Here We Go Again
Part 2

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By Whitney Tilson
June 6, 2003

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I'd like to believe this rosy scenario, but a number of things trouble me:

  • The job market is terribly weak. Unemployment is at an eight-year high and there are few signs of a turnaround. The Conference Board reported last week that its help-wanted index for April dropped three points to 35, down from 38 in March and 47 a year ago (it peaked at 93 in early 1999). On the same day, the government reported that continuing jobless claims rose by 83,000 to 3,763,000, and the unemployment rate for workers with unemployment insurance rose a tenth of a percentage point to 3% -- both 18-month highs. Finally, yesterday the Labor Department reported that new jobless claims rose by 16,000 last week, significantly worse than expected.

It's hard to believe that consumer spending -- which accounts for roughly two-thirds of the nation's economic activity -- can remain robust in the face of such high joblessness and record consumer debt (which rose at a 10% annual rate in the first quarter from the fourth).

  • The manufacturing sector continues to struggle, as factory usage is at its lowest level in two decades. Yesterday, the Commerce Department reported that U.S. factory orders, after rising 2.1% in March, fell by 2.9% in April, the largest decline in more than a year.
  • Overall economic growth remains tepid, growing at a 1.6% annual rate in the first quarter.
  • Let's not forget the tremendous risks posed by derivatives, which Warren Buffett called "financial weapons of mass destruction" in his latest annual letter (also see Fortune's coverage of Buffett's letter). Just yesterday, the Warren Buffett of bonds, PIMCO's Bill Gross, added his voice to the chorus, noting in a Reuters interview: "I'm on Buffett's side here.... They [derivatives] package the ability to lever a financial instrument to try and take advantage of the short-term rate. And all is well and good until that short-term rate goes up, and that's when you pay the piper."

However overinflated the stock market might be, the bond and derivatives markets are even worse. Investors are scrambling for yield, with little regard for risk, due to extremely low interest rates -- ten-year Treasury notes closed Wednesday at 3.29%, their lowest yield in 45 years, causing Jim Grant of Grant's Interest Rate Observer to say, "Treasuries are now offering return-free risk." He continued (according to my notes from the conference at which he spoke two weeks ago):

"Bonds are the new bubble.... Which area of the bond market is most repulsive? Corporates, especially investment grade, are for victims. So many things can screw you... 90 CCC-rated corporates are trading over par. Why does this asset class exist? As for competition for the worst credit? Munis. They're priced today as if they're risk-free, yet municipal budgets are in terrible shape."

Grant concluded: "There's an astonishing, obvious lack of value in the bond market, yet it persists."

There's an especially ludicrous bubble occurring in the convertible bond market. In May, there were a record 48 convertible-bond deals that raised $14.1 billion, the second-highest monthly amount ever, according to Morgan Stanley's Even dicey companies with overvalued stocks like Magma Design Technology (Nasdaq: LAVA) have been able to issue debt that pays no interest by offering significantly out-of-the-money conversion options (generally 30-60% above the current share price). Or get this: Lucent (NYSE: LU), a company with serious issues, recently raised $1.5 billion in 20- and 22-year debt at an interest rate of only 2.75% merely by offering conversion at a 48% and 38% premium, respectively (click here to read the details).

As investors chase yield, one would expect money to pour into junk bonds, which is exactly what's happened: According to The Wall Street Journal, "High-yield funds netted $14.4 billion through April 30. That's more than any other fund category and just shy of high-yield funds' net cash flows over the past two calendar years combined, according to Boston fund consultant Financial Research Corp." So much money inflates short-term returns but depresses yields, meaning that today's investors are unlikely to be getting paid sufficiently for the risks they're taking.

Pension obligations
I would be remiss if I didn't highlight an issue that appears to have fallen off investors' radar screens: massive underfunded pension obligations across corporate America. Credit Suisse First Boston analyst David Zion wrote in a report this week:

With the stock market up 20% from its March lows, defined benefit pension plans have been getting much less attention.... Why? It's the market. With the stock market going up, pension plan assets increase in value and pension plans get healthier. Assuming a 65% equity/35% fixed income mix of plan assets, we estimate the average pension portfolio is up 8.5% year-to-date.

However, there is a problem with the analysis above. It ignores the other side of the pension equation: the pension obligation. As interest rates fall, the discount rate used to value the pension obligation falls and the pension obligation grows. With the dramatic drop in interest rates this year, we estimate the pension obligation has grown approximately 10% year-to-date, outpacing the growth in plan assets. In other words, the pension plans are not getting healthier; they are getting weaker.

Our suggestion: Don't forget about the pension plan. The combination of record-low interest rates and the very powerful smoothing mechanisms in pension accounting could result in deja vu come the beginning of the fourth quarter. Remember, when companies announced third quarter results last year, it seemed as if every company was talking about their pension plan and most of the talk centered around the negative impact that the plan would have on earnings, the balance sheet and cash flows in 2003. As companies get a clearer picture of the health of their pension plans later this year, we would not be surprised to hear the same type of discussion when providing 2004 guidance.

Despite the many troubling issues I've raised, I'm actually not especially bearish about the U.S. economy (in fact, I'm cautiously optimistic that it has bottomed and might start to improve a bit). Rather, I am bearish on both stocks and bonds because of their prices -- I feel that they already reflect a best-case scenario, meaning that investors have little upside and significant downside. Consequently, in marked contrast to mid-March, when I used every penny of cash I had to buy mostly retail and restaurant stocks (many of which I recommended in two columns at the time), I've been aggressively selling and even shorting in the past few weeks.

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Whitney Tilson is a longtime guest columnist for The Motley Fool. He was short IGW and QQQ at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or at The Motley Fool is investors writing for investors.