At Least Don't Buy Bonds
January 22, 2004
by Porter Stansberry
"All bondholders must consider that a new cycle could be arriving...after 24 years, we are closer to the end of the bond bull market than the start of it."
- Chris Weber, "Global Opportunities Report," Jan. 15 2004
Alan Greenspan was on TV, speaking to a German audience, about the grandiose accomplishments of his American monetary policy.
He was saying that the Fed's 13 consecutive interest-rate cuts had saved the U.S. economy (and therefore the world). He proclaimed that such cuts would not cause a rise in inflation, as "there has been no systematic rise in prices."
Simultaneously, the FOX news scroll running along the bottom of my screen told me that soybean prices had reached a new, 6-year high price.
And it's not just soybeans, Mr. Greenspan.
On January 13, the Commodities Research Bureau, which tracks the futures prices on a broad basket of commodities, reached a new ten-year high. Other new highs posted the same week include copper and precious medals, which have literally flown off the charts.
If you go back and look at the early 1970s, you'll see that inflation follows a pattern: precious metals move first, then soft commodities, and finally oil. Soybeans are the first of the soft commodities to jump...the others soon follow.
But the more dangerous inflation - asset inflation - is not so easy to track or quantify. In fact, Chairman Greenspan claims that economists cannot detect asset price inflation (otherwise known as a stock market bubble) without the benefit of hindsight. I disagree. I think common sense gives plenty of warning.
Last summer there were only 12 companies trading in the United States with both a market capitalization (a total value) of over $1 billion and a price-to-sales ratio of 10 or greater. This $1 billion / 10-times sales hurdle is my favorite measure of bubble valuations: it's simple and objective. It makes sense. When a very large company is trading at 10 times its annual sales, it's hard to imagine how it will be able to grow fast enough to provide an economic return to new investors.
A new investor would have to expect the equivalent of 10 years' worth of sales in retained earnings to break even on the investment. Without a very high rate of earnings growth, that cannot happen. And a high rate of earnings growth in very large companies is extremely difficult to achieve, especially in a global economy characterized by poor pricing power and overcapacity.
Today there are 98 companies trading in the United States that have at least $1 billion in market capitalization and a price-to-sales ratio equal to or greater than 10.
Let's examine one to see if we can find any asset inflation.
Veritas (NASDAQ: VRTS) is a Mountain View, California based developer of software used in storage networks. The firm's software works with all of the major labels - IBM, HP, Microsoft, Sun, etc. The company undoubtedly produces fine software. Sales have grown magnificently from $200 million in 1998 to over $1.5 billion by 2002. Through the first nine months of 2003, sales remained strong: $805 million.
If the test of a great business was its ability to develop high-quality products and sell them, we would rate Veritas a great company, if not a great investment at its current price. Of course, the test of a great business is its ability to develop great products and to sell them at a PROFIT. And, turning a profit seems just beyond the grasp of our friends in Mountain View.
According to the company's balance sheet, the company has sustained accumulated losses in excess of $1.5 billion. I find it hard to fathom how a software company, which has gross margins in excess of 80%, can lose money year after year. Yet, Veritas found a way...
In fact, the losses on Veritas' financial statements only hint at the actual losses sustained by the company's investors. You see, software companies are only as good as their software engineers. The market for such employees is incredibly competitive. Thus, Veritas pays for these employees with stock - a form of currency that does not get charged to the company's income statement, but is paid for out of the pockets of the company's shareholders.
A closer inspection of the company's 2000-2003 results paints a bleak picture for anyone in the market for Veritas shares.
In Millions: 2002 2001 2000
Net Income (As Reported) $57 -$642 -$628
Stock-based Compensation $294 $290 $151
Adjusted Net Income -$237 -$932 -$779
As you can see, vast improvements to the company's official bottom line have not yet overcome the rising cost of employee stock options, which of course are paid for with the investor's balance sheet, not the company's balance sheet. Even the strong resurgence of the United States economy has solved this compensation problem for Veritas shareholders. Through the first nine months of 2003, the company booked official profits of $168 million...but for the same period it had to pay out an additional $238 million in stock options to its key employees.
Judging from the last six years of Veritas' operating history, a reasonable investor should wonder why anyone would want to own this business - at any price. It seems unable to make an accounting profit with any regularity, let alone a genuine profit that would result in an economic benefit for its owners.
Certainly the people who know the company best want no part of it: insiders have sold close to a million shares of stock in the last six months; none have bought.
Despite all of these facts - which should be well known to all Veritas investors - the shares of Veritas trade hands today for $40 per share, a price which values the entire company for an astounding $17 billion. Which is in excess of 10 years' worth of its current sales.
There are another 97 companies I could have detailed for you, all of which present investors with the same kind of value you'll find in Veritas - that is to say, none.
And yet, Mr. Greenspan sees no inflation in the United States economy. He will continue to say he sees no inflation, too...because in fact it is his policies that are causing the new inflation - in commodities and assets.
Brian Wesbury, one of the best young economists in the country, explains:
"At 1%, the federal funds rate is 3.9% below the current 2- year annualized rate of growth in GDP, the widest spread since 1978...We are now in a period that looks like the 1960s or 1970s all over again. Both the 10-year yield and the federal funds rate are significantly below the rate of growth in nominal GDP. It does not matter whether productivity is rising, or if lower tax rates are boosting the output of goods and services.
"The Fed is focused on the wrong threat. Gold, commodity prices, the value of the dollar, the steep yield curve, and the relationship of nominal GDP growth with interest rates, all point to the same conclusion. Monetary policy is excessively accommodative, and in an unsustainable position."
Sooner or later, rising commodity prices and the falling exchange rate will filter into rear-looking measures like the Consumer Price Index (CPI). When the Fed is forced to raise interest rates to preserve the purchasing power of the dollar, long-term interest rates will soar, causing bond prices to plummet.
The last time (2000) an asset bubble was pricked by raising short-term interest rates, long-term interest rates fell because the dollar was strong and commodity prices near all-time lows. This provided a substantial "wealth effect" cushion for the U.S. economy. Lower interest rates sparked a rally in homebuilding and a rise in credit-inflated real estate prices.
When the Fed raises interest rates again, CPI inflation will be a real and growing threat. Commodity prices will be high and moving higher. The dollar will be weak and growing weaker. And long-term interest rates will move higher, not lower. The wealth effect that cushioned the stock collapse of 2000 will work in reverse this time, savaging both home prices and bond prices.
If you are bold enough to look beyond the headlines into the real economy, as measured by commodity prices, exchange rates and asset prices, you cannot miss the building of another bubble - one that's even more dangerous than the last.
Stocks and bonds may trend higher for the next several months. Given the amount of inflation we're seeing - as measured by the Fed Funds rate versus the growth rate in our economy - it would be almost impossible for stocks and bonds not to appreciate.
Traders may have a field day.
But we are in the twilight of a 24-year bull market in financial assets and at the dawn of a long bull market in commodities.
Regards,
Porter Stansberry, for The Daily Reckoning
P.S. Don't be fooled by the size of this sucker's rally. This stock market is not safe for any buy and hold investor.
Editor's note: Porter Stansberry is the founder of Pirate Investor LLC, a financial publishing group dedicated to providing high-quality research for high net-worth investors. The former editor of several well-known financial letters, including Latin American Index, China Business and Investment, and the U.S. edition of The Fleet Street Letter, Mr. Stansberry is regularly quoted in leading financial journals, such as Barron's and World Money Analyst.
Porter is also the publisher of Extreme Value, an investment letter that seeks to uncover the safest, cheapest shares in the market. Read on to discover the gems the Extreme Value team have recently laid bare in the real estate market:
The World's Best Real Estate - At a 99.6% Discount
http://www.dailyreckoning.com/