Stock Market Themes

The following is an extract from commentary that was posted at www.speculative-investor.com on 24th February 2002. 

The stock market, stock valuation and the economy

Last week's stock market action was consistent with a theme that has been running through the market for the past 2 months. That theme is that the economy is going to recover this year and there are many stocks that are going to benefit from the recovery, but a return to modest growth does not give investors a reason to pay 7-to-15 times annual sales for a company. We'll now elaborate on this theme.

Below is a chart comparing the NASDAQ100 Index (NDX) with the Morgan Stanley Commodity Related Equities Index (CRX). Both the NDX and the CRX rallied strongly from late-September through to early-December of last year, at which point the NDX began to roll over while the CRX continued to move higher. Since the group of large-cap tech stocks that populate the NDX and the group of commodity-related stocks that populate the CRX both stand to benefit from an economic recovery, why has there been such a divergence in performance over the past 2 months?
 

There are two important differences between the NDX-stocks and the CRX-stocks that, we think, have caused the NDX and the CRX to take divergent paths. The first, and at this stage the most important, difference is valuation. On a price-to-sales basis the commodity stocks are, in general, much better value than the tech stocks (for cyclical companies, price/sales ratios are better measures of valuation than price/earnings ratios because such companies will often be losing money near the bottoms of economic downturns). Even if the economy is going to experience robust growth this year it does not make sense to pay 7-15 times sales for the stock of a large technology company. It was possible, by using some imagination, to make an argument for paying large multiples of sales for companies such as Cisco Systems and Sun Microsystems during the late-1990s when these companies were growing their revenues at rates that were several times faster than the economy itself was growing. However, they were only able to achieve such phenomenal growth because their customers - telecommunications and internet companies - were spending money at rates that bore no relationship to economic reality. These telecommunications and internet companies were, in turn, able to do this due to the almost limitless availability of debt and equity financing. 

The world is obviously now a very different place - companies like Cisco and Sun will not be able to grow faster than the economy because their major customers a) do not have much money and b) no longer have ready access to cheap financing.

The large-cap commodity producers are facing similar problems to the large-cap tech companies (reduced demand for their products due to slower economic growth), but the problems may have already been fully-discounted in their stock prices. Hence, the CRX's strength relative to the NDX over the past 2 months.

The other important difference between the NDX-stocks and the CRX-stocks is that tech stocks tend to flourish when the environment is perceived to be 'disinflationary' whereas the stocks of commodity producers tend to benefit when the trend is perceived to be towards higher inflation. The CRX's recent out-performance could be put down entirely to the valuation issue discussed above, but the below chart comparing the Australian All Resources Index (XAR) with the Australian All Industrials Index (XAI) suggests that inflation-expectations could also be playing a part. Note that the XAI (representing the stocks that benefit more from 'disinflation') moved up to a resistance level at the end of last year and has since traded sideways, whereas the XAR (representing the stocks that benefit more from inflation) blasted through similar resistance and continued upward.
 

Gold stocks and the stock market

A question we occasionally get asked is: will a substantial decline in the overall stock market also push gold stocks lower? This is a reasonable question because a) a substantial decline in the overall stock market is likely at some point this year and b) there have been several occasions in the past when gold stocks have fallen with the general stock market. Here's what we think:

Based on price action since last September the owners of gold shares should not be concerned about the prospect of large declines in the major stock indices. As the following chart comparison illustrates, gold stocks have trended in the opposite direction to the large-cap tech stocks (as represented by the NASDAQ100 Index) over the past 6 months. Since a substantial decline in the overall market is likely to be led by the large-cap techs, gold stocks should continue to benefit from general stock market weakness. 
 

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