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2Q Is the Economic Bottom, Right?

There is very little economic news out this week. All eyes will be on Friday's release of the revised first quarter GDP. Economists expect GDP to be revised down due to the larger trade deficit posted in the first quarter. Last Friday, April's $31.2 billion deficit shocked economists, which were expecting a more benign $29.5 billion. For the first quarter the trade deficit grew to a record $91.3 billion, $6 billion more than last year.

On Monday, the Federal Reserve Bank of Philadelphia released its Survey of Professional Forecasters. The survey found that economists have lowered their economic growth forecasts and increased the probability of a recession. The forecasters slashed their forecasts for the current quarter to an annualized 1.2% from 2.2%. Growth for the second half was also dramatically reduced to 2.3% from a previous estimate of 3.6%. Growth rates for 2002 were also adjusted downward to 2.8% from 3.6%. Not surprisingly the forecasters have increased the likelihood of a recession. A recession in 2001 has a 35% chance, while 2002 is only 20%. Not surprisingly, unemployment is expected to continue to rise, up to 4.8% by year-end.

The recent Manpower survey does not bode well for the labor markets. Only 27% of companies expect to increase payrolls in the next three months, while 9% plan to let go workers. Just a year ago, 35% of employers expected to add workers with only 5% anticipating reducing employees. Not surprising the manufacturing sector expects the weakest hiring forecast. Only 24% of manufacturing companies expect to hire additional workers compared to 15% that plan to pare back their workforce. This is the weakest showing since 1982.

To see how U.S. companies are handling the weakening economy as a whole, I ran a couple reports on aggregate revenue for the first quarter. I included companies that have reported net income and revenue since the first quarter 1999 (so there is some degree of survivorship and new issue bias) and traded on one of the three major exchanges. There were just over 4,100 companies included with revenue totaling almost $2.3 trillion.

($ in billions) 1q01 4q00 3q00 2q00 1q00
Revenue $2,283.9 $2,352.3 $2,195.1 $2,139.7 $2,027.5
Y-o-Y Growth 12.6% 14.8% 14.7% 16.6% 18.0%
Net Income $68.2 $56.6 $122.6 $115.0 $128.7
Y-o-Y Growth -47.0% -44.4% 5.6% 0.0% 27.0%
Special Charges ($28.4) ($57.5) ($4.4) ($11.1) $1.5

While revenue growth has clearly declined, it is far from drastic. The "profit recession" that so many are discussing appears to be accurate. However, the degree that accounting charges have reduced the current period's income must be examined. It is amazing that during the past two quarters there have been more than $85 billion in special charges. This only includes items the company places in a line item before taxes. Not all charges are included. For example, this number only included $1.3 billion of Cisco's $3.4 billion worth of charges in the first quarter. Compustat included the $2.25 billion inventory charge in cost of goods sold. There are probably countless other "missing" inventory charges in the number above. Just adding Cisco to the special charges would increase the total by almost 8%. I still find it amazing that less than 90 days from when the auditors look over the books, there could be so much "excess" inventory, goodwill, and other assets discovered.

America Online announced a $1.95 increase in access fees. While this only appears as a 9% jump in prices, it comes at a time when free providers are changing their business model by limiting access time or assessing fees, or just leaving the business. This essentially is raising the total price of access. It also shows that AOL thinks it has pricing power. If more companies realize they have pricing power, the inflation picture could get very precarious.

There is starting to be more and more rumblings about inflation, although the consensus is still not worried about it. But it cannot be too encouraging for the doves to see the government yields significantly above the levels before Greenspan's cut-a-thon. The idea of stagflation sure has been inflating lately. Doing a quick periodical keyword search using Lexis-Nexis, "stagflation" retrieved 566 references so far this year. That’s up from 217 last year to May 23. There were a total of 698 references for all of 2000 and 424 in 1999.

Inflation is starting to spook a few out there. Edward Yardeni's concern should ring familiar to readers of our commentaries; "I'm more concerned about the potential for another speculative bubble in the stock market." Yardeni said that reinflating the bubble "could be a lot of fun and very profitable…But it's not in the best interest of the economy."

We have been discussing the energy problems the Pacific Northwest is experiencing, especially the Bonneville Power Administration (BPA). In an unprecedented move, the BPA has spent $500 billion buying back electricity it has contractually pledged to its industrial customers. The BPA is hoping to avoid widespread price increases and blackouts by buying back electricity from its heavy users. The smelters buy a constant 2,000 megawatts of electricity from BPA, which is enough to light two million homes. So far it has worked, but with ramifications. Many of these companies are shutting down and laying-off workers. While many of the agreements call for companies to continuing paying employees while the plant is idled, it has certainly caused concern about the future. Oregon reported over 7,000 lay-offs this year, more than double just last year.

The weakening manufacturing sector, soaring energy prices and a strong dollar continue to take casualties in the steel industry. Northwestern Steel and Wire Co. began shutting down one of its plants putting 1,400 employees out of work. LTV Corp. is starting to get close to the end of its rope negotiating with the United Steelworkers of America. Currently LTV is losing more than $1 million a day and is looking to finish a restructuring that would save $800 million annually. To what extent LTV is using its financial condition is unknown, but it says "If the agreement is not made in the very near future, the company's restructuring plan would not be able to go forward, and if that were to happen, the company would shut down permanently."

With the trade deficit running at a record rate it seems the only thing the US is exporting is inflation and energy problems. Brazil is asking for its companies and households to reduce electricity consumption by 15% to 20%. Brazil generates about 85% of its electricity by hydroelectric plants. A recent drought is cutting into the amount power the generation plants can produce. Today, the FT reported that the proposed plan to cut electricity consumption hit a couple snags. First, it looks like the courts are ruling that it is illegal. Second, employees at one of the largest power distributors, Light, went on strike. Lastly, opposition parties are stepping up anti-rationing rhetoric.

The semiconductor industry continues to languish. The semiconductor equipment book-to-bill ratio posted a record low of 0.42 in April. Wall Street was out saying this must be a bottom in the cycle since it has never been so low. Funny, I don’t recall them calling a peak when it was at record levels last March. Stanley T. Myers, president and CEO of SEMI, did not sound as hopeful, "The severity and depth of this industry correction is unprecedented." On Monday, Chartered Semiconductor, the world's third largest chip foundry, reduced its revenue and earnings forecast for the second quarter. Chartered now expects sales to fall 48% sequentially compared to earlier forecasts of a 25% decline.

Elsewhere in the semiconductor industry, Hynix Semiconductor, the second largest memory chipmaker, is desperately trying to raise capital. Hynix plans to issue $1.5 billion in global depository receipts (GDRs) in the next couple weeks. The funds are integral part of a restructuring plan. If the funds are not raised a $4.4 billion financing package by current creditors will get pulled. Anyone interested can contact Salomon Smith Barney. Sounds like it might be a tough sell.

In the shadow of the NASDAQ bear market, Wall Street is attempting to establish a "code of best practice." Additionally, Congress is expected to hold hearings to determine what degree conflicts of interest lead to the mania. The Association of Management and Research (AIMR) is helping to establish the new code. It seems it would be much easier if AIMR simply just enforced its existing Code of Ethics and Standards of Practice. Here are three pertinent sections from AIMR's Standards of Practice.

A.1 Reasonable Basis and Representations. Members shall:
a. Exercise diligence and thoroughness in making investment recommendations or in taking investment actions.
b. Have a reasonable and adequate basis, supported by appropriate research and investigation, for such recommendations or actions.
A.3 Independence and Objectivity. Members shall use reasonable care and judgment to achieve and maintain independence and objectivity in making investment recommendations or taking investment action.
B.7 Disclosure of Conflicts to Clients and Prospects. Members shall disclose to their clients and prospects all matters, including beneficial ownership of securities or other investments, that reasonably could be expected to impair the members' ability to make unbiased and objective recommendations.

It does not seem that these "Standards" were practiced by many during the Internet mania. Looking at the first "Standard", it would take a lot of convincing that an appropriate measure of a company's value was the number of eyeballs viewing a webpage. The "Chinese Wall" concept of keeping the investment banking division separate from the research department is demanded in both Standard A.3 and B.7. To have a research analyst's pay even partially dependant on the amount of business he brings to the investment banking division is clearly a violation of AMIR's Standards.

Speaking of "Reasonable Basis," is it reasonable for a money manager to buy Cisco just because it is X% of an index? Granted, it might be for an index manager, but how many managers were buying Cisco because they "had to" because they are evaluated by relative performance and Cisco makes up a large portion of an index and it was going up.

Details have come out about Heartland Fund's muni-bond fund blow-up. I cannot do it justice by summarizing it, so here is the story from the Chicago Tribune, Fund fiasco traps investors.

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