Stockscom Report for Sunday, December 17, 2000

The Bear Tightens Its Grip

Buy Interest Rate Surrogates and Natural Gas Drillers

Add to Short Positions

No one should have been too surprised that Microsoft joined the ranks of the many companies seriously downgrading their sales and profit expectations. Our only regret is that we inadvertently covered our short position in the stock, albeit at a reasonable profit.

Our updated thinking is that the bear market in stocks is intensifying, with many leading Dow stocks joining the downhill parade and justifying initial; short positions or, in the case of some stocks already in confirmed downtrends, adding to them.

We hesitate to guess how far the bear market might go or how long it might last. All we can say with certainty is that the majority of stocks as well as all the standard stock indexes are now in confirmed bear markets according to the definition that they have a confirmed M and a downward zigzag on the monthly chart. You can make intelligent guesses about the extent and duration of a bear market by making comparisons with what happened in the past. However, you can never tell until after the event whether you are going through a relatively mild market cleansing like the one in 1990, or whether a really big one is starting like the one in 1973/74. Our best guess is that this will be one of the very big ones. There is the informal law that a bear market tends to go to equal and opposite extremes versus the bull market that preceded it. The corollary of that is that the biggest bull market in stock market history is likely to result in an immense hangover.

You may recall that during the big bull market there were sometimes huge retracements that did not negate the major upward direction. The same thing in reverse ins likely to happen during this bear market. Indeed we saw something of that phenomenon on December 5, when the NASDAQ 100 had its biggest gain ever. Then it just rolled over a few days later, when it stopped at its declining 40-day moving average, in the process putting in place a high that was clearly lower than the previous one. It has not yet put in a new low for the move but it looks all set to do so.

One of the things almost eerie about the current bear market is that even now there remains the most incredibly high level of optimism about stock prices. Almost universally investors are prepared to stay with their stocks in the belief that everything will turn out all right in the end. That is not the kind of sentiment you get at market bottoms. A real long-term market low at the end of a bear market requires a prevalence of general loathing for stocks among investors.

Many people including ourselves assumed that there could be a worthwhile rally as soon as the uncertainty of the US presidency was clarified. That this did not happen is exceptionally bearish. In the near term there still could be a significant rally into year-end, possibly driven by what the fed says on Tuesday about interest rates. However, nothing that investors do or that the Fed says and does can make the economy turn up when it is choking on its past excesses. If the economy doesn’t turn up, then there will be many more major disappointing sales and profits announcements, and of course stock prices will continue working lower.

Note that on almost all fronts there are signs of economic slowdown which are extremely likely to turn negative. Car sales are down. Pre-Christmas retail sales are down. Bankruptcies are up. Banks are, at last, finally beginning to admit to bad loans on the books. Announcements are coming in almost daily of shrinking capital investment intentions. Intel, for example, is delaying the opening of a new factory in Ireland for a year. In addition, it is cutting back next year’s capital expenditure from $6 billion to 2 billion.

Many telephone companies, as we have long been observing, are in serious trouble with their balance sheets and their capital investment plans. They don’t have the money in the till to carry out their planes and they can’t raise it by any means, not by selling more stock, not by selling bonds, nor by borrowing from their bankers. The banks already have too much exposure to this weakening sector. So they will pull in their lending, with the result that many companies will implode and then they will really have bad loans on the books.

Say it again. This is how depressions happen. And what is the difference between a recession and a depression? A recession occurs when overextended consumers choke on their overindulgence and have to take a break. A depression occurs when a capital investment boom ends. That’s what happened in Japan in 1989. There the economy, and the stock market, are still in trouble more then ten long years later.

Opportunity Still Exists To Buy

In this environment, we still see opportunity. We see opportunity for short sales almost across the board, and we also see opportunity for equity investment in two select areas. We want to buy bonds, closed end bond funds and fixed interest surrogates. We also want to own stocks involved in natural gas, with as pure a play as possible in that area rather than just buying into all energy generally, including crude oil exploration, production and marketing.

The point about buying bonds and fixed interest surrogates is that in an economic downturn interest rates decline. Declining interest rates are the reciprocal of rushing bond prices. It is actually somewhat more difficult than you might think to lock in high interest rates at present. There are relatively few really secure long-term bonds which are trading below par ands which will deliver a capital gain on redemption. If you buy a bond above par, at perhaps 110 and it has ten years to run, then you will; incur an eventual capital loss on redemption. That’s no good.

We believe we may have found a way to lock in a reasonable immediate rate of return and also to secure a long term capital gain pretty well whatever happens. To achieve this we want to buy natural gas pipeline stocks, and have come up with Kinder Morgan(KMP) and Trans Canada Pipelines(TRP). TRP has been a troubled company as a result of attempts at diversification. That’s all over now, with assets not related to its core business now almost all sold off. As we see it, demand for natural gas can go nowhere but upward and we are hard put to see why pipeline companies should not continue to make good profits whatever the price of the gas they are moving. TRP, incidentally, has just applied for a rate increase, which should largely flow through to profits, perhaps half of the increase anyway.

Depending on your tax status, you can pretty well buy any of the closed end funds traded as stocks that comprise government bonds or, alternatively, muni bonds. Among the former are BDF, ACG and TTR. Among the latter are MYI and MVF. We do not recommend buying corporate bonds or corporate bond closed end funds. What you get in increased yield, you are liable to lose in downgrades. Government issuers are relatively unlikely to be downgraded, although it did happen in the 1930s.

Among the strongest and most purely natural gas plays that have good technical charts, we have a very short list, with somewhat more interest in the drillers than the explorer/producers. For those who need or want income, we are recommending Occidental Petroleum again, with its dividend yield of 4.5 percent and a selling price at an estimated three times cash flow. The downside for the stock is questionable manageable but you still get a lot of real assets for your money, unlike what you get in high tech.

Opportunity Still Exists To Sell Short

All of our current short sales warrant new positions right here. We particularly like the idea of selling IBM short. Its program of buying back stock has to be an exercise in doing the worst possible thing at the worst possible time. This is exactly what they did in the early 1980s, and it nearly broke this once mighty company.

One industry group that has been holding up well for the most part is banking. The view is widespread that banks can only benefit from declining interest rates. Our view is that while that might, in isolation, be true, there is another far more serious problem. When declining interest rates reflect an imploding economy, no group will be harder hit than the financial institutions that became overextended on the way up. Among them, none is more highly priced than General Electric, which is mostly now a financial institution, and priced about double what its counterparts sell for. Technically this stock looks as if it is just starting to break down. We also include Bank One, which was already in trouble with credit card lending and we doubt the situation has been restored enough to cope with an implosion of consumer credit debt.

Then there’s our old unfavorite stock, Coca-Cola. This company has recently been losing out badly to Pepsi and its PE would be absurd even if there were no problems with competition and with the economy generally. We see this stock as a potential loser for 50 percent or more from here, with relatively little upside risk.

New Recommendations

Gas Pipelines/Interest Rate Surrogates:

Kinder Morgan(KMP)$49.81

Trans Canada Pipelines(TRP) $11.19

Oil & Natural Gas, Petroleum Service Companies:

Alberta Energy Co. (AOG) $41.81

Occidental Petroleum(OXY) $21.19

Precision Drilling(PDS) $32.94

Ultramar Diamond Shamrock(UDS) $28.25

New Short Sales

Coca-Cola(KO) $53.50

General Electric (GE) $49.81

Bank One(ONE) $33.00

Stock Positions to Sell/Exit

None

List of Current Stock Recommendations:

Action Ratings

The following is the legend for designating immediate action for our stock recommendations. The first is B, meaning the stock is timely to buy but the case for doing so right here is not overwhelming. Either the stock may have got ahead of itself and may be vulnerable to a retracement or else the stock has been performing disappointingly but may simply be regrouping. B+ and B++ indicate stocks for which there is a technical case to buy now, with plusses adding weight according to how many there are, up to a maximum of five. Stocks rated H are ones to hold, awaiting confirmation to buy more or to sell. SELL, of course, means what it says. It seldom pays to override this designation.

Stocks marked # are eligible for Canadian RSP funds. Otherwise there is a 20pc restriction on foreign stocks held in these accounts.

First bought Entry Last

No stocks held long (owned)

Short Sales

First Sold

12/13/00 Amazon.com(AMZN) 26.56 22.88 Sell Short ++

12/1300 Cisco(CSCO) 55.19 48.26 Sell Short ++

12/13/00 Dell(DELL) 21.50 19.88 Sell Short ++

12/13/00 IBM 94.88 87.81 Sell Short +

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