Last March, as the market bottomed just before the war in Iraq, I was buying stocks like crazy. Primarily because I was finding many bargains, but also because I was convinced that we would win the war decisively (which is what happens when a military with an annual budget of nearly $400 billion encounters one with a $1 billion annual budget), and that there would be the mother of all post-war relief rallies.
Both of these micro and macro viewpoints ended up being correct and they made my year, despite my best efforts to snatch defeat from the jaws of victory by becoming nervous too early (though I haven't changed my opinion). In fact, the only way not to make money in 2003 was to be short anything or long the dollar. Otherwise, everything -- and I mean everything -- went nuts, as all but one of the 87 industry groups in the Dow Jones U.S. Total Market Index rose last year. (Trivia question: what was the lone declining group? Answer below.)
So, what about now?
What does 2004 hold for investors? Before I answer that question, I want to share some of the wisest words ever spoken about investing, by (surprise!) Warren Buffett at the 1992 Berkshire Hathaway annual meeting:
If we find a company we like, the level of the market will not really impact our decisions...We spend essentially no time thinking about macroeconomic factors...We simply try to focus on businesses that we think we understand and where we like the price and management.
I agree with Buffett that one should have a bottoms-up approach to stock picking, but when it comes to managing my overall portfolio -- how much to have in cash vs. long positions vs. shorts/puts -- I think it's important to have a general opinion regarding a few big factors, such as the economy, interest rates, and overall valuation levels in the stock market.
So, without further ado, my opinion on these three factors is quite bearish. In contrast to the current cheery consensus, I think that the economy is not as strong as it appears, interest rates have nowhere to go but up, and high stock valuations already reflect a best-case scenario -- so there's little upside and substantial downside.
The bull case for the economy
There are genuine signs that the economy is finally picking up:
- GDP grew at a remarkable annualized rate of 8.2% in the third quarter and is expected to grow at a still-strong 4% rate in Q4.
- The Institute for Supply Management's index of manufacturing activity soared in December to its best gain in two decades.
- Unemployment has fallen to 5.7%, the lowest level in a year, and initial jobless claims, after peaking at 459,000 during a week in April, fell to 339,000 in the last week of December, the lowest level since President Bush took office.
- The U.S. service sector grew for the ninth straight month in December (though the pace of expansion slowed, contrary to expectations).
- Consumer confidence is improving. The University of Michigan consumer survey showed that "the highest proportion of consumers in two decades anticipate a falling unemployment rate."
The bear case for the economy
That's a strong bullish case, but I think the bearish one is equally, if not more, compelling. Summarizing the bearish argument, to quote Jeremy Grantham, we're experiencing "The Greatest Sucker Rally in History" as investors pile back into the most speculative, profitless companies, while ignoring many dark clouds on the horizon, among them:
- The economy, especially consumer spending, which accounts for roughly two-thirds of the nation's economic activity, has benefited mightily from two short-term factors: easy year-over-year comparisons and a massive injection of liquidity from low interest rates, tax cuts, increased government spending, and the lingering benefits from the massive wave of home refinancings. When these factors pass -- I can't think of any more liquidity levers that the government or Fed can pull -- look out below!
- By almost any measure, the American consumer appears overextended after 47 consecutive quarters of increased spending. As Fred Hickey notes in the latest The High-Tech Strategist: "Consumer debt (credit cards and auto loans) have more than doubled over the past 10 years to $2 trillion, with the rate of growth accelerating in the last two years. That equates to every household in America with $18,700 in credit debt. This does not include mortgage debt, which has soared at a 14% annual pace over the past year...Consumer credit as a percentage of income is at a record 19%. Household debt as a percentage of household assets is also at a record. Total U.S. debt is $33 trillion, or three times GDP. No major nation has ever carried such a sum (in dollars or as a percent of GDP). The consumer savings rate is almost negligible at 2%. The debt is a ticking time bomb."
- There are some signs that the bomb could start to go off: The American Bankers Association just reported that the percentage of consumers who were late on their credit card bills hit a record high in the third quarter of last year, and retail sales during the holidays were disappointing, despite very easy year-over-year comps.
- The latest employment figures aren't promising either: The Labor Department report released this morning showed that while the unemployment rate hit a one-year low, the number of workers on U.S. payrolls outside the farm sector in December increased by just 1,000, far below expectations of 150,000-200,000. And the manufacturing sector, which many expected would finally take on new workers in December amid signs of a turnaround, instead shed another 26,000 jobs, the 41st consecutive month of declines.
- Oil, natural gas, gold, silver, copper, and other commodity prices are at exceptionally high levels.
- The trade and budget deficits are high and rising, causing the dollar to plunge to multi-year lows against many major currencies.
In short, there's a lot to worry about, yet both stock and bond investors seem oblivious to the risks.
With interest rates at or near multi-decade lows, it doesn't take a genius to figure out that the next big move can only be in one direction. I don't know when and by how much interest rates will rise, but when they do, imagine what will happen to the highly leveraged American consumer (not to mention corporation).
This is why I reject the argument that stocks today should trade at a high multiple of earnings because interest rates are so low: The market is (or at least should be) forward looking and anticipating higher rates eventually. Buffett pointed out the mistake that investors are making today in a brilliant 1999 article which showed that one would have been far better off historically investing in stocks when interest rates were high, not low.
According to the Wall Street Journal, the S&P 500 is trading at 28 times trailing earnings and 20 times 2004 estimates. The Nasdaq is at 63 times and 39 times, respectively, while the Russell 2000 has negative trailing earnings (hence, no P/E) and is trading at 41 times 2004 estimates. These figures are far above historical averages, and the multiples are especially egregious in the most popular sectors such as the Internet, nanotechnology, biotech, and semiconductors. It's mind-boggling that so many investors are piling back into the same sectors that crushed them only a short while ago, like moths drawn to a flame.
Given these concerns, one might think that my advice is to sell everything and sit on cash -- but it's not. Based on my bottoms-up analysis of individual stocks, combined with my big picture viewpoint, I'm doing three things:
1) As always, I'm focused on owning the stocks of solid, well-run businesses with improving financials. Of course, price is critical as well and true bargains -- let's call them 50-cent dollars -- are exceedingly rare today, but I'm content to hold (though I'm not buying more) a number of 70-cent to 80-cent dollars. Among my favorites in this category are McDonald's
2) Avoid speculation and rich valuations at all costs. While I wouldn't characterize the entire market as frothy and wildly overvalued, there are large pockets to avoid, such as the sectors I noted above. Look at what insiders are doing, according to Hickey:
Insider sellers currently swamp buyers by nearly 40 to 1, with insider selling the highest on record and insider buying at the lowest rate in 10 years. Of course, the heaviest selling of all is from tech insiders.
Now would be a good time to go through your entire portfolio, reevaluating each position. If you're not certain that it's trading at least 10%-20% below your conservative calculation of intrinsic value, sell it!
3) If you're a sophisticated investor, consider shorts, puts and/or credit default swaps, which now account for a bit over 20% of my fund, the highest percentage ever. I've made such bearish bets -- both on specific companies like Farmer Mac
It's an especially good time to be humble and cautious, and to listen to investing legends like John Templeton (who has "never been more bearish"), Bill Gross (from his latest commentary: "bonds (and stocks too) will be low return asset classes for the foreseeable future"), Marty Whitman, George Soros, and Warren Buffett (who said he's "not finding anything" in the stock market and has purchased foreign currencies for the first time in his career because of his concerns about the U.S. trade deficit).
I fear investors are repeating the deadly mistake of projecting the immediate past indefinitely into the future and pricing stocks accordingly. They are acting as if the future is quite certain, when it is in fact highly uncertain.
Answer to trivia question: The one losing group was fixed-line communications, including the Baby Bells and long-distance phone companies, which was down a mere 4%.
Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of Berkshire Hathaway, McDonald's, and Yum! Brands and held bearish positions on Farmer Mac, the Nasdaq 100 tracking stock and the Semiconductor Holders Trust 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 at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/. The Motley Fool is investors writing for investors.