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January 4, 2005
Preview 2005:  Make My Day, and I’ll Pay You Back Tomorrow
The best recovery borrowed money could buy faces many challenges in 2005
By Brady Willett

As rigged as the government statistics are there is no denying that the U.S. economy expanded smartly in 2004. Moreover, and despite the run-up in commodity prices (thanks in part to the slumping dollar), growth in corporate profits suggests that inflationary pressures remained well in check last year. As for the two most noted dangers in 2004 – the slumping U.S. dollar and the threat of rising interest rates – they failed to negatively impact in the financial markets.  Rather, the dollar’s decline was largely a sideshow, and, even as the Fed raised interest rates 5-times in a row and commodity prices increased, the yield on the 10-year Treasury actually declined last year.

As of December 31, 2004 the S&P 500 was trading at 23.29 times 2004 core earnings estimates (or 18.03 times operating earnings estimates). Nether the core or operating estimates paint the S&P 500 in an undervalued light. In fact, you could argue that the S&P 500 – which since 1935 has traded with an average P/E multiple of 15.63 – is seriously overvalued today.

Overvalued or not, the U.S. stock markets ended 2004 on a strong note, and yesterday’s mania monkeys - including Abby Joseph Cohen and Ralph Acampora - are cheering that 2005 will be a very good year. Assuming the dollar doesn’t collapse, U.S. interest rates do not rise all that much, and more greater fools can be corralled by cowboy analysts, the optimists may end up be right…

2004 In A Nutshell

On October 26, 2004 the S&P 500 closed at 1111.92, or down 0.07% from December 31, 2003. February Crude hit an intraday peak of $54.75 a barrel on October 27 before closing at $51.81. President Bush was reelected without a recount or terrorism disruption on November 2.  These three dates are all that is required to understand the year in stocks: following the election the Soros type speculators started covering their bets, money piled into mutual funds, and - with each drop in the price of oil - this trend has been in place ever since.


As for the Wish List, the three selections for 2004 all gained and one company – ML Macadamia Orchards LP – shined.  NUT was trading at depressed levels leading into 2004 and most investor’s did not recognize that spot prices for macadamia nuts were considerably higher than the USDA’s and Mauna Loa’s price. With a higher reported selling price and an improved long-term outlook thanks to the Hershey takeover of Mauna Loa, NUT shares have rallied sharply in 2004 and are no longer undervalued today.

2005 Outlook

U.S. dollar warnings from Warren Buffett, Robert Rubin, and Paul Volcker proved prescient in 2004, and will likely continue to be valid in the years ahead. Quite frankly, given that the U.S. current account deficit has shown no sign of contracting and the U.S. budget deficit outlook remains ominous, the conclusion is that the U.S. dollar has more room to fall. Perhaps the only bullish signal in the near term for the dollar is that so many are bearish on the dollar.

Incidentally, if you question the value of the U.S. dollar longer-term there is only one answer: gold. Although the recent slump in the price of gold has not opened a new buying opportunity, holding the metal is a must for dollar bears.

Can Greenspan Do It Again?

Not surprisingly, the most memorable quote from 2004 came from Federal Reserve Chairman Alan Greenspan:    

“It seems persuasive that, given the size of the U.S. current account deficit, a diminished appetite for adding to dollar balances must occur at some point”.
November 19, 2004

Although Greenspan has warned on the unsustainable U.S. current account deficit before, the above speech – his most blatant to date - was delivered when the U.S. dollar was already falling sharply. Such is why the dollar falling in 2004 was a non issue in the financial markets (i.e. stocks and bonds): because it was exactly what U.S. policy makers wanted.

Obviously there will come a time when a falling dollar is no longer a U.S. policy goal.  And while the ECB, BOJ, and others hope that this point comes sooner rather than later, it is worth remembering that the dollar’s decline has not been profound enough to spawn a concerted against China (to unpeg its currency). With this in mind:  

* In 2005 look for U.S. policy makers to adopt a ‘stable dollar’ policy in place of the current ‘benign neglect’ policy. Also look for another Plaza Accord and/or a Chinese currency revaluation (if not in 2005, then in the years ahead).

The dollar is not all that Greenspan has to worry about. Rather, Mr. Greenspan is obligated to try and raise interest rates to a ‘neutral’ level and/or acquire more ammunition so that the Fed is better prepared for unexpected shocks.  Exactly how much ammo Greenspan will acquire before rate hikes impact economic growth is the million dollar question leading into 2005.  

When it comes to forecasting currencies, interest rates, and the U.S. economy over a 1-year time frame speculation is the order of the day. Nevertheless, the outlook for 2005 is for more dollar volatility, an end to Fed rate increases, and a weakening U.S. economy.  Contrary to the popular opinion, I don’t envision a major spike in long-term U.S. interest rates.  Rather, the pace of economic growth in the U.S. is already slowing and long-term interest rates (and mortgage rates) have not increased over the last year.  Point being, a small increase in long-term rates will immediately slow down a U.S. economy that has grown increasingly reliant on consumer borrowing/home equity leveraging. 

As for the argument that China and Japan need to continue buying U.S. debt or the dollar will collapse and/or U.S. interest rates will skyrocket…this is why you own gold. To be sure, if China, Japan, or hedge funds (
Caribbean Banking Centers) decide to dump their U.S. Treasury holdings there is nothing anyone can do to stop interest rates from moving higher.  There are no painless solutions if the U.S. dollar slide begins to get unorganized. 

In short, if Greenspan can nudge interest rates back to neutral territory without inflicting severe damage on the U.S. economy/housing market then he truly is The Maestro.  In 2004 Greenspan lied when he said home buyers would be wise to consider adjustable mortgage rates.  How soon will it be before Alan will have to lie and say an unorganized dollar sell off is ‘overdone’?

A New Recession Indicator?

One industry that isn’t in recession today but could be an indicator for recessionary times tomorrow is payday loan stores and/or pawn shops. The companies in this group provide high interest short term loans, they cash checks for obscene fees, and offer pawn shop asset backed loans to consumers in need. As the soaring stock prices suggest, business has never been better for these lenders.

As recently as 5-years ago you could brush off strength in this tiny industry as unimportant.  For that matter, if you go back 14-years the industry didn’t exist. However, the number of payday loan stores nationwide has more than doubled since 2000 to more 22,000 (in 2003), and revenues have consistently grown by double digits since the 2000 recession.


Are consumers feeling so good about the economy that they are running out to hock their guitars and family heirlooms?  Are people taking payday loans with sometimes a 276% annual interest rate (EZCorp in Indiana) because their savings are in order?  Obviously the answer to both of these questions is no: business is booming at payday loan/pawn companies because the so called ‘recovery’ has left so many Americans behind. 

ACE Cash Express, EZPay, and a host of others (including FastBucks Franchise Corp) are planning to aggressively expand in 2005.  What bears watching is whether or not these companies are vying for a larger piece of the pie or whether or not the pie itself is growing. If the type of expansion being planned by payday loan companies was being mirrored in say liquor stores there would be nationwide outcry about the evils of alcoholism.  Instead of decrying loan-shark-like lenders, the consumers that are forced to take short term loans to make ends meet are ignored (by contrast, consumers that refinance their ever escalating home price are celebrated). 

Although more evidence was not required, growth in payday loans and pawn shops tells us that more Americans are stretched to their financial limits.    

Speculations and Conclusions

Yahoo trades at more than 100-times earnings, more than 700-times stock option expensed earnings (2003), and 80 times free cash flow. If Yahoo paid out all of its free cash in dividends its divided yield would only be 1.25%. With this in mind, two future scenarios for the fast growing Yahoo arise: 

1) Yahoo continues its strong financial performance and, eventually, this translates into equity gains and more reasonable valuations.
2) Yahoo falters and/or investor appetite for the stock wanes and YHOO shares crash by 50% or more.

While the near term direction of the U.S. stock markets can not be predicted using P/E’s, dividend yields, and Tobin’s Q ratios, the investor that buys companies for the long-term should not completely avoid scrutinizing risk/reward scenarios using basic valuation tests.  Quite frankly, if you are paying a hefty premium against the business returns you expect a company to generate you should be prepared to lose money and/or dollar cost average in the near term. 

In the case of Yahoo, the returns from the business for every dollar invested are pitiful, which makes owning the stock risky.  As for the rewards of owning Yahoo, the rational conclusions are that shareholders are playing the greater fool and/or are so knowledgeable about how Yahoo will be performing many years from now that they do not mind holding a loser for some time (using current growth estimates Yahoo will be trading at less than 20-times non expensed earnings 7-years from now. The company, like all U.S. companies, will be forced to expense stock options in June 2005). As for explanations from the mainstream business media that ‘Yahoo shareholders are winners because the company’s stock price has rallied’, these celebratory viewpoints bring back memories of the 1990s. Shareholders are, by definition, part owners of a business.  Accordingly, how happy would you be if your $52.49 billion business returned $542 million over the last 12 months (or 1.032%)?

Suffice to say, the 1990s stock market mania didn’t happen because investors were a little off on their ROE calculations.  Rather, the 1990s mania happened because many unknowledgeable investors chased stock prices to absurd levels.  Since the 1990s ended (?) valuation levels have generally come down. However, the 1990s participation mania is still alive and well today.  By ‘participation mania’ that is to say that very few 1990s newcomers have left the markets. Indeed, the vast majority of mania owners are still handing capital over to fund managers that purchase companies like Yahoo at any price today.

What is becoming increasingly clear that the participation mania will not end until a severe U.S. recession arrives and completely changes the average investor’s opinion on stock ownership.

As for the last U.S. economic recession, it followed none of the traits of previous recessions.  Rather, U.S. consumers welcomed the 2000/01 business led recession by borrowing and spending more money, and Greenspan/Bush kept recovery hopes smoldering with unsustainable stimulus policies until growth caught fire in mid-2003.  This fire is still being fueled by low U.S. interest rates and easy money policies today, and now Bush wants to allow Social Security funds into stocks.

In sum, if the dollar doesn’t collapse, U.S. interest rates do not rise all that much, and more greater fools can be corralled by cowboy analysts, the optimists may be right about 2005.  The alternative is that U.S. interest rates rise, a series of asset bubbles (stocks, home prices) get knocked down a notch and the stock market Yahoos banking on good times run astray.  As for the U.S. dollar, its destruction should not be longed for...At the end of the day gold needs to be priced in something or the pawn companies have no method of acquiring scrap gold from desperate U.S. consumers.