Mid Year 2000:  Bears See Darkness at the End of the Tunnel

_{As expected, Greenspan woke up in 2000 and began to take control of the economy once again; he tightened money supply growth because Y2K  was a now show, he raised interest rates 100 basis points to a 6.5% federal funds, and to date he has showed few ambiguous signs of stopping his corralling methods.}1 <sub>Since the Fed is on the ball, and the old saying quaintly goes "don't fight the Fed", don't put too much faith in the third and fourth quarter rally scenario many bulls are pushing.  The speed limits of economic growth, a tightening employment situation, and sky high equity prices may have been reached in early 2000 when inflation began to smile and stocks capsized lower.

Productivity gains didn't stop inflation from arising in early 2000...the goldilocks economy has limits.

While discovering these vague boundaries, the economy has been test driven to the limit and  is only now beginning to reflex back.  Whether the following relfection in stock prices, which started off very actively in April, is violent or smooth remains to be seen.  But what may be a given, is that in  regard to what we learned about the economy in the last 6 months; there is limits, and supply versus demand remains the walls which bound any economy.  Investor perception can certainly change the value  characteristics of the markets, but can not change the economy so dramatically.

A contradiction arises then, when directly comparing what the economy is about to battle through over the next 6-12 months and what  the stock markets are going through.  It is an obvious comment to assume many "greater fools" are present in the marketplace at any one time, but how high has this number grown to?  If the economy is indeed  going to slow, by nearly all accounts this is going to take place, then how in the world will stock prices keep rising, and by many accounts on the Nasdaq, rising to new records?</sub> 2  <sub>Will this happen because of increased corporate margins?  Global sales picking  up the slack?  Or do many investors believe that economic growth will only slow moderately, and that investors will continue to pay great premiums for stock prices?

After second quarter earnings excitement  subsides (provided it begins) there isn't much investors have to look forward to.  Sure, give the bulls the odd rally after important economic statistics come in benign, and let them have a two or three week party  around election time, but that doesn't mean the bull market will regain its once maniacal shape.  All it means is that the already materializing secular downtrend in stock prices will be met with abrupt, and  temporary, rallies...

Underlying the drop in equity prices, or perhaps even presaging it, will be the shift from equity based mutual funds to either fixed securities or alternative funds and a decline in the  amount of equity funds in the markets.  Since 1976 to present there has been the creation of over 3792 new equity funds.</sub>3  <sub>This is somewhat mind boggling. As the fund explosion continues, there was over 400 new funds created last year, the closer we come to the ponzi perception ending, whenever that may be.  Capital must be continually be put into these new funds for them to crop up, and the signals thus far in 2000 are not what you would consider normal. In all of 1999 total  redemptions in equity backed mutual funds was over $256 Billion and in the first four months of 2000 there has been $396 Billion in redemptions (cash taken out). But blurring this trend also lies the fact net new cash  flows are still $167 Billion for the first four months of 2000, or more than double the mark set for all of 1999.   Volatility underlies the trend.

As mutual funds make their way through a transitional period of perpetual growth, to perpetual capital movement, the IPO market has already began to slow.  Goldman Sachs, which is the most active underwriter of IPO's this year thus far, averaged 7 releases a month  from January to April, but in May/June this total had had dropped to a 4.5 average.  Although this may be a temporary blip, the fact remains that when investment banks are not active their profits can suffer,  especially if the volatile markets take a bite out of previously miraculous growth figures. For instance, Goldman Sachs reported over $2.1 Billion in Trading and Investment revenues in the first quarter of 2000  (3 months ended Feb 25,00).  They credited these gains to favorable global equity markets (trading volumes on commissions), solid investment gains (technology and telecommunication stocks) and FICC (Fixed Income,  Currency and Commodities).  If you look back to third quarter of 1999, when the markets were acting less favorable, GS reported only $1.4 Billion in Trading and Investing revenue, actually down from $1.7  Billion in the second quarter.  Point being, that active markets allow a company like Goldman Sachs to be valued with a current P/E of 15.   Which could be high for an investment bank.   As you  might expect GS's share price climbed when they made excellent revenues off of the bull market (stock touched $128 in March), but since those earnings are in question the stock now falls (bottomed out at $70 before  June).  

In GS's most recent earnings report (3 months ended May 25) revenues from Trading and Investing had faltered to just $1.4 Billion, or 19% lower than last years mark and 33% lower than  the first quarter.  Of GS's technology and telecommunication holdings revenues were $321 million negative, and accounted for a 0.19 cent negatives earnings impact.  On the plus side, Investment banking  revenues did reach record, in large part to European activity, but the longer term realization is that it is unlikely GS will handily beat its torid earnings pace over the next 2-4 quarters; can the markets remain  favorable this long?

In the end, the transitional period from the perceptual bull to a bear market naturally can continue to drag companies like Goldman Sachs lower. There was 548 IPO's brought to market in 1999, and another 483 filings in the first half of  2000, a maintained calm period in this medium can impact the eager underwriters and is a direct comment on investor psychology.

The Slow Down Will Arrive...
To those bulls craving an economic slow down, don't fret, it is coming.  But when it arrives, in full force, don't be surprised if the Fed isn't so quick to loosen the reins this time around; recent negatives (Asian crisis in 98, last  year with Y2K) had forced the Fed to adopt a plan of attack which, at least in small part, has helped bullish investors feel like unstoppable-trading-dynamos.  Now that the markets have fallen like dominos, and the economic slowdown remains, the building blocks for economic excesses seem less likely to arrive.

A slowing economy, a vigilant Fed and less euphoria in the marketplace ...no wonder bears are confident.   When corporate earnings peak (second quarter 2000 may be remembered for exactly this), the only question left to ask if how high the dive off the cliff is.  We will find out soon enough....</sub>