Dear Clients and Friends,
We received an unusually high level of
questions and responses to our latest Stock Market Update, so we thought it
would be helpful to summarize these questions and our answers for all our
clients.
How much longer will this bear market
last?
The market break started April 2000, so it's
already been 18 months. Bear markets can be as short as 3 months
(October-Dec 1987) or longer (1973-4 bear market was 22 months.) Normally,
we would be concerned about September because of pre-annoucements and October
because of mutual fund tax loss sales. This year pre-announcements look
light because companies have aggressively talked down earnings earlier this
year. Indeed the best new recently is that companies like Cisco and Intel
are affirming that their lowered guidance looks to be on target. Last year
was particululary vicious for tax loss selling because many mutual funds had
realized large gains earlier in the year. This year, we think that tax
loss selling will be muted (47 of the top 50 funds as ranked by Morningstar a
year ago are showing negative returns and therefore have few gains to
offset.)
The biggest weight on the market right now is
mutual fund redemptions (funds selling stocks to meet shareholder
withdrawals.) Any evidence that the market had truly bottomed (and we have
already been faked out twice in the last year) would cause cash to pour back
into stocks. Earnings estimates for this quarter show average declines of
17%, and declines of 4% for the quarter ending December 2001. Preliminary
estimates for 2002 GDP are currently at 3.1%, up from the most recent 0.2%,
which should drag earnings growth back into positive territory. Valuations
are fair with a current P/E of 20 on the S&P 500 - high compared to the
bottom of previous bear markets but not out of line in the context of continued
low interest rates. Visit the Dismal Scientist Stock Market Valuation
model at http://www.dismal.com/cgi/stocks.asp.
Even with no growth (0%) in earnings over the next year and the yield on the 10
year rising to 5.5%, the S&P 500 is undervalued by 10%.
What is the worst case scenario?
The worst case scenario is a situation where stocks
don't make new highs for a decade, for example, 1929-39 during the Great
Depression, more recently between 1965 and 1982 including the vicious 1973-4
bear market, Japan from 1989 to present. The standout factor of those bear
markets was a period of economic and societal transformation (during the
Depression, from a primarily agricultural to manufacturing economy, in 1965-82
from manufacturing to services.) The current Japanese malaise stems from
the inability of Japanese political and business leaders to manage the
transition from a manufacturing to a services based economy.
The current bear market in the US is driven by a
sharp slowdown in corporate spending after a period of intense capital
investment. Corporations are little inclined to increase spending in light
of a capacity glut. However, inventories are lean and manufacturing is
already picking up replace stocks. Our society does not have to be
transformed in order to move beyond this bear market.
Why haven't the Fed cuts worked?
The recent series of Fed cuts is the fastest and
deepest on record, yet we see little benefit so far. As described above,
corporations will not spend to increase capacity right now, now matter how low
rates are. They will spend as demand increases. Many corporations
gorged on technology in the run-up to Y2K and in response to the Internet.
Within 1-3 years, those hardware and software purchases will become
obsolete and we'll see another wave of tech spending.
The primary reason why consumers borrow is for
housing. Mortgage rates have been falling for 1 1/2 years and are
currently at a multi-year.
30 Year Mortgage
Rate
Consumers have taken advantage to refinance, which
put more disposable income in their pockets now (much more so than the tax
cut.) Low rates also make housing more affordable which is why house
prices rose 8% over the last year (ignoring special case markets like New York
and San Francisco.)
So bottom line consumers are still spending, albeit
with discretion, while businesses have cut back sharply. The net effect is
a barely growing economy.
Is President Bush and the Republicans responsible
for the lagging economy?
No, the economy was already heading south by
mid-summer 2000. In any case, modern presidents have little direct control
over the economy. 1/3 of the budget is transfer payments (Social Security
etc.), 1/3 is defense spending, 1/3 is long term government commitments.
The President has little ability to increase spending to stimulate demand.
The tax cut will have little impact on the economy because most people can't
figure out what their gain will be (unlike the benefit of refinancing a mortgage
at lower rates.)
Is the Fed responsible for the lagging
economy?
The Fed (along with most investment strategists
including ourselves) underestimated how sharply the economy would contract in
2001. Aside from dropping rates 7 times, the Fed has also pushed more
money into the economy by increasing the money supply at the fastest rate in a
decade.
In 1994, the Fed was concerned about a flair-up of
inflation and reduced the money supply. Less money means less demand for
goods which lowers the inflation rate but also drove the economy into
recession. This time around, the Fed is trying to head off an actual
recession. In a climate of low inflation, the Fed has the leeway to
sharply increase the money supply.
Is there any good news at all?
Energy prices, particularly oil, are flat to
lower. The summer of brown-outs failed to materialize in California(we
said back in April that crisis would be self-correcting.) There's much
less risk in stock market investing coming out of an economic slow-down than
when the economy is running flat out as we saw last year.
Should we cancel automatic mutual fund
deposits?
Many of our clients have automatic mutual fund
purchase programs in place. Although it's annoying to see purchases from
earlier this year showing a loss, these clients are buying more shares with the
same dollars, and will have a correspondingly bigger return when the funds turn
higher.
Should we sell equities and buy treasury bonds? or
go to all cash?
We've had many requests to sell equities and buy
treasury bonds. This is the equivalent of selling low and buying
high. Bond prices have rallied as a flight to safety over the last year
and will fall when equity markets recover. To buy the ten year treasury
today locks you into an annual return of 4.85% which is to say breakeven after
taxes and inflation. Other clients have asked us to sell stocks now, leave
the proceeds in cash and then buy back into the market later this year.
Most sales would incur capital gains in taxable accounts, however, leaving the
client with less than they thought. Generally any company we buy
we're planning to hold for five years, which means we're looking beyond the
current slowdown for better performing companies. Lastly, once the rally
starts, it could be explosive to the upside as we saw in April this year.
So we may leave 10-15% on the table just in the time it takes to get
reinvested.
Should we implement a stop loss
program?
In bull markets, a stop loss program generally
takes you out of stocks right before big rallies. In a bear market, we
suppose this strategy would have taken us out of quite a few of our companies,
but then we're stuck with paying taxes and the problem of when to get back
in. We haven't ever figured out how to do these short term moves
successfully.
Why are corporate bonds and bond funds doing
badly?
Even though government bonds rates have been
falling, investors have been shunning corporate bonds which has driven prices
down and yields higher.
Credit Spread*
*
= 10 yr BB2 rated industrial bonds minus yield on 10 yr
Treasury.
This chart shows the gap between
treasuries and corporates widening. We think a yield of 8.65% on
corporates is pretty attractive, but the market doesn't see it that way right
now (the concern is that the slow economy will cause more corporations to
default.) We'll wait and see for now.
What would we do differently next
time?
We plan to keep to our strategy of investing in the
fastest growing sectors of the economy - technology, healthcare and financial
services. This past decade's investment in information services, inventory
management and demand forecasting hasn't eliminated the business cycle, and
appears to have made the economy more volatile. We will adjust our horizon
in terms of how quickly the economy can change direction. Our
clients haven't experienced the catastrophic losses that other investors have
seen over the last year, but we are always looking for ways to do a better
job of capital preservation in the next bear market.
As always, we are available to discuss client's
individual situations.
