“All people are most credulous when they are most happy.”
Here we go again. The financial markets continued their romp during the second quarter, picking up the pace of the rise in prices that began late last year and leading to one of the longest periods ever without a meaningful setback (a “correction” in Wall Street parlance). The popular market averages hit records almost on a daily basis and bond yields -- along with mortgage rates -- are now at their lowest levels since before the Federal Reserve action of last year. Some foreign markets also surged. Mexico's, for example, rebounded as more and more U.S. institutional investors became convinced that the same people that brought you last year's disaster have now learned the error of their ways.
Appearing along with this rise in prices have been the usual signs of excitement that are always dangerous in this business, among them: trading volume -- especially among the more speculative issues -- has been extremely heavy, cash flows into mutual funds have increased, and the market for initial public offerings (where companies sell shares to the public for the first time) has been heating up. With regards to the latter, we made note of one newly public company that had 1994 revenues of $12 million and quickly attained a stock market value of $1.4 billion. What a great time to sell a business!
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We spend a great deal of effort trying to help our readers develop a sense of history with regards to financial affairs, to enable them to put some perspective on what they see happening in the Wall Street realm, and hopefully help them avoid the allure of risky adventures with potentially costly outcomes. For those inexperienced in the ways of Wall Street, it is easy to overlook the fact that little really new ever happens there: mostly just the names and faces change. Indeed, it is a source of endless astonishment for us how, in the investment world, history repeats itself time and again with the same sorts of consequences and apparently little learning from mistakes.
Yes, its history lesson time again. What prompts our latest pedagogical furor is the appearance in the financial press of articles rooting for the continuance of the current bullish action in the stock and bond markets. In particular, a few articles quoting certain “experts” who have implied stocks can be purchased at any price have really riled us up. For example, the Wall Street Journal of June 26 reports that we don't have to be concerned with the “dizzying level of prices today” if only we look out to what will happen over the next 5 to 10 years. This is a comforting thought! No matter what price we pay, the future will bail us out.
Our indignation with such drivel prompted us to recall other readings we had done in connection with our interest in previous periods of market exuberance. In the mid-1920s a couple of books appeared which had a great impact on the investing world, professional and amateur alike. Edgar Smith's Common Stocks As Long Term Investments (1924) demonstrated the superior returns offered by equity investments over various holding periods and economic conditions. Investing In Purchasing Power, by Kenneth Van Strum (1925), offered a statistical analysis of the returns after inflation generated by stocks and bonds, again under varying economic conditions. In his introduction to the latter book Professor Irving Fisher of Yale University, a prominent academician of the day, concluded that “the moral of [the] book for the conservative investor is that he must not be afraid to invest largely in common stocks.” By themselves such studies were innocuous and contained some perfectly valid conclusions -- over time equities do offer superior returns. However, in a time of general economic growth, optimism and market enthusiasm, they were used in arguments for paying ever higher prices and fed the rising speculative fever of the latter half of the 1920s. The debate progressed logically to an article written in 1929 entitled “Everybody Ought to Be Rich”, in which John J. Raskob, a well-known Wall Street personage at the time, maintained that it was easy to attain wealth simply by investing a small amount each month in “good common stocks.” Subsequent history proved it's a lot harder to get rich than it seems in the midst of high-spirited bull markets. As an aside, also in 1929 the above-mentioned Professor Fisher proclaimed the New Era: stock prices “have reached what looks like a permanently high plateau.”
We do not intend to imply that we feel a great crash is imminent. As in previous letters we merely point out that evidence of a combination of incautious behavior and high valuations puts us on guard. And valuations are quite high now: our work indicates that the average stock is overvalued to the tune of 20% or better when viewed on a long term earning power basis. The point is that no one can consistently predict how long trends will continue and a lot of surprises can happen in 5 or 10 years. High prices reflect confidence that trends will continue and that there will no surprises. Credulity indeed! In fact, unless one is an institutional investor operating according to imperatives which really have nothing to do with investing, there is no need to pay high prices. Other than the wisdom of keeping funds in some form other than cash, there is no compulsion to invest at all.
The rise in the market averages we have seen this year has been accompanied by a tremendous run-up in the share prices of almost any company having anything to do with high technology. Even the largest, most entrenched companies have seen their market valuations double or triple in the space of 6 months. These types of stock-buying frenzies eventually feed on themselves as the institutional, relative-performance crowd piles into the popular issues in its attempt to keep up with the Joneses. Even some of the larger, so-called “diversified” funds now sport huge allocations to the volatile technology sector -- not exactly appropriate for widows and orphans, in our view. Given the big exposures of some of the largest mutual funds, the question naturally arises: What happens when they all try to get out? After all, we are talking about tens of billions of dollars of investments -- not everyone can exit at favorable prices should the need arise.
Fund managers' responses to such concerns have been interesting. One recently expressed confidence that he will have sold out by the time that Wall Street's perception of technology changes and prices decline. The manager of the largest growth fund, who has invested 45% of its assets in high tech, said: “I'm not going to tell people what I'm doing.” Yet in almost the same breath he added: “Whereas technology shares have done well over the last year, now I feel cyclicals are poised to do well over the next year.” We would also point out that this same fund manager was very open in discussing his activities some months ago shortly after he had placed his bet on technology. Caveat emptor.
As conservative investors with a fetish for doing boring things, we confess to being more than a little leery of owning businesses involving technology much more complicated than a can opener, since we prefer not to be in a position where we absolutely have to be right about something or disaster will ensue. Having to explain to our clients a year later why such and such a gadget didn't work or was obsoleted is not something we wish to worry about. To be sure, it may be possible upon occasion to purchase small amounts of shares of companies in these businesses, but even then we are cautious and, besides, that time is long, long since past in the current cycle. Speaking of cycles, in keeping with the historical theme of this letter, we see in the current technology craze certain parallels with the one in 1983 when excited Yuppies would stop by their brokers' offices on the way to work, checks in hand, with orders to purchase whatever happened to be on the “tech stock of the day” list. The débâcle that followed, during which many companies with “promising technologies” were extinguished along with their stocks (proving that the future doesn't always bail you out), seems too great a precedent to ignore.
We find it increasingly difficult to acquire appropriate investments for our clients in the current environment. While ever watchful for the unusual instance -- usually caused by institutional stupidity -- the general excitement tends to inflate all issues rather indiscriminately. Consequently, our activity has remained subdued throughout the year. Since we choose not to participate in silly, short term-oriented institutional relative-performance games, we are not too concerned about this state of affairs. Cash does not burn a hole in our pocket and money fund or treasury bill yields in excess of 5% aren't bad until better opportunities turn up. We'll wait.
Dennis Butler, MBA, CFA