Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

January 1996

Stock and bond prices rocketed even higher during the last three months of the year as expectations of falling interest rates, robust earnings and hopes for a political settlement in Washington, D.C. added fuel to the speculative fires that had been burning brighter over the course of the year.

The U.S. financial markets staged an impressive advance in 1995, providing holders of the most popular stocks with total returns of approximately 37.5%, one of the largest gains in history. 1995's run-up was all the more notable since previous ascents of this magnitude have usually occurred on rebounds from market washouts (the case in 1974-75), or after extended periods of weakness, as occurred during the late 1970s and early 1980s. Many stocks were weak in 1994, but the year was hardly a catastrophe for shareholders (compared to 1973-74 when share prices fell over 37%), and with the sole exception of 1991, prices had been advancing smartly for several years previous. Such was the strength of the buying last year that the averages reached new highs on fully 69 occasions throughout the year and the popular, though narrow-gauged, Dow Jones Industrial Average pushed through two new millennium marks. Even airline stocks, notoriously variable and unpredictable, had their day in the sun. Prices rose in a remarkably steady fashion as well, with setbacks amounting to less than 4%, making for one of the least volatile years on record. Bonds, too, found eager buyers after a truly disastrous year in 1994, causing interest rates to fall to levels last seen in 1993.

 

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After a year such as the one just concluded, we once again find ourselves in the position of being fresh out of ideas, for, being buyers of undervalued securities, higher prices by definition limit the available choices. How long this state of affairs will go on is beyond our ken, but we are certain of an eventual return to sanity and the reappearance of good investment values, just as we are certain that the total underlying value of American business did not suddenly jump by over one-third in a single year, an interpretation that the recent stock market action would lead some people to make.

What to do? Not being “market-timers” we are no more likely to advocate taking profits and running than we would buying more stocks simply because we felt prices were going higher still. Much as we complain about them at times, high prices do not really make us nervous. They happen. Since we own businesses -- ones we feel we understand and believe will do well over time -- and are not too concerned about short term market fluctuations, we are not always inclined to sell just because prices are up. Since we find very little to interest us in the way of new purchases, we will content ourselves for the time-being with doing very little while keeping a watchful eye open.

 

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For anyone with an inclination to collect factoids, we'll offer this one: the average holding period for 30-year treasury bonds is about 90 days. To see why this is so and why we find the current market environment somewhat alarming, let's review a little history.

In our Commentary of two years ago, at a time when market conditions were in some ways similar to the ones we see now -- high prices, optimism over interest rates, earnings, etc. -- we discussed how some rather racy behaviors signaled the existence of a disturbing level of speculation taking place beneath the surface of a relatively benign-looking investment scene. Among these were the activities of certain investment organizations known as hedge funds that were employing large amounts of leverage (debt) to place bets on the direction of interest rates. A favored way of executing such a strategy is to use treasury securities (due to the ease with which they can be traded); hence, the short holding periods for the 30-year bonds. This strategy worked well as long as the interest rate structure did not change. Unfortunately, it did, and huge sums were lost in 1994 as these bets went awry and bonds had to be dumped on the market at a loss.

Since we try to enlighten our readers in the ways of players who thrive on the excitement of bubbling markets, and to point out the implications of such activities for investors, it should come as no surprise to learn that the same game is being played now, only the mechanics of the trading operations are slightly different. Traders have added a new twist: they are taking advantage of Japanese authorities' attempt to stimulate their economy by cutting interest rates, in some cases to as low as 0.5%, by borrowing in Japan at little cost and using the funds to make bets in the U.S. market, in the process compounding their exposure to potential losses with currency risk. Obviously, Wall Street is home to some creative people, but they seem to have forgotten the pain caused by speculation run amuck, both for themselves and the markets in general.


As in 1993, there were other signs of excess last year. New security issuance and insider selling reached high levels once again -- usually a good sign of lofty prices and, therefore, heightened risk. Initial offerings of new companies' stocks drew intense buying interest, in particular when the company had “tech” somewhere in its name. Internet and related concerns saw their share prices soar to multiples of their offering prices in the first day of trading. Little was made of the fact that some of them suffered from a dearth of revenues. Even less attention was paid to the matter of earnings, which were nonexistent in most cases. The entire high technology sector, from semiconductors to cable connectors, showed signs of being caught up in a speculative binge as institutional money managers of all stripes looked to these companies -- Intel, Micron Technology, Microsoft and a host of others large and small -- as an engine of growth for the American economy and a source of outsized investment returns for their funds. Such was the feeding frenzy in high technology that at one point in the year the stocks accounted for over 25% of the returns achieved by the market averages.

Although the equity markets, as usual, grabbed most of the headlines, bonds had their moments as well. Corporations took advantage of low rates and ready buyers to float new issues and pay off older, more expensive ones. But in the midst of this normal kind of activity there appeared, after a few years' hiatus, the 100-year bond, a frothy market security if there ever was one. Although not many issues of this type of debt instrument came to market, one that did was of interest since the company that sold it is a media conglomerate whose debt ratings are only a couple of notches above the “junk” level. Seeing things like this reminds us of reading about some long since forgotten railroads which, during a similar period of business optimism in the 1800s, found willing buyers of bonds maturing in a century.

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Meanwhile, as technology stocks boomed and mutual funds attracted increasing amounts of cash from a public entranced with visions of high returns, the average dividend yield on stocks fell to historic lows. This and other standard valuation measures pointed to an overheated market. Only by making optimistic assumptions about earnings and interest rates -- future prospects -- could one justify paying the prices that had been reached in the bull's romp. We will repeat what we have often said in the past: paradoxically, it is during those times when optimism is abroad, when certainty seems greatest and when the view to the horizon appears unobstructed, that investors should be the most cautious.

 

Dennis Butler, MBA, CFA