Outside the bubble in the Nasdaq stock prices have virtually gone nowhere this year. As of this writing, the Dow and the S&P 500 have gone back into negative territory. The action this year has been in the techs with the Nasdaq up over 4 percent for the year. Individual tech issues within the Nasdaq 100 are up even more and investors are bidding up Internet stocks to ungodly multiples. Given the action in some of the techs, you would think that the 90's bull market is back and that there is a technology boom in the country. That is the spin, but reality is much different. Yes, Texas Instruments made a profit instead of a loss. However, they also reported that chip sales are slowing down. Microsoft beat estimates but their earnings were up less than 2 percent. They also lowered guidance going forward. IBM saw its sales increase thanks to an acquisition, but saw profits fall short of estimates. Intel saw its earnings drop over 2 percent and EMC actually made money instead of losing money the year before. Nobody would question the fact that conditions inside the tech industry are better than where they were last year at this time.
The question of improving profitability, thanks to cost cutting, is not an issue. The issue with techs is what it has always been: valuation. What do you pay for a company who is only growing its earnings at an annual rate between 2-8 percent? Even then, earnings are still questionable because many of the tech companies are still diluting shareholder value through the issuance of stock options. They still aren't fully accounting for payroll expense and therefore are understating earnings. Accounting rule changes expected later on this year will require the expensing of stock options, which is as it should be. Many of today's highfliers are going to see share earnings drop if that accounting rule change becomes law. A recent study of the S&P 500 companies showed that actual earnings would have been over 60 percent lower than reported had companies treated stock options as an expense. Therefore, we are still dealing with accounting tricks and games to make the numbers.
A greater issue at hand is there is still no visible evidence that tech fundamentals have improved. Inventories of goods are still piling up in all sectors of technology. There are too many mobile phones, PC's, DVD players, PDA's, and game players. There is still plenty of excess capacity. Companies such as Applied Materials is still operating at less then 70 percent capacity and still laying off workers. Companies still lack pricing power and the competition is decimating profit margins. Even electronic retailers such as Circuit City, Best Buy, and Office Depot are heavily discounting prices to unload unwanted inventory. PC channel distributors such as Tech Data have warned that due to a drop in demand and falling margins, profits and sales would come in less than expected. Cisco reported another negative book-to-bill quarter while at the same time the company reported that deferred revenue on product sales also fell. Conditions still remain highly competitive within the industry, and the tech sector is still plagued by excess capacity and mounting inventories. The tech glut is still with us, nor has excess capacity been worked off. Unless there is a remarkable new revolutionary technology, it is going to take years before much of this excess is worked off and the malinvestments are cleansed from the economy. Until then, conditions in the industry will remain unremarkable.
This brings up the temporary insanity that has taken over the tech sector by institutions and fund managers who have been loading up on individual tech and Internet issues in the belief that the boom is back and that techs are going to lead the economic recovery, predicted to take place in the second half of the year. I have never had an issue that the U.S. has some of the best technology companies in the world. I only question what an investor would have to pay for owning a share in these fine businesses. Looking at this sector from a business point of view, would I as an investor be willing to pay 40-75 times earnings for a business that was growing its earnings at less than 10 percent a year? I don't think so. There are other businesses which are growing their earnings at a much better rate and whose earnings are much more predictable. Furthermore, these companies pay dividends, have better cash flow and don't have to plow back all of their earnings just to stay in business.
This weekend's edition of Barron's featured a story over the return of the Internet bubble. They have been one of the outstanding performers in the market these last 10 months. After losing almost 90 percent of their value in the bursting of the technology bubble, many of these companies have seen their share price appreciate 30-50 percent this year. From their nadir last year several of these companies have more than doubled. Shares of Yahoo have tripled from last October. Yahoo made close to $43 million last year. It has made a profit in only two out of the last five years. During that five-year period, its cumulative earnings were only $56 million. Its profits have been unpredictable. Yet it currently has a market cap of $15 billion with sales of only $953 million and a profit of $43 million. An investor would have to invest only $860 million in 5 percent bonds to earn the same return that Yahoo provided to shareholders last year. Given Yahoo's market cap of $15 billion an investor buying a 5 percent treasury coupon would receive a predictable return of $750 million a year on that very same $15 billion dollars. From a business and investment point of view, $43 million on a $15 billion investment is a very lousy return. Yahoo would have to grow its earnings at a 33 percent annual compound return for a ten-year period to produce the same return that an investor would receive in making a similar $15 billion dollar investment in Treasuries today. Furthermore, the investor would not have to wait 10 years to receive the $750 million in interest. The same purchase today would immediately produce $750 million in interest each year.
Yahoo isn't the only Internet stock that has been bid up to such extreme valuations. Amazon.com, a company whose services I use each week in the purchase of books, is another overvalued company. Amazon.com has lost money each year and has yet to earn a real profit, yet it has a market cap of $9.5 billion. By contrast, Barnes & Noble, which is actually making money and has done so for four out of the last five years, has a market cap of only $1.2 billion. Borders a similar company, which has made money every year, has a similar market cap of $1.2 billion. Fund managers having been dumping Borders and Barnes & Noble and instead are buying Amazon.com. Go figure. EBay, a company that actually has growing and consistent profits has a market cap of almost $28 billion on sales of $1.2 billion and profits of $249 million. It trades at 101 times trailing earnings. Taking my Treasury example, EBay would have to grow its earnings at an annual compound rate of 20 percent to achieve similar returns. EBay out of all of the Internet stocks would be the only company that I see that could possibly pull this off. Even then, you would have to factor in the time value of money in waiting for ten years to achieve those returns.
The earnings unpredictability, the large cap values of many of these same stocks, and the plethora of more profitable alternatives tells me fund managers and institutions are playing the "Greater Fool" theory. They are buying expensive and overpriced tech stocks at high prices on the assumption that a gullible public will be willing to pay an even higher price. So far John Q isn't buying, other than the day trader types that chase momentum. It appears now the only gullible investors are the fund managers themselves.
Bankable Returns
I expect after the next hard leg down in the markets that we will get a countertrend rally that could last well into next year. The Fed is hell-bent on reinflating the economy and the markets as the Greenspan bubble machine operates at full capacity. After creating the greatest financial bubble in U.S. history, the mad hatter that chairs the Fed is busy creating credit and monetizing assets in an effort to avoid a depression and its deflationary aspects. In the process, he just may give us hyperinflation. I’ll get to that in just a moment. Given the fact that there is a distinct possibility for a powerful countertrend rally to emerge because of a major stimulus package out of Washington, and a major reflation policy from the Fed, what should a reasonable investor be looking at? I recently have been running screens on companies with predictable earnings, high returns on equity, steady dividend increases over the last ten years, dividend increases annually of five percent and yields of at least 5 percent. These companies are actually earning more money than the tech companies, their earnings are much more predictable, they have better growth rates and are spinning off more cash flow, which is supporting higher dividend increases. I'm happy to say that the news is much more pleasant than what I would have expected. There are plenty of better opportunities to be found in the food, tobacco, drug, oil, publishing, and defense sector. We found many companies in the financial sector that met our requirements but are avoiding financials because that is where the next trouble spot lies.
The good news is that after the next downturn many of these companies, which now offer 4-7 percent dividends, sell at 7-13 times earnings, and have great business franchises and strong balance sheets, will become even more attractive after the next sell off in the market. By summer if all plays well, these companies will be even cheaper. Unlike the high tech and Internet stocks, most of these companies pay great dividends that have gone up each year. The best part about a dividend is that it is bankable. These companies are still growing their businesses so an investor would not have to sacrifice on growth. In a stock market that seems to be operating on the "Greater Fool" theory, I'll take a predictable earnings stream and a bankable dividend at a reasonable price over a stock whose return is based on another idiot willing to pay even a higher multiple to own the same fluff.
The Mad Hatter
The Greenspan Fed is hell bent on reinflating the bubble in the economy and in the markets. Since the tech bubble burst in 2000 the Fed has been responsible for creating multiples bubbles in mortgages, housing, and consumption. Now the Fed is looking to reinflate both the economy and the financial markets. For those who are naïve in believing that the Fed doesn't intervene in the financial markets, they should be reviewing the Fed's balance sheet. The Mad Hatter that heads up the Fed has been busy monetizing debt. In the week ending April 2nd the Fed monetized $2.6 billion in debt. Over the last year, the Fed has purchased over $67 billion in Treasury debt. Foreigners are also buying Treasuries. They now own $899 billion of our outstanding Treasury debt. The M&M's are still growing and the monetary base has increased by close to $50 billion in the last year. If there is deflation anywhere it isn't obvious in the monetary aggregates. The Fed is now in unchartered territory with monetary policy now becoming a grand experiment. It is becoming a battle on whether the Fed can win against the forces of a deflationary debt collapse without creating hyper-inflation in the process.
Suffice to say that with monetary aggregates now shifting into hyper drive and fiscal stimulus ready to head into the stratosphere, it remains a question as to where all of that excess money creation is going to flow. I believe the US could experience one last great hurrah, or at least a temporary reprieve from the claws of the bear. But first a shift downward precedes it. The VIX and the VXN are giving a strong sell signal. Maybe the Fed, the PPT, or ESF never allows the markets to go below their July and October lows of last year. However, there are those events that are unexpected that occasionally surface, going beyond the Fed's ability to control. Any number of unexpected events coming out of the geopolitical sector or the leveraged and highly geared financial sector offers numerous possibilities.
Looking at today's casino results the blue chips headed south while tech crazed Nasdaq managed to squeak by with a minor gain. It has been interesting to note that insider selling in the tech sector has accelerated. Even Bill Gates has been busy dumping shares of Microsoft. The Dow and the S&P 500 lost ground and went negative for the year, while the Nasdaq managed to hold on and increase its gains for the year to over 4.4 percent. Apple Computer said its profits fell 65 percent as the company spent more on developing new products. Coke missed analysts' estimates but said beverage shipments rose 4 percent. 3M was the biggest drag on the Dow falling close to $5 after analysts cut earnings estimates for the year. There were other disappointments coming from Safeway, Maytag, and Verizon. After the market closed Sun Micro reported lower than expected sales and profits. Broadcom lost only $0.25 cents, which was better than expected. A year ago, they lost $0.63 a share. Advanced Micro reported losses after it said sales were flat.
The good news is that year over year, earnings for most companies have been steadily climbing. The only problem is that they are growing at a snail’s pace and certainly not at a rate that would justify today's high prices for most stocks. There are still plenty of surprises out there and many undiscovered minefields in earnings. Options and pension expense are just two of them.
Volume hit 1.54 billion on the NYSE with eight shares dropping for every seven that rose. The VIX edged up .05 to 26.09 and the VXN rose .55 to 37.05.
[Overseas Markets European stocks fell, led by drugmakers including AstraZeneca Plc, after Akzo Nobel NV said competition from copycat medicines ate into its profit. Lloyds TSB Group Plc sank amid concern rising consumer debt and waning confidence may hurt earnings growth. The Dow Jones Stoxx 50 Index slid 1.6 percent to 2304.27 after earlier rising as much as 1.8 percent. The Stoxx 600 lost 1.1 percent, with drug stocks leading declines. Benchmark indexes slipped in 14 of Western Europe's 17 national markets.
Japan's stock benchmarks rose, led by computer-related shares such as Tokyo Electron Ltd., after earnings of U.S. peers beat some analysts' estimates and a report showed increasing worldwide sales of chip-making equipment. The Nikkei 225 Stock Average rose 40.66, or 0.5 percent, to 7879.49. The Topix was little changed, adding 0.72 point to 788.96.
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