Happy Days are Here Again?

This past, week, the Market gave us a glimmer of the strength of its longer term upward bias. After a dozen or so days in a pullback mode, February 5 was the day they just couldn’t trade it down anymore, from whence it marked time for a few days and then started to act like a Bull again. By the close on Thursday, after four up days, it really was ripe for a fall when the Fed came out with its “rate hike” (which was nothing more than a technical adjustment that was sure to happen within the next month or so anyway). The after hours crowd tried to make something scarifying out of it, but we got little more than a speed bump jiggle in a Market that really acts like it wants to go up. Solid earnings, a benign inflation report, and a few reminders that M&A is back in mix were enough to stretch the rally to five days. I still think there will be a more serious correction than that which marked late January sometime this year, but this is one healthy Bull.

The economy seems to be mending at least as well as I would have hoped for only a few months ago. Like all recoveries, this one will have its weak spots and exceptions, but it is definitely on the mend. I am not so sure that there is some surprising substance to it so much as we are proving out the truism that at the peaks and valleys, it is never as bad as it seems or as good as it seems. The Panic was bad, no getting around it, but it was just that, a panic. Emotions got a hold of nearly everyone, and fears regarding the immediate dangers were compounded by all kinds of “what ifs”. That moment, which felt like an eternity, has passed. Damage was done, but the system held together. All kinds of pent up demand (consumers starting to do the things they felt forced to put off as far back as three years ago) is coming unstuck. There will still be plenty of anecdotal evidence for the Gloom-meisters to peddle (it is, after all, a great, big country) but we are more in danger now of overheating (to the degree that some of that stimulus money finally starts to kick into an up and running economy next year and beyond) than slipping into that “double dip” that kept so many investors in safe havens last year.

More fundamentally than even earnings, I think it matters to that proverbial investor at the margin that the U.S. has demonstrated that political accountability is not as dead as had been presumed. In other words, the rascals in Congress are running scared, too scared to aggressively screw things up. A year ago it seemed that the American people had finally given their assent to the Road to Serfdom. Subsequent events have proven otherwise. The caricature American of fat, lazy and hedonistic, willing to forfeit successively dearer liberties for bread and circuses (or medicinal marijuana and HDTV), is not completely without basis, but even if it were generally true (which I suspect it is not) there are still plenty of kicking and breathing exceptions running around the place. A normally irenic slice of America responded to statist overreach in a way that suggests that a much more vigorous people live here than that media perpetrated caricature had led many of us to believe. We have some big problems looming in the future, and there will be some pushing and shoving around how to deal with them, but such has always been the case. I think what has developed early this year is the prospect that incumbent legislators might not be as secure, and therefore unaccountable (and therefore susceptible to corruption), as the experience of the past generation or so had led us to suppose. The people have been aroused, but in a thus far civil sort of way, and as a result the governing class is cowering in a way not seen in a very long time. This is good news for the owners of the corpus, not so good for the parasites.

We even have seeming good news with respect to the prosecution of the 1000+ Year War. I say “seeming” because it is always hard to know if an apparent change is actually taking place or are they just reporting differently. I am referring to what seems like an uptick in remote control assassinations in Af-Pak. Others have noted the strange disconnect in a policy that overtly confers Constitutional rights on those who proudly admit to terrorist acts on U.S. soil but is willing to apply a missile to the back of the head of a mere suspect along the Af-Pak border. So we have this dissonance between what the Administration says and what they are apparently getting done. What we don’t know is whether the drones have been operating effectively all along and they just started reporting results (driven by that cynical need to tend to appearances) or did we in fact take things up a notch. It is also possible that this relatively new technology for administering lethal doses of heavy metal has seen something of a step-change improvement. This could be the integration of improved sensor technology, or even a breakthrough in how on the ground intelligence gets processed into dispatch protocols. I suspect there is a good bit of this behind the recent successes, as our somewhat uniquely American ability to apply collaborative innovation to making things work better plays out, but there is at least a smidgen of “we’re getting results!” spin in there, too. At any rate, while this War will not be going away in our life times, it just might be getting knocked back down from flickering to smoldering as the Taliban runs out of places to hide.

After its tear of the past five days, the Market is good and ready to pause in a way that will tempt the nervous nellies to despair, if only long enough to sell something that a week later they will wish they had not. They should resist this temptation. The past few years were some kind of storm, and damage was most definitely done to the organism that is the U.S. economy. But it is a mighty, sprawling and resilient organism, much more firmly rooted than we seem to understand. Surely there will come a day when our experiment in ordered liberty, such a departure from the stultifying slow motion decay that embraced Eurasia for so many centuries, will peter out, but it is not now. Stay long, stay strong!

Waiting Out the Squall

This week finds us in a waiting-it-out mode. Waiting out gloomy winter weather that keeps us inordinately attentive to the wood stove, and waiting out yet another of the Market’s corrective phases. We need to remind ourselves that there is an ocean of money sloshing about that is oblivious to our multiyear investment orientation. Who knows just how many $B are all about day-at-a-time, or even moment to moment. This money prospers to the extent it can discern whether the path of least resistance in share prices is up or down. Every day it has to test that direction, and the rest of us go along for the ride. When a change of direction becomes discernible, it piles in, and we feel it. As it becomes less apparent that what has been the path of least resistance still is, it trickles back to the sidelines. Apparently, “up” stopped being the easiest direction for this kind of money to push prices sometime around New Year, and for a few weeks the path of least resistance was down. This becomes less apparent with each passing day, and at some point, it will be easier to gull the crowd in the direction of buying than to convince them to sell, and the “correction” will be over.

Of course, the keepers of consensus will manufacture excuses for every little price squiggle, and this latest pullback has been no exception. We are supposed to be alarmed by the deteriorated credit worthiness of a couple of Euro states, as if Greece and Portugal were somehow more reprobate than they were a month or a year or a decade ago. For reasons that as of yet are not forthcoming, the travails to these two comatose principalities are threatening the stability of the global financial system. Now, I would grant that perhaps there is information value here with respect to the feasibility of the whole concept of a Euro-zone, of intractable problems in integrating such diverse people groups into a single economic entity that only the passage of time was going to reveal, and now it has. If it comes to pass that this “incident” is just one in a series of indicators pointing to a “What were we thinking?” moment in Belgium a few years from now, then a moment of pause might be in order. But really, should anyone be surprised that at least a couple of the more decrepit states within that long doddering venue that is southern Europe would not try to game their more responsible brethren? These are not exactly economic powerhouses to begin with. The GDP of Greece is about a third of Mexico’s, and in line with the Gross State Product of Massachusetts. At least a dozen U.S. states are larger. Florida is twice its size, California, which is afflicted with some of the same budget busting issues, more than five times its size. Portugal, which seems to have boomed on alternative energy, tourist venue development and remittances from New England is roughly two-thirds the size of Greece economically, about the size of Indiana or Tennessee. Is what goes on in Lisbon or Athens really that much more economically significant than what goes on in Nashville or around Elkhart or within a dozen or so miles of Rt. 128? Why the outright disappearance of either of these two Euro-backwaters should cause the value of U.S. equities to shudder for more than an instant or so is mysterious indeed. It is on our minds at all because day to day, the Market as voting (as opposed to its longer term weighing) machine runs on excuses, and any old “crisis” will do.

So we wait out the correction, ignoring as best we can the noise generated by the fast money and its enablers, and focus on the main chance of favorably evolving Commercial Reality. As the most recent Musings have noted, this is most apparent among companies who own proprietary capabilities that are enabling Web 2.0. The virtuous cycle is back, and this time its not just “WinTel” and “if we build it, they will come”. Indeed, the future that the Tech Bubble was anticipating 10-12 years ago is arriving. The value proposition, as perceived by the billions of people who are willing to pay for devices, access and perhaps even content on a carte blanche basis, is being persistently improved by a gamut of technologies. Many of these technologies are getting tricker to push forward, but what the end customer sees, buys and experiences is still a palpably improving value. It has occurred to me that one of the worst things about investing in Tech in past few decades is now working in its favor. That would be the tendency for states like Korea and Taiwan to pile into markets and in so doing wreck them as businesses. They were preceded by Japan in this respect, but with the passage of a few decades the supply chain has bifurcated into the highly proprietary and the highly commodity. Both types of components need need to get better and/or cheaper for the value proposition to continue to advance. Once upon a time, Asian DRAM makers threatened Intel’s existence. Now, Intel does what only Intel can do, DRAM is a whole other market, open to anyone who want to pour money into it. To the degree that cheaper DRAM is a part of what makes computers more affordable and functional, Intel actually benefits from the DRAM guys beating each others brains out as if to try and end up the “last man standing”. These manifold, interdependent markets have sorted themselves out. Not all of them will prosper their shareholders, but the ones who have proprietary, damn-near-impossible-to-replicate process and product technology, who are within shouting distance of last man standing, are just beginning to reap a reward that was decades in the making.

I have also noted that one of the things you want to have a clear understanding of in assessing the Commercial Reality of an enterprise is as basic as possible an understanding of the human needs that its offerings address. I have posited that Web 2.0 has the legs it does because it addresses an appetite for “connectedness on one’s own terms”. It is very appealing to be able both holding favored relationships closer and to manage a broader array of less intimate, perhaps only vicarious (as in “connecting” with celebrities) ones at a comfortable, controllable remove. Further inquiry suggests the basic attraction of what the Web provides is even more basic than than that. The relative leisure that has marked my circumstances for the past year has given me a chance to study some of the things that eluded me (or I eluded them) during my formative years. (e.g., some of the writings of St. Thomas Aquinas, which are as foundational to Western, modern thought as any). One of the things that has gotten clearer for me is that humans are endowed with a need to know that is as essential as their need to breathe. Like any other need, or appetite, this need is essentially good, but it tends to be corrupted. I learned that in the classic sense of the word, curiosity connotes a vice, an aspect of human nature gone bad. (The complementary virtue, or impulse cultivated toward its intended end or good, was called studiousness.) Through the eyes of those who studied human nature before electricity was understood as anything but the issue of heavenly fracas, we can see that what seems to be a perverse need for 24/7 connectivity is not so surprising after all. Our natural, inborn need “to know” can be attenuated by bad or deficient nurture, but more often is corrupted into a lust, conflated with other vices (like greed, pride or sloth) into something that grows steadily more a master and less a servant.

Why is this? It is that restlessness, that dhukka or “out-of-jointed” as diagnosed by the Buddha, perhaps best put in the observation by Blaise Pascal that all the trouble in the world can attributed to a man’s seemingly inability to sit quietly in his room. We are restless because we are lost in the cosmos (Walker Percy’s 20th Century classic). Stumbling in the dark, we seek connection with both the novel and the familiar. Indeed, these two desires are endlessly in tension with each other. When the familiar gets too much so, we crave novelty and seek it in adventure. Then when adventure gets too much so, and our lostness wells up in anxiety, we yearn to connect with the familiar. Always looking forward to the next adventure, then looking forward to getting back home. Web 2.0 makes the easy management (in the sense other addictions are managed) of this tension available to almost everyone.

Another, related, construct that has crossed my path is that of spectacle, which is that fascination humans have had with things like bad accidents or public executions. This was remarked upon by Augustine in his Confessions, citing a friend who found himself addicted to attending blood sport spectacles. It seems to be about managing the dhukka, of diverting our attention from our inner restlessness. Most people in most times and places got all the diversion they needed just struggling to meet their basic needs. We seem to be hardwired to struggle, but postmodernity has dealt with basic necessity to a degree that billions of us only find struggle vicariously and/or synthetically. Again, Web 2.0 makes this cheap, easy and ultimately addicting.

The notion of spectacle wrought wirelessly into the home or office brings us full circle to waiting out a Market correction. It has helped me to understand a certain lurid fascination with the carnage that sometimes appears in the form of stock prices. Though I know that daily price movements mean next to nothing with respect to the rationale for owning what I own (i.e., a convergence of Price reality toward a hopefully improving Commercial reality working itself out over the next several years), I seem to be no better than the most Mountain Dew addled video game enthusiast when it comes the hold that such spectacle can sometimes have on my mental state. In this age of such readily available informational feedback, much of which ends up being counterproductive, it is paramount for investors to recognize and avoid such diversionary spectacle. Yet, although able to dodge or contain nearly every other vice that life has thrown at me, the siren song of Yahoo Finance holds us in its thrall. Paraphrasing Augustine, “Oh Lord, make me indifferent to whether my stocks go up or down today, but not just yet.”

Toe-to-Toe With Willful Ignorance

This week we take up where we left off regarding the seeming disconnect between the prospects of so much of the global economy represented by what investors call the Tech Sector and Market’s recent rough treatment of so many of the stocks in that sector. If you own Tech Stocks, you are all too familiar with the recent divergence of improving company fundamentals (Commercial Reality) from share prices (Price Reality). This disparity started to abate during the first days of February, but only time will tell if the Tech Stocks are leading us into a full blown and inevitable (at some point in 2010, IMO) correction (i.e., >10%) or just another pullback for the Bull to catch its breath. This disparity matters to me because I have some very large bets in place that Tech has more going for it than the proverbial dead cat bounce. After decades of erratic evolution, it appears that certain parts of the Tech Sector have undergone a fortuitous tipping point very much likely what the Aerospace Suppliers experienced almost a decade ago. Consequently, I expect that over the next few years, some of these Tech stocks to remind investors of what some of my favorite aerospace & related stocks (e.g., CRS, ESL, HEI.A, LDSH, PCP) did for us over the 2004-2007 period.

Before we delve into what seems to be a subtle yet seismic shift in where supply (or capacity) meets demand in the Tech sector, it is important to consider the competing point of view. The pullback in many Tech stocks suggests a strongly held point of view that differs from my positive assessment. Of course, the very ability to buy or sell shares dictates that somebody else, with access to the same (theoretically available) data has arrived at a conclusion opposite to one’s own. (And sometimes, they’re the ones who are right!) Opinion at the margin, in stocks that are not so small as to be “off the radar”, is generally dictated by Street, or sell-side, analysts. To the extent that their various opinions have been made knowable to me (what gets published and widely disseminated might differ from what is shared privately with favored clients, some of whom work for the same firm), one of us (me or them) is clearly missing something. Only time will tell who is closer to the truth, but consensus opinion seems driven more than anything by willful ignorance. There is a charitable understanding of the subject (ignorance), but not so much the predicate. Sometimes a change can be “too big to see”. This is especially so to the degree experience has “hardwired” one’s perceptions. The preponderance of sell-side analysts have less than ten years of experience. This means that they know only the past (“two-bust”) decade wherein the Tech infrastructure spent most of its time struggling to grow into capacity thrown up to meet the expectations that developed during the Tech Bubble. You would think that analysts who have been around for much more than a decade would have that advantage that comes with having lived through multiple cycles. That can indeed be a great advantage, but it is not unalloyed. This is because such an analyst has spent their entire adult life in an industry that from the start was grossly over-hyped and overcapitalized. Such experience would give rise to habits of thought and perception that would make it difficult to recognize if and when nature taking its course had evolved the industry into something else. In this sense, there is a charitable explanation for why leading analysts might be missing a fundamental shift in the basic nature of the businesses they have spent their lives following.

There is also a less than charitable understanding of this tied up in the willfulness by which such ignorance is perpetrated. This relates to the incentive structures and implicit terms of employment both in the Street and the financial media. As I have suggested before, one doesn’t have to believe in a nefarious “they” who manipulate or even control the markets to recognize the inevitability of unwholesome influences that accentuate volatility. Wall Street firms and media companies live and die by the reality that every day there is a story to be told. They compete for attention, and if they stop showing up with compelling stories, they are quickly crowded out by others. Every day, someone has to decide what the stories will be and what the “slant” will be. That means individuals, heads of research, editors, etc., who like any other malleable human being have needs and aspirations. This means that on any given day, “the story” will come with a slant that has at least been influenced, if not effectively determined, by someone whom such a gatekeeper is trying to please, impress or otherwise score points with. (This is probably why a century ago, G.K. Chesterton dismissed newspapers as playthings for rich men.) It should be patently obvious to anyone who has trafficked in the ebb and flow of share price volatility that there is tremendous advantage to be had in being able to influence such gatekeepers, to be privy to what the slant is going to be. Most analysts and financial journalists know, or at least fear, that they are in the best job they will ever have, and that the next step down is a doozy. Thus, they are probably a lot more susceptible to the promptings of the gatekeepers than we would like to think. So viewed in terms of a rational and utilitarian understanding of life, how surprised should we be, and how much can we blame them, that willful ignorance is coloring consensus opinion of these companies and their stocks.

So what is the basis of this “tipping point”, or, switching metaphors, sea change that this grizzled old Market observer thinks he sees? It is nothing less than a fundamental shift in those irreducibly basic determinants of commercial reality that are Supply and Demand. Like so many industries that burst on to the scene with great promise but for the first generation or so delivered decidedly mixed results for investors, Tech, or at least certain parts of it, has come of age. Gross overcapitalization has abated, and the ability to deliver a steadily improving value proposition is spurring demand at well above normal (i.e., GDP or population growth) rates. The last time I saw this was in Aerospace. Like that industry, Tech was grossly overbuilt, albeit for different reasons (dazzling future prospects v. the geopolitical necessity of standing down Communism). Both involved collaborative innovation to steadily improve the value proposition, be it the “all-in cost of travel” (time, safety, convenience, etc.) or what Moore’s Law did to the unit cost of computer power. Both address human needs, deeply rooted in “connectedness” and desire for novelty, that are coveted by a persistently increasing share of the world’s population.

Like the aerospace industry, Tech has weathered gross but steadily declining overcapacity for a very long time. (40+ VC backed HDD start-ups in the 1980s, plus in-house capacity at nearly every consumer electronics producer of note, now down to two strong companies with a 60%+ share plus three captive producers, exemplify this.) These not what the sage of Omaha would call great businesses, but they are a damn sight better than what they were, and certainly better than what an analyst who has experienced the past 10, 20 or 30 years (or learned from those who have) is likely to think they are. It is important to bear in mind that Tech is a lot of businesses, some of which will probably always be lousy (like DRAM, foundries or passive components), but others of which have evolved to near monopoly, statesmanlike duopoly, or the sort of “one big dog and one stalking horse” that, again, emerged in aerospace coming out (or perhaps just before, but we couldn’t quite see it yet) its debacle of 2001-03. The determining factor here resides in the other big driver of consolidation: high and rising barriers to entry. There will be parts of Tech that will stay commodity-like, but the parts that are “a trick to do” seem to be getting a lot more attractive. For a dozen years at least, I was beat over the head with the question of why Precision Castparts was not a commodity business. Part of the reason they are doing as well as the have in the past five years is execution, but it is also this kind of evolution in the commercial reality of the business they are in (which they had a hand in effecting). The same thing has gone on with the likes of Intel, Cymer and the two dominant HDD makers, to name a few. The barriers to entry are not just the massive expense of building plants. They are also intellectual, at least as much about process as product (very important given the cross-licensing that has been imposed by the customer base). Importantly, the collaborative innovation needed for the ongoing interplay of process and product technologies is difficult if not impossible to replicate in what have been described as “low-trust” cultures (i.e., China & India are unlikely to compete successfully at it anytime soon). Such technical progress is a steepening curve, and after a while only a very few can continue to climb. Finally, it would seem that where decades of improving value proposition have been at work, the end product has a way of evolving from a luxury enjoyed by a very few to something that is woven into the preferred lifestyle of all but the very poorest of the earth’s billions. This brings us to the demand side of the equation.

Demand for what the Tech sector delivers can be seen in the sheer growth in the amount of data that gets generates, transfered and stored. It has seemed to be steady and inexorable, but closer examination indicates discontinuity in the rate at which “digital” has been embraced as a part of how we work, play and otherwise live. This is because like any other good, it grows as a function of its perceived value, which in turn is a function of utility and price. It has also mattered that numerous technologies have had to develop, each of which facilitate the perceived value of the others. These include the devices themselves, “content”, the means of distribution (i.e., networks) and various enabling technologies that do not fit neatly into such categories. The technologies that make all this possible have developed at varying rates and with varying consistency, and the progress of the whole will be “gated” by at least one of them. Looking back, we can see this caused progress to be a bit more discontinuous than expected. For example, computing power and content had to wait on more widespread, acceptably price broadband for Web 2.0 to commence.

Viewed in this light, 2010 finds us with “all systems go” for a protracted season of strong demand for that which facilitates “things digital”. The growing robustness and ubiquity of wireless networks has enhanced the value of that plethora of hand held devices. This in turn is causing the network providers to scramble to invest in their networks. It has been helped along by advances in technologies which compress and then decompress files (like what Netflix uses so that customers with bucolic wireless providers like me can watch what seems like a streaming video). Lower cost devices mean multiple devices per household, and in many more households around the world. Content providers are responding not only to the enlargement of their markets but to the improving ease with which data can be shipped and stored, by increasing the data “richness” (bits used to produce images. I am told that whereas bit-count used to be an annoying constraint for content creators, they have in recent years exulted in being able to bulk up the digital complexity of their works.) This symphony of improving value is what has driven the breakneck (40%? 60%? Who knows, but its high) growth in demand for data storage. This growth is not a fluke, it is a host of interdependent technologies all seeming to be making enough forward progress that the value proposition will not be slowing down any time soon. This does not mean that every part of the sector will be something investors would want a part of (segments where a Taiwanese or Korean conglomerate can spend their way to market leadership come to mind), but the segments that resemble the capacity side of this discussion should do very well indeed.

A necessary part of demand worth investing in is that it can be understood in terms of addressing a very basic human need or desire, preferably as in a luxury coming to be perceived, and sufficiently available, to be a necessity. This has been the case with air travel, which in June 2003, in depths of the worst recession aviation had ever seen, prompted me to write “Not Going Back to Greyhound”. Much as air travel has become simply a part of how growing millions of us choose to live, the “connectedness on one’s own terms” made possible by the collective offering of this thing we call Tech addresses a very basic human need. It is a big part of why Tech’s ability to grow its share of discretionary and not-so-discretionary spending will persist as long as there is any forward progress in the value proposition. However, since I last posited that driver of demand, my reading has brought me to an even more basic understanding of why humans crave what “all things digital” delivers. This will most likely be the subject of the next Market Musings.