Anatomy of the Bull That Will Not Die
Part 3: Stock Factors

by

Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
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 and dismay.

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 other ways.)

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 matter.

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 the World."

Copyright 2004 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to www.millerrisk.com.