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The Y2K relief rally is imminent:
Get ready for profit-taking opportunities
by James Passin
It's been a disappointing year for the Armageddon crowd. The dreaded GPS clock rolled over: nothing happened. "9/9/99," the trumpeted "end-of-run" computer doomsday date, passed unnoticed into wastebasket of history. And it seems, according to recent polls, that even the occult- and equity-crazed masses aren't panicking in front of the baddest doomsday prophesy of them all: Y2K.
Don't get me wrong. Y2K could cause material disruptions. On New Year's Eve, I plan to party far away from the urban warfare that could erupt in New York City. Don't be surprised if I pack a loaded semiautomatic 9mm Beretta underneath my tux as I swill champagne in celebration of another profitable year for Taipan subscribers. And I'll stock up on scotch for water purification "just in case" the public utilities collapse.
But as far as the financial markets are concerned: Y2K is dead.
Fist full of quarters, eyes full of sand
The psychological effects of Y2K are most clearly manifested in the credit market. In "risky" times, no one wants to be a lender, but everyone wants to be a borrower. This affects the "spread" between risk-free government paper and high risk corporate debt. The junk bond/U.S. treasury spread is a good indication of the level of fear in the market (other measures include the emerging market debt/U.S. treasury spread and also the forward treasury swap rate).
 Corporate treasury managers and nervous nelly bond dealers are terrified that it will be impossible to sell debt in the fourth quarter. Consequently, companies have dumped paper into a nervous market. This has raised the cost of refinancing long-term obligations. Credit swap premiums have soared above the 1998 Long Term Capital Management "nerds on leverage" crisis peak.
However, there is clear evidence that the Y2K panic is subsiding: credit spreads and forward swap rates are declining. The 10-year treasury swap rate has broken below the 40-day moving average. The chart has formed a classic technical pattern called a "double top," which indicates further credit risk premia contraction. I believe that the Y2K panic has topped out -- and that the unworking of Y2K paranoia will create significant opportunities for contrarian speculators.
Boring old macro-economics
The same Y2K fears are hitting the general level of interest rates in the U.S. The U.S. is a massive, chronic borrower. The current account deficit is running at a record annual rate of US$299 billion. Since the U.S. consumes more than it exports, it needs foreign capital to fill the financing gap.
It hasn't made front page news, but the dollar is collapsing against the yen. In my view, the fall in the dollar/yen rate reflects the relative current account balances of Japan and the U.S. The U.S. economy is consuming cash, while the Japanese economy is generating cash. The Y2K panic has soured market sentiment towards risky assets. This has supported money flows out of the U.S. and into Japan. The fall in the dollar and sale of U.S. treasuries by Japanese institutions have pushed bond rates above 6%.
Taipan subscribers were fully positioned to profit from current market conditions. As I wrote (if you will indulge me in the distasteful exercise of self-quoting) in the Perspectives 2000 issue of Taipan (December 1, 1998): "Taipan predicts that the yen will rise to 100 against the dollar... At the same time, rising commodity prices will trigger a 10% jump in the CRB index by the summer. Rising commodity prices and a falling dollar will force the 30-year Treasury bond yield as high as 6%."
This scenario has unfolded with absolute precision. But there's one missing piece of the puzzle: gold. I anticipated a massive rally in gold. The rally never occurred. Given the decline in the U.S. dollar and strength in commodities (from copper to DRAM), it is shocking that gold failed to break above US$265 per ounce. While there's a host of convincing excuses for gold's odd behavior (producer hedging, central bank sales, short seller conspiracy), the technical implications are unequivocal: inflation is not spiraling out of control.
The bottom line
An inflationary spiral emerges when people spend money as quickly as possible, because they are afraid of rapid rises in prices. Unless this behavior is observed in the stores, in the banks, on the internet, you can be assured that inflationary pressures will not ignite a self-generating loop (whatever happens to the dollar, money supply, or the stock market).
If an inflationary spiral can't set in when Y2K is looming, the stock market is bubbling, and the job market is tight, it never will. Short of an inflationary spiral, the dollar should be close to setting a major bottom against the yen. While the U.S.'s current account deficit is a large dollar amount, it only represents 3% of GDP. The Asian tigers collapsed when current account deficits exceeded 10% of GDP. There's too many bond bears to allow rates to move much higher (according to Market Vane, only 23% of advisors are bullish on bonds). The preconditions exist to support a radical decline in U.S. rates. The bond rally will be triggered by a reversal in the bearish dollar trend.
All the "smart money" has exited the Dow in anticipation of Y2K. At conferences, on airplanes, in diners, I keep hearing: "I sold my stocks and will buy back after the Y2K crash." You can see the evidence of Y2K selling in emerging markets, internet stocks, bonds, and other risky assets. Based on my view of contracting credit spreads, I believe that a massive rally in "risky" assets is imminent.
Lotus rising
I recommend remaining fully invested in our Asian-Pacific regional stock picks. While Asia (with the exception of Indonesia) is no longer a screaming out-of-favor buy, it has not entered the crazed bubble phase that would warrant aggressive profit-taking. Asia is still exotic fare for CNBC or the New York Times -- a healthy contrarian sign.
 The strong yen is raising Japan's purchasing power. This is bullish for countries that export to Japan, including New Zealand. In general, money flows into Japan should promote regional trade in Southeast Asia.
The incredible resilience of commodity DRAM exporters like NEC (NIPNY-NASDAQ) in the face of rising currency costs suggests that the balance of power in the semiconductor industry is changing hands. The emergence of post-Wintel operating systems and digital architecture is returning value from the box makers (DELL, CPQ) to the chip fabricators, suggesting a structural break with Moore's Law -- and a rebirth of global Japanese dominance of high tech (even if the semiconductor bounce turns out to be purely cyclical, Japanese tech is enjoying a broad renaissance in industries including internet and multimedia).
Our top play on the Japanese economy remains Uni-Charm (8113 -- Toyko Stock Exchange). Uni-Charm is up 75% over the last three months in U.S. dollars. Volume is expanding with every rally, a very bullish technical sign. Japan's rapidly aging population is finding an ever-increasing need for Uni-Charm's adult diaper products (including the revolutionary diaper with side pockets for comfortable waste collection ). National nursing insurance kicks in next year, helping to finance adult healthcare expenditure. As a pure domestic play, Uni-Charm will continue to benefit from a strong yen (and as the economy picks up, repeat trips to the sushi bar and golf course will do the trick). I anticipate further gains from the stock.
The New Zealand equity market hasn't delivered the blockbuster performance I anticipated. However, the market has held up in a tight range with a gradual upwards bias. It's only a matter of time before Kiwi stocks explode to new 52-week highs.
I strongly recommend avoiding the cyclical/ commodity stocks revered by mainstream investors. Strategically, it's a terrible time to load up with pure cyclicals. Lumber has failed to sustain the robust gains enjoyed by other commodities. The only way to play the Kiwi market is with consumer franchises and value-added manufacturers.
Fisher & Paykel (FAP-NZSE) broke below NZ$6 on news of a labor strike and general apathy. Management turned the stock around by issuing surprisingly bullish long-term financial targets for the company, including 15% per annum growth in the healthcare division and material margin expansion in the appliance business. FAP is an obvious target for a takeover if management fails to deliver on its promises. At an EV/EBITDA ratio of 6, FAP remains a strong turnaround story.
There is one market to avoid in Asia: China. China is trapped in a deflationary spiral resulting from excessive debt and overinvestment (when I toured Southern China in September 1998, I was sickened by the endless necropolis of half-empty skyscrapers crowned with cranes that swam into the mandarin haze of the polluted horizon). The general levels of prices keep falling. The junk electronics churned out by Chinese exporters are not generating enough hard currency to keep the real economy liquid.
The Chinese government is itching to devalue the currency, but this is rendered impossible by the strength in the yen. Exchange controls and an overvalued currency keep the Chinese stock markets artificially propped up. The government is brazenly manipulating the market by forcing citizens to buy stocks and through open market purchases. If you're a short seller, it makes sense to take a close look at Chinese ADRs. I recommend avoiding China at all costs.
The next Euro-convergence play
One of the most brilliant trades over the last five years was the "Euro-convergence" trade. All you had to do was find the most marginal, corrupt, debt-ridden countries scheduled to join the European Union. Spain and Italy fit the bill in 1995 -- and they returned huge profits to visionary contrarians. Greece was the Euro-convergence play of 1996. The Athens Stock Exchange is still hitting new highs. In my view, the next Euro-convergence plays are the fringe Eastern European countries, including Latvia.
A week after my recommendation of Ventspils Nafta (VNFT -- Riga Stock Exchange) hit the press, Latvia's Economy Minister requested that the privatization regulators draw up proposals to protect minority shareholders. VNFT was cited as an example of an undervalued company hurt by shareholder rights concerns. This is consistent with my belief that VNFT is too important to the Latvian economy to remain in questionable hands. I continue to rate VNFT as a long-term contrarian buy at current levels.
Recession-proof play on technology
Computer Learning Centers (CLCX-NASDAQ) released results that were in line with my expectations. While pedestrian wise guys might be thrown off by the headline earnings per share loss, serious investors should look behind the numbers. The real issues with CLCX are enrollments, gross margins, overhead costs, and balance sheet liquidity.
Total and same store enrollments were down on a prior year comparison. In my opinion, enrollments should be analyzed on a sequential basis (even though this will get distorted by seasonal factors). CLCX is recovering from regulatory actions, shareholder litigation, and bad publicity. The sequential rebound beginning in July bodes well for Q3 and Q4 enrollments. Since CLCX has high fixed costs, profits are highly leveraged to enrollment growth.
The popularity of higher costs programs is bullish for gross margins, since CLCX will generate more sales per student. CLCX kept a tight lid on SG&A and marketing expenses. Despite the bearish prognostications of CLCX shorts, provision for doubtful accounts only rose US$690,000. If you take away the tax benefit and add back in depreciation, CLCX's cash operating loss margin was only around -7%, revealing that CLCX is operating very close to break-even.
The US$5 million decline in net cash (cash-long-term debt) over the last six months is entirely accounted for by capex (US$5 million according to the 10Q). Receivables remain under control. CLCX remains in a comfortably solvent financial position.
Rebounding enrollments, together with the popularity of higher-cost programs and continued cost control, should result in a rapid return to net profitability. In my view, CLCX is a highly cash-generative franchise. The recovery should become readily apparent by Q4.
At current levels, CLCX is trading near book value and has an enterprise value (EV)/student multiple of only US$9,530 -- a 57% discount to the industry average. The only big negative is the 1 million share overhang resulting from the shareholder lawsuit settlement. However, this should be easily absorbed by the 2.5 million share short position. I continue to believe that CLCX is absurdly undervalued.
Exodus
Our exits from both Elbit Medical (EMITF-NASDAQ) and Elscint (ELT-NYSE) were timely: two weeks after my "sell" recommendation hit the press, Motti Zisser announced that he was transferring all of Europe Israel's real estate assets in exchange for EMITF's and ELT's cash. The charts gave me an advance technical warning that value was being transferred from the subsidiaries to the parent. This kind of vagrant minority shareholder abuse is rare outside of Russia. But there's no sense whining about the past: both EMITF and ELT generated substantial profits for Taipan subscribers.
I just got off the plane from a trip to Kazakhstan. Hurricane's (HHLFQ-NASDAQ) proposed restructuring plan has just been announced. It looks like management is very eager to hand the company over to the bondholders. I will provide a full update on the grim outlook for Hurricane shareholders in the next issue.
James Passin is Chief Portfolio Manager with Firebird Management and Contributing Editor to Taipan. Firebird Republics Fund is currently a shareholder in Ventspils Nafta.
James Passins' views are his own and not necessarily the views of Firebird Management or Taipan.
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