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August 6, 2004
On the Brink
This week stocks collapsed and next week the Fed is expected to raise interest rates again.  Are we witnessing the first psychological shift in inventor sentiment in more than a year?

Auto sales make up about 1/5th of retail sales.  Despite a rebound in July sales, auto inventories are near record highs and U.S. automakers recently began to offer even more incentives to consumers. The ominous realization is that if inventories are not soon drawn down production slowdowns/layoffs could begin arriving later this year and in 2005.

With the U.S. stock markets floundering at 2004 lows why is the auto industry worth mentioning?  Because just as many investors were fooled into believing that the auto industry was strong because of record sales numbers many have also been fooled into believing the U.S. economy was embarking upon a sustainable recovery because of improving growth figures. In fact, the incentives offered by automakers are no different in principle than the growth incentives offered by President Bush and Chairman Greenspan: unsustainable.

With the U.S. economy hitting its first soft patch since mid-2003 does this mean that more growth incentives are on their way?  No. Rather, the Fed is actually trying to hike interest rates in an effort to acquire some much needed ammo, and another tax cut package is not likely to arrive anytime soon. In short, while the automakers are aiming to reduce inventory levels by any means possible, the U.S. economy is flirting with the possibility of a cyclical decline in growth. To be sure, should no new driver of economic growth soon emerge – i.e. more jobs, stronger wages, or another Greenspan induced asset bubble – the consumer retrenchment seen in June/July could linger.  Such is why U.S. stocks are on the brink.

‘Transitory factors’ Terrify The Fed

On July 20, 2004 Chairman Greenspan said that “transitory factors such as the surge in energy prices” had negatively impacted consumer spending but that softness in spending “should prove short-lived.”  Less than 1-month after this statement – which was made in the first paragraph of Greenspan’s testimony – the Fed is surely unimpressed. After all, oil prices are hitting new records and reports continue to suggest that consumers are tightening their belts.

Summer Doldrums Not Likely

Hamlet’s tragic flaw may well have been that he was a man of inaction. However, remember how quickly Hamlet’s character changed when he finally caught the ‘conscious of the King’. In other words, TIP may be worth selling on strength soon, and a handful of stocks may be worth buying before summer is over.  Value investors must be ready to adapt to volatile markets.  

Notwithstanding the possibility of a relief rally when, and if fears surrounding oil/terrorism ebb, those investors that decided not buy into the incentive driven U.S. markets in late 2003 have done well this year. Yes, given that bear showed its first real sign of returning this week, the investor should be patient when selecting long-term equity positions.  However, Buffett’s mantra of buying when others are fearful is worth remembering.  Using historical ICI fund flow estimates and S&P 500 price levels, more than 50% of the new capital that has arrived since mid-2003 is currently holding losing position. Will these investors sell if evidence of an economic slow down persists? 

The tragic flaw of the average U.S. investor - a flaw that became apparent when fund flows turned extremely negative in late 2002 (at the bottom) and extremely positive in early 2004 (at the top) - is that they buy into strength and sell into weakness.  In sum, my speculations are that fund investors will soon start selling, that the consumer’s garage has enough cars in it, and that - record oil or not - wages/disposable income will not increase strongly enough to provide a new round of economic growth.  It goes without saying that the Fed will have enough trouble saving the dollar without trying to create/sustain another asset bubble, and that the U.S. economy is weaker than many expected it to be.