Very interesting article in Barron's this morning:
interactive.wsj.com
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The Credit Peril
A veteran market-watcher says too much risk has shifted to
stocks
An Interview With Larry Jeddeloh ~ The chief of TIS Group in
Minneapolis pens a daily newsletter that's widely appreciated by big
investors. Jeddeloh has followed the markets for more than two decades,
once working closely with market watcher Steve Leuthold and later advising
Union Bank of Switzerland's private-banking operation on market strategy.
Traditionally a value investor, Jeddeloh was early to divine that the Fed's
massive credit creation benefited momentum stocks, "the ultimate liquidity
plays." One fan is Alfred Roelli, the global chief investment officer for
Deutsche Bank's private client group in Frankfurt. "He has unusual, creative
perspectives on the market," says Roelli.
-Leslie P. Norton
Barron's: Recently you commented that stocks are the "moral hazard"
of the current cycle and asked if the market is too big to fail.
Jeddeloh: The public has transferred a great deal of risk to the equity
market, forcing policy makers in Washington to pay far more attention to the
financial markets when they set economic and fiscal and monetary policy
than they have since the 1920s. That's why we posed the question. Of
course, the market isn't too big to fail; it has its own cycle. What pushed this
one to such an extreme duration is the unprecedented buildup of credit in the
U.S. It is the great hazard in the stock market. We have a different kind of
stock market because our economy now is based almost entirely on credit
growth. Savings from personal incomes used to be the driver; this time it's
the massive expansion of money supply since 1995. And a massive
expansion of credit growth by both the private sector and parts of the
government sector. A credit-driven economy like this is not self regulating.
Q: That puts the Fed in an interesting position, as you pointed out.
A: In a typical business-cycle expansion, interest rates can be used to
regulate the economy. In a credit economy like the one we're in, you need
the economy to run faster and faster as debt builds up. Every time you
remonetize throughout the cycle, the demand created by all that new debt
just makes the economy run faster. Paper assets become the saving vehicle.
And that is not a self-regulating mechanism. As you build up this pyramid of
credit, the debt market seizes up, just as it did with Long-Term Capital, with
Russia, with some Korean debt. The central bank -- in this case, the Fed --
had to turn the printing presses back on to get the markets functioning again.
In the process, they created more credit. So you get an economic cycle with
no recession, with never a bear market, an economy that goes faster and
faster because it has to. Liquidity short-circuits every decline. As those
cycles mature, stocks go to extreme valuation levels. Now you have some
stocks that you can't build a valuation model for. The ultimate liquidity play,
of course, is stocks with no sales!
Individuals and institutions realize that every time you have
a problem in the credit, debt or financial markets, the
central bank will step in and prevent a serious dislocation.
Thus, the American public has bought every dip and has
been right in every single case. As long as you continue
this cycle, the stocks are also pyramided up.
Q: What happens now?
A: Stocks have been such an integral part of economic
and monetary policy that, for political reasons, it isn't
really feasible to let them go down and stay down. We've
had corrections, but I don't think you can allow them to
stay down for any significant time. So you will see more of what we've just
had: Greenspan raising rates to fight inflation, and continuing to allow credit
to be created among the quasi-government agencies like Fannie Mae and
Freddie Mac. He will supply ample liquidity to the banking system. You'll
see some selected increases in margin requirements. He is walking a very fine
line. He has only three to four months to tighten the screws on the parts of
the U.S. equity markets that are the most speculative. Then, over the last half
of the year, for political reasons, the Fed probably will and should go quiet.
Q: How aggressive will the Fed be?
A: I expect them to raise rates two to three times between now and July.
One of the increases will be 50 basis points. If oil prices go much higher
here, a 50-basis-point [half-percentage-point] hike is a shoo-in. For me, the
greatest risk for U.S. shares is here and right now. It has already started.
Look at stocks like Federated Department Stores, down from 55 to 35 in
two months. The Nasdaq and Russell 2000 are up for the year, but the
Dow, the S&P, and nearly every index we look at is down. The Old
Economy/New Economy argument is really only a reflection of the fact that a
bear market is under way, starting last April. Many of the mid- and
small-cap names are beginning to revive. You are getting a rotation, but you
also have plenty of stocks that are down and headed lower.
Q: How much could the Dow and S&P fall?
A: For the Dow, to between 9250 and 9275, or 10%, looking at the
technical picture. I'd put the same kind of number on the S&P. In the near
term, the Nasdaq will go the other way -- say to 5200-5300 before it heads
lower. I have no conclusion yet as to how low it might go after that.
Q: What else should we worry about? Let's start with oil.
A: There's very much a political aspect to oil pricing, beyond the
supply/demand component. As I've written several times in the last two
weeks, I think OPEC could use the oil weapon to get the Middle East peace
talks to come to an end. The lack of resolution probably will play a role in oil
pricing.
It's also very curious that everyone assumes the supply of oil indicated in the
numbers is always there. I've noted recently that Iraq has come up short in
their monthly loadings by about a million barrels per day. Iraq hasn't properly
maintained its wells since the war with Iran in the early 'Eighties.
Let's pose these questions: What if the depletion in the older oil fields has
been much faster than expected, what if the new energy-services
technologies drew out recoverable oil faster than anybody thought? That's a
different kettle of fish completely than OPEC simply saying, "We are going to
cut production." There is far more to the price action than the OPEC
production cut. That said, Iran and Saudi Arabia resolved their differences
over OPEC production, so that could translate into $25 oil and a further
selloff in energy shares.
Q: You're also concerned about points farther east.
A: There's a good deal to be concerned about in the China-Taiwan region.
They are very large holders of U.S. dollar reserves and Treasury bonds. It's
a financial weapon the Chinese would not be afraid to use. If the U.S. were
to threaten to intervene in a China-Taiwan dispute, it wouldn't surprise me to
see the Chinese threaten to rapidly sell those holdings, which are probably
quite a bit higher than officially reported. The military, for example, keeps
substantial assets on hand.
Finally, I worry about the trade deficit. I don't
think Europe and Japan will be forever willing to
finance a billion-dollar-a-day trade deficit with the U.S. I understand that at
the March 23 meeting in Lisbon, one of the things to be discussed is about
conveying that message to the U.S. They also want to begin to talk about
reducing the military role of the U.S. in Continental Europe. Europe really
needs its capital to develop those markets in Eastern Europe.
Q: Let's talk about Europe. Last fall you gave us a list of 40 European
merger candidates [October 18, 1999, "Blitzkrieg!"], and six have been
taken out. What should we look for over the next 12 months?
A: We have been long Europe, as well as the U.S. Many of the same
arguments apply. The one difference is that if oil goes to $40 a barrel, only
the companies able to move quickest and restructure fastest will be
competitive for the rest of the year, especially with large-caps.
But if oil doesn't go to $40, the outlook for European equities is still very
interesting. Government policy has created some really attractive situations.
They put the currency down. They have low interest rates. They have low
inflation. They are beginning to cut taxes in core countries like France and
Germany. They started to restructure five years ago. What's not to like? And
the mergers-and-acquisitions forces will continue -- technology, increased
levels of Anglo-Saxon shareholders with near majority positions, industry
fragmentation, globalization. Vodafone-Mannesmann is really a bell ringer,
culturally and legally unlocking the German market to M&A activity.
Once you get this capital-gains elimination issue resolved this year, you could
see German corporate taxes lowered to 25% from 40%. The whole idea of
restructuring old core relationships into something more productive will gain
momentum. The new tie-up between Deutsche Bank, Dresdner Bank and
Allianz was another confirmation of our European M&A theme. It leaves our
principal German banking target, Commerzbank, exposed and in need of a
partner, possibly a big U.K. bank needing a Continental presence. So, yes,
stay long Europe for the next 12 months, with the caveat that if the Dow
goes to 9200, drops 10%, then Europe may drop a bit more.
Q: How about the euro?
A: The European Central Bank is quite happy to let the euro depreciate. I
do think that by this time next year, there may be a more formal realignment
of the global currency system. The euro, dollar and yen now trade against
each other at narrow bands, which it seems to me are probably enforced by
the central banks. They may decide to formalize those price relationships
more, which would take a great deal of pressure off the desire of the U.S. to
have the rest of the world fund our trade deficit. Without such an agreement,
the euro may go to a significant new low.
Q: Let's move on to Japan. New Japan now trades at big premiums,
while the economy struggles.
A: Let's take the political outlook first. Once the budget gets passed, the
election must be called by October. Prime Minister Obuchi has three to six
months to get everything right: the economy moving, the stock market up, to
keep interest rates in place, to give the consumer confidence. They need to
get through this period when the post-office deposits start maturing, and
make sure the money doesn't disintermediate too rapidly and disrupt the
entire financial system. By the time we see the election in the fall, you will see
nothing but good news from Japan.
Q: For example?
A: The economic numbers aren't as weak as people focus on. I could spit
you out a string of numbers, but the best indicator I know of in terms of the
Japanese economy is telephone bills. They break down into mobile phones
and so forth, but they've been rising at a double-digit rate since last fall.
That's one of the best indicators of the new economy I can identify. Capital
expenditures, an important part of the Japanese economy, will be directed at
the sector.
Most people also miss that two-thirds of consumer spending and two-thirds
of the labor force are in the small- and mid-sized companies in Japan.
They've already restructured. I think that's the reason the Bank of Japan
started to create credit again in late '98, to let small businesses borrow up to
five million yen on a signature. Then the OTC market took off like a shot,
followed by Jasdaq. That's the key to Japanese consumer confidence.
The small-cap bull market has really been a global phenomenon. Jasdaq hit a
new 10-year high just the other day. You have brand-new mutual funds
devoted to technology and the New Economy in Japan. That's also where
the jobs are being created, so that's why they're investing.
Q: Does it concern you that Japan's credit rating is sinking into junk
status?
A: They are absolutely aware of the gravity of losing an investment-grade
rating from Moody's. That said, Japan is better equipped to deal with that
than most other countries. I also think they're now rejecting the idea that
raising taxes is always the solution to their credit-rating problem. Governor
Ishihara of Tokyo, for all his populist support, is running into government
objections to his plan to raise taxes on city banks. Bank debt and consumer
confidence are their two serious cyclical issues, and the aging population is
their secular one. If I were the Japanese government making a case to
Moody's, I would describe what we've done to rejuvenate the
small-business and housing sectors -- allowed companies to restructure,
decided against raising taxes -- then point to the mass of savings in the
banking system. I would sell Moody's on the idea of giving us more time. But
how much debt does Japan really need to sell in international markets, given
the amount of savings swirling around their own system or in the foreign
assets they hold and can bring home?
Q: Let's move on. What do you find attractive?
A: Our best trade this year is long the Russell 2000 or the Nasdaq, and short
the S&P 500. Those small- and mid-sized companies acting the way they are
makes perfect sense, since in the U.S. they have also been forced to
restructure, thanks to Y2K. Higher oil prices and higher interest rates make
them move immediately. So the move in small- and mid-caps has legs, and it
is actually the place to be invested in the U.S. for the entire year. We run
$200 million in onshore and offshore accounts. They are a third in value,
two-thirds in stocks with strong price and earnings momentum. For value
stocks to begin to outperform here, I really think you need a bear market that
drives all stocks and the economy lower and changes investor sentiment to
one of outright fear.
We like the whole health-care theme, and specifically biotech, which we think
will overtake some parts of IT as the hot sector this year. One company we
invested in is Oxford Glycosciences in the U.K., which is working on the
Alzheimer's biomarker area. It went from 600 pence to 3,000p in the last few
months. Now it has a market cap of 1.1 billion. My guess is it is worth far
more. The completion of the Human Genome Project is coming faster than
anybody thought, but in a cruder form. When you have a commercial
application to this kind of technology on the horizon, research efforts take on
a life of their own and solutions are found quicker than anybody suspects. So
the first drugs will be introduced as a result of Human Genome research much
more quickly than in 10 years.
Q: How do you play it?
A: We've been buying a package of biotechs globally, mostly here in the U.S.
They are Evotec, which trades on the Neuer Markt in Germany, Imclone and
Geron, which trade on Nasdaq, and Qiagen of the Netherlands, which also
trades on Nasdaq. We are interested in the pure play, not the big-pharm
stocks with biotech exposure. If this sector has the next generation of drug
therapies, the big-pharm companies are going to have to buy them out. You
will see a huge move in the next couple of years to buy science.
Q: How about medical technology?
A: We've owned a company for some time called ATS Medical here in
Minneapolis. They have a heart valve made out of pyrolitic carbon, a
super-hard substance, that's very close to being approved by the FDA. It
turns like a couple of saloon doors, so you don't get the same kind of
coagulation and blood clots a typical heart valve produces. There is plenty of
cash. I think they will get the approval some time in the fall. The stock is about
11 1/2 today, and when they get the approval, you'll see estimates rising
towards 50 cents the first year, and probably 75 cents to $1 a year later. If I
were a large med-tech company, I would not leave that one unattended. I
think it's a $20 stock.
Q: What else do you like?
A: We're interested in making a switch from the New
Economy to the Old Economy. We're moving into a third
phase of the Internet. Let me give you an example. There's
a mail-order company here called Fingerhut. They were
bought out by Federated. Now Federated stock dropped
from 55 to 34 in the last two months. This is not a
second-tier name. It has Bloomingdale's, Macy's and
Fingerhut.
Q: Lots of bricks and mortar.
A: But the interesting thing is that by acquiring Fingerhut,
they got a premier direct-mail catalog operation. Fingerhut processes and
inventories and delivers thousands of goods out here every year. Yet
Federated trades at nine times earnings. We think it earns $4 for the current
year ending January, $4.50 for '02. The whole market cap of Federated is
only $7 billion. What I think they ought to do is take Fingerhut and make a
tracking stock. This is just too cheap. It got taken down, somewhat unfairly,
with all the other Old Economy stocks.
Q: Any other themes?
A: We like gold, which is extraordinarily cheap. We look for firms that made
it a corporate policy not to hedge. Harmony Gold Mining is a South African
company traded in ADR form in the U.S. It's a fabulous story. It has a great
track record and good management. They just got control of Randfontein in
South Africa, which will give them about 2.25 million ounces of gold
production per year, making them the second-largest gold producer on the
planet, up from sixth- largest. Their market cap is all of $600 million. It is way
too cheap. They trade at about one times revenues. By comparison,
Anglogold, its principal competitor, trades at 2.5 times revenues, Homestake
Mining, the largest U.S. producer, at 2.6 times, and Barrick Gold, the premier
North American producer, at six times. Even Ashanti GoldFields, the
company that had problems with all those short positions several months ago,
trades at 1.2 times. Harmony is the fastest-growing gold miner in the world,
has the best price leverage because they openly say they will never hedge,
and earnings grew 45% last quarter. At 6 1/4, the stock is a steal.
Q: How about overseas?
A: The Japanese shareholder-culture-change theme. We go through
corporate announcements periodically and look for changes on the board of
directors. We look for firms where they're cutting the number of board
members from 50 down to 10, say. And by the next meeting, those 10 board
members suddenly vote themselves stock options. And occasionally, that gets
expanded to a buyback. Very frequently, that comes up within three to six
months. And those stocks do extraordinarily well. So we are watching
Hitachi. We have bought a little, and we think they're going to go down that
same path.
The home IT theme is also a great one. Everybody knows Softbank. But
there are a number of venture companies starting to pop up in Japan: Jafco
and Trans Cosmos. Trans Cosmos has a good core business. They operate
call centers and help desks for other computer manufacturers. Five years ago,
they started buying U.S. and Japanese Internet-related companies, which
they're now starting to take public in Japan. The first one was 7% of Liquid
Audio Japan, which went on to Japan's new Mothers market. The stock went
from Y3 million to Y12 million. Earnings will triple in the next couple of years.
They will roll out these assets one after the other on Mothers or on Jasdaq,
and maybe in the U.S.
Q: What is the valuation?
A: It isn't cheap. It trades at 400 times earnings. But the only way to play
Japan right now is through momentum. If you are going to play Japan, you
play New Economy: the Jasdaq, the over-the-counter market, just buy every
IPO. Last year it worked 95% of the time.
Q: Thank you very much.
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