STOCK OF THE WEEK: CISCO SYSTEMS INC

STOCK OF THE WEEK: CISCO SYSTEMS INC

NASDAQ SYMBOL: CSCO

One of the original “Four Horseman” of the NASDAQ back in the late 1990’s, Cisco rode the information superhighway to a stock price in the stratosphere. Led by the old technology hand John Chambers, whom made his bones at IBM but left a promising career at Wang Computers to join the online revolution and provide the telecom equipment and infrastructure it operates on; he once predicted that Cisco would be (paraphrasing) “the single greatest company in the history of the world.”

Despite presiding over one of the single largest losses in market capitalization in history, John Chambers remains at the helm. His tenure has actually seen CSCO’s revenues soar from just a little over a billion dollars in 1995 to nearly 30 billion today. Sure there was a bubble for which he cannot be blamed however he can take credit for the company emerging out a stronger, leaner operation.

To this day, Cisco remains a bellwether for the technology space and specifically the telecom equipment space. Its rival Juniper has also done well but enjoys a value of 1/10 of Cisco’s market cap. Cisco also continues to make savvy acquisitions which have boosted its presence in both the enterprise markets and inside of governmental red tape.

As more municipalities, cities and states create public WI-FI hotspots, Cisco will reap the rewards. It is only a matter of time until the entire country is wireless and by then the stock should have recovered much of what it lost. Also consider that many of the large technology companies caught up in the NASDAQ bubble bursting in 2000 are reporting their best and most profitable numbers today—with sounder balance sheets and better educated global workforces.

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Crisis of Confidence

Despite the Fed’s best efforts to shore up the credit market, a “crisis of confidence” remains firmly in place. The mortgage space is still horribly illiquid, as lenders are unable to issue new debt via “Asset Backed Commercial Paper (ABCP).”

I firmly believe that until this sector begins to price closer to its actual value, the stock market will be on hold. Presently AAA and AA rated debt is still trading at junk levels—even causing fear amongst money market managers which a handful have expressed fear that they will be unable to meet redemptions, that would likely spread should a run on the bank occur.

Now is the time for lenders and other financial institutions with heavy exposure in the credit markets to become more active. Countrywide Financial was able to secure a line of credit that will essentially fund all operations, meet debt covenants and help maintain liquidity for several months to come. Their predicament came somewhat as a surprise to participants as only a short while earlier the company’s spokesperson made clear their exposure to “sub prime” loans was less than 5% of their overall portfolio. Let this be a lesson to the rest of the sector that they will be unable to meet reserves with some of the same tricks they used for decades, like swaps and such.

Now is the time to liquidate portfolios, lock in credit lines and focus on staving off any dramatic interruptions to their normal business. Thornberg, much like CFC became proactive last week as well, as they were able to sell a loan portfolio over the course of last week for about $20 billion, helping to reduce leverage and free up cash for operations

Purging stupid, aggressive, speculative behavior in the financial sector is simply a function of capitalism. Only companies like those mentioned above with solid balance sheets are going to be able to get the funding they need to continue without declaring chapter 11. The Fed can intervene and cut rates until they are blue in the face but that will not prevent sub par institutions from going belly up.

If the government or central bank were to go ahead with an airline style bail out, that would prevent speculators and the like from learning a much needed lesson, basically guaranteeing we would see the same sort of wanton behavior occur again in another asset class, though unfortunately on a much greater scale likely to take the economy down with it.

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Capitalism, the Federal Reserve and Purging Stupid People

Capitalism without risk is like religion without sin. Capitalism only works when people respect the risk-reward relationship and have a firm understanding of its ability to purge stupid behavior. A good example of this would be the 2000 market top and subsequent bear market. People that bought internet stocks that were hemorrhaging cash but had a lot of “page views” were annihilated, just the same as certain classes of investors should be subject to today.

First we have the mortgage brokers and lenders, in this case the original sinners. In order to drum up business and capitalize on a booming real estate market they made a lot of really bad decisions. People with $40,000 in income were able to buy million dollar homes (that were not only overvalued), something that is (and should have been) way out of their league. 10, 20 or 50 years ago this was impossible as mortgage companies actually turned people down for loans.

Today the FOMC cut the Discount Rate by 50 bps, left the Fed Funds/ Prime rates alone and basically altered their bias toward the dovish side in reaction to the deterioration in credit and the weakness it will generate. The Fed has also stayed active in the Repo market with an additional $5bil intervention this morning, further attempting to buoy the credit market by adding more liquidity.

It is difficult to be sure whether or not this will work to the satisfaction of the market, or even the bankers themselves. While interest rate adjustments typically take 6-9 months to work their way through the system, the repo activity should be felt first, if and only if lenders pass that on through and ignore the urge to squirrel it away in their reserves above and beyond their minimum maintenance.

I don’t know if the Fed took rates too low in the wake of the 2000 recession and I don’t know if they took rates too high after the economy recovered. What I do know is that the actions of central bankers globally are impacting the risk profiles of market players by mitigating the risks inherent in investing, spurring perhaps an even bigger flood of cheap money into the next asset class looking for funding.

Much like the breakthrough visit to China by the US in the 1970’s, President Nixon and Henry Kissinger met with their counterparts on the mainland. During an icebreaker conversation Kissinger asked Premier Chou Enlai what he thought about the French Revolution. Enlai responded, “too soon to tell.”

Gentle Ben and the “Greenspan Put”

Since Black Monday in 1987 when the market went down 22% in a single day, Wall Street has become accustomed to a proactive, sometimes aggressive Central Bank. Greenspan was responsible for defusing many disasters-in-the-making (and downright carnage during 9-11), namely the Asian Crisis, Long Term Capital, and Russian crisis; with some deft words and proclivity toward intervention.

While Greenspan did provide lots of liquidity via the Repo market in the days following September 11^th, his vehicle of choice for calming down the street was interest rates—often lowering them dramatically—even sometimes unscheduled. Many people confused this as a sign that the Federal Reserve would bail out the markets which may have led to the speculative excesses that brought on the March 2000 market top and subsequent burst of the bubble.

As a result, the extra liquidity swishing around the system seemed to fuel other asset classes, this time in real estate and the bond market (which financed the real estate boom). It almost seems like it’s a big game of “Whack-a-Mole” trying to seek out the next area of froth in the economy.

Chairman Ben Bernanke is not a likely candidate to adhere to the actions of his predecessor. For one, he appears to be far more preoccupied with inflation, which is more in line with the intended (sic) mandate of the Federal Reserve of maintaining price stability. Low inflation is an idyllic setting for a strong economy, but as we have seen— can be difficult to achieve during a war-time economy that is fueling a commodities boom.

Whilst Greenspan presided over an economy underpinned by the service sector, bolstered by huge gains in productivity and supply chain improvement; the Bernanke economy has its roots in manufacturing. The Energy sector represents the largest share of the S&P 500 that is has in nearly 50 years while minerals, transportation and engineering companies have provided the infrastructure for this economy.

Greenspan’s tenure was by in large a peaceful one; although it did extend to 9-11, Afghanistan and the beginning of the Iraq War. The 1990-2000 Bull Market was built upon the “Peace Dividend,” following the end of the Cold War and a relatively quiet decade geopolitically. The United States today is engaged in a two-front war militarily and faces a whole new layer of threats from rogue states like Iran, North Korea, and even possibly Pakistan (as President Musharraf faces a growing internal threat fueled by radical fundamentalists).

Different times call for different measures. The credit market crunch does pose a very real threat to the economy, though cutting rates isn’t necessarily the answer. The government or its central bank shouldn’t be bailing out anybody in a capitalist society, let alone speculators. What the Fed needs to do is send a message to the market that risky behavior will be met with consequences, not a safety net. In many ways, the Fed is responsible for today’s situation as taking rates down to 2.5% after 9-11 created a ton of cheap money, much of which became principal in the sub prime market.

In addition, labor markets are extremely tight and commodities prices are still sky high. Cutting rates now will only help push the dollar even lower, thereby increasing the prices of things like unleaded gasoline, milk and corn for consumers. This will unfairly punish people for the actions of mortgage lenders, hedge funds, commercial banks and others involved in the sub prime home giveaway at the center of the controversy. As it stands, many cattle farmers cannot afford to fatten their animals up with feed and have instead looked to other sources to make up the difference. And where does that cost get made up? Of course the farmers aren’t going to eat it all themselves so they pass it on to the wholesale level.

Consumers are also spending the most money on staples (as a % of their budget) that they have in 30 years. Dairy, vegetable, energy and travel prices are aptly shrinking discretionary dollars from Joe Six-pack, forcing him to conserve. Conservation destroys demand and eventually will lead to an inventory build, decline in output, or both. Either way what you will have is a contraction in the economy. Two consecutive quarters of contraction and you have yourself a recession.

So if the Fed knows what is best for our economy and prosperity, it will not bail out another speculative excess. We cannot allow traders to push markets to the brink of extinction by looking the other way while they are running it up and then providing a cushion for the fall. President Bush understands that we need to let markets correct. Natural market forces will not be deterred; intervening will only put off the inevitable for another day.

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