Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

April 1996

Comet Hyakutake wasn't the only object traversing the heavens during the chilly days of early spring. Clearly visible to the unaided eye, stocks, too, vaulted skyward and appeared to be taking a permanent position among the celestial spheres.

As if 1995 were not enough, U.S. stock prices staged a vigorous upward move during the first three months of this year, breaking records that had often been set just the day before. Foreign equity markets joined in as well. All of this in spite of unsettling developments such as the one-day 170-point drop in the Dow Jones Industrial Average and weak fixed income markets that drove up the rates on long term treasury bonds to about 6.7% from 5.9% at the beginning of the year. But with mutual funds pumping in excess of $20 billion into the equity markets each month and corporate takeovers proceeding at a furious rate, nothing else seems to matter.

Our Enchantment With Equities

While the definition of a bull market tends to vary according to the needs of the definer, it is reasonable to trace the beginnings of the current trend of rising stock prices to the mid-1970s, the period following the calamitous declines of 1973-74. Since nothing succeeds like success, the rising trend over so many years (interrupted at times by sharp, but temporary setbacks) has attracted growing amounts of attention and money. Magazines, talk shows, investment clubs, best-selling books about non-professional individuals “beating the market” (e.g. Beardstown Ladies) -- all bespeak Americans' fascination with investments, especially the stock variety. Recent data on cash movements indicate that the flows into stocks have reached an onslaught of proportions that would have been unimaginable not many years ago. On March 26 it was reported that assets held in mutual funds surpassed $3 trillion for the first time -- nearly one-half was in stock funds. Keep in mind as well that most of this money (indeed most of the money ever invested through mutual funds since their invention) came into the markets very recently --during the last few years. The reaching of another interesting milestone was reported just the next day on March 27: $1 trillion worth of stocks had changed hands on the New York Stock Exchange so far this year -- the earliest point in the year that such a dollar value of trading had been reached. Not only are funds being added to equities with a vengeance, they are apparently being moved around at record rates as well. While there is some evidence that their direct holdings of equities have declined somewhat, it seems clear that, through their mutual funds, retirement assets and stocks, Americans, many of them new to making investments of any kind beyond bank accounts, are now exposed to the equity markets to an unprecedented degree.

It could be argued that there is nothing necessarily threatening to be found in these trends. Demographic changes in the U.S. population imply that increasing amounts of savings will be available for investment purposes. Certainly the idea behind using mutual funds is valid: they permit small investors to pool their resources and gain access to a wider variety of financial instruments as well as professional management -- an excellent solution to the investment problem for many people. And investors in general could do with a larger commitment to equities than has historically been the case because, over sufficiently lengthy periods of time, equities generally do produce better results relative to other types of holdings.

In our view, however, investors must take into account the financial environment in which they operate. Just as a couple of years ago when we admonished our readers to be wary of the widespread complacency regarding security valuations at a time when signs pointed to dangerous levels of euphoria and speculation in the financial markets, we now believe that the gusto with which people have embraced the concept of having equities in their financial portfolios is indicative of an equal disregard for valuation and risk. However attractive equities may be over the long term and however much sense it may make to own them, there are times, such as now, when the valuations are so extreme and the risks so high that this perfectly valid reasoning no longer applies indiscriminately to the commitment of new or additional funds. The enchantment factor only serves to make matters worse: the commitment to equities gets divorced from a process of logically assessing potential opportunities and becomes based on expectations of continued favorable trends, thereby turning what the investing public considers to be an investment process into one that is the equivalent of speculation. Popular strategies, such as buying index funds, also exacerbate the problem since such funds by their nature have to purchase the securities which make up their underlying index with no regard for valuation.

Although a longstanding upward trend has taught newcomers and some heedless professionals alike to either ignore market reverses or use them as buying opportunities, we doubt such resolve could hold out in the face of a really steep market decline, the likes of which have not been seen for over 20 years, or a long drawn-out period of weak prices. Real estate, after all, was for many years viewed as a no-lose proposition until prices became unrealistically high in the late 1980s and latecomers were left dumbfounded that their properties were unsalable at prices even matching their cost. Or more recently in 1993 the complacency induced by economic and monetary conditions widely interpreted to be “the best of all possible worlds” led to high expectations that were quashed early the following year when interest rates unexpectedly rose and many suffered in the bond market collapse and widespread stock declines of 1994. It is dangerous to extrapolate from trends, especially positive ones and ones of long duration. The trend may falter and the enchantment may fade. As Benjamin Graham, the father of security analysis and a great student of human behavior, once observed, “A great bull market has never become a financial institution.”

When dealing with investments, particularly those involving the volatile equity markets, it is always a good idea to give some thought to what the future could bring and be prepared to protect against it. In this light it provides a useful perspective to note that “enchantment” hasn't always characterized the prevailing attitude toward stocks. Surveys following World War Two, for example, showed that 90% of the public opposed buying stocks, despite the fact that businesses were selling on the stock market at steep discounts from their underlying values. Still traumatized by the Great Crash and not yet recouping the losses from the high levels of 1929, investors seemingly preferred the apparent “safety” of bonds yielding less than 3%. Such a state of affairs represented the pendulum at the most distant point in its arc, opposite the current enthrallment with stock ownership. Likewise in the 1970s and early 1980s, when inflation became a more persistent problem in the public consciousness, equities were shunned in favor of things with “real” value, such as gold. It is indeed instructive to remind ourselves that each of these periods of pessimism about stocks was succeeded by long term price upswings that eventually led to outbreaks of investor euphoria -- in the late 1960s-early 1970s and now.

Whether the current enthusiastic embrace of stocks will be succeeded, as was the similar mania in the early 1970s, by an unexpected and painful breaking of the magical spell surrounding the financial markets remains to be seen. As usual we shy away from attempting to predict the future, although we are ready to point to the high level of risk. Despite the hazards it is possible that investors will avoid the ultimate fate met by manias of the past. Perhaps participants are wiser this time. Perhaps the flows of retirement funds are enough to support prices for a long time. Maybe inflation will remain under control. We remain skeptical, however, and would rather defer to the wisdom of Mr. Graham, who, after observing the ebb and flow of emotions and markets over the course of his long career, said, “I refuse to attach a permanence to anything I see around me.”

 

Dennis Butler, MBA, CFA