of the Bull That Will Not Die
Part 3: Stock Factors
Ross M. Miller
Miller Risk Advisors
May 10, 2004
The past week started out as a good one for the
inflationary-boom meme; however, by the final hours of Friday's trading the
it's-all-one-market meme reasserted itself big time. On Monday, we hit the
trifecta--Nasdaq Composite, gold, and ten-year Treasury note rates all up on the
same day. Friday's solid employment numbers, critical external confirmation of
the boom, drove interest rates through the ceiling once again, but with a more
muted impact on gold and an encouragingly odd impact on the Nasdaq Composite,
which opened about 0.3% lower (programmed selling?) and then immediately rallied
up almost 1.5% from there. This did not last.
By 10 a.m., gold was off nearly $10 an ounce and in the
afternoon stocks of all stripes marched steadily downward. More than 9 out of 10
NYSE stocks ended down for the day. While maybe its all Rumsfeld's fault, a
retreat this broad can point to indiscriminate selling that comes at times of
financial distress. The rumors have already begun to fly and the coming week
could be very revealing, particularly if the end-of-week inflation numbers shock
Still, when the numbers are tallied for the week, tech stocks
managed not to go down with the interest-rate undertow. Despite the benchmark
ten-year Treasury falling more than 2 points and picking up 28 basis points in
yield (a big climb up from 4.50%), the Nasdaq Composite was down only 0.1%.
(Parts of the Nasdaq survived the Friday downdraft with 828 issues up vs. 2341
down, a far better showing than the NYSE.) The Dow and S&P 500, both chock
full of financials, were down around 1%.
This final look into the bull's anatomy will focus why some
companies will benefit disproportionately from an economic boom driven by the
ongoing shift from a borderline deflationary to an inflationary environment. As
one who writes from the general proximity of New York State Attorney General
Eliot Spitzer's main office, I will go out of my way to avoid mentioning, much
less publicly picking, individual stocks. Instead, I will provide some general
insights that you can adapt to your own requirements.
The principal reason that companies with good growth prospects
must naturally benefit from any economic boom, inflationary or not, comes down
to simple mathematics. If all the economy wants to do is trudge along at 1% or
2% real growth a year, there are many ways that such a lackluster expansion can
be achieved. On the other hand, if the economy is to sustain substantially
higher growth, say 4% to 6%, for more than a few quarters, some sectors will
have to grow rapidly to compensate for other sectors with intrinsic constraints
on their growth. Hence, growth companies, which include most technology
companies, lead the way during an economic boom.
Inflation adds a second dimension to the boom. In an
environment with stable input prices, stable output prices can be maintained
using the same old methods. But a company that faces the dual pressure of higher
input prices and customers who are unwilling to pay more, is forced to change
(or run to the government for protection). Offshore outsourcing is the form of
change that is getting the most media ink, but technology provides another
avenue of change. Indeed, remarkable progress in telecommunications technology
is what has made offshore outsourcing viable.
So, technology looks good during an inflationary boom because
it promotes growth and cuts cost (or, in the Greenspanian worldview, increases
productivity). But tech has more than that going for it. Even before Sir Alan
lifts a finger against the dragon of inflation, the vigilant Bond Knights have
upped cost of borrowing to head off a conflagration. While many companies,
especially certain financials, feed from the trough of the debt markets,
technology companies tend to have low debt loads. For one thing, the riskier
technology companies tend to raise money elusively through stock issues because
their credit is poor and that makes debt too costly for them. For another thing,
those that have reasonable access to the debt markets have had a long time to
load up on debt for the next ten years at stunningly low interest rates. Hence,
most tech companies are essentially immune to higher rates going forward.
Technology companies are also relatively immune to higher oil
and commodity prices as well as to any bottlenecks that might surface in the
transportation system. Tech items from microchips to stents are very value-dense—they
are worth far more than gold on a per ounce basis. Their resource cost of
production and the cost of shipping are miniscule relative to their total cost.
Software is even better—it need not have any physical embodiment.
Of course, all technology companies do not fit this mold. The
domestic computer companies that remain produce few of the high-value components
themselves; instead, they take orders and ship bulky machines into channels that
may be subject to disruptions. Indeed, the big companies Nasdaq 100 companies
are not the best bets for an inflationary boom and even the Nasdaq Composite is
an inadequate proxy for "the market" that is likely to benefit if the
inflationary-boom meme ultimately prevails. Narrowing down the field to the
winners is where a quantitative view of the world becomes useful.
If one looks at the daily percent changes of the three major
averages—the Dow Jones "Industrial" Average, S&P 500, and Nasdaq
Composite—one will quickly notice although these averages tend to move
together, they do not move in lockstep. That is because even of these averages
contains a different mix of factors. Viewed at an abstract level, the stock
market is not so much a market of stocks as it a market of factors.
("Factor" is used here in a specific, technical sense derived from the
statistical technique of factor analysis even though factors can be computed
A very simple, but powerful, quantitative analysis of the
stock market shows that it is dominated by three factors. The first factor is
known simply as the "market factor" and the S&P 500 serves as a
reasonable real-world approximation to this factor. The beta that many
data services list for stocks is a rough measure of how much of this market
factor a given stock contains. This is the factor that the typical investor is
aware of—it is the great ocean that raises all ships when it rises and sinks
all ships when it falls. When someone asks, "What did the market do
today?" this factor is what they are talking about.
To adherents of the it's-all-one-world meme (see Part
1 for details), the market factor is the only one that matters. Still, as
evidenced by the fact that there are many days when the Dow and Nasdaq move
independent of the S&P, there are other factors and sometimes they do
Dow Jones Industrial Average companies are not only bigger on
average than S&P 500 companies, they are more stable and reliable. They can
also borrow on more favorable terms if they need to borrow at all and they tend
to pay higher dividends. In other words, they appear more like high-grade bonds
than the typical stock does. While there is more going on with the Dow than
merely this "bond factor," it is a significant part of what causes it
to behave differently from the S&P.
As you may have guessed by now, the Nasdaq Composite tends to
move the way that it does because of the third major factor. We can call that
factor the "tech factor." Still, the Nasdaq Composite (and the Nasdaq
100 even more so) has a good deal of the market factor mixed in with it.
The key to playing the inflationary-boom meme is to create a
portfolio of stock that isolates a specific strain of the tech factor satisfying
the properties described above. This can be done using a combination of good
old-fashioned research and quantitative ingenuity. Or, if one is so inclined,
one can simply purchase a technology mutual fund that specializes in such
companies and hope for the best.
The skeptical reader of this nascent series of market
commentaries will notice that I have blithely failed to take into account the
many hazards of human existence that those of a more bearish persuasion delight
in. Next week, I will acknowledge these concerns in "Waiting for the End of
Copyright 2004 by Miller Risk Advisors. Permission
granted to forward by electronic means and to excerpt or broadcast 250
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