“There is a time for everything, and a season for every activity under the heavens” – (Ecc. 3:1)
I believe we are now in the final year of The Seven Fat Years and that the lean years are ahead of us. How one manages the approaching storms will depend on your perspective and preparation. As I wrote in the beginning of this installment, our seasons of weather are determined by the rotation of the earth's axis around the sun. The angle of the earth relative to the sun's radiation determines whether we are experiencing winter or summer. At exactly the same time it is winter in one part of the world, while it is summer in the opposite side of the globe. It is exactly this perspective one must keep when viewing the investment markets. While the financial markets head towards winter, summer is approaching for hard assets and natural resources.
20th Century Stock Market Chart
When reviewing the 20th Century, two points are obvious. # 1 Bull markets are not a permanent condition. # 2 There are periods when financial assets do well and there are periods when hard assets lead the market. When financial assets are in a bear market, hard assets are usually in an up-trend. Going back to my weather analogy, one man's winter is another man's summer.
Human nature being what it is, there is always a disposition by most investors to think that existing trends go on in perpetuity. When the market has gone up for as long as it has, there is a tendency to believe that this trend is permanent and irreversible. A bull market of rising stocks for 18 years has given way to complacency by investors in thinking that this time it is different. There are special circumstances associated with this boom that make it unlike its predecessors. New paradigm theories propagated by the financial press only reinforce this view. In his classic, The Stock Market Barometer, William Peter Hamilton wrote, "Prosperity will drive men to excess, and repentance for the consequences of those excesses will produce a corresponding depression. The problems of humanity do not change, because human nature is what it has been as far back as human record tells. Cycles are as old as organized humanity."[12] Hamilton, a friend and student of Charles Dow, echoed Dow regarding his view that the only permanent fact in the financial markets was change itself.
A Lesson From the Seventies
When I entered the investment business in the late 70's, it was dominated by hard assets. Mutual funds occupied only a small corner of a page in the Wall Street Journal. Taxes, inflation, and high interest rates had decimated the financial markets throughout the late 60's and the 70's. Fortunes were being made in real estate and oil. Gold and silver soared until their apogee in 1980. No one invested in stocks back then. Only a small minority of the investment public saw its potential growth. You couldn't give away financial assets. Financial publications like Business Week declared the death of equities. Stocks sold at seven times earnings. Dividend yields were over 7% and in the case of utilities over 13%. Treasury bond yields had risen to 15% and money market funds were paying investors over 18%. Nobody bought stocks and bonds because they thought bond yields were heading higher and stock prices lower.
Back then the consensus was that gold prices were going to hit ,000 an ounce and silver was going north of 0. Oil was at a barrel and analysts saw 0 a barrel in the not too distant future. Wall Street and investors paid little attention to the changes being brought about by Paul Volcker, the new chairman of the Fed and the new American president, Ronald Reagan. Volcker was raising interest rates and Reagan was lowering taxes and reducing regulations from hamstringing the economy. In a short time, the investment landscape was going to change dramatically. Spring was just around the corner with the greatest bull market of the century about to be launched in the stock market, while hard assets and the rise in metals and energy were heading towards winter. The few who saw it coming were scorned or derided as kooks.
Discerning the Shift
Wall Street hates change and it is slow to react when it comes. The investment public is no different. The public usually jumps on board a trend when it is in its final stage. The only information that is valid for today's investors is the movement of prices. Price reflects the aggregate knowledge of Wall Street and all that it knows about coming events. Even then it may not notice or react when market conditions change. A long trend, if in place long enough, may blind investors to the fact that circumstances and conditions have already changed.
As this graph shows, the stock market has gone nowhere since January 2000. For Dow theorists, the market signals when a change is in place. Charles Dow once wrote, "It is a bull period as long as the average of one high point exceeds that of the previous high point. It is a bear period when the low point becomes lower than the previous low point".[13] Hamilton expressed it better when he said, "The thermometer records actual temperature at the moment, just as the stock ticker records actual prices. But it is essentially the business of a barometer to predict".[14] The market is not saying what it is today. If it did, it would only be useful as a thermometer. What the market is telling us by its price actions is what conditions will be in the months ahead.
The stock market of today is saying is that a long-term trend in place for so many years is about to be reversed. Its volatility, the gyration of prices, and the sudden swoon in the indexes are signaling a coming storm. Nobody seems to want to listen to this message of the markets. To quote Hamilton again, "Is the American public so ungrateful to its Micaiahs and Cassandras as this? Yes, indeed, and more so. It does not like unpleasant truths" the prophet of calamity will make himself hated in any case, and hated all the more if his predictions come true."[15] Investors still want to believe in the past. Everyone is waiting for the tech sector to rebound and return to its glory days of double-digit returns. Those days are past and only blind faith keeps it alive. As the above chart on the technology sector shows, new orders are in a free fall. A new trend is in its formative stage.
One Man's Winter is Another Man's Summer
As these three graphs indicate, we have been experiencing a bull market in financial assets and a bear market in hard assets. It is inconceivable by many that these trends would reverse. However, a graph of the financial markets over the last century may be helpful to remind us of these reversing trends.
Why Do Trends Die Off?
There are many reasons why these trends reverse. It can be explained by basic economics. Low prices leads to low returns for an industry. Therefore, they discourage new investment. When low prices remain in place for a long enough period, it leads to consolidation within an industry. In an effort to cut costs, companies either merge or shed assets in an effort to remain competitive. The weaker players fold or are absorbed by the strong. This is what happened to the energy sector during the 80's and 90's. Decades of low prices caused the industry to consolidate. It became more profitable for companies to buy other companies than it did to explore for new oil. The result has been an energy complex that is frayed and worn out and is short of excess capacity. Low prices kept the industry from expanding and rebuilding its infrastructure. Meanwhile demand continued to increase as a result of expanding economies and growing populations. New demands were placed on energy with the technology boom. We are now at that point where supply is no longer capable of keeping up with demand, so prices are on the rise.
For precious metals it is exactly the same. Low prices have caused the industry to contract. There are fewer players today than a decade ago. Like energy, demand for precious metals has continued to grow while supply has been unable to keep up with demand. So we are running supply deficits, which have been met by central bank sales and leasing. For silver above-ground stocks of inventory have been used to make up the shortfall created by the lack of new mine production.
These conditions can only go on for so long. There isn't an infinite supply of precious metals or energy. It will take higher prices to create the investment incentives to explore for new oil and natural gas. In the case of precious metals, central bank stocks of gold aren't infinite. Eventually sales and leasing by central bankers may come to an end. The Washington Accord in September of 1999 has signaled that the gold leasing game is nearing its end.
Phase Two of a Bear Market
Referring to the chart of the financial markets over the last century, it clearly illustrates the winter and summer seasons in the financial markets. We have had bears markets in the past and we will have them again in the future. In my opinion, we are already in phase two of this one. The first stage of the bear market began last year and took the froth out of the stock market. The second phase is what we are experiencing now. It is a long, drawn out process where stocks began to react negatively to each news event. Instead of going up when interest rates are lowered they rise momentarily only to recede even lower. During this phase of the bear market, bear-o-metric pressure increases and the storms forces begin to build until they reach maximum power. At that point, we will enter the third and final phase of the bear market where the damage will be greatest. During this phase we will transition towards a new trend, which will become the genesis of the next big favorite in the financial markets. I believe it will be a bull market for natural resources.
The Darlings of the Decades
| S & P 500 Ten Biggest Stocks by Decade (Index Weight) | |||||||
| 1970's | 1980's | 1990's | 2000 | ||||
| IBM | 4.3% | IBM | 3.0% | Microsoft | 3.9% | GE | 5.043% |
| AT&T | 3.8% | Exxon | 2.9% | GE | 3.3% | Microsoft | 2.752% |
| Exxon | 3.8% | GE | 2.3% | Intel | 2.4% | Exxon/Mobile | 2.589% |
| Std Oil IN | 2.5% | Philip Morris | 2.2% | IBM | 2.1% | Pfizer | 2.495% |
| Schlumberger | 2.4% | Royal Dutch | 1.9% | Wal-Mart | 1.9% | Citigroup | 2.210% |
| Shell Oil | 1.9% | Bristol-Myers | 1.6% | Cisco | 1.9% | Wal-Mart | 1.954% |
| Mobil | 1.9% | Merck | 1.6% | Lucent | 1.8% | Intel | 1.826% |
| Std Oil CA | 1.8% | Wal-Mart | 1.6% | Exxon | 1.8% | AIG | 1.725% |
| Arco | 1.6% | AT&T | 1.5% | Citigroup | 1.5% | Merck | 1.660% |
| GE | 1.5% | Coca Cola | 1.4% | AT&T | 1.4% | AOL | 1.657% |
| Source: Wall Street Journal, 8/27/99 and Bloomberg | |||||||
Each decade has been dominated by a different trend. During the 1970's, 7 out of the top 10 stocks in the S&P 500 were related to energy. In the 1980's, drug, retail, and consumer product companies dominated the S&P. By the end of the 1990's, technology dominated the list. Today's dominance is more dispersed with a mixture of finance, technology, drug and industrial. The heady days of technology have receded. Microsoft, Cisco, and Intel no longer have market caps exceeding half a trillion. Today only GE approaches that level. As I've written in "Trains, Plains and Dot Coms" technological innovation is nothing new. It has been a hallmark of American Industry. There have been four distinct technology cycles beginning at the turn of the century, the 1920's, the 1960's, and more recently the 1990's.
There will be another cycle in technology, but I believe it will not dominate this current decade. I believe companies in natural resources and industrial development and construction will become the market leaders at the dawn of this new century. America's infrastructure has been allowed to decay. From roads, bridges, airports, water systems, and energy, to new plants and equipment – all will have to be rebuilt. Unless we do so, we will lose our industrial lead. In addition, our energy complex will have to be repaired and rebuilt and new sources of alternative energy will have to be explored. We are living in the sunset of the petroleum age. We are now at a point at which prices will slowly begin to rise. By 2010 we will arrive at a point where energy shortages in oil and natural gas will be a common experience.
Please note: All references listed in this article will be included forthcoming concluding piece, Acknowledgements & References.
