to be not much more than a two generation distraction from a much more timeless struggle.

Something "laughable if it weren't so damning" about that more enduring conflict has been brought out by the tragic murders which took place at Fort Hood. I am not as appalled by the murders themselves (hate-fueled mass murder is always tragic, always wrong, but always happening in one venue or another) so much as to much of the reaction to it. We see pundits and politicians tying themselves up in knots, utter moral confusion that is a polar opposite of what we saw in Reagan, Thatcher and a certain Polish pontiff. We hear a lot of babbling about our inability to understand this murderer and his motive. Well, duh. Of course we will never "understand" exactly why he did it, but how often is exact understanding of heinous acts ever forthcoming? I think a large part of the moral confusion which has set in here can be attributed the way the very word "hate" has lost its meaning. When the subjective element of definition is allowed to run amok, words eventually lose their power. This act was committed out of hatred, as classically understood. As such, hatred is a motive that transcends intellect and even emotion. It is what motivated  Hutus against Tutsis, Iroquois against Algonquin, Nazis against anyone they thought weak enough to dominate, etc, etc. It is murderous and implacable by its very nature, and so demands an effective response. Thus defined, "hate" has the power to explain and so provide a focus for an appropriate response. But as we have witnessed the definition of this word expand to include any action or even perceived attitude which a subject perceives as hurtful, the definition is effectively gelded, "hate" explains nothing, and the chances of coming to any kind of consensus as to how to respond to it go to about zero. It would seem that over the course of the past twenty years, we have been diminished in our ability even to think and talk about the evils which must be resisted if not overcome.

A similar erosion of moral certitude seems to be in play in the dance around financial regulation. We have in the last year gone through the financial-near-death-experience of a lifetime, and are still picking our way through the wreckage. It is pretty obvious, in my estimation, that the repeal of Glass Steagall (G-S) in 1999 was a key ingredient in setting this conflagration in motion. I remember hearing it said that when one decides to tear down a wall, its a good idea to make sure you know why it was put up in the first place. Chances are, there were circumstances "back then" that have changed, but there might also things that haven't changed. In this case, these would include the human propensity to greed, the seeming inability of most of the players in "alpha" positions within financial organizations to comprehend the idea of "enough". It was also fallacious to assume that just because a moderate amount of deregulation had been beneficial that further deregulation would be without unintended consequences. 

The consequences we reaped were in large part due to the powers that be having been seemingly oblivious to the fact that the post 1999 model was subsidizing any and all manner of risk taking. The game was redefined, and the sharpies did what the sharp always do. They ran with it, reaping what they could before the not-so-sharp figure it out. I would submit that the aspect of G-S that made sense and served us well comes down, once again, to the meaning of words as classically understood. On this basis, commercial banks and investment banks serve fundamentally different purposes, and we should not pretend that whatever similarities they have outweigh their essential difference. As classically understood, banks existed for the same reason as bunkers (note the etymological similarity), to provide safe haven; to protect what its depositors already have. This was easier to understand when money was more tangible and what we call law enforcement was spotty at best. That such entities should assume a moderate degree of risk by lending against its depositors' assets was a reasonable development. The same can be said for a scheme to insure against such risks, funded by the member banks and administered by the government. 

Exactly what we mean by "investment bank" has always been a much slipperier term. Opportunistic by nature, their ability to succeed rests in large part on their ability to evolve with changing circumstances. However nebulous a classic understanding of the term might be, though, what we have today is something synonymous with "casino", a venue for gambling. Why, pray tell, if we were starting from scratch, would we want to put the imprimatur of the taxpayers' dime anywhere close to what investment banking has come to mean? As it is, this government sanctioned backstop to unbridled risk has fueled the consolidation, initially wrought by technology having all but eliminated the friction of distance in matters financial, that has brought us entities deemed "too large to fail". Policy makers face a Gordian knot of a problem as to how to implement reforms which reduce the chances of a repeat of what we just went through at some point in the future. Until they summon the moral clarity to recognize that what started out as a government administered insurance scheme to restore the confidence of savers has transmogrified into a seemingly limitless backstop to all manner of risk taking, the "too big to fail" problem will just keep getting worse.

The governing class probably likes it that way. By raising the stakes (i.e., how much those with the best seats in the casino can potentially take home), they increase the value of having influence on what the rules will be. This goes a long way in explaining why political contributions by casinos and their best patrons (e.g. hedge fund operators, private equity funds) have grown in lockstep with the size of the prize. Regulation has become a way of facilitating the flow of campaign funds rivaling if not surpassing Tort Inc. The ability to influence changes in regulation (i.e., the rules of the game) or at least understand them and adapt a step ahead of the crowd comes at a price, but it is also the price of admission to the best seats in the house. Combine this unholy alliance with the attenuated moral fiber which I have alluded to, and the chances of "too big to fail" going away any time soon look remarkably slim.

That said, bear in mind that crashes are all about wholesale rottenness and delusion, which takes time to build up, being flushed out in a hurry. An awful lot of this just got flushed, and more is trickling out. Crashes like we just endured are years if not decades in the making. The issues I have touched on are if grave concern in considering what we will leave to our children and grandchildren, but are unlikely to bear on how the economy and the Market will unfold in the months ahead. With the caveat that the consequences of diminished moral clarity in the face of sudden emergency cannot be anticipated, optimism remains the more prudent and profitable attitude for facing what investors refer to as the "foreseeable" future. But if in thinking about 2019 or 2029, we are any more confident than we were about an "end of history" right after 1989, or our faith in markets is anything like it was in 1999, we will be surprised in ways that I frankly don't like to think about. 

 

 

A Turning Tide Beckons

The last big slug of Q3 earnings releases are behind us. A few hours ago, the polls closed. The people, or at least some of the people, have spoken. They have spoken up for the rest of us who cling to the notion that the government is there to serve and not to re-define every little detail of our lives. Damage has been done, and will continue to be done, but thus it ever is, but the system is showing every sign of working. America is still a center-right country, not yet willing to forfeit principles based on the dignity and worth of the individual over to the soul of the hive. As the political class will now be operating with a high degree of re-election anxiety for the foreseeable future, they will be less inclined to meddle with and otherwise burden their Producing class. All but a scant few of them are not so obtuse as to not be able to read what the folks in NJ and VA have scrawled on the wall for the rest of us. We just might have another sustained economic recovery in us after all. 

Meanwhile, here in South Central Texas, it looks like the tide will be all the way out in about four hours and then start racing back in. The red tide recently brushed some of the outer beaches but stayed out of the bays behind North Padre. The winds are remarkable calm and it looks to stay that way until late Saturday. If I leave now, I can have my yak in the water before the reds know to follow the tide in. It sure would be nice to not be plugged into this silly Market for a few days. I'm out of here. 

Scary Season

All Hallows' e'en finds us looking back on a week that was frightful enough already. As scary making as the action in most of my stocks has been over the past two weeks, we should not be surprised. That a Russell 2000 ( RUT, the index that best exemplifies most of my holdings) should drop nearly 10% in two weeks is perfectly understandable in light of its having levitated 80%+ in the preceding seven months. What we are going through is a lot like what happened in May, June and into July. After a rip-roaring 7-8 weeks through the end of April, the indices basically went sideways for more than two months. The Q2 earnings season found stocks good and ready to respond to a positive catalyst. This time, the Market anticipated the catalyst, frustrating those prognosticators who assured us that September was synonymous with sell-off. The fabulous earnings reports were like a shot of caffeine late into an arduous day, keeping it going through the motions, but to no productive avail. As in the June correction, when the major indices fell peak to trough nearly 10%, the RUT a little more than 10%, the RUT peaked a little earlier. It is now lower than it was on August 1. So to the extent that that element of Price Reality we call "correction" is about time as well as price, we are actually well along in the process.

As always, the Talking Heads find it necessary to come up with substantive reasons why gravity has finally set in. Many of them seem to appear every time the indices dip for more than a day or so to pronounce, one more time, the end of the "sucker rally". It has been my experience (which is starting to become considerable) that there is real wisdom in the maxim that Bull Markets climb a wall of worry. There will be abundant reasons for the Market to roll over and play dead all the way up. Why should 2009 be any different? We hear and read a whole lot of what looks like confusing cause and effect ("The dollar sold off, so investors bought commodities, which..") Who the Hell knows?!  The concerns voiced about how much of the strength in technology spend is inventory rebuild is legit, but probably overdone as a result of forgetting that the "pipeline" is just a metaphor. One wonders about what it would be like to have followed the Tech Sector for the past ten or twenty years. It seems likely that they all have been conditioned to just "know" that if it's good news, it won't last. There is no gainsaying just how cyclical these markets have been since silicon started to stand for something besides beaches and big boobs. So what if big parts of what we call Tech evolved down the same road as autos, airplanes, tractors and trucks (in their early decades both life-changing and wildly cyclical, but eventually less cyclical and more rational)? Would the analysts whose insights seem to determine sentiment at the margin, conditioned by their experiences of the past decade or two, be able to recognize it? I am inclined to expect a wild but ultimately very fruitful ride here.

One common theme that we keep hearing in many of these gangbuster earnings reports which could be causing some heartburn is how much help these earnings got from marked down labor and materials. This is the result of last year's abrupt shift from sellers' to buyers' markets, a fortuitous condition for consumers that is simply not going to last. Users of all kinds of commodities benefitted from a brief period when their suppliers went from hoarding to trying to raise cash, and deals could be had. Similarly, we saw not only a great deal of cost reduction in the form of lay-offs (quite a few of which would have been untenable at any other time in this litigious age) but outright wage & salary reductions as well. (If this was happening in past downturns, I missed it.) These, too, will be reversing in the quarters just ahead. Indeed, there is a whole lot of "offset to inflationary pressures" in the cost of all kinds of things that will probably start to go the other way next year. This adds not only margin pressure against earnings but the specter of outright inflation to our Wall of Worry.

One other thing that the Market is probably holding its breath over is the referendum to be held on Tuesday, November 3. It's a piddling little off-year election, but it will speak volumes about how HopeNChange is going down with the folks who care enough to show up and vote. It feels like piling on to point out how despite the huge imbalance in campaign spending, that the outcome in a state like New Jersey should hang on the impact of a third candidate is not exactly positive feedback for the In party. The Mandate is more or less dead in the water. Its centerpiece, Health Care reform, which our Fearless Leader wanted done by the August recess, has morphed into a 1,990 page political tar baby (like the trickster edifice of folklore, sensible politicians see that they embrace it at their own peril). Expect to see a whole lot of bobbing and weaving, of "we gave it our best shot but the evil obstructionists played dirty", hopefully followed by some bipartisan efforts to effect some badly needed incremental reforms. 

To the extent this referendum forces the Administration to act more like the Clintons post-1994 (somewhere between gridlock and triangulating) a stultifying uncertainty will be abated. That would be the way most small business owners must be feeling right now. In addition to the usual uncertainties faced in a cyclical downturn, these key decision makers are facing a set of moving pieces that mostly boil down to "how much is this going to cost me?". Now it must be admitted that the Administration has done a splendid job of at least one thing. That would be demonstrating that running a successful campaign does not necessarily translate into the competence to govern. As I noted as early as February, their accomplishments will fall well short of their agenda, but damage will be done. We might not be getting the structural changes we worried about, but for the entrepreneurs who, for example, have pay to have OSHA, the wildlife biologists et al weigh in on how they resurface the parking lot, it is a dreary slog, with miles to go. Intrusive government is inflationary not because it unbalances the budget but because it causes producers to say, "To Hell with this, it's not worth the aggravation. I'm done!" and there goes another piece of the latter half of the equation that understands inflation as "too much money chasing too few goods". This genuinely worries me. It's what made the Seventies so "special". Hopefully, the referendum at hand will clear some of this up. If not, there will be a somewhat more comprehensive one in about 365 days.  

A Decidedly Less Enjoyable Phase in the Market

The waning days of October find the Market decidedly into what is at least a Correction-in-Time. The number of days when we are tempted to gloat, to have to remind ourselves that we are not geniuses just because "everything is up!" are decidedly fewer and further between. Ninety days ago, earnings season triggered a strong broad rally. This time, "buy the rumor, sell the news" is definitely back in fashion. The substance of the news embodied in the earnings released this time around has been almost uniformly heartening, the stuff of enthusiasm if earlier this year you were genuinely convinced that global depression was upon us. The Market has shrugged. Case in point: last week's belwether, Intel. While the Q2 release triggered an immediate and enduring revaluation of roughly 18% (from c. $16.50 to c. $19.50), eight trading days after an even more ebullient Q3 report finds the stock at $19.74, down nearly 4% from its close just prior to the announcement. It would seem that despite three months of burgeoning indications of the robustness of demand for all things digital, it was all pretty much "in there" by the end of July.

That glorious, seven month/50%+ rally that was the Market's reaction to our collective underestimation of the resiliency of the global economy is over. In its place we now have a Market that in terms of Price Reality wants to go higher, but in terms of Commercial Reality simply cannot. To the extent that investors do their homework and try to appraise the valuation and prospects of the enterprises underlying the stock symbols, it has become very difficult to muster the nerve to buy. This unwillingness to "pay up" is exacerbated by the extent to which the economic "re-set" inflicted by the Financial Panic has rendered fundamental data much less helpful than we are used to. (It also does not help that memories of being so dreadfully wrong about how cheap stocks can get, regardless of how "conservative" we thought we were being in our analysis, are still very fresh and tender scars.) This is more of a problem in some industries (producers of commodity building supplies come to mind) than others (dominant global technology companies) but it definitely undermines one's ardor for ownership across the spectrum. 

While the fundamentals are holding most investors back from all but a select few "stories", Price Reality continues to exert an upward bias. Price Reality is that part of the equation that is about fear and greed, momentum and sponsorship. It is the reason prices fluctuate so much more dramatically than underlying values do, which is to say hardly at all. I remain bullish about equities in part because of the demonstrable resiliency of many parts of the global economy, but also because of Price Reality. Right now it is more about Fear than Greed (which is probably doing damage to traders who mistook the seven months following 3/9/09 for normal). Its obviously not the same fear that was taking our breath away this time last year. Rather, it is the fear of missing out, of being left behind. Investors focused solely on fundamentals last spring found themselves wishing for a pullback that never really came. It never really came because every time the Market gets a little winded and shorts wade in, the "afraid of missing the boat" crowd jumped in and bid things back up. 

I think this fear based reality has legs and will underpin the Market until conditions evolve to where Greed can take over. Not only are the professional investors going to continue to have to pre-empt the charge of "We don't pay you to sit in cash!" but a mutation of this fear bug is going to make itself felt, a fear that over the next couple of years will reach into millions of households.  Just as we have been enjoying a respite from commodity price inflation, thanks to the 100 or so day undoing of global manufacturing activity early this year, savers (investors oriented to meeting present or anticipated income needs out of their financial assets) got a rare but fleeting windfall out of the Panic. We saw yields on assets debt instruments of moderate risk and duration driven up by the forced liquidation of leveraged players and other manifestations of panic. Astute savers reaped a windfall. With the passage of time, though, asset prices are normalizing and these savers are finding very slim pickings without adjusting their risk tolerances. The free lunch of 5%+  AAA tax-free munis is more or less over. One by one, households presently or prospectively dependent on their savings in order to maintain a standard of living will succumb to the fear that paltry "risk free" yields simply won't get it done. As the credit markets come back to life and the bonds get called, the yield needed to maintain one's standard of living will no longer be there. This, more than anything, will influence the appetite for risk among millions of household savers, which means mountains of money flowing into equities in the years just ahead. 

Expect the remainder of the year to be tough going. There will be stocks that work, but they will probably be exceptions. Perhaps the communal disappointment that follows such an encouraging earnings season being unable to lift the indices will fester into a real 5-10% pullback. This would be helped along no doubt by whispered data suggesting terrible holiday sales (and probably followed by a rally when holiday sales turn out not so awful after all; a familiar pattern, no?) Portfolio performance, or the lack thereof, is likely to determined by fewer issues than in the "just be there" experience YTD. Expect lightning in the form of M&A activity to strike more frequently than we got used to over the past few years. Stocks may be out ahead of themselves as reckoned by security analysis (chastened as its practitioners should be at this time) but not so for those enterprises who are sitting on cash and pondering the "acquire or be acquired" imperative. This Bull Market is more than a little tired right now, but still very young and durable. 

 

The Web 2.0 Belwether

This past week presented an opportunity to write about the one company on my List I thought I was least likely to be writing about (see my July 14 Note.) Intel has once again emerged as a clarion bellwether of global economic recovery. A Market which had been stumbling about looking for a place to rest after a six day sprint was adrenalized by the Q3 results posted by Intel after the close on Tuesday. Revenue and EPS blew away the consensus of the forty or so sell side analysts who purport to follow it, despite the company's "warning" in late September that the rate of recovery was continuing to quicken. The catalytic effect was spectacular on Wednesday AM, though it is proving to be not as enduring as when the same thing happened in mid-July. (Back then, the Market had been in a distinct corrective mode for about a month and so was poised for a protracted soar. We are now well evolved into an era of "whisper estimates" carrying more weight than what dopes like me are reading via Yahoo Finance.) 

Intel's part in the drama of the moment stands out in at least three ways. As the hands-down global leader in the advancement of low-cost microprocessor computing power, something which has found its way into just about every economic activity which is measurable (and some that aren't), it is indeed a worthwhile indicator of how the global economy is faring . It is also what I like to call a locomotive of innovation (akin to Boeing in the aerospace world) which must be moving forward for all the other cars in the train to get anywhere. This "train" moves ahead because it is able to deliver, at declining real cost, something that great and growing masses of humanity want to make more use of, resulting in a virtuous cycle of increased consumption funding further innovation driving lower costs begetting increased consumption. Finally, there is the part about what Intel has delivered these past two quarters that is entirely to the credit of Intel, a company of outstanding DNA which seemed to have lost its way, but once the dose of humility had been swallowed found its way back to its stuff of greatness.

It is not my normal practice to own mega-cap stocks, but INTC presented something of a classic opportunity a couple of years back. At the time (late 2006, early 2007), I was enamored by the observation that the "big blue chips" were at close to record low valuations. I have subsequently come to conclusion that in most cases there are probably good reasons for this apparent "cheapness", but only time will tell us what they are (unless I have a little brainstorm, in which case I will.) The real motivation for looking at and eventually buying INTC was that it was a paragon of world-changing innovation that had seemingly lost its way. In 2006, there was this crazy notion that its one and only competitor of note, AMD, had arrived as more or less of a peer and would inexorably eat into Intel's 75%+ market share. There was just a bit of a kernel of truth for this whopper to take root in, as AMD had achieved a performance breakthrough in a line of server chips that put Intel in a catch-up mode for the first time in a very long time. The stock had been a dog since Y2K. Indeed, in mid 2006 it was not far off of its 2002 Tech Bust/Bear Market low despite solid sales and earnings growth. 

Despite my rather trailing edge orientation to IT and CE (I own one vintage 1993 TV which is used as a monitor for a DVD player.), the life changing nature of that global phenomenon that is Web 2.0 is not lost on me. And as previously suggested, if any company is the locomotive of innovation pulling this construct forward, it's Intel. It was helpful that its financial posture was so strong (lots of cash, with more pouring in daily; minimal debt. Not every so-called "blue chip" has this going for it, and when the wind starts blowing in the direction it did in 2008 the weak holders who own because its a blue chip sell it with about as much thought as went into buying it.) What really helped, though, was that clarity and candor which often takes hold when a great company has been laid low. That opacity which one usually encounters when trying to get to know a typical mega cap was in this case greatly ameliorated. I had the good fortune of connecting with an IR person, since retired, who patiently helped me up the learning curve and arranged for me to participate in some very helpful conversations. The more I looked and listened, the more apparent it was that the DNA which made this company great was still there and that a chastened management was determined to get the company back on its game. I also increased my understanding of how pervasive the roll-out of Web 2.0 was likely to be, and got to thinking about the manifold changes which will occur as a result.

All of this work did not quite get me to a "buy" decision. Despite its modest relative stature, AMD seemed to have done well enough to convince the leading customers that they could be a reliable clear alternative to Intel. With this in mind, as of late 2006 it seemed that past financial performance was unlikely to be replicated. In that world order, it seemed more likely than not that increased competition would cause margins to trend lower over time. All this changed, however, when AMD bet the ranch on a big acquisition. While we had no idea how this would affect AMD over time, we knew that there would be no immediate benefit, and it was crystal clear that AMD had put itself in a position of greatly diminished financial flexibility and so no margin of safety against unforeseeable adverse developments. This lead to a purchase decision which looked really smart for a time, at least until the Financial Panic of 2008 changed everything. 

These past two earnings releases by Intel are telling us many things. They are indicating that while the global economy was rendered briefly catatonic by the financial panic, it is coming back to life. The rising tide is lifting all but the most dry-rotted of boats, but it is lifting some of them faster than others (i.e., the ones which leverage the longstanding strengths of the U.S. economy, such as its deep pools of intellectual capital, to serve truly global markets). Intel is leading the way in this recovery because it is leading the way in providing for a very basic need, that human desire for connectedness on terms of one's own choosing. That is what Web 2.0 is all about. It never really stopped, other than for about six months in the manufacturing chain when folks crawled under their desks and waited for someone else to sound an all clear. Even more so than the economy in general, the resiliency of this has been badly underestimated.

Also underestimated, IMO, is Intel itself. Since arriving at that moment of truth that was 2006, they really went after their costs and their processes. From Q3 08 through Q1 09 the effects were masked, but they came out shining in Q2 and Q3. AMD is still out there, and the customer base will see to it that there continues to be some kind of alternative to the big dog on the block, but Intel seems to be calling the tune as to what prices will be (i.e., bringing them down at a pace which spurs volume but optimizes profitability). If there is anything at all to Web 2.0, this growing connectivity and increasing ubiquity of computing power, in the households of the second richest billion as well as the richest billion people, then barring an economic relapse INTC has a very promising half decade or so ahead of it. One wonders if the analysts who have spent the past decade following INTC are any better equipped to understand its prospects as an investment today than those who followed it through the 1990s were ten years ago.

This consideration of decades gets me thinking about just how long it has been since the Tech sector has had a truly silly season. The Tech Bubble and its subsequent deflation is getting to be a very long time ago. (How long ago does the demise of Lehman et al and the emotions that gripped those days seem already? It feels positively past-life to me.) This is not to say that at least some issues are not at what will prove to be ludicrous valuations already. Who knows what the next ten years will tell us about what GOOG, thus far a one-trick-pony if ever there was one, was really worth. Or MSFT, which hasn't really gotten anything but optimizing its ancient cash machine right for what, fifteen years?, reduced  to a point where the reason to own it is that 7 will not screw them up like Vista did. But when I shift my thinking to Price Reality, to that which accounts for the lion's share of stock price movement, I can't help but wonder if we are not due for something of a reprise of the Tech Bubble, the blow-off phase of Web 2.0.

My sense is that barring the usual unforeseeable disruptors, a silly season revolving around the enablers, purveyors, providers, pretenders and panderers of Web 2.0 is inevitable sometime in the coming decade. This is not the sort of thing that is worth trying to predict, but the experienced investor will equip himself so as to be able to recognize it before it is too well developed to do anything but short the sucker (and probably get killed doing so prematurely). What Web 2.0 is about strikes so deeply into that which makes us human that I feel fairly certain that it will once again be the backbone of a major global Bull Market. Having revisited the sheer proportions of what the NDQ did in the 1990s (about doubling in the first six years, then doubling again in the next three, then more than doubling again in 18 or so months), it is quite clear that it took a very long time to cultivate the degree of silliness which defined 1999. My sense is that Web 2.0 is a little too close to ripe for this much time to play out. More likely, it will be a somewhat less dramatic affair than that, sometime within the next five or so years.

A little more earthbound way of thinking about the prospects for outsized gains in stocks like INTC might derive from the notion that the 1980s did not exactly prepare analysts and investors for how to think about INTC for the 1990s. Likewise, the experience of the 90s was less than helpful in terms of anticipating what it would be like to own most tech stocks for most of the decade that is now drawing to a close. I strongly suspect the tide is way out in the ways that matter most, and that success (outstanding returns) will revolve around financial flexibility but even more around being the "last man standing" (or nearly last, as the customer base goes all out to keep the "clear alternative" in the game) in critical, next-to-impossible-to-replicate technology. My personal orientation to this can be seen in the List, as well as some small holdings in AMAT, DELL, KEME and MSFT. (These aggregate 2.5% of my liquid net worth, and could be described as among the last bits of residue from my prior employment situation.) INTC stands at 2.0%.  If I am right, if the parts of the global technology supply chain which these companies represent have evolved to a point of relative rationality, if the human propensity to desire connectedness on one's own terms is what I understand it to be, and global economic activity does anything but roll over and die, these stocks ought to appreciate over the next five or so years in a way that beats the bejeebers out of whatever inflation starts to rear its ugly head in the mean time. And really, at the end of the day, that's about all we can hope to do in our little affiliation with Mr. Market. 

Gotham Revisited

Last week found us taking something of a sentimental journey to a most unsentimental place. Having been a resident (briefly, at the 47th Street Y and then just off Bay Ridge Avenue in Brooklyn), a commuter from New Jersey for several years and then a more or less monthly visitor from Rustic Upstate for a decade-plus, it was interesting to see the Great Gotham as a pilgrim from the hinterlands. Coming after a five year hiatus, it was not surprising to see this mighty city, as battered about as it has been during the latter half of that interval, with a whole new perspective. (The fixity in Time of that prior visit was assured by the occasion of standing in Times Square, within a day or so of nineteen years from when I first arrived in NYC looking for a job. Gone was the Nathan's Famous just up the block from the welfare hotel I had found in "New York on $15 a Day" and stayed in for the first two nights of my new life. A world class tourist destination had replaced an exemplar of sleaze.) 

I found a city a bit worse for the wear of relentless waves of financial comeuppance, but still emanating a magnetic pull on the ambitious and the well-heeled. For once, I was actually pleased that there was an extra twenty minutes or so of flight time. The circling prior to landing at LGA as afternoon was giving way to evening provided a splendid reminder of why New York City is one of the world's great natural harbors. The bus ride in from the airport was actually about the same price as the van ride in 1985, and immeasurably less stressful. The triggering of memories began in earnest at the Midtown Tunnel, which once you are inside of might as well be the Lincoln Tunnel. This brought back a flood of memories, of catching that 6:18 Lakeland Express out of Dover, NJ, and of stepping out into the freezing cold much more than the relief of stepping into air conditioning after a long summer's slog to and through the Port Authority. The next vivid memory jogger was probably that subway aroma which wafts up through the grates in the sidewalk as I made my way past Grand Central and up to my night's lodging (which set me back more than our  monthly rent was for the first few years we were married).

We might be in the wake of an immolation of consumer net worth of historic proportions, but NYC does not seem to have stopped drawing tourists from all over the world. I overheard one, inadvertently funny as she mangled a familiar riddle to a tour guide, "Where is Grant buried?", and I just might have heard a permutation of "How do you get to Carnegie Hall?". Of course, one also hears an array of peculiar utterances from some of the true (24/7) locals of midtown, such as a remarkably realistic and persistent meowing from one old fellow shuffling along under the scaffolding. The tourists were probably a bit more skewed to foreign than I remember (as were many of the apparent owners of buildings). Midday along the lower edge of Central Park saw the horse drawn carriages hard at work (the horses anyway), as well as a bit of a dust-up between cops and pedicab drivers (which don't strike a chord, memory-wise), which I later found out via the NY Post was part of an ongoing roust. 

Speaking of transportation, the cabs seem to be evolving in the direction of either crossover SUVs or the more eco-friendly but so-small-we-better-take-two direction. A few of them sported a refreshingly candid ad by a law firm, "Complicating Divorce Proceedings since 1971". They also seemed to be much more available than what past experience would have deemed normal, but maybe it only seems that way when you don't need one. One of the great things about midtown Manhattan is that if you are reasonably fit and the weather is not at one of its occasional extremes you can get around very easily on foot. While there seemed to be fewer people to step over than I can remember (from the early years, anyway), there seemed to be more trash to step over, even in parts of town that recollection strikes me as more or less immaculate. The municipal entity that is NYC is clearly straining under pressures it was not feeling in 2004. Building security, on the other hand, would seem to be in about the same overbearing state as it was at that last visit. 

It was a pleasant and productive trip, but I find myself in no great hurry to go back, and not just because pricing of meals, rooms, etc. seem to be set with "someone else's pre-tax dollars", and I am using my own now. The "glamour" of travel went way down hill about 24 hours after arrival, where back at LGA it was ascertained that my flight to ATL would be delayed. (due to bad weather in NY, they said, though whatever rain fell that morning had stopped before noon.) Indeed it was, just enough to induce an unintended extra night on the road. Along the way, I would be reacquainted with that nemesis of travelers, CNN. There seems to be almost no place one can stand in a gate area and not hear the iterative bleatings of a succession of people you could not pay me to voluntarily abide (Okay, maybe for $50/hour, but for no more than two hours a day.) What an inducement to get back home to where such pariahs can be forcibly ejected, were they to have to bad sense to show up at my doorstep. This is one of my lingering doubts about the very long term future of air travel as a consumer good, a very slow and subtle addition to what I have previously referred to as the all in cost of travel.

New York City has clearly been chastened by all that was coming undone on a more or less daily basis this time a year ago. It has been badly stretched, as it was when I was working on Sixth Avenue in 1990 and saw the building under construction out my window just stop going up (and stay that way for a couple of years at least). Something tells me, though, that no matter how badly some of its parts and some of its players might have been mangled, it is a very long way from a breaking point. 

Deal Heat Continues to Glow

While the Market continues to shudder and shake at every little indication of economic activity (or the lack thereof), the warm glow of Deal Heat continues to brighten.  As noted in these pages on September 5, the coming-unstuck of pent-up M&A activity is starting to supplant decompression based on "Oh my, it's not the end of the world after all" as the most likely driver of outsized share price appreciation. Recent days have seen this heat go from reddish to something approaching white, especially in the Tech World. That construct which has divided hardware from software (in the minds of investors, anyway) seems to be disappearing, as one big hardware player after another (HP/EDS, Dell/Perot, Xerox/ACS, Cisco/Tandberg, Viasat/Wild Blue) makes a big grab in the direction of software, with Oracle's pursuit of Sun Microsystems reaching in the opposite direction. 

This seeming gold rush is in one sense nothing more than ongoing evolution, that continuous redefinition of how what once upon a time was called data processing gets done. Distinctions between the legal entities which make up the enterprise have on balance continued to blur, and many of the hazards of vast scale have been substantially mitigated. It only makes sense that these Big Dogs-on-their-respective-blocks are seizing the moment. They are seeing limits to growth in their most familiar pastures, and have been sitting on cash waiting for just a wee bit more clarity than we had when Financial Panic was shaken the foundations. It is also understood that once recovery really takes hold, prospective sellers will start getting greedy again (not that every would-be seller has an entirely reasonable understanding of what his company is worth to begin with). 

Given the plethora of companies who are cash rich but face moderating organic growth prospects, we should expect the Tech sector to dominate the M&A headlines, but it will certainly not be the only part of economy feeling deal heat. One transaction that has really intrigued me of late was the just closed acquisition of privately held Carlton Forge by Precision Castparts (PCP). Especially striking, to me anyway, was the $850MM price tag. PCP has done an outstanding job on the acquisition front (at least under the tenure or Mr. Donegan), so much so that it was hard to believe that they they could have overpaid to a degree that shareholders would eventually regret, but it still struck me as a big number. It probably had something to do with 25+ years of watching deals get done in the aerospace supply chain, memories of so many folks looking askance at anyone paying more than about seven times EBITDA for a metal basher. There was no reason to think that PCP had broken from its pattern of paying 8 to 9.5 times EBITDA, though this valuation metric has always rung a little flat for me. (Besides being susceptible to the dramatic cyclicality of earnings in this little cranny of the economy, it begs the question, "whose EBITDA?" The seller we probably don't know, who might have been on the very top or their game, or might have been sleepwalking? Or, in this instance, what Mr. Donegan and his team will be getting out of it after a few quarters?) As Carlton was private, an exact valuation is not forthcoming anyway. We know that Carlton was a well-regarded forge works, the larger of two in North America capable of producing seamless rolled rings in the size ranges used in jet engines and industrial gas turbines. This market might have exceeded $1B in good years, and Carlton's margins are very unlikely to have compared favorably with PCP's traditional businesses. As such, it is pretty obvious that PCP paid a price that would have been deemed awfully rich not too many years ago, and certainly back when they acquired Wyman-Gordon. 

It occurred to me that $850MM for a forge operation that might have done $500MM in a good year might seem rich to me because it was not so long ago that the market capitalization of the entirety of PCP was right in that very neighborhood. A quick peek at Value Line revealed that, yes indeed, in the late days of 2002 (etched permanently on my memory as a time  spent rooting around for signs of a bottom, but mostly  reminding clients that barring the extreme unlikelihood that aviation turns out to be a fad, a robust up-cycle was looming not so far off in the future), the market cap of PCP was only about $890MM. To be fair, they were carrying about $500MM in debt, but this could be more or less offset by the value of operations which PCP has since disposed of. Perhaps sometimes our experience works against us. In this case, it seems to have provided the basis for a quick inference that an experienced and purportedly rational buyer had just deemed Carlton Forge to be worth more or less what the just a few years ago the Market (in one of its fits of despond, to be sure) adjudged PCP's world-beating ability to make structural castings large and small, airfoils, seamless pipe, refiner plates, and a whole lot more to be worth. Happily, the thought process of addressing the dissonance which arose from this inference resulted in a couple of realizations about the present state of the aerospace supplier base.

There are two really good explanations as to why a smart company like Precision Castparts might pay as much as they seemed to for Carlton Forge. The simplest, and my personal favorite, is: because they can. In my estimation, no other company could pay anything close to what PCP did for Carlton and then get a return anything like what PCP is positioned to get from it. It's not because of PCP's sheer size (which cause any bumps in the consolidation process to get lost in the rounding) or its access to low cost funds (at 6/30, PCP had over $600MM in cash on its books and nearly $1B available on its credit line), although these factors certainly help. What really sets PCP apart in terms of what it can pay for an acquisition is its management systems, which have proven to be very effective at getting good businesses running like great businesses, and something which it only came into a few years ago. That would be its vertical integration into nickel-based alloys, which has been built around its acquisition of Special Metals and, importantly, includes highly developed capabilities in capturing raw material from scrap and revert. These are important advantages. They do not mean that PCP could not possibly overpay for an acquisition, but they do mean that PCP is able to get far more out of certain categories of assets than just about any one else could, including the sellers, and so can afford to pay what some of us out here in the cheap seats might consider "steep". However much they are making out of the Carlton operations a few years from now, when the JSF and 787 are being produced in volume and the A-350 is starting to show up, will be lost in the mix. Expect it to bet will be a considerable portion of a stream of earnings that will make most of us wish we had bought more PCP than we did back in 2009. 

That this acquisition seems rich by my experiential standards is also reflective of the era that constituted that experience. As in many of the niches that make up the aforementioned Tech World, consolidation has been going on for a very long time in the aerospace supply chain. Way back in what for many of us were formative years, ample capacity to make just about anything that might be needed to build military hardware was a given, but in 1990 that started to change. Year by year it was almost imperceptible, and for the longest time did not amount to much, but it was relentless. There had been considerable consolidation by 2001, but we saw that it was still a buyers' market for these kinds of capabilities when the first ever downturn in global air travel took hold. Since the time when traffic subsequently recovered, though, there have been indications that it is no longer quite the buyers' market that it once was (i.e., suppliers' pricing power). The number of companies that can do the highly-engineered, non-commodity "parts of the puzzle" has shrunk considerably. Capabilities like ring rolling, which seem simple enough until you try and do it yourself, might not be quite the commodity that they were a dozen or so years ago. The past two decades have also seen how for some reason these capabilities are resistant to attempts at transplanting them outside of the cultural realm which could loosely be termed "the West" (something about collaborative innovation being utterly dependent on a high-trust culture, IMO). It is not a stretch of the term "knowledge based economy" to include knowing the intricacies of something as seemingly simple as shaping metal into engine parts. Such knowledge has come to reside in fewer and fewer enterprises, and everyone who lives in that world knows it.

$850MM for a respectable ring rolling operation reflects the scarcity value that has taken hold in the aerospace supply chain after twenty years of consolidation. As long as there is a more or less growing population with the means and the desire to consume air travel, this scarcity value will continue to grow. We should not be surprised in the months ahead to see a few more deals in aerospace that would have seemed ridiculously overpriced ten years ago. We should also not be surprised, once the cycle has turned upward, to see the Market ascribe much higher valuations to the publicly traded aerospace suppliers. This will be especially true of the ones who have assiduously carved out a place doing where there is almost nobody else left who knows how to do it. 

 

A Weak Pretext for an Overdue Correction

 We finally seem to be getting the correction we've all been waiting for.  The stage was set by that long, drawn-out "gosh, does this thing have an intermission?" symphony of feel-good announcements that reached a crescendo with the Fed's meeting notes on Wednesday afternoon. Twenty or so minutes later, though, the thought kind of sunk in, "Okay, now what's gonna make stocks go up?" and indices quickly showed us how badly this young Bull needed to take a breather. The improving unemployment claims report the next morning sent the Bears scrambling, but this only lasted until the report on existing home sales came out. This particular statistic is about as shaky a figure as you can hang an excuse to buy or sell on, but in the Market's present condition it was good enough to get the correction back underway.

The headline "reason" that the Market rolled over was a surprise 2.7% drop in existing home sales, to a seasonally adjusted 5.1MM. This was said to be a "surprise" because it had been up for four months in a row. Understanding just how weak a pretext for a sell-off this is starts with the "seasonally adjusted" element of the statistic. Its been more than a few years since I did so, but if you take a peek at what goes into seasonally adjusting activities like home sales, you will know how foolish it is to put any weight on a single data point (unless the change is a whole lot bigger than 2.7% of the annualized level of activity). There is simply not enough actual information in this "data" to tell if home sales are actually slowing down. 

Even if we grant some validity to the statistic as an indication of slowing, this should hardly be a surprise. I can think of two things that should be happening right about now that should be like a tap on the brakes for home sales. The first is that we are probably reaching the end of what was a buyers' market of a lifetime for housing. Beyond what amounts to subsidized mortgage rates and the tax credit for first time buyers, we also had legions of despondent sellers sitting on a mountain of inventory. Down another 10.8% in August, to a not unreasonable 8.5 months supply, the glut isn't what it used to be. It is probably not unthinkable then that at least a few sellers are no longer dancing a jig at the thought of someone, anyone, making an offer on their cash sucking albatross. As a market becomes less distressed, we should expect at least some transactions to drag out to include negotiation between parties who are on much more equal footing than it seemed six months ago. It is, no doubt, still a buyers' market in most markets out there, but "desperate and highly motivated" is becoming at least a little fewer and further between.

It is also likely that the rate at which home sales close has slowed because the real estate industry probably got caught flatfooted by the recovery. This industry (think of it as all those purportedly indispensable folks who seem to line up with their hands out when you want to buy or sell an home) had to shed a lot of capacity in a hurry last year. Should we be surprised that a genuinely surprising upsurge in the number of folks looking to re-finance or maybe take a flyer on a re-po or whatever caught them by surprise? So maybe by August it took longer to close a deal than it did before the recovery started getting noticeable. A few extra days for loan approval would definitely move the needle on a thirty day period of activity, even without the effect of annualizing.

So throw in the bonus thought that maybe Cash for Clunkers soaked up a bit of buying power, or at least consumer "bandwidth",  and we should hardly be surprised if the recent fire under home sales cooled a bit in August. A sane and experienced individual would not dump equities because of this bit of non-news, but a Crowd certainly will. We have seen even weaker "reasons" than this one "explain" inflection points. The aforementioned symphony of encouraging news has indeed taken a brief intermission. You do not want to be out in the lobby when the music starts up again. 

The Power of Wishful Thinking

This Market is crazy, but no crazier than we've seen it before. Experience all but dictates that it is overdue for some kind of meaningful correction, in time if not in price, but it keeps on levitating. I find myself thinking really hard about taking money off the table. Indeed, I have let a few marginal, legacy holdings go and have written some calls against some stocks I would lighten up on if they "get there by then". The resurgence in the animal spirits, though, is so  remarkable that it is hard not to just let it ride. What's up with this?

What's up is the asymmetry of those two prime drivers of Price Reality, Fear & Greed. Most investors fail to grasp that Bull Markets are not all about Greed and the Bear counterpart all about Fear. Both fear and greed are always at work. In a Bear Market, fear is most evident, but the greed of short sellers is also a factor. This was much less evident from the 1930s until hedge funds emerged in a big way, bringing formidable intellectual firepower and capital to the short side of things. It certainly helped things along during that Crash we all just lived through. The issue at hand is the overlooked fears that are turbocharging resurgent greed in the early innings of this Bull Market. I suspect that for every player who is bidding up stocks because they have recently become greed-addled there are at least a few others who are operating in more of a fear mode. There are the aforementioned short sellers. I can personally attest to what it feels like to have started shorting stocks because the Market has run a long ways in a hurry. In 1991, having watched an unleveraged account rise some 60% in a matter of months, my attempts to "take advantage" of the Market being "ahead of itself" resulting in such unforgettable moments as having 1000 shares HWP open 15 points against me one morning. Believe or not, this did not cure me, at least not right away! More recently, short selling was so easy for so long, and then it wasn't, and an awful lot of bright young things have gotten the same sort of education. Some of them are slow learners, though, so their bouts of renewed confidence followed by the panic of being "wrong again" will continue to add fuel to the melt-up until all but a few of them are either long gone or gone long.

Fear would also describe the mindset of those who are being held to relative performance benchmarks and have prudently been taking some profits and waiting for a pullback. Such a proper and ultimately profitable way to strategize over the long term, but oh so difficult to execute a day at a time when the feedback is so powerfully against you. "Inevitable" (as in "inevitable correction") has a way of taking its time. There is also the more widely experienced "fear of missing out". Bring all these fears together, and blend in a quickening sense of just how contrived the Street Theater that rendered a normal correction into a once-in-a-generation blowout actually was, and we should not be surprised to see price recovery that makes as little sense as the capitulation of thirty or so weeks ago. 

The Greed side of the equation does not yet smack of, say, late 1999, but it too has an element that is less apparent than what we think of as greed (i.e., an excess of natural acquisitiveness). I have observed in the past that most investors have a built in tendency to assume unrealistic rates of return on their life savings. This is simply because for most investors (all but the very rich and those with little or no capacity to save) life, both in the present and in the future, looks a whole lot rosier if you assume a double digit return on your savings than if you assume something closer to the risk-free rate. What indulgences you can afford today, and how worry-free your post-wage-slavery days will be tend to be astronomically greater if you assume, say 9% returns over time rather than at, say, 4.5%. This is not about the difference between skinflints and spendthrifts, this is about the freedom to make a few high-utility choices at the margin, both in the present and prospectively. So the money flows that bid stocks up are in large part driven by a bias to probably-not-realistic returns that can persist for a very long time.

With the exception of initial positions in an oil refiner and the preferred stock of a property manager, I find myself in the "waiting for the next pull back" mode. My year to date returns would be a pretty good four years, realistically speaking, and part of me wants to raise cash every day. Right now, though, the part that recognizes that the unnatural seeming strength of buying conviction out there is not so unnatural after all, says "Let it ride".