After the war, can we win peace and prosperity?
Peace and a prosperous economy may be much more difficult to achieve because there’s still too much capacity in many industries. And the only battle plan that will fix the problem is time.
By Bill Fleckenstein
Contrarian Chronicles
In the canyons of Wall Street, you won't find any statues to the "gods" of speculation and technology. But if somebody had chiseled them, chances are they'd still be standing erect. The concrete Hussein is now Humpty- Dumpty, but the will to speculate, especially on technology stocks, seems at times shatterproof.
However, there's nothing like a birds-eye view of the technology business to hack away at the myths that keep speculation going. And speaking of myths, did you hear that one about the government's "plunge protection team"? It, too, deserves to come down with a thud.
For anyone who doubts that speculation is alive and well, last Wednesday's action in our stock index futures -- as the tanks rolled into Firdos Square and Hussein's statue spent its final moments in an upright position -- should set the record straight. About an hour before the open, the futures were indicating a sell-off to the tune of about 0.5%. But lo and behold, when the tanks appeared, they staged an immediate turnaround, which enabled the market to open slightly green. As it became clear the statue would be toppled, the futures started to motor off their lows. They were kind of being jammed straight up just as the rope broke on the first attempt. Next, we saw a little sell-off in the futures, followed by a small, straight-up move when the statue actually came down. That was the high for the day.
Emotional trading
What these details show is just how emotional the tape seems to be, and how it continues to respond to news in a purely amateurish fashion. I mean, to buy the futures simply because the statue was coming down is absurd. To buy and sell each and every war or terrorist rumor is equally absurd. I think such behavior points out the fact that there is still a great deal of speculation on the tape. If it really weren't so sad, it would be hilarious.
In any case, with all the good news about the successful waging of the war now discounted, the market is going to have to digest ugly earnings, and may in fact come in for some rough sledding. Consequently, I beefed up my shorts last Wednesday, and now have a modest-sized short position. My expectation is that the market will have a hard time going up through earnings season. However, after earnings season, we may get the second installment of the war rally -- that being the phase where everyone tries to make the excuse that all of our problems were related to the war, and now that it's behind us, and the bad earnings are behind us, we can embrace higher stock prices.
I am not saying that will happen for sure, but I can certainly see how bulls may try to make that case. I don't want to get too far ahead of myself. For the time being, it looks like there's a good chance that bad corporate news may matter. The burden of proof is now on the bulls.
Cold-shower counsel from Ellison
Of course, overpaying for stocks has never been a hard sell in the tech arena, and that brings me to some worthwhile comments from Oracle (ORCL, news, msgs) CEO Larry Ellison in a recent Wall Street Journal interview. I assume he had an agenda (though I'm not sure what it was), but in any case, his points in “Oracle's Larry Ellison Expects Greater Innovation From Sector” should provide food for thought for those folks who cannot shake their longstanding love of tech. "What's going on," he began, "is the end of Silicon Valley as we know it . . . The next big thing ain't computers." According to the story, Mr. Ellison believes it's biotechnology.
We are in agreement. Biotechnology is a better business than technology. When one gets a product through the FDA, it receives patent protection for a number of years. On the other hand, the technology business is highly competitive, plagued by low barriers to entry and the fact that technology hardware is, in essence, a commodity. The stock market mania of the 1990s masked a lot of these warts as companies misallocated their capital on a technology buying spree. The illusion was extended by stock-option accounting, in which companies deducted employee options from the tax bill. That enabled them to create the impression of generating lots of cash. So, in my opinion, what people saw in the 1990s was a big distortion of how the technology business really works and looks.
The interview went on to lay out this view as follows: "Mr. Ellison, sounding like a modern-day Cassandra, paints a dark vision of the computer industry's future: increasingly standardized products with little distinguishing technology and thin profit margins. . . . 'There's this bizarre notion in the computer industry that we'll never be a mature industry.’ "
I think that misconception is shared by many tech stock investors, whose admiration for technological innovation blinds them to the dog-eat-dog nature of the business. (I would just add that during the late 1990s, an understanding of this distinction was irrelevant, if not an impediment, temporarily, to investing success.)
Excess, through largesse
As the interview shows, it was certainly lost on venture capitalists who helped to unleash the bubble's massive excess capacity: "Venture capitalists compound the problem, Mr. Ellison says, with a herd mentality that results in funding too many companies chasing the same idea." Of course, when one looks at history, one can see that boom-and-bust cycles in technology are always exacerbated by money flows toward venture capitalists.
When we have a rip-roaring bull market for tech stocks, venture capitalists get more money. They then go out and start more companies, which in a few years create a more competitive environment. This smothers profits and helps to create the bust. Then they can't get any money. And so then the companies that exist can get more profitable. And then we have the boom, and then the cycle repeats itself.
That's a simplified example of what tends to occur. Of course, the mania that we had in the 1990s exemplified this to the nth power. In any case, we still have too much capacity and we will continue to have too much capacity. We are also facing saturation issues for many products, including personal computers and cell phones. And the prices of many of the securities are way too high.
Back to the interview, the Journal turned to another source, both to buttress Mr. Ellison's view of overcapacity and to propose a way to get technology back on track: "Eric Schmidt, chief executive of Web-search company Google Inc., says Ellison has correctly diagnosed Silicon Valley's challenge. He says tech is plagued with chronic overcapacity, similar to the airline industry, because of rapid technological advances. But Mr. Schmidt thinks Mr. Ellison has the wrong prescription. 'The only solution is to come up with grand new visions, which we're particularly good at,' he says."
To that I would respond, people who find new niches may have a chance to do OK. But from here, investing in tech stocks generically as they are priced today is going to be a very, very dicey proposition for all but the most nimble, luckiest traders.
Fed cannonball hits the wall
Now for a look at a Journal story titled "Fed Weighs Alternative Stimulus Plans," which ran in the April 9 edition. Reporter Greg Ip discusses the Fed's plan to make sure that the inflation rate is at a level it deems acceptable. The potential ramifications may be far-reaching, and so I recommend that everyone track this story down.
I find it more than just a little ironic that the Fed, the great engine of inflation in this country, is preparing to "fight deflation." Now I do know that in the aftermath of a bubble, it is conceivable we could see some deflation. But I continue to think that is less likely than the prospect of seeing more inflation. After all, just look at what has happened to the purchasing power of the dollar in the 90 or so years since the Fed has been around. Depending on how you want to measure it, the dollar has lost between 90% and 95% of its purchasing power, and for better than half of that time, we were at least on some variation of the gold standard. Otherwise, I'm sure the results would have been even worse.
The Fed helped to create the biggest bubble in the history of the world. It has been trying to print money to stave off the bubble's aftermath. It has encouraged a housing bubble, a debt bubble and has financed an over- consumption boom. Now the Fed is getting the drift that since 12 rate cuts haven't worked, perhaps it had better do something else, because it may not be able to take rates too much lower. It's a case of the law of unintended consequences rearing its interesting head, which Ip describes as follows: "Another reason to keep rates above zero: Money-market mutual-fund returns, after expenses, would otherwise go negative, so investors would pull their money out. That would hurt the ability of industrial companies to sell short-term debt securities, such as commercial paper, to such funds."
The fact that we have completely deregulated the financial system in the last 20 years is now threatening to complicate the Fed's attempt to lower rates to solve the problems that it believes it didn't create. Obviously, if money-market mutual funds were producing negative returns, that would set off all kinds of problems. Every time I read about what the Fed has in mind, and I think about what the Fed has done, I can only conclude that the value of the dollar is absolutely going to get destroyed.
From war fears to Fed jeers
Now that the war has basically been won, I believe the markets will have to deal with winning the peace, which will be more complicated. People will have to deal with the rotten economy. At some point, they will start to focus on the predicament that the Fed has engineered us into. Once the world really gets a clear view of that predicament, our currency will take a beating. As protection against the lunatics at the Fed, and with the war premium out of the gold market, I think it is probably safe to add to one's precious-metals position, as I did last week.
A paper trail, to no avail
Finally, I'd like to spend a minute on the alleged "plunge protection team," a.k.a., market manipulation. Lots of people think that market manipulation goes on, and that the President's Working Group on Financial Markets (created to discuss financial policy after the October 1987 crash) is involved every time the market mysteriously rises. I have a view on the subject, but the time to articulate it here in the Contrarian Chronicles just never seemed right until this week. That view is closely encapsulated by John Mauldin in a piece titled "The Plunge Protection Team," which I read last weekend on investorsinsight.com. Obviously, if this is taking place, there certainly must be some trades that would produce a paper trail. I especially like the fact that he was willing to put his money where his mouth is, as you'll see below:
"You could not keep something of this size secret. Period. The orders would have to be entered somewhere. The theory is that Goldman Sachs or Citibank (or pick a firm) is part of this conspiracy. That means that multiple traders and officers would have to be in the know. You cannot mask trades of that size because it would essentially be the largest hedge fund in the world. Someone would spill the beans. Can you imagine the signing bonus from a book publisher if you could prove the existence of the PPT? I hereby offer a $100,000 advance against 50% of the royalties to anyone who can 'show me the trades.' Give me names and dates. I will write the book, and we both become famous."
Mauldin continued: "Further, can you imagine what political hay the opposition political party would make of the proven existence of a PPT? Do you think that the Dems wouldn't love to embarrass Bush with 'proof' of his manipulation of the market? Can you imagine Newt Gingrich or Tom DeLay (Republicans) not beating up Clinton and Robert Rubin for crimes against the market and for losing billions of dollars of taxpayer money? If the President's Working Group was really the PPT, do you think every former SEC and CFTC Commissioner (and there are maybe a dozen) would all keep silent after they are out? Do you think their wives (or husbands) would not tell all in a divorce hearing? Do you really think that Harvey Pitt would have allowed George W. to fire him if he could blow the whistle?"
Of course, this is not proof positive that manipulation does not occur in the form of some nefarious government agency. However, I think Mauldin's points are the key stumbling block to the arguments of those who believe that manipulation does exist. In the 15 years since its inception, one would think that if the President's Working Group on Financial Markets were engaged in plunge protection, somebody would know about it.
Bill Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At the time of publication, he owned none of the securities mentioned in this column. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC on MSN Money.
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