Centre Street Cambridge Corporation

Private Investment Counsel


October 1998

We have relearned in recent weeks that just as a bull market feels
unending and secure as an economy and stock market move forward, so it
can feel when markets contract that recovery is inconceivable.
–Federal Reserve Chairman Alan Greenspan


The U.S. stock market continued its gradual return to normalcy during the last three months, in the process creating the best conditions for investors that have been seen in many years. A price has been paid, however, for this sea-change. Market participants have discovered the unpleasant effects of a “reversion to the mean” that had been likely to occur at some point after years of far-above-average stock returns. Many now fear that prices will follow the lead of certain foreign markets and overshoot the mean on the downside. That could happen. But rather than speculate on where the market could go, intelligent investors would find their time is better spent studying the values that are appearing as markets are buffeted by the financial storms raging around the globe.

After reaching new highs in July, the major U.S. market averages were down anywhere from 14% to 16% from those levels at the end of September. However, the averages do not paint an entirely accurate picture of what has been happening due to their domination by the favored large-capitalization stocks. As of mid-September, the average stock on the New York Stock Exchange had declined about 40% from its high. The corresponding decline in the NASDAQ market was about 50%. It is not uncommon to find individual companies (in the energy sector, for example) whose shares are down 80%. Nevertheless, some averages were actually up from the beginning of the year, including a 5% rise for the S&P 500.

The recent drop in our market, not to mention the positive year-to-date results, represents a relative bastion of strength in comparison with what has occurred abroad, where some markets have suffered losses of a magnitude not experienced in the U.S. since the early 1930s. Russia is down 90% this year; Far Eastern shares are off 30-40% (Indonesia stands out at down nearly 70%); Turkey has lost about 55%; and in increasingly fragile Latin America, Brazil and Mexico both have suffered over 45% declines (Brazil's stocks have been rising and falling as much as 10% daily). Even Japan, the world's second-largest economy, still finds its market mired at levels over 65% below the 1989 peak. Market turmoil has been accompanied by political indecision, most conspicuously in Japan and Russia, dragging the world's economies into what Treasury Secretary Rubin has called the most serious financial crisis of the last fifty years.

As markets around the world implode, the investment community seems to have rediscovered the concept of risk, as anyone who reads the financial press or brokerage firm advertisements these days can attest. We are a little amused at the sudden change from an emphasis on gains to a concern with possible losses. Is the investor paying $45 for Merrill Lynch shares, as opposed to $109 a few months ago, taking on more risk? Is the buyer who shunned Deere & Co. shares when they were $64 last Spring now being foolhardy by picking up stock for $30? We think not. Not that we are recommending the purchase of these or any other companies. In fact, even after a drop of 1700 points on the Dow Jones average, the market still seems uninterestingly expensive at over 20 times earnings. But turmoil of the magnitude we have experienced tends to bang up individual stocks enough to create some worthwhile values. For patient investors not prone to nervousness, these are good times, indeed.

A Change of Tone

“As dismal news accumulates around the globe...,” began a recent New York Times article. Stories devoted to economic and political crises, falling security prices and steps the investor can take to protect against the above dominate the news: there's just no escaping the doom and gloom.

It seems like only yesterday when the Wall Street party line reflected the optimism of those accustomed to years of good times. True, one or two forecasters warned of the Year 2000 computer problem or excessive bullishness; otherwise, just last spring (an eternity!) it was still onward and upward. A protracted decline in stock prices that shows no sign of reversal has altered the mood remarkably. Gone is the talk of Dow 10,000. “Goldilocks” has disappeared from economic and market analyses. Gone is the notion that investing in so-called “emerging markets” can enhance returns and reduce risk. Questionable now is the long-popular idea that “buying the dips” is a sure way to easy gains. Seldom do we hear about the triumph of capitalism and the opening of markets worldwide and the seemingly automatic prosperity these changes will bring.

Preoccupation with the negative is typical of what happens during a sustained market downturn, at least among those who permit emotion to override reason -- a dangerous thing to let happen in matters of finance. Just as the euphoria-spawned optimism of a multi-year price upswing has been cast into doubt, so, too, a fear-inspired feeling that all is lost will be proven wrong eventually. In spite of financial and political turmoil, human needs will grow along with population. Products will have to move to market. Companies, countries and individuals will all require financing. All will require energy. In short: the economy will grow, a little more slowly at times, more quickly during others. Trends, upward or downward, generally contain the seeds of their own reversal. This is what permits investors who look beyond immediate travails to do well in the long run.

We are not suggesting that one should just ignore the challenges facing the world's economies and leaders; sovereign bankruptcies and hedge fund bailouts are serious business. Nevertheless, these events need to be put into perspective. All fears seem plausible during a time of stress, such as we are now experiencing, and all rumors have a ring of truth about them. But only once since World War One has the U.S. suffered through an economic contraction that wiped out broad swaths of corporate earning power. A repeat of such an event, while not entirely out of the question, is very unlikely. Monetary and fiscal authorities, at least in the U.S., know better than to repeat the mistakes of the 1930s and raise taxes and reign in the money supply during a time of deep crisis. Economic downturns such as the one which knocked nearly 50% off U.S. stock prices in 1973-74 seem more likely. Whether stocks will fall 50% or not remains to be seen, although it is worth keeping in mind that the U.S. markets did reach unreasonable levels earlier this year, just as they had in 1973. While the world economy will eventually work through the current crisis, it is not to be expected that it will end quickly. The problems are complex and require more than just money to fix. Although restoring liquidity is essential, fixing broken and corrupt financial systems is crucial as well; it doesn't make much sense to refuel a car that has run out of gas if its tank has a hole in it. These changes will take time.

Many have now discovered that playing in the financial markets is risky business. We and others argued months ago, while stocks were still rising, that the risks existed even then, especially in the midst of optimism. The time to think about these dangers is not, as Wall Street would seem to have us believe, after stocks have fallen 20 or 30 percent and private investment funds have required bailouts. Investors best protect themselves from untoward events by ignoring short term results and insisting, at all times, that the price they pay reflect an adequate margin of safety.

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Actions Louder Than Words Department: Last April we discussed market observers' interpretation of Warren Buffett's letter to shareholders in the Berkshire Hathaway annual report. At the time, the Dow Jones average stood at 8900 and enthusiasm reigned. Pundits interpreted as “bullish” Buffett's statement that current stock prices could be justified under certain conditions. We pointed out that (1) these conditions were extremely unlikely; (2) Buffett also stated that equities at then prevailing prices offered scant “margin of safety” to buyers; and (3) that Berkshire's Chairman had reduced some of his stock positions. Finally, we reminded readers that it is not Buffett's business or interest to concern himself with market forecasts.

Nonetheless, “Buffett may be turning more bearish” was the response when, at the end of a gloomy and pessimistic week in mid-September, with the Dow at 7900, it was reported that Berkshire Hathaway was holding $9 billion in cash. Such statements are inane and serve to reinforce our view that many if not most Buffett-watchers just don't understand what he does and how his businesses operate. Berkshire's operations throw off such tremendous amounts of cash that it would not take long to accumulate a sizable kitty. Furthermore, Buffett did not make a fortune by buying high and selling low: the idea that he would be “bullish” at 8900 and “bearish” at 7900 makes no sense. Buffett is neither bullish or bearish: he invests when the price is right. Presently, things are coming his way.


Dennis Butler, MBA, CFA