Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

January 1998

The best advice I can give today is don't buy this market. Don't buy any single stock anywhere in the world.
                        - An equities strategist in Frankfurt, October 28, 1997

Owing to its brief life span, the fruit fly has proven useful to science in the study of heredity. In a similar fashion, it would seem that Wall Street, renowned for its fleeting attention span, could be used as a sort of living laboratory to study the psychology of popular passions, changing emotions, and opinions. Financial history is replete with noteworthy examples of shortsightedness and lapses of institutional memory, perhaps due to in-breeding within the investment community. Look at what happened during the final quarter of 1997, for example.

The last three months proved to be one of the most interesting periods in recent memory, at least in terms of its entertainment value. Stock price declines reached 10% in the U.S. for the first time in several years, and foreign market retreats were in some cases much, much greater. Interestingly, prices have not quite recovered from the October chaos, although soon before its onset some on Wall Street had argued that quick rebounds from such drops were becoming the rule: after all, stocks required only seventeen days to recoup their losses following last Spring's 9.8% set-back. Also worthy of note was a report appearing one month before the “crash” detailing the growing appetite for U.S. equities among foreigners. As the old saying goes, “Foreigners never get in at the bottom.” We never did quite understand the mad rush to send money overseas. At any rate, American investors, after years of “buying the dips” in U.S. stocks, should find invaluable lessons in that experience when dealing with such markets as Thailand and South Korea.

 

The Death of Gold

One of the more popular investment-related publications to appear in recent years is a book entitled Classics: An Investor's Anthology. According to its editors, the volume contains essays that represent “the most interesting ideas and concepts from the literature of investing.” The authors represented include most of the important thinkers and practitioners of the century. Curiously missing from this compilation, however, is what we would argue is one of the most interesting articles ever written about investing, the notorious “The Death of Equities,” published in Business Week in August, 1979: notorious because it appeared at a time when equities were far from dead and were, in fact, extremely attractive investment vehicles; interesting because it provides important lessons for serious investors on how not to react to market situations and prepare for the future.

“Death of Equities” reflected the painful experiences investors suffered through during the 1970s, when high and rising rates of inflation and interest rates created havoc for Wall Street. In the 1968-1979 period, inflation ran at an annual rate of about 6.5%. Over that same time frame, stocks returned only 3.1%. Other assets proved better hedges against the currency debasement. Single-family housing increased 9.6% in value annually; diamonds 11.8%; and gold returned an astounding 19.4% per annum following its deregulation in 1971. Not surprisingly, investors turned in increasing numbers to hard assets such as gold to protect their savings, as well as to new financial products -- including CDs and money market mutual funds -- that provided high current yields.

The article gave vent to the prevailing pessimism over whether stocks would ever again regain the popularity they enjoyed in the 1950s and 1960s. During the 1970s the total number of shareholders had fallen by seven million, while the average age of those remaining rose as stocks were increasingly viewed as not being “where the action's at.” Between 1970 and 1975 the number of shareholders 65 and older increased by 30%; those under 65 fell 25%. The portion of investors' money allocated to equities also declined. Pension funds that had put 120% of new cash into stocks in the late 1960s (by selling bond holdings), now put only 13% into the equity markets. Of total assets in mutual funds ($65 billion) $22 billion were in money market funds. Stocks made up less than 50% of fund holdings, down from over 80% at one time. So-called “alternative equity” investments were growing rapidly. Trading in futures contracts, for example, grew 36% from 1977 to 1978 alone. Trading in options contracts grew from 1.1 million in 1973 to 57.2 million in 1979. In a view eerily reminiscent of the early 1930s, many investors had concluded that “the stock market represents speculation,” as the largest returns achieved during the previous ten years (including those of “safe” money market funds) had come from “taking the fewest risks.”

Remarkably, stock prices that averaged 60% of asset replacement value provided no incentive to buy (except for other corporations, which had embarked on an unprecedented takeover binge). A few observers did recognize the opportunity that existed in front of everyone's noses. In 1979 Warren Buffett wrote in Forbes that “stocks now sell at levels that should produce long-term results far superior to bonds.” For investors willing and able to look beyond the pain of the recent past, there had seldom been better periods during which to load up on equities. As Buffett concluded, “Those now awaiting a ‘better time’ for equity investing are highly likely to maintain that posture until well into the next bull market.” But most market observers and investors, apparently, were not even willing to wait for a better time. They had concluded that equities were dead, and unlikely to be revived.

Moving ahead eighteen years, what a difference a bull market makes! Equities not only revived, but with a vengeance, while gold, one of the “hard” assets so favored in the late 1970s, has actually produced negative returns since 1979. Likewise, the pleasure of owning stocks and the pain of owning gold have produced attitudes toward each asset that are polar opposites from the earlier period. Stocks now are the asset of choice, necessary if investors are to meet their retirement goals. Gold, now “dead” as a store of value and hedge against inflation and calamity, provides no return and has no place in our portfolios. Everyone from central bankers to speculators seems to be beating a hasty retreat from the metal, and mutual funds specializing in gold stocks are closing down. The remaining diehards tend to be old timers who, like the loyal stock investors of the 1970s, seem unable to abandon an old friend.

In Wall Street it is generally wise not to do what everyone else is doing. In this case, we think it would be instructive for investors to challenge the current consensus about equities and gold. The average equity now yields less than 5% on earnings versus an historical average of 7-8% (13-14% at market lows) and high-grade bond yields of about 6.8%. Other traditional valuation measures such as dividend yield or price to book value also suggest that stocks are quite expensive. The prospects of achieving acceptable long-term results from equities at such levels would seem far from assured. Gold, on the other hand, now sells for $280-290 per ounce, down from about $370 a year ago, above $400 in 1996 and an all-time high of $875 in 1980. Gold company shares are similarly depressed. In fact, investors can in some instances now purchase gold on Wall Street for less than the cash cost the companies incur in producing the metal. Like life insurance, which is cheapest when it is least likely to be needed, insurance against inflation and financial distress --gold -- is now very cheap because the consensus holds it is not needed. Following the same path that corporations took in the late 1970s, gold companies themselves recognize the values that are available and many are studying acquisitions of other companies in the current depressed environment. We would caution that purchasing gold (an asset with few real uses) in any form is very different from purchasing equities representing businesses that produce needed goods and services. Furthermore, volatile commodity prices can remain depressed for distressingly long periods of time. However, as sometimes happens in Wall Street, death is not necessarily a permanent condition.

 

Dennis Butler, MBA, CFA