Triple Waterfalls: excerpt from Basic Points
John Mauldin's Outside the Box

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Introduction

This week we look at another interesting essay by Donald Coxe, the Global Portfolio Strategist, BMO Financial Group. He is also the Chairman and Chief Strategist of Harris Investment Management in Chicago, and Chairman of Jones Heward Investments in Toronto. Coxe writes a monthly piece called "Basic Points."

This section of the report looks at what Donald refers to as a Triple Waterfall. This is a similar concept that many readers have seen from me before based on the work of Michael Alexander, Ed Easterling and my own research on secular market cycles. A Triple Waterfall is explained and then a forecast for technology and commodities is made. Enjoy this weeks Outside the Box.

- John Mauldin

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Triple Waterfalls: excerpt from Basic Points

Once again, investors are being deluged with bearish arguments. This time, the Street isn't focusing its bearishness on China: it is making the reasonable argument that the global economy can't long withstand expensive oil and a non-expansive Fed. This week's release of the minutes of the FOMC May 3rd meeting showed that the Fed shares the concern about oil slack, but not its fears for the economy. Yesterday's upward revision to Q1 GDP demonstrated that the Fed has reason for its insouciance on that score.

The Fed is much less concerned than the Street about another kind of bubble: housing. Visiting back-country Greenwich last week, we saw that our former neighborhood of beautiful old homes has been invaded by nouveaux riches from the Street who knock those houses down and replace them with 40,000 square-foot monstrosities. We're not sure these are bubbledomes, but they certainly aren't classy homes. Is it a peak when bad taste is unconstrained by lack of the funds to advertise it?

Once more, anxious clients tell us, "We don't believe we can wait for the long term. How soon will these commodity stocks bottom out?"

As computer users advise, when all else fails, read the manual.

Here's an updated version of The User's Guide to Investing in a Triple Waterfall World.

Triple Waterfalls and Their Inverse Corollaries Revisited

Our core investment thesis is the concept of the Triple Waterfall (TW).

It took me more than a quarter-century to develop the TW concept. From the time I entered the business in 1972, I applied the analytical skills developed at university, where I studied Modern History. Since most of my competitors relied on short-term investing strategies, I built my career by focusing on what I thought the economic historians a century hence would write about. Naturally, they would write only about the best and worst things that happened to the markets. The short-term squiggles would draw no attention.

Once I realized that each memorable market move was defined by its best and worst-performing asset classes, the principles of portfolio construction came quite readily.

In the biology of markets, a Triple Waterfall (TW) is a spectacular metamorphosis which takes all or part of three decades. The process is asymmetric: the easy money phase takes close to a decade, followed by two decades of decline, disappointment, and despair.

What a TW gives investors is a set of bookends for the market. In each TW plunge, the precisely-opposed asset classes outperform on a secular basis. One knows what both the best and worst asset classes will be--for years and years.

The process starts with base-building, followed by a sustained move to outperformance based on strong underlying realities. This is the Optimism phase.

Then, with the intervention of intellectuals, the normal ebb and flow of enthusiasm/skepticism gives way to Faith that a New Era has arrived. The upside momentum of the asset class takes on a life of its own that continually draws in new converts. The intellectuals, with their command of the media and universities, excite young people and normally-reserved investors alike into believing that the old investing rules no longer apply, creating a critical mass of enthusiasm that permeates an entire society. As George Orwell lamented in another context, "One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool."

The final orgiastic rush to a previously-unimaginable peak comes when Faith is transmuted into Fanaticism--and becomes a Mania. On the Street, the only voices heard are the Shills & Mountebanks, and they suck the oxygen from the market system, which previously had enough for doubters and critics.

The major characteristics of a TW:

1. Time

Like the aging of fine wines, a TW can't be hurried. The plunge takes a period of time that approximates one-half of the working years of a successful investment professional. That can mean that even an experienced investment manager may have never known a time in which that asset class has had true investment merits. When I finally turned bullish on the base metals, I heard over and over from savvy investors, "But, Don, these stocks have been lousy investments for 20 years! You gotta go back to ancient history to find a time when they were winners." Even though LME inventories of the key industrial metals have fallen, on average, by nearly two-thirds since yearend 2003, the memories of two dreary and/or disastrous decades still cast their shadows on the survivors.

2. Capacity Shortage to Capacity Excess to Capacity Shortage

The essence of a TW is massive capital misallocation. The long period of pain gradually wipes out excess capacity and excess enthusiasm. Once the punishment is complete, the asset class is ready for outperformance on a sustained basis, although by then almost nobody will believe it. In particular, the people who still have jobs in that industry or those members of the tiny, continuously threatened minority who follow it on the Street will be among the last to believe that a new, sustainable boom has arrived. The best investment opportunities come from an asset class where those who know it best, love it least, because they've been disappointed most.

3. Extent

During the long decline, the doomed asset class fully retraces (or even exceeds) the entire gain that it achieved in the first decade of its metamorphosis. Gold peaked in 1980 at $850 an ounce, and bottomed 21 years later at $250. Silver had a nearly-identical pattern. Commodity stocks had a 35% weight in the S&P 500 in 1982, but only 5% when they bottomed out shortly after 9/11. Commodity prices, as measured by the CRB Futures Index, started their runup in 1971 at 98, peaking at 330 in 1980, finally bottoming out in autumn 2001 at 185. The Nikkei capped a decade-long rush from roughly 7,000 to 39,000 at yearend 1989, and is in the process of completing its Third Cascade of Collapse, which should end within roughly three years.

In each of the decades of a TW's life, the best and worst-performing major asset classes within financial markets of the first half of the decade will maintain those rankings for the second half of that decade. That means we already know which asset classes will be the best through 2009--and which will be worst.

The worst performers in the 1970-74 Crash were Nifty Fifty stocks and long-term bonds. The best performers were commodities and nondollar cash instruments. Ditto for the second half of that dire decade.

During the 1980s, the worst performers in each five-year period were commodities and commodity stocks. The best were long-term bonds, financial stocks, and consumer stocks.

In the 1990s, the worst performers in each half-decade were Japanese stocks, commodities and commodity stocks. The best were 30-year Japanese Government Bonds, US stocks generally, but particularly technology stocks. (Japanese stocks and US stocks were opposed to each other in constructing global investment portfolios, because those markets made up three-quarters or so of total global equities. Global investors whose businesses flourished in the 1990s sold Japan and bought the US. Those who didn't couldn't compensate for that bad decision by getting Russia or Brazil right.)

From 2000 through 2004, technology stocks have been the worst asset class. Their opposites--commodities, commodity stocks, great dividend-paying stocks and long-term bonds--have given great to good returns. An investor who sold all tech stocks in March 2000 and redeployed the proceeds across those three inverse asset classes in almost any proportions has had five fine years in the financial markets.

TWs are financial market hubris writ large. Since 6th Century Athens, it has been understood that the gods punish individuals and societies who commit hubris. "New Era" manias are punished proportionately to the extent of their folly. Since no collective financial foolishness reached comparable arrogance with Nasdaq at 5,000, the punishment this time, stern as it may already seem, has just begun. I commend Dante's Purgatorio for clients who want to know what lies ahead for those who believed "The New Economy" was going to enrich retail investors.

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The Inverse Relationship Among the Key Cyclicals

If, as many strategists now opine, tech's travails are over, then it would mean that the commodity recovery was also over, because of the inverse correlation of those two asset classes.

Yes, as cyclicals, these two groups will, at times, trade in the same direction, because their top-line revenues are tied to global economic growth. They are fair-weather and foul-weather friends to each other. Techs as a group are still called, (by the obdurately nostalgic), growth stocks, but their vulnerability to economic slowdowns means that most of them are at least as cyclical as commodity stocks.

That single shared quality is trumped by their inverse correlations:
  • Techs are about the next new thing; hydrocarbons and metals are about stuff that been in the ground for eons.

  • Techs are about huge expansion in unit sales to compensate for falling per-unit prices; commodity companies raise production modestly, except for short expansion bursts when new facilities come on stream; profit gains come from scarcity, not abundance.

  • Techs are about near-perfect competition because there are so few effective barriers to entry; in contrast, to be a commodity producer, you must own and develop mines or oilfields. You can't just work in a garage for two years, issue a fat IPO, and become a formidable competitor to existing companies and existing ways of doing business.

  • Techs sell to OECD and Asian countries, while facing growing competition from China and India; commodity companies still sell mostly to OECD countries, but, at the margin the greatest component of growth in both sales and selling prices comes from demand originating in China and India--whoever produces those raw materials.

  • Techs should be valued on net earnings after charging up stock options; commodity companies should be valued on the basis of free (unhedged) reserves in the ground in secure areas of the world.

  • Techs respond to two cycles--the global economic cycle and the equipment and software replacement cycle. Commodities respond to two cycles--the global economic cycle and the long cycle of the growth of the middle class in China and India. The global economic cycle has probably peaked: the China and India cycle has barely begun.
Because of the powerful, unanimous evidence of market history during TWs, we are deeply uncomfortable with the idea that we should be recommending scaling commodity stock exposure back to neutral levels, even though the near-term technical and sentiment indicators for materials and energy stocks are discouraging.

From a trading perspective, we believe investors in commodity stocks should focus on the prices of the commodities themselves, rather than on the short- term swings in the stocks. We regard the oils and mines as the pre-eminent equity groups for the rest of this decade, but are certainly aware that this remains a minority viewpoint. Investors measured by the month are forced to adjust their exposure when momentum players exit from a sector en masse, but they should be eagerly looking for opportunities to rebuild their positions for the next major upswing. Unless commodity prices utterly collapse, the producers will be building increased internal value even though the market is pricing those shares as if they had never graduated from TW loser status.

The bears say you buy these stocks when the p/es are high and sell them when p/es are low. Since the absolute and relative p/es of commodities as a group have reached today's low levels only a few times since 1960, then the bears' argument, based on the evidence of the TW decades is clear: get out now.

Our arguments:

1. Barring a severe global recession, prices of raw materials are unlikely to plummet as they did in the past two decades, because the gigantic capacity excesses which the TW engendered gradually disappeared amid the despair. It was a great tree falling slowly in the global forest that almost nobody heard.

2. When stock prices fell in those decades, the leading commodity companies were financially distressed. They had little spare cash to buy in their own shares, let alone to buy other companies. Now, with Big Oil and Middle Oil awash in cash, they're already buying back stock, and will doubtless step up their acquisition pace if their stock prices plunge. They know what a barrel of oil in the ground costs to find and develop, and if its price in the Street becomes a fraction of what it costs in Angola or even deepwater Gulf of Mexico, they'll buy where it's offered most cheaply. The same applies to the mining companies, most of whom have financial strength they haven't experienced in decades.

As long as high commodity prices continue to produce impressive earnings for the producers, and their p/es remain at big discounts to the market multiple, these stocks remain superior investments.

And, oh yes, the state-owned oil (and mining) companies of China and India have somewhat longer time horizons than a hedge fund or even a mutual fund. They didn't have the cash to buy anything significant in the 1990s, but they do today.

There might even be another kind of buyer: the private equity firms are experiencing the pleasing pain of having too much cash available for investing. They try to find companies with nice, predictable cash flows, but they're running out of modestly-priced opportunities. Some of the commodity companies are now so cheap that they could attract attention from an unlikely quarter.

The rest of the US stock market continues to trade at high-teen multiples, as if Asian competition and an ambitious Fed didn't exist. The zestful May rally that began when hedge fund worries began to dissipate has been led by tech stocks--the Daring Duds of May. That venture in nostalgia is not the stuff of sustained rallies.

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Basic Points is a publication prepared by Donald Coxe of Harris Investment Management, Inc. ("HIM") and BMO Harris Investment Management, Inc. ("BMO HIMI") for the exclusive use of clients of BMO Nesbitt Burns Inc., Harris Nesbitt Corp., HIM, Harris Trust & Savings Bank ("HTSB"), BMO HIMI and Jones Heward Investment Counsel Inc. (collectively referred to as the "Global Asset Managers").

All rights reserved.

The opinions, estimates and projections contained herein are those of Donald Coxe and do not necessarily represent the opinions of HIM and BMO HIMI as of the date hereof, and are subject to change without notice. HIM, BMO HIMI and the other Global Asset Managers believe that the contents hereof have been prepared by, compiled or derived from sources believed to be reliable and contain information and opinions which are accurate and complete. However, the Global Asset Managers make no representation or warranty, express or implied, in respect hereof, take no responsibility for any errors and omissions which may be contained herein and accept no liability whatsoever for any loss arising from any use or reliance on this report or its contents. Information may be available to the Global Asset Managers which is not reflected herein. This report is not to be construed as an offer to sell or solicitation for or an offer to buy any securities. The Global Asset Managers and their affiliates and respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein as principal or agent. Any of the Global Asset Managers may act as financial advisor and/or underwriter for certain of the corporations mentioned herein and may receive remuneration for same. Each of the Global Asset Managers is a direct or indirect subsidiary of Bank of Montreal. Bank of Montreal or its affiliates may act as lender or provide certain other services to certain of the corporations mentioned herein and may receive remuneration from the same.

Conclusion

I hope you enjoyed this week's letter. To download the complete text of this issue of Basic Points or to listen to Don Coxe's weekly conference call, please visit www.jonesheward.com.

Your looking for the next Triple Waterfall analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 06-13-2005 2:48 AM by John Mauldin
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