Page Five:
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"Accessing cyberspace ought to be as easy as turning
on your toaster, but it's not."
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TSC: So much so that it could cut into profit margins?
Jeff Applegate: Yes, for some companies it will. The
challenge for companies is going to be getting down your
cost of goods sold faster than pricing power is falling.
And I think a lot of companies are in fact going to be
able to do that. But then you've got the additional issue
of, OK that's fine, it's a nice company, but is it going
to be a good security? And that gets to my concern about
a company that's as good as Wal-Mart trading at the kind
of premium valuation it's trading at, with expected
earning growth of 16% long term. That's good, but if
you look at what I/B/E/S bottom-up is for the market,
it's 17%. Should Wal-Mart really be trading at a
sizable premium to the market? I question that.
Meanwhile, by any metric, this is an extraordinary
business cycle. I don't find a lot of the history or the
cycles I've lived through to be a terrific guide to this
one. It's so different, in part because of globalism, the
world we put in place, which is a world we've never had
before. And now what's going on with IT, which is just
massive.
TSC: When you worry about things, what do you worry
about?
Jeff Applegate: Policy matters a lot to me, so there's
always the risk of a policy mistake, which then sends the
markets haywire. Russia defaulting was a policy mistake,
and obviously it didn't sit real well with the markets.
But the response to that mistake was an appropriate
response, so the markets righted themselves.
We pay an immense amount of attention to the Fed and what
we think they're up to and what's the risk for policy
mistake. I don't think the risk is high. They've gotten
it: Productivity has accelerated, GDP therefore can run
faster than traditional models will tell you, so we can
have more output, more income, higher stock prices, etc.,
than would be the case without inflation problems. And
Greenspan's next term started this month. So that looks
OK.
On the fiscal side and the election, both Gore and Bush
are free traders, so we have a hard time worrying that
we're going to have some protectionist idiot sitting in
the White House.
We had a legislative view that this China stuff was going
to get through Congress, and that that would be positive
for the market and would be the next step in terms of
China getting into WTO next year. The freest movement of
labor and capital ever is now on the margin of getting
even freer. The international trade policy mix is good
and in the process of getting better.
Both of the candidates have said the same thing: We're
going to save Social Security. And there's bipartisan
agreement in Congress to do that, too. That should mean
that most of the projected surplus is going to pay down
debt. And then whatever is left of the non-Social
Security surplus, then you'll monkey around, tax cuts
more with Bush, spending increases more with Gore. The
important point is that most of the money goes to pay
down the surplus. Public-sector-debt-to-GDP in the U.S.
is currently 42% roughly, on it's way to -- pick a
number, it's going to be a lot less.
So the policy mix looks pretty good, unlike in Japan,
where the policy mix has been a disaster for 10 years.
And obviously that shows up in their markets.
Then I come back to some of the fundamentals. This
capital-for-labor stuff -- I have a tough time
dismantling that. The compelling economics of why
consumers and businesses will increasingly move economic
activity to cyberspace -- I have a tough time dismantling
that. A forecast is a set of probabilities. One of the
reasons we've been generally overweight equities,
underweight cash and bonds for five and a half years is
that we keep coming down to the same conclusions. Yes,
there are risks and there will be bumps and nothing goes
up in a straight line, but on a forward 12-month basis,
all other things being equal, equities ought to do better
than other asset classes.
TSC: You mentioned before that you see the potential for
moderate multiple expansion once the Fed is done
tightening. You're not concerned that some of these big
tech names are still richly valued?
Jeff Applegate: Well, they've come down a lot. If you go
back to the peak in tech prices -- which, depending on
what index you're looking at, was around March 10 --
forward relative P/E of the S&P tech sector to the S&P
was around 220%, with the expected earnings growth
rate only about 40% better than the market. So, on a
simple PEG [P/E to growth] ratio, we were out there. No
question. I don't know where we are at the moment, but [a
few] weeks ago the forward relative P/E to the market had
come down to about 130%, with expected earnings
growth now 50% better than the market. We're
undervalued. We'll get overvalued again, because we
always do.
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"Both Gore and Bush are free traders, so we have a
hard time worrying that we're going to have some
protectionist idiot sitting in the White House."
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The other argument we've made is that the combination of
globalism and technology is further muting cyclicality.
If that's right, that should also mean -- not in a
tactical but a strategic sense -- that the volatility of
the stock market to the bond market is headed down. If
that's right, the equity-risk premium is still headed
down, and the P/E goes up.
If you go back 100 years, basically for every 10 months
we were in expansion, the economy was in recession for
about eight and a half months. It was a highly cyclical
local economy, as were all the big economies at the time.
When you fast-forward to the end of the 20th century, for
every 10 months we were in expansion, we were in
recession for about a month and a half. So radically
lower cyclicality, and what is further reducing
cyclicality is the advent of globalism and now
technology.
We're in one of those sweet spots where as long as you've
got this stuff further muting cyclicality, that should
continue to mean that equity valuation stays very rich
compared to history and maybe even gets richer.
Think of the simple algebra for the P/E. The P/E is equal
to 1, divided by k [the discount rate], minus g [the rate
of growth]. Once the Fed goes on hold, the discount rate
stabilizes. And g can accelerate because productivity is
accelerating. So potential GDP can go higher. So if the
value of k minus g is going down, P/E goes up.
Nothing lasts forever, and this won't either. But guess
what? It's a pretty good ride.
TSC: It looks like you guys came down a bit on your
interest-rate forecast [since the beginning of the
month].
Jeff Applegate: Steve Slifer, our chief economist, pulled
the forecast that the Fed was going to go in June,
although we still have them doing a quarter-point in
August.
Increasingly, my feeling is that the Fed's done. It would
be highly unusual for the markets to trough with a
20-week lead time to the final Fed tightening. But do
they trough with a four-to-five- week lead time? Yes.
TSC: And as far as the effects of all the hikes ...
Jeff Applegate: I think that's what's playing through
now. To me, one of the reasons retail sales have done
what they've done -- the Fed started tightening a year
ago, and it takes about a year for everybody's adjustable
rate mortgage to adjust. Suddenly, in April or May, you
had to write another check for $200 or $500 or however
big your mortgage was, and you had energy going up, so
you basically had disposable income shrinking. That
should have slowed things down, and it looks that to some
extent that has happened.
Another thing. Given that Japan is the second-biggest
economy on the planet, and you've got a credit situation
that is pretty parlous -- whether it's private sector or
public sector -- among the things we worry about is
whether the markets at some point get fairly
uncomfortable with what's going on in Japan. Should that
occur, the safety valve for expressing that is probably
the exchange rate. If you get a big swoon in dollar/yen,
which is not inconceivable, then you will stop the rest
of Asia's recovery dead in its tracks. Then we won't get
precisely a replay of '97-'98, but something not unlike
that. That is certainly a risk. It's back to policy; it's
because the policy-mix in Japan is still not correct.
TSC: Thank you very much.
Jeff Applegate: My pleasure -- some of it might even turn
out to be right.
Funny Guy!!Must Be A Clown -G- |
