The Chips Fall Down

Today was the first real down day we’ve had in a couple of weeks. There was no specific reason for it, which is usually a good sign. After several big up days (the S&P 500 had jumped over +6% in just 11 trading days), it was time for a little selling (the pros call it “profit taking”). The financial press blamed it on a Bank of America analyst who downgraded 10 computer chip companies, including Intel, because of a potential “inventory overshoot” next year. But European markets were falling before this analyst opened his mouth, so investors were already in a selling mood prior to the opening bell in New York.

What about this feared “inventory overshoot?” Well, chip companies, along with just about everyone else, have pared their inventories to the bone during the recession. Now they’re finally starting to restock in anticipation of future demand. The concern is that they’ll overshoot, and have too much inventory by sometime next year. This would cause them to reduce production in order to work off the excess inventory. Could this happen? Of course; no one can predict demand precisely enough to always have the right amount of inventory. Will it matter? Probably not. Temporary mismatches between inventory and sales are common in business. Besides, the semiconductor industry is anticipated to grow 18% in 2010; I expect it could be more than this.

I bring up this rather arcane story because of something that happened to me recently, and which reminded me how low inventories have become. I ordered some additional memory for my Power Mac at home: 2 GB DIMMs, direct from the manufacturer (Micron Technology). That was several days ago, and the order hasn’t yet shipped. Why? The manufacturer is out of stock! We’re in the deepest recession since WWII and Micron can’t keep up with demand for its memory chips. So we already have at least one mismatch between sales and inventory: too little inventory. With demand increasing, manufacturers are going to have to ramp up big time to replenish their meager stocks. Also, I wouldn’t be surprised to see a lot of the more popular items sell out over the holidays. (You might want to finish your holiday gift shopping early this year.)

Most economic data and corporate earnings continue to exceed expectations. Earlier this week, Japan’s GDP report showed annualized growth of +4.8% in the 3rd quarter, more than twice what was forecast. And just a few minutes ago, the Bank of Japan upgraded its view of the country’s economic outlook, while leaving interest rates at historical lows. The global economy is clearly on the mend, but hardly anyone seems to notice, focusing as they do on lagging indicators like employment.

Except the stock market, that is. Global equities (as measured by the MSCI ACWI) are up over +70% since their March low. That’s a very impressive move in less than 9 months. Yet there are more than a few who think this huge up move is a head fake—a “countertrend” rally in a longer-term bear market. They think that we’re in the 1970’s all over again. Back then, stocks made little headway for the 16 years from 1966 to 1982. If they’re right, so the story goes, that could mean little upward progress until 2016. Not a pleasant thought.

But even if we’re “back to the ‘70s,” the stock market’s future could still be quite bright. Because what you don’t hear about those 16 years of stagflation is that the low point occurred in 1974, just under 9 years after the prior peak. Between December 1974 and the August 1982 “bottom,” which marked the beginning of an 18-year bull market, the S&P 500 had a total return of about +125%. Not bad for a bear market!

Coincidentally, the March 2009 low of this bear is exactly 9 years from the March 2000 peak. So even if 2009 is like 1974, there could still be a lot of appreciation before the next “official” bull market begins, as stocks have so far only risen about half as much from their lows as they did from 1974 to 1982. So even the worst-case scenario doesn’t sound so bad.

Also, if this is a “counter-trend” rally, it would be the longest and most powerful in history. The previous record is held by the initial rally after the crash of 1929, when the Dow Jones Industrial Average (there was no S&P 500 back then) rose +48% in 4 months before beginning its dizzying 3-year drop. The current rally is already significantly stronger and more than twice as long. The chances that the bear market of 2007–2009 is not yet over are, in my view, incredibly small. (And if this really is the first rally of a new bull market, as I believe, there’s a LOT more upside ahead.)

Too bad for the average investor, as mutual fund data indicate that a great many have been sitting out this rally, waiting (perhaps hoping is a better word) for a big decline that will allow them to get back in at much better prices. They are likely to have a very long wait. I said it in March and I’ll say it now: I don’t think we will ever again see the S&P 500 at 666 or the Dow at 6,500. Not just in our lifetimes. Ever. So stop waiting for the other shoe to drop. Yes, there are lots of problems, and yes, there will be more economic crises and bear markets in future years. But there will be no more falling footwear in 2010.