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The Bear is dead: Now's the time to load up on selected tech stocks!
by James Passin
Don't worry: I'll stop ranting about carnivals. The "Year of the Dragon" has erased the egregious excesses of the first quarter. My downgrade of the majority of U.S.-correlated positions to Holds or Sells was timely.
NASDAQ crashed 36%. eToilet paper like KOOP appears to be on the brink of obliteration. Margins calls have wiped out over-leveraged day traders. Even George Soros capitulated, puking up tech stocks into a declining market. Newsweek ran a cover story on April 24: "Is the Bull Market Really Over?" I no longer hear bartenders or bellhops gloating about their stock portfolios.
Now that the weak hands have been cleared out, the U.S. equity market is on course for new highs. Hubristic euphoria has been crushed. The dancing girls have been torn to shreds by the lions.
It's hard to believe that a bear market could last two months. Call it a correction. But the dark days are coming to an abrupt end. It's time to feed.
"The limit of the evening and the morning is the Bear; and opposite the Bear is the boundary of bright Zeus."
—Heraclitus, 500 BC
There is some inflation in the U.S. economy no matter what the pundits say. I don't know about you, but I find that movie theaters, baseball stadiums and restaurants keep getting more expensive. U.S. Steel announced it is hiking steel plate prices by 6% to US$330 per ton — after reporting 11x growth in earnings. If domestic steel producers have pricing power, something is wrong. Air freight import rates surged 15% in April. Headline inflation statistics keep inching higher...
Everyone has a job. The labor market hasn't been this tight in decades. (Try finding an intern!) When the labor market is tight, employers are forced to raise wages to compete for workers. Rising wages give workers the confidence to consume, which gives companies the ability to pass on price hikes to consumers, degrading the purchasing power of wages, creating a vicious circle or inflationary spiral...
Inflation is dead...
However, I don't believe that an inflationary spiral is building up in the U.S. While the labor market is running close to full capacity (especially in high tech industries), Congress is considering loosening visa restrictions on foreign technology workers. And it's hard to believe that consumers will blindly accept price hikes when the Internet offers endless price discounting and comparison shopping.
To mitigate any Y2K-related bank runs, the Fed flooded the U.S. financial system with liquidity in the fourth quarter of 1999. The surplus cash ended up in the equity market, triggering an explosive rally in Internet and biotech stocks in December, January, and February. Rapid growth in the money supply neutralized the short-term impact of rate hikes, creating an "Iron Man" hyperbull market that contributed to inflationary pressures.
But the "Y2K liquidity bubble" was a one-time event. The temporary effects have already dissipated. In the absence of easy liquidity, Greenspan's rates hikes will inevitably restrain inflation.
The technical behavior of the market is inconsistent with an inflationary spiral. If inflation were careening out of control, the U.S. dollar would collapse. But the dollar is surging. The Euro has fallen to a record low. On a trade-weighted basis, the dollar is exploding higher in a seemingly unstoppable uptrend. Its strength is clear and convincing evidence that an inflationary spiral does not exist.
Another leading indicator of inflation is the Utility Index. Utilities are highly interest-rate sensitive. In a monetarily functional economy, the Utility Index should lead broader market indices higher. The Utility Index has carved out a "double bottom," breaking above January's peak after establishing a solid floor at 280. I have identified a 15-month cycle in the Utility Index that has persisted since 1982. In my opinion, the current bull market in utilities will last for another year. It is highly unlikely that Utilities would exhibit bullish technical behavior in front of an inflationary spiral...
Finally, gold remains weak. Personally, I like gold at US$280 from a ten-year prospective. But bullion is likely to remain a dog over the next several years. The spread between T-Bills and the gold lease rate has turned profoundly positive. In other words, it pays to borrow in gold and lend to governments. A wide, positive T-Bill/gold lease rate spread turns gold hedging and short selling into very profitable activities. In this scenario, it is unlikely that gold will stage a sustainable rally. Gold remains an excellent coincident to leading indicator of inflation.
Long live inflation
While structural inflation does not exist, widespread fear of inflation does. If you are afraid of inflation, the last thing you want is bonds. It's better to be an owner than a lender in an inflationary environment. Paradox-ically, in the absence of real inflation, inflationary fears are bullish for the stock market.
Given the strength in the dollar and utilities, and the weakness in gold, I am forced to turn bearish on inflation. With the absence of actual inflation, but the presence of inflationary fears, baby boomer retirement cash will continue to supply the equity market with liquidity. In this scenario, the bloodbath in NASDAQ represents an extremely healthy shakeout.
The clearest barometer of overall U.S. economic health is the spread between junk and treasury bonds. When the credit spread is rising, lenders are afraid to take risks, draining capital from the most vibrant part of the economy. When the spread is contracting, lenders are willing to take risks, infusing the most vibrant part of the economy with capital. While the spread has surged after the post-Y2K January low, it has given back over 30% of the move. This is very bullish for the economy. It also takes pressure off the Fed to keep hiking interest rates.
Who cares
I recommend aggressively returning to U.S.-correlated tech stocks. But market leadership will pass from dot-coms to entirely new themes. I am building up positions in ELBTF and other small-cap technology stocks. Based on my renewed confidence in NASDAQ, I am upgrading ELRNF and AVAN to buys. I will reveal the details of my current research into Gore-proof opportunities in nanotechnology, agribiotech and "Third World" Internet infrastructure in future Taipan issues and conferences.
James Passin is a Portfolio Manager with Firebird Management and Contributing Editor to Taipan. The views expressed are strickly Mr. Passin's and not necessarily those of Firebird Management or Taipan.
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