Farewell Scrooge

As we close out one year and start another, this is as great time to look at where we are in the business cycle.

THE GHOST OF CHRISTMAS PAST
Sometime in 2001 the last cycle came to a sudden halt, after almost 9 years. A helluva run. In some ways, the cycle had run well past its expiration date, prolonged thanks to Greenspan shenanigans and the pre-Y2K splurge of spending that continued into 2000.

Greenspan and Bush through everything but the kitchen sink at the economy, including massive reductions in the interest rate and tax cuts. It worked, but it came with a price. A stock market bubble was transformed into a real estate bubble.

THE GHOSTS OF CHRISTMAS PRESENT
I believe that the housing bubble is tugging us down in one direction while the manufacturing sector is tugging us upwards in a different direction.

First, the good news. Capital spending will continue in 2006. Here’s why.
In the run up to 2000, US manufacturing firms were on a capital spending spree. This slowed in 2001 as reality sunk in, and spending sank with it. Much of this spending was tied to dot.com growth and productivity gains. IT growth was specifically tied to Y2K and dotcom fever. (M = manufacturing, IT = Information technology, U= utilities, F=finance/insurance, MOG = mining/oil/gas )

US Census Capital expenditures $B
M IT U F MOG
1999 194 123 40 24
2000 213 160 61 131 33
2001 192 146 83 131 40
2002 163 89 67 126 42
2003 150 82 55 125 51

Not until 2004 did total spending reverse the decline.

What caused the timing of the turnaround in 2004 and what will drive it further into 2006? Not only the tradition that manufacturing investment lags recession recoveries. But also the 5 year amortization schedules. Basically, by 2004, massive dotcom spending was finally starting to be fully depreciated. 2005 saw massive replacement of equipment purchased in 1999/2000 which in turn was possible due to capacity being soaked up again.

Why do I think that the capital spending will continue?
Clearly, 2001 was a sign of over-buying. Capacity utilization sank amazingly low. Compare the low utilization levels of the two recessions: 74% (2001) vs. 78% (1991). To some degree, that suggests that some of that capital will not get replaced at all. Add to it the major and permanent manufacturing shift offshore (currently to China). This pushes against capital spending

But dig deeper. Manufacturing and mining/oil/gas are global in nature, so US spending does not define total actual demand. US manufacturing has dropped 25% ($63B), but it has been replaced offshore - so I see growing demand. Mining/oil/gas has grown in the US $18B, and much more globally (more mining and oil exploration outside of US than inside).
The real story is in IT where spending collapsed 50% (~$100B) mostly because of Telecom spending drops. I see this demand reversing dramatically this year thanks to several factors.
* iPOD – Bandwidth demand will surge partly from Video on Demand and partly from the humble demand for downloading movies and TV shows to the iPOD. This will spark much greater program availability and accessibility beyond the iPOD. The iPOD will be the poor man’s VOD, but it will spark availability that in turn will drive demand for more storage and bandwidth. The Killer Application VOD has arrived.
* Obsolete equipment – The Cisco paradigm follows the Wintel paradigm wherein equipment is obsolete within ~7 years.
* Competition – Cable and wireless companies will scare the Telecoms into spending again.

The turd in the punchbowl is consumer spending. The Housing Bubble is about to pop. We have yet to pay the price of a serial bubble (stock market bubble turned into housing bubble). We are entering a transitioning period where some signs point up and some signs point down.
Actually, only one sign is pointing up: housing prices continue to advance
All other signs indicate a looming slow down: November housing volume sales dropped 11.3% sequentially versus October, the biggest drop since 1993. Volume of unsold housing in Silicon Valley increased 20%+ in November. Indeed, Silicon Valley houses are staying much longer on the market versus same period last year. Also rates are rising, driving affordability in California to an all time low of 14%.

Experts predicted a slowdown with prices stabilizing. But the Housing market is dropping further and faster than the experts thought it would. In the face of 30% fewer sales, will they revise expectations about pricing as well?

The key to all of this is momentum. Real estate prices always have amomentum that takes a while to reverse (at the low and high ends). I see April as being a milestone when prices will begin to be rolled back. Housing is emotional and prey to psychology. It is worth only what people are willing to pay for it, and that includes expectations about future price movements. If prices begin to slacken, people will wait to buy and that will add downward pricing pressure as well. Supply will hit the market as well thanks to massive building (townhomes and condos) as well as speculators unloading. Supply will begin to outstrip demand.
Housing prices will not enjoy their current premium in light of townhouse price drops – never has, never will. They are substitute goods.
The Housing market slowdown will not happen in a vacuum. As is already occurring in Great Britain, consumer spending slows. And consumer spending is the backbone of our economy.
The first to slow will be luxury goods, cars and household durable goods.
At the same time, people who made windfall profits in real estate will be plowing those funds into the stockmarket.
But this will be unwinding towards the middle and late end of the year. That means the negative impact of housing bubble crashes won’t appear until 2007.
In the meantime, hello bull market of 2006.

GHOST OF CHRISTMAS FUTURE
I see a solid 2006.
Sectors to avoid:
Retail – Consumer confidence is strong enough to boost many retailers. And certain items like flat panel TVs will show rapid growth. But I don’t like getting into retail at this point in the cycle because I expect a slowdown soon.

Financial – A tightening of money flow, interest rates, and a looming housing bubble do not look promising. I see a flurry of activity as homeowners begin swapping out ARMs, but re-financing won’t be the same as massive new spending.

Housing – Beware. If you don’t know who the sucker is at the table, that means it’s you.

Sectors I like:
Telecommunications & Storage – Both personal (PSP, iPOD, Cell Phone) and commercial. I like Marvell because they have feet in all key growth areas – they make chips for the iPOD, make chips for disc drive storage, and make chips for telecommunications. Content delivery will be king. So I like BCSI for secure IP data flow and Akamai because they provide the delivery system for iTunes – and that business is just growing. Flash data storage is also booming, something Sandisk continues to ride as will disc drives, for which Seagate looks good.
Cisco and Juniper will also be poised for success


Mining Equipment – The biggest capital investment growth has been in mining and related equipment. And this equipment breaks – rocks have a way of causing wear and tear. We have JOYG and JLG for this one.

Energy – Like mining, this was another area of massive capital investment. If Telecommunications will begin infrastructure investing because they waited too long, energy is investing because the prices make it worthwhile. Energy is here for a while given ongoing near-term strong demand. I don’t like volatility from energy prices, so we have MDR as an energy equipment and infrastructure play.

Healthcare – Aging boomers. Trends will be to cut costs (generics like TEVA), offer alternative drugs and treatments (GILD, ISRG, ALC), care for the aged (SRZ), as well as a shift away from healthcare and more towards illness prevention via healthy living (Whole Foods, and eating/exercise facilities that are low impact and more elderly friendly – whatever those may be).

Transportation – I see global airline integration happening and I think JetBlue is poised to be a major player. When Heathrow opens up, watch for RyanAir or some other equally fierce player to tie in with JetBlue. Trucking is also going to improve – internet retail makes warehousing and shipping more centralized and flexibile shipping more valuable in the economic chain. Hence, truck shipping. USAK is poised for strong upsides.