This guy is simply brilliant. This is long and may be boring, but it is all you need to know about how he sees things.
Sucker Punch Coming
Jeremy Grantham says it's only a bear-market rally
November 3, 2003
By SANDRA WARD
An Interview with Jeremy Grantham -- His clients have been gathering the past two weeks at the venerable investment firm's Boston headquarters for its annual assessment of the state of the world's markets. In other words, to hear "Jeremy's jeremiads." With 35 years experience under his belt and $48 billion under management at the firm he helped found, Grantham is well worth listening to. His foresight and fastidiousness are the stuff of legend, as is the firm's ability to deliver superior results across asset classes around the globe over the long haul. For Grantham's latest prophecies, please read on.
Barron's: New bull market? Bear market rally?
Grantham: The simple story is the market is overpriced and will go to a trendline P/E, which we now believe is 16 times based on research that shows earnings tend to be overstated over time because assets tend to be underdepreciated during times of technological progress. Currently, the market is around 24 times trailing earnings, on a fairly generous earnings estimate. This is not just a bear market rally but the greatest sucker rally in history.
Q: There's nothing comparable?
A: Nothing in American history. In bear-market rallies, in the not-too-distant future, a new low is made. But the new low is only verified in hindsight. The normal characteristics of the leadership in a bear market rally flash back to the old leadership of the prior bubble.
That's not the case in a new bull market. In the three substantial, but not huge, rallies that occurred in 2000, 2001 and 2002, technology and growth stocks led the way, particularly flaky little companies. The scope of the speculation and the leadership of tech and the surviving Internet stocks is just not typical of a serious new bull market.
New bull markets typically start when the great bubbles have broken badly and stocks become very cheap: Eight times depressed earnings and way under half replacement cost. After this bubble burst, the market hit 19 times earnings, barely below the prior peak of the two previous great bull markets. Then it staged a big rally, with all of the indicators of a bear market rally except one: Bear market rallies typically don't have legs and in the U.S. have never lasted a year.
Q: But this one will?
A: It is the third year of a presidential cycle. The presidential cycle is enormously important. The presidential cycle for me starts in 1932. Before then, the whole idea of stimulus hadn't sunk in. Keynes explained the concept and in Franklin Delano Roosevelt he had a very interested listener.
From then on, administrations understood it is a good idea to stimulate the economy in year three, so that in year four unemployment -- and this is key -- is dropping. It's fine to have a strong economy, but it is unemployment that really drives the vote, our research shows. The third year in a presidential cycle is not just a bull market year, but one with a bubbly flavor to it where growth wins. It's the only year in the cycle that growth wins. The speculative stocks outperform the quality stocks and small caps do very well.
Q: How does this third year stack up against those in the past?
A: This is a classic third year. The absolute return, minus inflation, is
17% in the third year and believe it or not that is exactly where we are, up 17%. Growth outperforms its normal relationship to value by 5% and that is exactly where it is today, to the penny. Small cap does very nicely and this time has done twice as well because it has benefited from another kicker.
While there isn't a very strong connection between the economy and the stock market, there is one very useful connection: In the 12 months, sometimes 24 depending on conditions, but always 12 following a low in the economy, small caps do very well. Low quality or junk does spectacularly.
What we found, too, is that the third year is fairly indifferent to value. Years one, two and four are reasonably sensitive to value. In year three, it doesn't matter whether the market is cheap, expensive or in between, the market goes up. In 1999, the most expensive year in American history up to that point, the market went straight through the roof, like a pea bouncing off a tank.
Q: What should we expect in year four?
A: Year four is neutral. The market comes in on average, small cap is about average, junk still wins -- a little echo effect -- and surprisingly value comes back and typically has the best year on average in the cycle. Value matters.
This is, of course, a glorious heaven-sent opportunity to take advantage of the rally and reposition portfolios. This is a very important rally and it will probably last through the year and may easily carry over into one or more quarters next year.
But next year is much more up for grabs. It is a very expensive market and that will be a drag. We still have very low capacity-utilization and all the problems of excess spending that went on. We have the problem of debt.
Q: How critical is the question of debt?
A: What is unique to this cycle is debt has not declined. It has, in fact, risen dramatically at the government level, quite dramatically at the corporate level, dramatically at the foreign level and very substantially and steadily at the consumer level. This is not a good picture.
[b]Normally, it rises in bad times and falls in recoveries. This time it has not. This is a long way from today, but 2005 and 2006 will be a much clearer call than most years.
Q: How is that?
A: They will be painful years. A black hole.
Q: What should investors do?
A: There are fewer places to hide than any time in my 35-year career.
Bonds are not horrific, but they are vulnerable to someone deciding the way to get rid of all this debt is to inflate. TIPS (Treasury inflation-protected securities) are okay, but fairly priced. The returns at these levels are not terrible but neither are they satisfactory.
In stocks, value has come in and won't be too much help on the downside, nothing like 2000-2001. Same with small cap. Small cap has done brilliantly all the way down and all the way up this year. Small cap is not cheap in the U.S. Do not expect it to provide any material help on the downside; it may even underperform.
Real estate has been like a cat with nine lives. Housing prices have continued to rise to a multiple of income that is dangerously high. The next time at bat, you really have to count on the housing market coming down, not disastrously, but if the S&P comes down through 700, which is our estimate of fair value, it will very likely be accompanied by at least a modest decline in housing.
All the reasons that propped it up will have flowed through the system. It would be hard to imagine a two-year decline in the market that was coincident with a continued climb in real estate. Real estate is getting very expensive and quite unaffordable, and when rates rise that will make it much more so.
Meanwhile, REITs [real-estate investment trusts] went up in 2000-'01-'02 when the U.S. market went down. Then we have a 20% rally in the S&P this year and REITs are six or seven points ahead. Since we spoke last year, REITs are up 33.4% to the S&P's 23.9%, almost 10 points ahead.
Q: Why the outperformance? Aren't REITs out of favor now that other dividend-paying stocks receive a tax advantage?
A: Of all the questions I find hard to answer, that is No. 1. I can give you plausible B.S. but I don't know why REITs have done so well. They changed the tax on dividends, but not for REITs, and therefore other high-dividend stocks should surely handsomely outperform REITs. Yet REITs, without the tax advantage, are far ahead of other high-yield stocks. Go figure.
Everyone knows the fundamentals of office space are terrible and apartment rents have fallen and vacancy rates are up. We've had three years of brilliant outperformance in the worst bear market since 1974, and still REITs are outperforming. I don't get it, except underneath it all there is still a big gap between the expected return from REITs and the S&P. We are down to about a 4.5% estimate in REITs from 8.1% a year ago. Now 4.5% is not enough, but it is a lot better than about negative 1% a year, which we expect from the S&P.
Q: Are you still anti blue-chip?
A: I'm anti blue-chips in terms of absolute return. In terms of relative return, one of the places to hide in the U.S. market will be quality stocks. Quality stocks, whether large-cap, or small- or mid-cap, provide noncontroversial, straightforward return on equity, stability of profits and balance-sheet strength. Meat and potatoes. Those characteristics have underperformed continuously all year. This has been a junk year by every parameter.
The net effect is that quality is already pretty cheap. If this bear-market rally continues for quite a long time, then quality will become about as cheap or cheaper than it has ever been. In the event the market goes another leg down, accompanied perhaps by some measures aimed at the overleverage in the system, quality could be a terrific defense against huge declines. Quality stocks will still go down, unfortunately. But they will provide real resistance to big declines. They will be pretty heroic as will REITs on a relative basis. That's the important idea in the U.S. But the real play, of course continues to be foreign and emerging stocks and bonds.
A: The dollar has probably not seen its low. Even though we don't score it as cheap on traditional purchasing-power parity, we have a strong suspicion it will continue down because of the trade gap. Now the place to hide in relative terms is in foreign stocks, emerging markets and, paradoxically, high-quality U.S. and, if you insist, REITs.
The problem is, what do you do in absolute terms? Foreign is no longer cheap. It is a little expensive. The best you can say for it is if you are going into the second leg of a major bear market, it is better to go with the sectors that are only a little expensive. They will go down in sympathy with the U.S. but I think they will go down substantially less and the currency kicker will make a big difference.
The only one that may buck the trend is emerging markets. Emerging may actually go up in a fairly serious decline. We've been saying this for a long time and last year the S&P was down 22% and emerging was minus 2%. It almost made it; it almost did the impossible. Emerging is still absolutely a bit cheap. It is the only equity category that is absolutely a little cheap. Its profit margins are improving. Its GDPs are improving. If there is no out-of-left field crisis in, say, China -- and "if" should be underlined two or three times -- they are in better shape than they have been for years in terms of financials and currencies.
Q: Are you mostly focused on emerging Asia?
A: No. We like Brazil a lot. We like Argentina. We like Eastern Europe. We
don't like Korea. It is picking and choosing. But emerging is the only
category that might actually go up.
I am intrigued, too, by the growing interest in emerging equity. We are
seeing fairly massive increases in institutional interest in emerging
markets. And that is a market where a little bit goes a long way. If this
speculative phase in the U.S. market were to continue for as long as nine
months from today, I wouldn't be surprised if emerging markets didn't go up
another 40%. It has got everything lined up for it. If the market here
fades quicker than that, then it won't happen, but it still might do pretty
Q: What are your views on China?
A: It is working out very well, for the time being. Their imports are growing faster than their exports. Their imports are up 40% year over year. Mind boggling. Chinese imports represent almost one-third of the increase in imports globally. A country with an official GDP that puts it No. 7 or 8 in the world is accounting for 30% or so of all the growth in global importing. Stunning beyond belief. If it keeps rolling a lot of things are going to change in the world.
One of the interesting things is commodity prices. I always make a big fuss that there are only two commodity prices that have risen in the long run: fish and forestry.
What do they have in common? They started as free goods. When you start free and move to cultivation, that is known in the trade as an infinite increasing cost. Okay, it is an exaggeration but at least it makes the point that you can have a long, steady increase in price. Fish and forestry have risen and everything else has gone down in price.
It doesn't matter whether it is oil or soybeans, they have all gone down in real terms. And they've gone down because even those that have marginal increases in costs, such as oil, have had their productivity clock in a little higher than the rising marginal costs of extraction. It doesn't have to be that way, it just happens to be that way.
If China keeps up its growth rate, productivity -- which will not change just because China is growing rapidly -- will come in below the increasing marginal costs of extraction, and those commodities will tend to have a rising real price. Even though they haven't for a hundred years, they will have real price increases. If you push resources at the rate China is doing now, we are going to live in a world where commodity prices rise.
No doubt other interesting effects will fan out from that. With China increasing its imports by 40% and its exports something like 35% this year, what effect does that have on shipping? They're growing faster than they can build ships. Shipping rates have gone through the roof. China may push the whole infrastructure of shipbuilding pretty hard. It may take a few years to gear up to build enough ships to keep up with the incremental effect. Now if the rest of the world slows down a bit, that will mitigate the pressures enormously.
Q: So, how do you feel about the loss of manufacturing jobs in the U.S. to
A: There are only 14 million manufacturing jobs, down from 17 million four years ago. How many of those 14 for technical reasons are always going to be in America? Say 8 million. So between now and forever you are going to lose another 6 million jobs. You just lost 3 million in the last four years. It is really seriously hard to get too excited in a population of 250 million about the eventual loss of an incremental 6 million jobs.
The huge pain of the economy going from 80% manufacturing in 1900 is behind us. That is really bullish. There are plenty of countries where this is a serious factor, but for the U.K. and the U.S., the two most advanced in this way, what used to be bad news has become the good news. The U.K. and the U.S. are service-driven economies.
Q: What about the migration of services jobs at this point?
A: Migrating service jobs is much more complicated. You certainly wouldn't want them to go too fast because that is the area where we are growing and that's where our comparative advantage always has been.
But in the end, global trade benefits everybody. It may also hurt some people, but net-net, it increases the total wealth of the majority of people and so it will go on. We should welcome it. But it is tough if you are the computer programmer who just lost his job to someone in Mumbai.
Q: And so are you investing in commodities?
A: Commodities will probably be a nice place to hide and well worth looking at. We have been considering doing a real-asset fund using stocks. We probably will not, but we are working on it just to have an extra weapon to consider according to the circumstances.
A fund we will probably do is a quality stock fund. A lot of our funds are tied to benchmarks and there is a limit to how much they can tilt to high-quality stocks or should. A quality fund will allow us to target quality stocks more emphatically.
It's gonna get bad. Watch for the academic types who will try to tell you that it's a "new" economy, or that the paradigm has shifted or that the market is "efficient" - meaning that prices reflect fair value. They were saying the same things during the TMT bubble and look what happened.
This is essentially the opposite case that Laffer makes. Obviously, I am swayed a bit since I work for Jeremy, but I tend to agree with him immensely....
Quick reply becasue Im at work and dont have a ton of time:
"Real estate is getting very expensive and quite unaffordable, and when rates rise that will make it much more so."
Dont really understand this statement. Nominal Price and Interest rates have an inverse relationship. If anything, I would think there is a bit if a bubble and RE prices would fall more as interest rates increase. The amount the average person pays per month for a house would probably remain the same, just the amount of principal paid would be less. This ccould be an advantage to some as interest is deductable. But before making any claims, I would really have to research this, this is just a gut reaction.
"The dollar has probably not seen its low. Even though we don't score it as cheap on traditional purchasing-power parity, we have a strong suspicion it will continue down because of the trade gap. Now the place to hide in relative terms is in foreign stocks, emerging markets and, paradoxically, high-quality U.S. and, if you insist, REITs."
Not exactly sure were the dollar was when this was written, but I think we have seen the stop of the dollar drop. Trade deficits are coming in, and The EEC most likely will cut interest rate (Germany GDP -.1%, lots of comments by EEC sgovernors suggesting this.) This act alone would stabilize the dollar (people would stop selling the dollar and buying the euro to purchase the higher returning Euor bonds) and be bad news for gold (essentially an inverse dollar play)
"If China keeps up its growth rate, productivity -- which will not change just because China is growing rapidly -- will come in below the increasing marginal costs of extraction, and those commodities will tend to have a rising real price. Even though they haven't for a hundred years, they will have real price increases. If you push resources at the rate China is doing now, we are going to live in a world where commodity prices rise."
While commodiy prices have increased greatly against the dollar, they are flat against the euro. Not sure if this is the commodity bull run everyone else does, it might just be a dollar play. But, I do think Steel prices will continue to increase regardless of the dollar, China's appetite for it is insatiable. There was a great interciew in Barrons a few months back where Arnie Schneider makes a great argument for stell and think he nails it. I'll try and post it if I find it.
"But in the end, global trade benefits everybody. It may also hurt some people, but net-net, it increases the total wealth of the majority of people and so it will go on. We should welcome it. But it is tough if you are the computer programmer who just lost his job to someone in Mumbai."
This is my favorite point in tthe article. I know it sucks for unemployed people right now (heck, I was just unemployed for 6 months besides a rugby coaching job.) I am a big believer in free trade when its fair (agreed with the steel tarriffs because the industry needed some protection while it was changing and price dumping would have killed the US steel industry.) I know Bit is always sasying how jobs arent coming back and he is right. The old jobs arent coming back, but that is not a bad thing IN THE LONG RUN. Where US Job growth will be will be in new areas, some we may not have even heard of yet. Not ytoo sound like a Barrons salesman here (In know, my third time using it ) but the main story in the Jan 4th issue was /how jobs are going to change in america. Ill post both articles in the next 2 posts.
I dont know how to repsond to the presidential-economic cycle argument. I have heard a similar argument before.
" What is unique to this cycle is debt has not declined. It has, in fact, risen dramatically at the government level, quite dramatically at the corporate level, dramatically at the foreign level and very substantially and steadily at the consumer level. This is not a good picture.
Normally, it rises in bad times and falls in recoveries. This time it has not. This is a long way from today, but 2005 and 2006 will be a much clearer call than most years."
Dont know about the truth of this statement. Reagan-onomics debt levels rose to record levels, and was a great expansionary period before the early nineties recession. I really dont see teh evidence he provides that will lead to this black hole.
A savvy investor makes big bets on economic recovery with basic industries
By SANDRA WARD
An Interview With Arnie Schneider -- When, for the second week in a row, one of the smartest investors we know highlights steel and coal stocks as his favorite ideas, it gets hard to deny there is a major shift underway in the leadership of the stock market. Last week, it was Jeff Gendell. This week it's Arnie Schneider, chief investment officer of $2 billion Schneider Capital Management of Wayne, Pa. We have found it pays to listen to Schneider. Through November, his Schneider Small Cap Value Fund is up 93.6%, compared with a gain of 40.9% in the Russell 2000 Value index; and the Schneider Value Fund is up 46.2%, compared with a gain of 22.5% in the Russell 1000 Value index. Since starting the firm in 1996, private accounts managed by the firm have advanced 17% a year on average. Careful attention to global economic developments, an uncanny ability to accurately assess a company's true value and a knack for identifying the catalysts that will unlock the value, enables Schneider to deliver consistently superior results. It is the same performance that distinguished him during his tenure at Wellington Management and elevates him above his peers. For how he intends to make people richer in the coming year, please read on.
Barron's: What is your view of the market here?
Schneider: Look at valuations and you might be amazed. The stock market is pretty fully valued by any measure you want to use. We are looking at single-digit returns going forward. Although, considering the alternatives, that may not be so bad.
Q: High single-digit returns or low?
A: Mid-to-high-single-digit returns per year over the next three-to-five years. In this low-inflationary environment, that isn't so bad. It is better than current cash levels. You'll be lucky to get your coupon at best with fixed-income, and so stocks will be superior to that. And high-yield is no longer a great investment.
Schneider has a "more bullish outlook for global economic growth" than for domestic growth next year.
In some ways, stocks are still the only game in town. We are in a sweet spot. We have a good nine-to-12 months before the global central bank interest-rate tightening cycle begins. The market could go higher from here, maybe meaningfully higher, for all those reasons. But as a long-term investor, the prospects aren't nearly as compelling as they were a year ago, when you could jump in and know you were going to make very good money. We expect to be in a trading range in 2004. The market's price-earnings ratio is no longer going to expand. We are shifting from a liquidity-driven market to a profit-driven market.
Q: Profits have been coming through. Do you think that will continue?
A: Profits are going to be very good, and we will see double-digit growth next year. But mathematically we are probably in a second-derivative environment because profits have been so strong, up more than 20% in the third quarter. We will have a positive year because profits will continue to come in very strongly. People are also underestimating the positive impact of the lower dollar on corporate profitability. Supply and demand is good in terms of the market: People still want to get in the market. They are underinvested after three years of poor returns. Initial public offerings are very quiet right now, but that will pick up.
Q: What about the economy? Job growth?
A: We are in a global, synchronized recovery. Jobs are picking up. It is lagging, but recent unemployment claims data has been very strong. Household data on employment as opposed to payroll data has been much better. But even payroll data -- the statistic everyone looks at -- for the last four months has come in positively. I don't expect a strong job recovery, but we are getting a recovery and it will continue.
Q: Is it enough to keep the economy humming? If the job recovery isn't a strong one, is there some concern about consumer spending?
A: I have a more bullish outlook for global economic growth than I do for domestic growth. Within domestic economic growth, we don't expect a robust consumer-led recovery. The consumer has led the U.S. recovery, and China and the U.S. have led the global recovery since the recession began a couple of years ago. Now, the baton is being passed from the U.S. and China to the rest of the world. Within the U.S., we still have the trade deficit and balance-of-payments deficit, and the savings rate is still low, although much improved from the bubble era. The vast majority of the imbalances are gone, but there are still some vestiges of the bubble era. It is hard to say the U.S. consumer is going to accelerate from here.
But business spending is more than ready to pick up the slack and is actually turning up, and that is what will lead U.S. economic growth for the next few years, possibly dramatically. Third-quarter capital expenditures were up, led by tech, and non-tech capex is moving up. We have record low inventories in proportion to sales both domestically and globally. Exports will be very strong growth because of the lower dollar. The collapse in capex spending the past few years was enormous -- the biggest in more than 40 years. Non-tech capital spending right now is a record low 4% of gross domestic product. Yet we have had huge free cash flow at the corporate level, so as companies shift their focus from cutting costs and paying down debt to improving revenue growth, we are going to see capital spending continue to accelerate.
Q: So why more bullish on the rest of the world than on the U.S.?
A: Virtually all the global growth we have had since the recession has come from the U.S. and China. The U.S. isn't necessarily going to slow down. We will have 3%-to-4% GDP growth. I'm less optimistic on the consumer component of it and a little bit more optimistic on the business component, but I'm bullish on global economic growth. We have a bigger output gap globally now than we had in 1991, so I think the central-bank cycle is largely on hold, at least in terms of the key players: the European Central Bank, the Bank of Japan and the Federal Reserve. The emerging markets are leading this global recovery right now in addition to the U.S. and China. Japan and Europe are recovering and because we have such a large output gap, it is hard to see inflation picking up meaningfully in the intermediate term to choke this off.
Q: Does that mean you are placing more bets overseas or in emerging markets?
A: No. Where we see the opportunity now and all next year is in the cyclicals, in general, and the basic materials stocks, in particular. We find these companies primarily on a bottoms-up basis. But if you take a step back to the peak of inflation in the late 'Seventies and early 'Eighties, when inflation was in double-digit territory, and you look at the performance of the Morgan Stanley Cyclical Index versus the Morgan Stanley Consumer Index, you find that since the end of 1979 -- the last 24 years or so -- the Morgan Stanley Cyclical Index is up 10.6% through November and the Morgan Stanley Consumer Index is up 16.2%, a 560 basis-point difference per year. We had a 20-year bear market in commodities from 1980 to the year 2000. This disinflation has meant lost pricing power for the cyclical companies, though it was a benefit for the buyers of their goods.
Most of the period was a very strong dollar period, one of the reasons that the cyclicals underperformed. Even though the dollar is down significantly in the past year or two, it is still higher than in 1981. We have put our manufacturing and industrial base though a tremendous firestorm. They have gotten very lean and efficient with what is left of the manufacturing base.
Look at absolute commodity prices, not adjusted for inflation. Coal and gold are half of what they were in the early 'Eighties. Grain is lower. Steel and metal prices are lower. Supply growth in the manufacturing segment of the U.S. economy is the slowest in 15 years, which makes sense because this area has been such a woeful underearner and hasn't even earned its cost of capital over that period of time. Now, in the first synchronized global recovery in a long time, facing a lower dollar based on the trade and balance-of-payments deficits and the fact that these basic materials companies have had very little capital reinvested in them, the outlook for them is quite good, even after the recent outperformance. These look to me to be the leadership stocks going forward.
Company Ticker Price
United States Steel X $28.23
Massey Energy MEE 12.80
Consol Energy CNX 23.07
Navistar International NAV 42.29
Q: Is this a temporary trading opportunity or something more lasting?
A: It is hard to generalize with all the various commodities. They are cyclicals, after all, and you can't buy them and put them away forever, but, in general, because of the massive underinvestment in this area, it is going to be very difficult for the fundamentals to be disrupted in the next few years because it takes so long to put new capacity on line.
Q: But there will be disruptions.
A: The Baltic Freight Index, a measure of dry-bulk shipping prices globally, has gone up significantly over the last six months. The increased trade is straining the global infrastructure to some degree. It raises the cost of importing steel, and we import a significant portion, about 25%, of our steel right now.
There are several pressures on the price of steel. Freight rates are up. Scrap rates have been setting new all-time highs. That is a pure cost of production that has to get passed through to customers. The dollar has significantly changed the competitive dynamics of imports, and two other raw materials for steel -- iron ore and coke -- are in extremely short supply and those prices are exploding as well. There are massive forces pushing the price of steel up, and they will continue to push the price of steel up. That's a good development for U.S. Steel because they don't use as much scrap as Nucor. U.S. Steel is back-integrated into coke and iron ore. In other words, they control the raw materials they use, which is unique. They will also clearly benefit from the lower dollar.
Q: I take it you own U.S. Steel.
A: Yes. That's my first pick. U.S. Steel really is in the sweet spot of the steel industry right now. They produce the two key raw materials used in steel and they are the only ones that will be able to benefit from these cost increases. Scrap isn't a major issue for them because they produce steel by blast furnace. But the real key to U.S. Steel is the $200 million in cost savings from a 20% work-force reduction they achieved after they acquired National Steel. This changed the whole nature of U.S. Steel, which was previously a high-cost competitor globally. The high cost of labor was a big reason why the steel industry in the U.S. was one of the worst-performing groups in the S&P 500 for the last 10-to-20 years. The steel companies only made money at peaks in the cycle and lost tons of money at the trough, and that's why a third of the steel industry was bankrupt 12 months ago -- because we were so uncompetitive on a global basis. U.S. Steel is now an integrated low-cost producer with a good physical plant and reasonable competitive labor contracts. We now have a globally competitive company with an operation in Eastern Slovakia called US Steel Kosice -- which is the largest Central European flat-roll producer, also a low-cost producer -- that is ideally situated to ship to the new, low-cost plants being built in Eastern Europe and to Western Europe. U.S. Steel now has two globally low-cost centers in the world. They are in very good shape to earn a lot of money in the next few years.
Q: Are they making any money now?
A: They will in the first quarter. They should earn about $3 a share next year and peak earnings should be $5 a share.
Q: Are they out of the woods on pension liabilities?
A: Yes. The pension fund is only $400 million underfunded. Their balance sheet is at least in average shape, relative to most U.S. basic material companies, especially when you compare it to the chemical industry. Actually, their debt levels are really pretty reasonable. And they will get some benefit from the Medicare bill.
Q: Is that your only pick in the steel industry?
A: We own one other small-cap company, but mainly we own a lot of U.S. Steel. It's one of our top 10 positions in the company.
Q: What's another pick on the basic-materials side?
A: My next picks along those lines come from the coal industry. There has been 15 years of underinvestment in coal. In the late 'Seventies, when oil prices were thought to be going to $100 a barrel, everyone was investing in the coal industry. Of course, oil prices went up quite dramatically after 1973 and there was a lot of investment. Then oil prices collapsed in the 'Eighties and coal prices went down dramatically. The industry has been through a lot of duress, lots of bankruptcies, pretty similar to the steel industry, and like the steel industry, there has been no reinvestment in the industry.
Now, the coal mines are reaching the end of their useful lives and are mining lower and lower ore grades at deeper and deeper levels that are more and more expensive to reach. Supply is running below demand. Inventories at the utility level have been drawn down below normal.
We favor Central Appalachia coal, which has a high BTU, or British thermal unit, energy content and is low sulfur. Production was down 5% in Central Appalachia in 2002 and will be down another 4% or 5% in 2003-04. There are only one or two companies that can even hope to moderately increase their production. One of them is Massey Energy, the No. 1 producer in Central Appalachia. They have a 20% market share and 30% of the reserves. And they have a long track record of low-cost production.
Q: What about the environmental concerns? Is that a hindrance to these companies ever seeing their full potential?
A: Natural gas is the cleanest fuel, but it is in short supply. For the moment, we have chosen not to increase our nuclear power plants. The only competitive fuel is coal. And Central Appalachia coal is a cleaner coal because of its low sulfur content. We have coal plants in the U.S. that aren't running at full capacity and as they naturally increase their operating rates, it will be very cost effective to add production.
Q: And what else besides Massey do you own?
A: We also own Consol Energy, which is in the northern Pennsylvania coal seam. Massey is more in the West Virginia-Kentucky-Virginia area. Consol is a little bit different story, in that they have a very nice natural-gas unit with low finding costs and a long reserve life, which we think is worth more than $1.2 billion conservatively. They will benefit from some of the same things as Massey. Plus, the management is no longer controlled by RWE, a German utility, so they are doing things to maximize the value of their resources. They are selling some land for mall development and they may be able to take more steps to highlight the value of the natural-gas division now that they are out from under RWE. We own this in size.
Q: Where is Consol trading now?
A: It is about $23.
Q: What kind of potential does it have?
A: Consol could earn $3.60 in peak earnings. And we think Massey could earn about $2.50 in peak earnings.
Q: And where do you stand on natural gas at this point? That was a big play of yours this past year.
A: We actually sold the two picks we had last year -- Burlington Resources and Nabors Industries -- at higher prices this past spring. The stocks were bid up and they hit our price target so we got out. We aren't negative on natural gas. Natural-gas supplies are still tight and will remain tight until liquefied natural gas capacity comes on in 2007 or so. But I also don't think the price is going to go much outside this range it has been in, of $5 to $6 per thousand cubic feet.
Q: IMC Global, the fertilizer maker, didn't work out as well.
A: That was my dog last year, but we still like it and own more of it than we did. The grain story played out as we expected, particularly soybeans. Soybean prices have gone up significantly to about $7 a bushel and supplies are very tight as are supplies of corn and wheat. We are at the lowest inventory levels in probably 20 years so the potential is there for all three to move further up in price. The grain thesis is good and getting better.
What didn't work to IMC's benefit is that diammonium phosphate, or DAP, margins have stayed very, very low. There are three main types of fertilizers: potash, diammonium phosphate, and ammonia. Potash margins have moved up nicely, but IMC is bigger in DAP, and DAP margins haven't moved up. It is typical bottom-of-the-cycle behavior. It is taking longer than we expected. Acreage planted has been going up and will continue to go up. Farmers are going to buy more fertilizer. Demand is good. But we need to get to that magic point where you tighten capacity and get price increases. It is very close. It is just a question of time.
Q: What's another fresh idea?
A: Navistar International. Like some of the others I mentioned, this was a poorly run company for a long time, with high costs in a bad industry. But it has changed. It is going to make money at the trough -- $2 a share. It has gone through a metamorphosis and will be a dynamic investment because not only are its fortunes improving, but people will look at it differently.
Q: How have its fortunes changed?
A: Navistar makes medium- and heavy-duty trucks. We are currently in a cyclical upturn for heavy-duty trucks. The truck industry has been through so much duress and they haven't ordered much in the way of trucks in the last three years. The age of the fleet now is more than five years, which is the oldest its been in about 10 years. Freight demand is picking up.
Navistar itself has gone through a huge manufacturing restructuring. They have fewer platforms than they used to have. They have moved to Mexico for low-cost manufacturing. They just signed a more flexible United Auto Workers contract. They also formed a joint venture with Ford Motor called Blue Diamond to make Class 3 and 4 trucks, smaller trucks, next year. The Blue Diamond venture could significantly contribute to sales in 2007. We expect it to do $1.5 billion in sales by then, up from zero when it was first formed in 2001. It's a new market opportunity for them. Navistar should earn $8 at the peak of the cycle in either 2005 or 2006.
Q: Why Navistar and not some other heavy-duty truck maker?
A: We own Paccar, but Paccar is a little pricier than Navistar. We still like Paccar, but while it's a great company it doesn't have the benefit of an internal restructuring as Navistar does. Navistar will benefit both from the truck cycle and from the restructuring, which will increase its peak earning power. That is why we own a lot more Navistar than we do Paccar.
Q: How does the presidential election next year factor into your outlook?
A: The biggest issue would be a change in administration and the uncertainty that would create. My working hypothesis is that Bush is re-elected because the economy is going to be better. Reining in spending would be a good thing and that is the direction we are going to have to head in. But as the recovery unfolds, revenues will increase and deficits will be smaller than forecast, because people will underestimate the cyclical benefit of the economy. It is happening now. Any discipline imposed on spending will be a positive.
Despite the rise of offshore labor, Americans will have plenty of work
By GENE EPSTEIN
THE OLD, TIRED IDEA that America has only a finite number of jobs -- and that we must guard them zealously against raids from cheap foreign labor -- has been making a remarkable comeback. The only difference is that its upside-down view of the economy has plumbed new depths.
In addition to protecting factory jobs, now there's a move to circle the wagons around a new target -- white-collar work performed by the folks with advanced degrees.
Rarely have so many been asked to protect the privileges of the few. True, the high-speed coaxial cables that girdle the globe courtesy of information technology have opened the gates to a new level of skill -- and new possibilities for offshore labor.
But those who imagine a scarce reserve of skilled jobs that can only get drained by developing nations should wonder why the U.S. didn't run out of them a long time ago. Whatever has been "stolen" by cheap foreign labor is nothing compared with the long history of grand larceny from new technology, rising productivity and changing tastes. But since human desire has no limit, there's always an infinite amount of work to be done. And in this market economy, an abundance of new opportunities.
Over the next 10 to 20 years, in fact, skilled jobs will be on the rise as never before. They will proliferate in nursing, computer science, entertainment, financial services and entire fields that may now be just a gleam in the eyes of the innovative. The upshot: Today's toddlers and teens will be handed enormous opportunities for challenging and creative careers. There should be plenty of work for older folks, too.
At least five broad trends promise to transform the jobs market. Start with three that are nearly certain to occur between now and 2025. The baby boomers will become senior citizens. The labor force will grow at a much slower rate than before. The Medicare system will be hit by a financial crisis of major proportions.
Two others are worth betting on. The IT Revolution, Part 2, is about to begin, with new kinds of information technology developed to serve the needs of the increasingly prevalent "knowledge workplace" -- fields in which brain power, rather than machinery or processes, drive production.
This second revolution will be powerfully reinforced by our fifth and final trend: Spending on intangible capital, or IC -- assets like patents, copyrights, brand names, trademarks and trade secrets -- will continue to grow faster than outlays on tangibles like structures and equipment. That's because of both a boom in products developed by science and a proliferation of niches in the global marketplace.
How will these trends influence the kind of work we do? The major effect will be to boost the share of the labor force with "knowledge worker" in their job description. The growth and development of both IT and IC should bring millions of new recruits to the knowledge workplace.
For example, the number of computer programmers, systems analysts and scientists almost doubled from 1992 through 2002, to 2.4 million. No surprise if another doubling occurs in the decade to come.
But greater investment in intangible capital also requires a diverse range of knowledge workers, including biologists, physicists, nehru-scientists, advertising writers, Web designers and high-end salespeople.
Knowledge workers will also find huge opportunities in serving the aging baby boomers, mainly in health care but also in financial services, particularly since older investors often demand personalized attention. Smart, personable bankers and brokers will be in greater demand than ever before.
Since boomers will have time on their hands, they'll create expanding opportunities for travel agents and gambling croupiers, for actors and directors in film and video, and for experts in Interned-related work.
On the darker side of things, as the elderly population starts growing much faster than the working population, the "dependency ratio" between productive and unproductive people will decline. That falling ratio will spur the unraveling of Medicare, although the inefficiencies and misallocation endemic to the health-care sector will also play a major role.
The boomers, of course, will be hit even harder. One way they'll cope is to keep working for a paycheck far longer than older people do currently. Ironically, the numerator in that falling ratio -- slower growth in the sales force -- will in this case operate in their favor by creating greater demand for their services.
So expect an increase in the average age of retirement, and a huge expansion in temporary and part-time work done by seniors. Firms may spring up that specialize in placing older people.
There may also be rising demand for another kind of knowledge work -- that of therapists, psychiatrists and substance-abuse counselors. The upheavals in health care should cause trauma enough. Plenty of folks may have a hard time adjusting to the strains and anxieties unique to the knowledge workplace.
Next month the Bureau of Labor Statistics will publish its biannual job projections, with 2012 as the target year. The report will include the usual nuggets of insight. It will also remind us of the old joke about economists showing their sense of humor by putting decimal places in their forecasts. Literally hundreds of job categories will be listed, each with its own estimate for 2012 running in the three figures. Moreover, says Peter Francese, founder of American Demographics magazine, the whole approach is static. The BLS would have us believe that no job on its list is in danger of going extinct, and that none it doesn't already know about has a chance of being created.
For example, 10 years ago, no one expected to be able to apply for the job of Web designer. And since November 2002, Amazon.com has employed a "chief algorithm officer."
The future could bring such new job titles as "artificial-brain designer," suggests Leonard Nakamura, staff economist at the Philadelphia Federal Reserve. "Artificial brains," such as hearing aides wired to the gray matter, have already cured deafness. Since blindness, dementia and poor sexual response have yet to be adequately taken care of, ABDs should be in great demand.
Good-Bye to the Butcher
Before venturing further into the realm of tomorrow's jobs, it's helpful to look at the trades likely to fall by the wayside. Among them: butchers, whose work is being usurped by food-processing plants; barbers, who live in the increasingly remote hope that men will desert their hairdressers for cheaper trims; and workers in the farm sector, where productivity just never stops rising.
As for factory jobs, management theorist and futurist Peter Drucker remarks in an interview that they are likely to follow the path of farm jobs. With 14.5 million positions as of November, manufacturing accounted for 11.3% of all U.S. jobs, down from a peak 32.1% in 1953.
Table: Where the Jobs Will Be
Drucker predicts that 20 years from now, manufacturing employment will have fallen to its pre-World War I share of 7%, as robotics continues to make inroads into every conceivable task. For example, "systems integration" proposes to connect the factory floor with the scanners at Home Depot and Wal-Mart, eliminating middle-men between factory and store.
The main cause of past and future job declines is the unceasing growth of productivity driven by information technology.
Yes, cheap foreign labor has definitely contributed, but if manufacturing jobs were really "fleeing" at the rate folklore imagines, we would first have to see a dramatic decline in domestically produced output. After all, whatever foreign labor produces is reported as imports, not as anything produced locally. And if anything, we're seeing just the opposite.
Real domestic output of manufactured goods (measured in terms of value added) has actually been growing faster than the rest of gross domestic product. From 1990 to 2000 -- the last two peak years of the business cycle -- manufacturing rose at an annual rate of 3.7%; real GDP excluding manufacturing, by 3.1%.
Over the same period, output per worker in manufacturing grew even faster than output itself, so employment fell.
The decline of secretarial and clerical work is essentially the same story. The main difference is that no one thinks offshore workers are responsible. Instead, blame e-mail, voice mail, personal computers, cellphones, PowerPoint, Palm Pilots, BlackBerrys and Excel spreadsheets.
The number of clerks in the U.S. rose at an annual rate of 2.4% from 1985 to '92. Then, from '92 to '02, growth slowed to 0.6%, one-fourth that rate. At the end of that period, 14.4 million people were in clerical positions.
For secretaries, it's not a matter of slowed growth, but of absolute shrinkage. Their number peaked at 5.3 million in 1987, and then fell in every succeeding year, to 3.5 million by 2002.
The long-term decline should continue with clerks following not far behind. Here's why:
First, it's only a matter of time before the generational divide in the use of information technology melts away. Among managers and professionals, there's still a rough inverse correlation between age and the degree to which IT is used to do things.
A Midwestern lawyer, age 56, has been ordered by his firm to stop dictating his briefs to a secretary and start composing them directly on a computer. He hasn't complied. How, he asks, can he change his modus operandi after so many years? Eventually, his breed may be extinct.
The second key reason springs from a lead/lag theory: Private use of labor-saving technology leads to government use, in this case, with what seems to be a five-year lag. From 1992 to 2002, a disproportionate share of the increase in the clerical workforce occurred in the government sector; and over the same span, the decline in the number of secretaries occurred mostly in the private sector. The same data also reveal that government has been running about five years behind the private-sector trends in both categories. The onward march of new technology is the final reason to expect a long-term decline in clerks and secretaries. For example, companies are scrambling to develop better voice-recognition software, enabling your personal computer to take dictation with minimal glitches.
As in manufacturing, the high end of these professions will survive. Administrative assistants now do relatively little old-style secretarial work; they've mainly been transformed into knowledge workers. And now that computers can be programmed to decide how information should be sorted and used, the high-end clerical workers will have to know enough to countermand those decisions when necessary.
The Case for Tech Jobs
Speaking of computers, alarms have recently been sounded about the transference offshore of computer analyst, scientist and programming jobs. According to media reports, there's been a flood of such moves lately and it may be the start of an alarming trend.
However, apart from anecdotes, the only evidence the alarmists cite is the jump in joblessness to 5.2% in 2002 for computer-systems analysts, scientists and programmers. But that 5.2% was lower than the overall rate of unemployment. And the total number of jobless technology workers that year -- 2.35 million -- was still below that in any other years, except for the wonder years of 2000 and 2001 at the tech boom's apex.
Not that jobs aren't moving abroad. But in this case also, the high-end will remain. No creative team can function properly when key participants are 8,000 miles apart. Also, new developments are coming so quickly in technology that offsite workers are usually a little behind the curve, says the Philadelphia Fed's Leonard Nakamura.
Because so many people flocked to this industry in the boom years, the shakeout may still be going on. From 1.5 million in 1995, the tech labor force peaked at 2.6 million in 2001 and then began to decline. But another doubling in the next 10 years looks easy. A growing economy will create more job opportunities, but the real turbo-charging will come from new products.
For example, Toshiba has developed a hard drive the size of a quarter, and IBM has built a computer that cuts computing time in half (yet again! for large applications. Big Blue also is offering "on demand" service to firms that don't want to pay for an expensive server.
Moreover, the looming second IT Revolution will require far more effort and innovation than the first. One reason is that so much has to be undone: Many systems now in place aren't very effective at serving either workers or customers.
An expose that was well ahead of its time was published in 1997 by the Palo Alto Research Center of Xerox. Written by PARC researchers Jack Whalen and Erik Vinkhuyzen, it described in harrowing detail a system installed in call centers run by the fictitious "MMR Corp."
In fact, as Simon Head reports in his recent book The Ruthless Economy (2003), MMR was Xerox itself.
At the time, Xerox was using a system called CasePoint for employees who took calls from customers having trouble with their equipment. The employee was a kind of cable connection between customer and computer. With no training in how Xerox equipment actually worked, all he would have to do is click on certain icons based on certain words the customer uttered. Scripts flashed on his screen that he had to recite, while the software was supposed to figure out everything.
But as Head reports, the results were ruinous. CasePoint went haywire whenever customers used unanticipated words to describe a problem, presented information in circuitous steps the program couldn't follow or simply failed to mention relevant facts.
A Xerox spokesman told Barron's that CasePoint has been replaced by a system that gives workers more room to intervene.
More such reforms seem inevitable, giving rise to work for skilled computer specialists. But unfortunately, as Head reports, in many of the over 60,000 call centers in the U.S., employing up to six million people, the employee-as-cable-connection approach is still being used.
Another kind of knowledge work is also on the ascendancy -- diverse specialties that create, research, develop and maintain intangible capital (IC).
Examples of powerful intangible capital abound throughout American industry. The formula for Coca-Cola is a trade secret. Coke ads keep the brand from depreciating. Without their drug patents, shares of drug companies like Merck and Wyeth would be worth a fraction of their current price.
Indicating that investment in intangible capital is on the rise, nearly twice as many patent calculations were filed in 2000 than in 1989. In addition, spending on IC accounted for 40% of nonfinancial corporate overhead in 2000, up from 10% in 1978, according calculations by Nakamura.
The rise of IC also answers the Hollowing-Out Riddle.
The hollowing out of the corporation, which began in the 'Eighties and continued through the 'Nineties, was designed to eliminate layers of middle management. But then, why do managers and executives account for a record share of the workforce -- 15% in 2002, versus 12% in 1989?
A clue is that one of the fast-growing categories in Bureau of Labor Statistics data is "Managerial, n.e.c." -- for "not elsewhere classified." It stood at 8.5 million in 2002, having risen at an annual rate of 3.2% since 1992. Many of these jobs are those of intangible-capital workers. More than likely, the answer to the Hollowing-Out Riddle is that IC work is soaring.
Why? The explosion of new products is one reason. Another lies in the potential of the global marketplace itself. As Nakamura points out, niche markets can now be created that could not have existed before. IC workers now account for about one of eight members of the private-sector labor force, he adds. Among them: scientists, marketing consultants, ad writers and creative people not elsewhere classified. He plausibly predicts that the figure will rise to one in six in 10 years.
Meanwhile, the baby boomers aren't getting any younger. This year, the youngest will be 40; the oldest, 58. So within 10 years, the number of folks 55 and older will begin a growth trajectory that outstrips that of the younger segment nearly fourfold. The number of U.S. residents 55 and older will rise from 63 million today to 83.7 million by 2014, and 101.4 million by 2024.
This army of gray will make staggering claims on the health-care sector. The Bureau of Labor Statistics counted 10.1 million health-care workers in 2002, including physicians (825,000), registered nurses (2.3 million), and a broad category of "nursing aides, orderlies, and attendants" (2.2 million), which includes nursing-home workers.
That 10.1 million represents an annual rate of increase of 3% since 1992. Fast by any standard, but not so fast compared with what's to come, as the boomers become this sector's prime customers.
Cost constraints that are already taking their toll mean that the fastest-growing segment of this workforce will consist of cheaper support staffers. The number of registered nurses actually grew more slowly than physicians from 1992 to 2002 (2.5% a year versus 3%). In fact, it's been estimated that nearly a million new R.N.s must be recruited over the next five years alone.
That's led to higher pay and hiring bonuses for nurses in many areas of the nation, making it more likely that Americans will be drawn to this demanding profession. In addition, the shortage has led the National Council of State Boards of Nursing to decide to offer licensing exams overseas this year. Now that foreign students view nursing school as their entrée into the U.S., the number of test-takers is likely to soar.
For another cost-saving measure that seems almost inevitable, the digitalized results of MRIs and related tests will be routinely interpreted by a specialist in Bangalore or Beijing.
More Work for Seniors
The financial noose will tighten still further as the "dependency ratio" falls. There are now 3.6 workers for every non-working person 55 and over. By 2014, government estimates say, the ratio will have fallen to 3.1 workers for every senior, and by 2024, to 2.4-to-1.
Not that you should believe those forecasts. There will have to be a lot more workers per senior to help prevent a fall in their standard of living -- and many of those workers will consist of seniors themselves.
The 2003 Retirement Confidence Survey of the Employee Benefits Research Institute found that 70% of all baby boomers expect to be earning a paycheck past retirement age. A good idea, under the circumstances. From 2004 through 2013, the Treasury will have to borrow an additional $3.9 trillion to pay for Medicare and Medicaid combined, according to calculations by economist Jagadeesh Gokhale of the American Enterprise Institute, based on estimates by the Office of Management and Budget.
To make matters worse, Social Security will start running a deficit around then. If nothing is done to cut costs or raise revenue, additional borrowings through 2023 will hit $7.4 trillion.
Pressure will build on the health-care system to do things more cheaply, or not at all. Outsourcing firms will seize the opportunity to market new ways of exploiting cheap labor, both locally and offshore. Will there be floating hospitals beyond the nation's 12-mile limit?
Along the way, placing seniors in temporary and part-time work will become big business. Also, companies may institute "phased-retirement" plans in which employees gradually reduce their work time, says Dallas Salisbury, chairman of the Employee Benefits Research Institute.
Finally, about 15 years from now, the boomers will start exiting the stage in large numbers. Deaths per day, which now run 6,700 nationwide, will tack on another 1,000 by 2019 and take off from there.
Nearly 60,000 licensed funeral directors are currently doing business. Won't we need many more?
Author Thomas Lynch, who owns a funeral home in Milford, Mich., believes it all depends on the kind of funeral boomers want. If the no-frills trend doesn't abate, rising demand will probably be met by paraprofessionals. "The actual death rate is still about 100%," he notes dryly. "But we can't get folks enthused about dying more than once, and even then they're not that enthused."
On the other hand, he believes that job openings for funeral directors will remain plentiful. The turnover rate is incredibly high, and probably won't change. Rookies soon find it's hard to get rich in this line of work, but easy to become resentful over having to respond to calls at 2 a.m. to fetch a dearly departed.
But Lynch, who has published a series of engaging essays about his profession, adds that the work is deeply satisfying. When he does his job well, it matters. So the psychic income is enormous.
Of course, other kinds of knowledge work -- ranging from surgeon to teacher to computer programmer and financial planner, not to mention the many jobs yet to be created -- can also be rich in psychic income. Contrary to the alarmism borne of old superstitions, jobs like these should be even more abundant in America's workplace of tomorrow.