Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

July 1994

Wow, how do you like these news stories?!!

“Dollar's Woes Create a Turbulent Investment Climate: Failed Intervention Could Send Stocks Falling Even More.”
–Wall Street Journal, June 27, 1994
“Overseas Markets Plunge; Near-Term Climate Is Grim.”
–Wall Street Journal, June 27, 1994
“Dollar's Plunge Is Seen Turning The Stock Market Into a Minefield.”
–Wall Street Journal, June 27, 1994
“The flow of money into mutual funds remains spotty, creating doubts about whether the stock and bond markets can do better in the second half of 1994 than they have through the first six months of the year.”
–The Boston Globe, June 30, 1994

Reading this stuff, you'd think that international finance and investments were subject to forces of such an unpredictable and uncontrollable nature that we'd all be better off with our money in mattresses. Funny how when prices decline some people find stocks less interesting. Meanwhile, in the real world, life went on as usual: commuters commuted, babies were born, and so on. Even in investment land things proceeded in typical fashion, with the Dow Jones Industrial Average rising almost 50 points on the very day the Journal articles cited above appeared.

The financial turmoil discussed in our last issue continued into the second quarter of the year. A period of calm led to generally higher stock prices in April and May. However, our currency (also the world's reserve currency, we hasten to add) continued to decline in value, falling to record lows versus the Japanese yen and raising a hue and cry among free-marketeers for government action to prop up the buck (and probably stem their own trading losses). The inflationary implications of a weaker dollar (it makes imports more expensive) and the type of central bank action needed to strengthen it both imply higher interest rates - a no-no for stocks, which were again subject to selling pressure later in June.

That select group making up the readers of our quarterly essays should be smug in the knowledge that this year's market wobbles were predicted in these very pages. Well, maybe “predicted” is too strong a word; “forewarned”, perhaps. Actually, we have complained about high prices for so long that some might accuse us of having a “Chicken Little” approach to forecasting the market. That may not be such a bad analogy. But instead of saying “the sky is falling”, we have simply and repeatedly argued that the sky will fall at some point and it's best not to assume that trees will continue to grow to it.

Although some clouds have gathered this year, the sky is still pretty far up there by our reckoning. In spite of the bellyaching on Wall Street, average stock prices haven't been hurt too much this year.  The S&P 500 stock index returned -3.4% as of the end of June. From its record high in January-February the index is down a little more: in the 6-7% range. To give you some perspective, the S&P 500 fell 37.3% in 1973 and 1974 (the last truly vicious bear market), and its low point during that period was about 45% below its high mark. In terms of valuation the average stock is still quite expensive. The S&P dividend yield, to mention only one statistic, has ranged from about 2.7% to around 6% over several decades, with an average in the 4.0% area. Currently the yield is under 2.9%, a level associated historically with very high risk. As usual, we make no predictions about the stock or any other market. Who can tell? To use a term frequently heard during the first 8 months of 1929, perhaps we really are in a “New Era” when stock prices won't decline very much; when mutual funds will always grow and when market dips, while unfortunate, are nothing more than “buying opportunities.” But we remain as skeptical as ever about such ideas and are as determined as ever to invest based on sound values rather than expectations of higher prices.

UNCERTAINTY is our word of the day. You hear a lot about it these days. There's uncertainty about the dollar; uncertainty about the Fed; uncertainty about Clinton's policies; uncertainty about the market. Wall Street hates uncertainty!

In a strictly scientific sense there may be no certainty at all; but from a practical standpoint the concept is useful in our daily lives. For example, our being certain that the train will arrive at about 6:19 A.M. permits us to order our morning routine and can even help determine where we live and work. But watch how this concept is transmogrified when it is applied to finance, economics and, especially, the financial markets.

“Certainty” on Wall Street typically results from the perception of trends. “The trend is your friend,” as the saying goes. “The market is going up.” “We are in a bear market.” Translated, these statements mean: “The market has been rising and will continue to do so” and “Market declines aren't over yet.” Here, certainty is equivalent to extending lines drawn on stock price charts. Uncertainty, of course, exists when a trend has broken down or when a trend-less situation gives no clue to the “direction of the market.” Sound circular? You bet. We are certain when the market has seduced us into believing in a trend one way or the other and uncertain when we can detect no trend from the squiggly movements of prices. All of this is probably just a reflection of some psychological need to be reassured that the world makes sense, or something like that. The fact is, however, we never know with any degree of certainty what is going to happen to security prices. For those who need crutches, we can offer no comfort. Sorry.

This discussion probably seems like our usual ranting, but there are practical consequences to such illogic. Just a year ago, for example, brokers at some of the big Wall Street houses were urging their customers to pay high prices for European securities (Well, they didn't exactly put it that way.) because European central banks, bonds and stocks would (and they were very certain about this) follow the pattern set by the U.S. beginning in 1990 when Fed easing led to lower interest rates and soaring stock prices. (We point out merely for information purposes that most European markets have fallen over the past several months.) Back in 1982, when we first ventured out onto Wall Street, the markets had been depressed for some time and there was talk of the Dow falling to 500 from its then current level of about 750. At 750 on the Dow the stock market rarely got cheaper - the Depression era was one exception. We all know what happened afterwards in the securities markets. Finally, just recently we noted that 81% of economists in a survey see dollar crises continuing in the months ahead. Surprise, surprise.

In each of these situations, decisions involving real money (usually someone else's) could be made based on a sense of certainty bred by patterns established in the recent past. If nothing else, the last six months have taught us that these cozy, trend-is-your-friend feelings, and the complacency they invoke, can be subject to unexpected and rather unpleasant disturbances. Expectations of continued low inflation and interest rates and a “positive outlook” were quickly replaced by fears about future inflation, rising rates, a declining dollar and a host of other concerns which tend to be ignored during bull markets. But, who knows? Maybe, as some market gurus would have us believe, we are simply experiencing a “correction” in an ongoing bull market.

In these troubled times our clients and readers - by definition an intelligent group - know they can rely on us, like a beacon in a storm, a foundation on bedrock, to thrive on uncertainty. From our perspective (a view shared by vultures and ambulance chasers), uncertainty and - even better - calamity, create opportunity. Institutional investors, who almost by nature are obsessed with what's around the next corner, may dump stocks when the outlook becomes the least bit clouded. Novice mutual fund investors (or, to use our preferred term, “market participants”), as we have seen of late, show an odd inclination to redeem their shares, as in the case of some bond funds, or at least slow down their cash additions when the underpinnings of “investor confidence” get shaky or when stocks don't automatically bounce back from dips. These actions have rattled the investment scene a bit, so, although the market averages haven't declined by impressive amounts, individual issues have literally been trounced, declining by as much as 90% in a few instances. One investment author (who, incidentally, is based in Cambridge) likens these episodes to a pot of stew. While cooking, the ingredients tend to settle into layers: vegetables here, broth there. Stirring mixes everything up.

There is evidence to suggest that our investment activity has picked up of late as opportunities have appeared. This is gratifying to us as our embarrassment over our near morgue-like state of quietude was growing. We have been frustrated as well, watching near-opportunities pull away from us once again. What will the next few months bring? In answer to this question and in closing we can't resist including another quotation, a real jewel of gobbledygook found not long ago in one of the popular business dailies.

“If the Dow can make it over 3720 during this thrust, then I think there is a chance if it holds the low on a test, it will rally back over 3820. However, there's a chance the Dow could break the low and fall further.”

The guy who said this was obviously on the cusp of something: I think it's Wall Street's version of certainty. If the market goes up, it will go up. If the market goes down, it will go down. Don't scratch your heads too much.

If the prices of businesses we understand and like go down enough, we will buy them. If prices rise, we'll have to reassess. You can be certain of it.

 

Dennis Butler, MBA, CFA