Dolan Capital Management - The LUV Connection

THE LUV CONNECTION

LUV. That’s the big question these days. Will the market bottom appear in the form of a traditional “V” shape (à la 1998), or will it be a less dramatic turnaround such as a “U” or maybe a double “U”. Historically, a Fed easing of the magnitude that is now in place has generated significant returns during the subsequent six months, especially when accompanied by falling bond yields. But as our last commentary suggested, this time may be different. I think the best we can hope for is a double “U”, or “W”. Let’s look at the facts.

A Fed easing, by itself, does not necessarily induce additional business activity or consumer demand. Presently, manufacturers are seeing slowing consumer demand, continued import competition, much higher energy prices, and escalating non-salary benefits. Even though labor productivity was excellent in the last quarter, employers are moving quickly to reduce payrolls. The bottom line is that unit labor costs are increasing, but unit prices are not. This is a sure formula for margin compression. It doesn’t matter if we’re in a true recession or not. It’s the extent of the profit decline that the market cares about.

Just as the technology stock bubble signaled the “end of an error” (not era) a year ago, so too did it signal (with a lag) the end of consumer overconfidence and overbuying. Now we have seen the two sharpest declines of consumer confidence in fifty years. Now that stock ownership is more prevalent in households than at any time in our history, the vicious cycle is becoming more vicious, i.e., stocks go lower, confidence declines, earnings decline, stocks go lower, etc. (This is akin to the Japanese experience of the 1990’s.) It will take some time for the consumer to regain her footing and this will occur as consumer balance sheets stabilize. And given the rather high levels of household debt, the return to normal buying patterns will depend on mortgage refinancing and an improvement in the savings rate. This could be a longer process than most realize, and could lead us to consider an “L” bottom.

On the corporate side, there is the insidious overlay of a technology industry in recession that clouds the outlook. For the last two years, industrial production of non-technology industries has been flat to modestly declining. The tremendous increase in technology-related production masked this underlying weakness, but now is has become transparent. A good way to think about this is in terms of capacity utilization for each sector as can be seen in the following chart.

As you can see, since year-end 1997, industrial production for non-technology companies relative to their capacity has declined by five percentage points, e.g., steadily deteriorating. As of this writing, it is close to the recession lows of April 1991. The more volatile technology-manufacturing component has depended so much on international economic conditions and product introductions that production (and capacity utilization) oftentimes “zigs” when non-technology “zags”. The current situation has been exacerbated by the fact that both components are now moving downward at the same time and may in fact feed upon one another. We believe the Federal Reserve has noticed this trend. On the other hand, the banking system is going in the opposite direction. The January Senior Loan Officer Survey (by the Federal Reserve) indicates that banks have tightened credit standards and widened spreads over the past three months in greater proportions than at any time since the last recession. Now, however, these banks are increasingly concerned about consumers’ financial health. My sense is that this situation means that growth will not recover sharply and that the pattern of the market will follow a “W”.

Anticipating market psychology shifts is difficult, if not impossible. We observed a fairly high level of negative sentiment in late November, certainly enough to establish an intermediate bottom. However, with the tech stocks acting so poorly, one can no longer look at the S&P 500 to understand the crosscurrents. Below are some benchmarks that portray a different story.

INDEX*	THREE MONTH RETURN (01/31/01)
S&P Large Cap Growth	-12.06%
S&P Large Cap Value	3.98%
S&P Mid Cap Growth	-9.82%
S&P Mid Cap Value	15.29%
S&P Small Cap Growth	-7.12%
S&P Small Cap Value	15.01%

(*) These are all Standard & Poor's/BARRA indexes.

Clearly, smaller stocks have been outperforming their larger brethren over the last three months as well as the last year, and value stocks (those selling below a prescribed price-to-book ratio) have been outperforming growth. The cause of this is threefold:

The valuations (such as price to earnings) relative to projected growth rates are much better for the small- and mid-cap areas than for the large cap. Many of the largest blue chips are selling at highly inflated multiples relative to their growth rates.

The valuations of the “value” stocks vs. “growth” stocks offer a better deal when growth rates are declining, as is happening now. There is no “momentum” premium being paid at present.

The valuations of the “value” stocks vs. “growth” stocks offer a better deal when growth rates are declining, as is happening now. There is no “momentum” premium being paid at present.

There are, however, some good things happening that we should focus on:

Lower interest rates equals lower mortgage rates, and this is causing a sharp increase in applications for mortgage refinancing. This will help reliquify the consumer balance sheet.

This last winter produced the coldest temperatures in over a decade, keeping shoppers away from stores. There is pent-up buying power now being unleashed as the weather becomes warmer.

The proposed tax cut will also help to improve consumer balance sheets, although longer term this might cause Treasury bond yields to be higher than with the current budget surplus.

The money supply has been improving since December, and this bodes well for the second half of the year.

We remain not so much cautious about the markets as we do about the large capitalization high multiple stocks that drive the most widely recognized indexes. One never knows when an improving economy will be discounted by investors, but now that the Fed is in an easing mode, we want to remain fairly exposed to equities as a class. This is not to say that we believe it is best to be a “market investor” but instead that picking the right stock or the sector are the key ingredients for investment success.

--John K. Dolan

S & P 500: 1288.06
February 20, 2001

The information and opinions in this report were prepared by Dolan Capital Management. The investments discussed or recommended in this report may not be suitable for all investors. Investors must make their own investment decisions based on their specific investment objectives and financial position and using such independent advisors as they deem necessary. This report is based on information available to the public. No representation is made that is accurate or complete.