Writing on the Wall
Adam Hamilton June 23, 2000 2556 Words
Sixty-two miles south of Baghdad, in what is now Iraq, lies the ruins of one of the most powerful and greatest cities in the history of the world, Babylon. In September 539 BC, Babylon was the fabled heart of the legendary Babylonian empire. The city was considered militarily impregnable. It had walls that Herodotus claims were 15 miles in circumference, sixty feet high, and thick enough to race six chariots abreast on top of the walls. The mighty Euphrates river flowed through the center of the city, providing virtually unlimited water in the event of a siege. Vast storehouses of food and even growing space existed within the city walls. On October 10, 539 BC Belshazzar, the co-regent of Babylon, was informed the mighty armies of Cyrus the Persian were raiding Babylonian territory. Rather than prepare, Belshazzar threw a great party for the nobles and intelligentsia of the city. After all, the city was unconquerable, so why worry? After a lavish celebration full of debauchery, King Belshazzar was terrified to see a disembodied hand scrawling a cryptic message on the wall of his royal banquet hall. He was so scared, he offered to make anyone who could interpret the message the third most powerful man in the Babylonian kingdom. The conventional astrologers, soothsayers, and analysts could not decipher the text, as it was in code form and also in another language. The famous Hebrew profit Daniel was brought in to read the cryptic scrawlings on the wall before the king and his court. Daniel understood, and told Belshazzar his kingdom had been weighed and was found wanting, and that Babylon would be taken by the Persians that very night. Belshazzar, of course, was in a state of disbelief and denial until he was executed several hours later by the Persians. Cyrus, a military genius, had his army divert the Euphrates river into a Babylonian canal system in the north. The river water level dropped to thigh level under the walls of Babylon, and Cyrus’s general Ugbaru and his troops were able to walk in and subdue the greatest city in history without a battle.
This week in the markets, the equity bulls were feasting in their royal chambers, confident that no force on the planet is powerful enough to damage the new empire built by US worker productivity and super technology. Although no reports of a disembodied hand have been reported on bubblevision, it would appear the writing is indeed on the wall for the end of this US equity bull market of legend. This week we will briefly explore the financial equivalent of Cyrus’s army advancing on the supposedly unshakable US financial markets, a neo-incarnation of financial Babylon.
The DJIA ended the week off ½%, the NASDAQ was virtually unchanged at –1/3%, and the S&P bled 1.5%. Yawn… Contrary to the continued emphatic denial of the bulls of a fundamental valuation problem, earnings surprises continued to indicate serious problems in valuation levels in even the falsely labeled “Old Economy” stocks. This week, blue-chip Dow component Honeywell announced lower than expected earnings. Historically, a negative earnings surprise on a normally valued company would cause it to lose a few percent of its value before it stabilized. With unsustainable valuations, however, investors are always looking for an excuse to liquidate a stock. Honeywell, previously trading at 2x the 13.5 historical market norm price/earnings ratio, plummeted 17% on the day of the announcement, and lost another 9% the following day. It finished the week a dismal 28% lower than its Monday opening. Honeywell is certainly not an exception. Other solid companies apparently not living up to stellar investor expectations and incredible valuations have been punished as well. A week ago, Xerox traded at 24 times earnings. In the trading day following its negative earnings surprise, the market obliterated 18% of its market capitalization. In prior weeks similar events rocked Motorola, AT&T, and Proctor and Gamble. In the higher valuation stocks, the carnage is even worse following a bad earnings announcement. Great Plains Software was valued over 50x earnings before it underwhelmed analyst expectations. It immediately plummeted 48% on a poor quarter’s results and is still falling. Even positive earnings surprises are not having the expected effect on tech stocks. Oracle announced a record quarter this week, and saw its stock lose 6% in after hours trading immediately following the announcement. The incredible selloffs on negative earnings surprises coupled with the lackluster effect of good numbers is a great “Writing on the Wall” indicator of investor burnout and valuation limits being exceeded. In a low volume and dangerously overvalued market, people are looking for any reason to sell. So far, it has been company specific. When the urge to purge hits the broader markets, however, it will be “Katie, bar the door!” time in the US equity markets.
Another curse on the wall is faintly visible by analyzing the disconnect in logic behind the stock market bulls’ lack of supply chain analysis. The current market darling sectors appear to be the semiconductor companies and computer manufacturers. Although analysts remain aggressively positive, the prospects of these sectors are deteriorating rapidly. Dot coms are cratering and falling from the sky like frantic ducks on the opening day of hunting season. As these companies pick up their toys and go home, corporate demand for chips and computers is dwindling. Analysts continue to expect a huge increase in chip and computer sales, however, and seem to be stuck deep in the proverbial trees. The strategic view of the forest indicates the death of the computer industry’s biggest customers would be bad for the semiconductor and computer industries. And that is not even considering the thriving used market in high-end computer hardware, the machines that used to run many dot com sites. There is no functional difference in utility between a brand new computer server and a slightly used and six month old computer server. As a further maelstrom on the chip and computer horizon, retailers selling computers to increasingly cash-strapped consumers are reporting dismal sales prospects in the next two quarters. For some mysterious reason, the Wall Street analysts are not reading between the lines. If semiconductor and computer companies’ corporate and consumer customers are greatly reducing their purchases, one would tend to infer the industries themselves would be in for slower sales. The Philadelphia Semiconductor Index (SOX) closed up this week and is near record levels set in March. So why are Wall Street investment houses paying technology analysts seven figures to ignore the obvious? One can only surmise their purpose is to HYPE stocks to the unsuspecting public, not to provide sound analysis. Can you hear the disembodied hand scrape the wall with its quill?
Oil remained at high levels this week, closing above $32/barrel. As the OPEC Oil Ministers tried to meet quietly in Vienna, Gore and Bush began a political cat fight over the relatively high gasoline prices in the US. Gore screamed that the big oil companies must be gouging consumers. Bush fired back with allegations the State Department had done nothing to persuade OPEC to increase output. As the US government tried to jawbone and manipulate yet another commodity market (taxpayers’ oil from the United States Strategic Petroleum Reserve was released this week), OPEC agreed to a very slight increase in oil production that is unlikely to retard continued rising of oil prices. Knowledgeable petroleum analysts continue to assert that most nations of OPEC are effectively at full production capacity, limiting the probability of much more oil on the market in the near future. Oil will no doubt be a hot issue until the election. Al Gore has emphatically promised the environmental lobby he will “never, EVER” allow the tapping of vast oil reserves in Alaska due to wildlife concerns. This may come back to haunt him if gasoline is $4/gal in November! The real cause of the oil action is the supply and demand dynamics in the global crude market. Artificially low oil prices last year depressed exploration, and the speculative folly in the technology stocks sucked valuable and scarce capital away from the oil industry which needed to increase capacity. The available supply of oil is rising much slower than global demand, which is booming. Until higher oil prices last long enough to entice capitalists to bring vast new reserves online, the crude prices are likely to go much higher before they reach a market clearing price. The soccer moms in the States driving their massive urban assault vehicles haven’t seen anything yet.
In real terms, oil actually has a LONG way to go before it reaches 1980 highs. The graph below shows the oil price inflated by the Consumer Price Index in constant May 2000 dollars, oil that is CPI deflated and inflated by constant January 1980 dollars, as well as the nominal dollar price of oil.
The red line shows the nominal price of oil, and the red dotted line indicates the trendline of 20 years of tops. It would appear oil is once again expensive when not considering the effects of inflation. Looking at inflation adjusted dollars, however, oil is still very CHEAP compared to the early 1980s. The blue line shows oil in the early eighties was over $85 a barrel in today’s inflated dollars. Notice the breakout of oil in early 2000 from the dotted blue top trendline. The same breakout is visible if oil is priced in 1980 dollars, as the intersection of the green dotted trendline with the solid green line indicates. These breakouts have huge technical and fundamental implications. The folks running the OPEC nations are not stupid. Tens of billions of petrodollars can hire brilliant financial advisors who realize the US dollar is rapidly inflating. I believe OPEC is conspiring to jack up prices because they don’t want to give away their only asset, a wasting asset at that, for a few paper dollars that are constantly falling in value. If a new full blown oil crisis develops, we would be looking at oil at a phenomenal US$100+ per barrel. This is the stuff of economic nightmares, and the hand continues to write on the wall.
Speaking of inflating dollars, even the equity bulls are beginning to grudgingly admit their “may be” some inflation. There is nothing like being whacked across the jaw with a 55 gallon drum of oil to emphasize the painfully obvious. The CRB saw new highs this week, cresting at 227 on Thursday. The GSCI brought up the flank with gains as well. Earlier this year, in March, bubblevision claimed rising oil prices would not hurt the so-called “New Economy” stocks, which are all outrageously valued. It looks like they will get their chance to test their shaky hypothesis in the next few months. As more and more Americans and foreign investors observe the effects of inflation in the economy, fewer and fewer dollars will pursue overvalued US equities. The NASDAQ, S&P, and even the Dow have some tough sailing ahead, and are likely to face a hurricane force gale of a headwind in the next six months. Grab your popcorn! It could be quite a spectacle.
The undisputed king of assets, gold, was hit pretty hard this week, losing 2% of its dollar value. It was probably related to the inexplicable rally in the dollar as the dollar index closed up almost 2%. As US economic and equity fundamentals continue to deteriorate, it is a constant source of amazement to see the US dollar maintain lofty levels and gold treading water right above the mud. In nature, there are some things that would be downright disturbing if one observed them. For instance, water flowing uphill or pigs flying. The immutable law of gravity should have an easily observable effect on swine and water alike. If someone saw a pudgy boar soaring through the sky in a ballistic arc, they would have to assume it had just been shot out of a cannon, as the laws of physics are inviolable. The action lately in the US dollar and gold has the same type of surreality surrounding it, and is screaming of unnatural intervention. With the relentless and ever compounding effects of ludicrous equity violations, inflating dollars, the oil rocket, rising interest rates, dropping sales, and political shenanigans, the barbaric relic should be soaring and the fiat dollar should be falling towards its true value. With neither of these natural and almost inevitable consequences of economics occurring, even the most jaded skeptics are finding themselves waxing eloquent on conspiracy theories of market interventions.
Next week should prove to be stimulating. The Federal Open Market Committee meets on Tuesday, and they have a tough decision to make. If interest rates are raised, it will put ever increasing pressure on the volatile US equity markets, where bullish analysts almost unanimously expect no rate hike. The Fed desperately wants to avoid being the catalyst that ends the biggest speculative binge in financial history. Since no one knows when and how the exogenous event that shatters all illusions will manifest itself, the Fed is walking on thin ice by tinkering with the machine. On the other hand, if the FOMC holds steady, the world finance community will immediately see it is not serious about staving off inflation and is disregarding unequivocal data indicating the urgent necessity of a rate hike. There is a small probability this could lead to an international selloff of the inflated US dollar. Damned if they do, damned if they don’t. A prime example of why bubbles should not be nurtured in the first place! The federal funds futures contracts on Friday were indicating a 25% chance of a rate hike on Tuesday.
Next week also marks the end of the month, when mutual fund managers play games with stock bid prices in order to jack up the value of their holdings and increase their bonuses. If you are a gambler, barring some totally unforeseen event, the odds are probably in your favor that the markets will ramp up towards the month-end equity mark-up. After the tape is dripping with paint, fresh greenbacks will arrive in the beginning of July from monthly retirement plan contributions to be immediately cast into the gaping maw of financial oblivion. All in all, without something very unexpected, next week is unlikely to see significant drops in US equity values.
Finally, I would like to humbly ask for a moment of silence for Amazon.com. Today investors shot off more than 19% of its total value as concerns about its revenue growth and credit worthiness cascaded through the market. As the bellwether internet stock (that has yet to make a single penny for shareholders) it could be a leading indicator of more carnage to come in the tech sector. It is a sad day indeed if generous Amazon shareholders are deciding to cease subsidizing the reading habits of studious goldbugs and contrarians actively seeking the truth in the financial markets. If Amazon folds, where else will be able to buy our books below cost?
The writing is indeed on the wall for US equity markets, and somewhere on the horizon, obscured by a dust cloud, the relentless hordes of Cyrus ride. Will the seemingly impregnable US equity markets withstand the might of the powerful fundamental forces attacking them?
Adam Hamilton, CPA June 23, 2000