Stockscom Report for Sunday Dec 2, 2001

Publisher: Colin Alexander     Editor: Ken Wilson (450-691-4617)

Subscriptions and Administration: Pierre Fichaud (866-487-9711)

The Case for Selling Stocks and Buying Bonds

and for Laying to Rest the Inflation Bogeyman

The Enron story shows why almost all stocks are likely an urgent Sell and why really good bonds are almost certainly a buy.

According to our criteria stocks are in a major bear market, one which looks to be ending an enormous rally. On the monthly chart the stock indexes have carved out a declining zigzag pattern, which is how in the broad picture we define a bear market. The recent rally has done nothing to impair that designation. For every zig there is a corresponding zag, and the designation changes only when the regularity of an upward or a downward zigzag changes, which can take a very long time, sometimes many years, as we see with the refusal of Japanese stocks to end their bear market.

The huge rally off the lows in September has been fueled by easy money and low interest rates. You have to ask yourself, however: What exactly are stock buyers getting for their money? One answer is shown by the report announced this week by the Bank of Montreal, owner of the great Harris Bank in Chicago. As a result of write-downs and provisions for loan losses, profits for the quarter have for all practical purposes evaporated. So investors in this stock have an investment where the underlying business is no longer expanding at a fair clip, but instead is contracting at a faster rate than it ever expanded in all its long history. Given the almost total evaporation of profits, the slide projects logically toward horrendous losses when more Enron birds come home to roost.

You can bet your boots that BOM is not alone in its distress. So how should such a bank respond? The first answer is to cut costs, and that is certain to mean laying off staff, or at least not hiring. Layoffs are not conducive to consumer spending, as the fear of ever more layoffs feeds on itself, and the economic spiral contracts accordingly. The second answer is to be extremely wary about new lending. Never mind what money costs, the spread between an optimistic 1 percent interest cost and 7 percent revenue is, obviously six percentage points. But what if the apparent 6 percent profit turns into a 100 percent loss? That would not be good. With bank credit, neither the consumer world nor the business world continue functioning.

So where has all that credit and easy money been going? Into some consumer purchases, of things like houses, but consumers will not go on buying houses forever if they fear for their jobs, however low the mortgage payments.

The other place money has been going, as always, is the stock market. In order to buy stocks which, evidently, have included the banks and other financial institutions.

But when stock buyers finally realize how illusory is the prospect of actually buying profits and, ultimately an ever-increasing dividend flow, there could be an implosion in stocks across the board comparable with what happened with high tech stocks. As we see it, it looks as if we may be in the early stages of an implosion in senior stocks comparable with the dot.com implosion. For a long time people thought that the likes of Corning and JDS Uniphase would somehow escape the ending of order flows to Lucent, Nortel and Cisco. But of course, they were all in the same food chain as indeed, the banks and all other businesses are.

The normal expectation of a rapidly expanding money supply is that it causes inflation. During the 1970s that meant inflation in hard assets. Since about 1982, it has meant inflation in asset prices instead.

It’s worth noting, however, how the money supply expands. One way is for the Fed to buy government bonds and T-bills. That puts money in the hands of the sellers, and they have to place the money somewhere else. In effect, this is an exercise in printing money, because the Fed doesn’t actually pay for the paper it buys except by writing a check on its infinite bank account. The money comes into existence by that exercise alone.

The other way, the most important way, by which the so-called money supply expands is through the banking system and its credit creation. One man’s loan immediately becomes a bank deposit, either in the borrower’s account or in someone else’s. Either way the money is back in the system and available to lend again, and so on ad infinitum. Not completely, as a matter of fact, because banks are supposed to maintain capital and reserves as a percentage of loans outstanding, usually of the order of 5 percent. In the extreme, which can happen, a bank might have to write off 5 percent of its total loan portfolio. In that case, the bank is running on air rather than on shareholder’s equity. Banks have been known to run on air for many years, as indeed did Citibank for a time a decade ago.

In any case, it is obvious that a bank running out of capital is one likely to restrict lending to all but those that don’t need it. A loan paid off does not have to be money lent out again. Bank credit does not have to be always expanding. It can also contract.

During the 1930s, the economy was working off an excess of capital investment. Business activity peaked in June 1929, and then shrank. Bank credit and the money supply both shrank. Investors sold stocks, often because they had to, and selling led to more investors being forced to sell. Never mind the fact that interest rates were declining, at one point to one half of one percent for overnight money, in the summer of 1932.

With business activity declining, and stocks declining, prices also fell. But bonds rose significantly, expressing lower long-term rates, though not as low as short-term rates. Despite the immense lowering of short-term interest rates this year, bonds rates have generally not declined much. The Ford Motor long-term bond that you could have bought in the summer of 2001 still yields 7 percent. Part of the failure of Ford’s bond to rise in price reflects credit deterioration. However, the principal factor holding up long-term rates is fear that the expanded money supply must lead to inflation:

But what if money has nowhere to go? As banks take money back in loan repayments, they do not lend it back out again. The credit is taken out of service and no longer exists in anyone’s bank account.

Then there’s the destructive power of bankruptcies and defaults. When an Enron’s debt becomes worthless, the credit, counted one way and another as money in the system, dries up and the money supply contracts. Regardless of whether you count ownership of ENE’s debt as money in and of itself, you had better believe that holders of worthless paper are worse off. The paper is no use for collateral to finance other expenditures as a result of this very real loss. Credit can be created out of thin air but credit disappearance has to be paid for by someone with real money.

As credit contracts, the money supply declines and away flies the threat of inflation. Whatever the Fed does to force interest rates lower has no effect on the real economy if no one wants to buy consumer goods or to make new capital investments. It’s like pushing on the proverbial string. It’s also similar to what’s been happening in Japan for almost 12 long years now.

So the apparent expansion of the money supply, and the correspondingly perceived inflation risk may be a bogeyman. (Whatever the majority is saying, consider the possibility that they may be fighting the last war and that the opposite may now be true.) The risk is, of course, that contracting business conditions will not only affect the credit quality of an Enron, but that there will be downgrades across the board, in many cases to the point of extinction, and only US federal and agency debt is truly secure.

One more point about inflation. For all practical purposes, all commodity prices (with the possible exception of lumber), and all manufactured goods are in a perpetual bear market in real terms. Despite and arguably in part because of ever-increasing real wages, productivity improvements bring down real costs over time. Traditional attempts to measure inflation by looking at the price of a loaf or bread are as structurally unsound as they are for a laptop computer. Effective long-term measures of inflation are confined to such prices as real estate in Manhattan or the City of London, and the cost of hiring a well-trained live-in nanny.

Finally, of course, note that you can’t buy much stock at the eventual bottom of a bear market if you haven’t raised cash previously when the raising was good, when stock prices were relatively high. Given the level of complacency among investors, there are still buyers at a relatively good price for most stocks (not Enron, of course). Toward the end of a really severe bear market there generally comes a time when many stocks are difficult to sell to anyone, assuming they are still trading at all. So people simply sell what they can sell. That’s when it’s time to start making new investments slowly and selectively. Sure as heck, we are not there now.

Our Stock Picks

SO continues to fall, which is probably fallout from the Enron fiasco. However, we would not be prepared to suffer a further loss in capital if price closed below $22 so that is where we are putting our stop. Weekly stochastics are heavily oversold on SO and historically the reaction to this has been for the share price to appreciate. As those stocks that have benefited most from the rally begin retracements, the likes of BCE and SO offering strong dividend growth should see share price increases.

New Buy Recommendations:

None.

New Short Sales

None.

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 gotten 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 two. 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. In the case of stocks held short, the rating is S where positions should be retained. S+ and S++ indicate stocks for which there is a technical case to add to the positions with plusses adding weight similar to long positions. The maximum number of plus signs is 2.

Stocks marked # are eligible as Canadian content in Canadian RSP funds. Otherwise there is a 30 percent restriction on foreign stocks held in these accounts.

*    FE purchased GPU – prices reflect share exchange of 1.2318 shares of FE for each GPU share