Broker Check

Quarterly Newsletter April 2003

Quarterly Comment| April 2003

It was a difficult first quarter, with virtually every equity asset class showing losses. Uncertainty over the prospect of war with Iraq was a drag on the markets through most of the first two months, followed by further unrest over the progress of the war as the quarter came to a close, with a brief but strong rebound in between during the first week of the invasion. Most indexes showed losses in the single digits, with large-caps outperforming small caps, and growth stocks—led by the NASDAQ—outstripping value stocks across the market-cap spectrum. Junk bonds did well, besting both stocks and investment-grade bonds.


It's no secret that investor psychology has a material impact on financial market volatility over the short run. Many stock pickers are fond of pointing out that the huge volatility in the prices of individual stocks over any given year doesn't reflect the actual change in value of the underlying business. Stock prices are volatile; business values are much less so. Stock price volatility does reflect change in what investors are willing to pay for a share of those businesses. What impacts these perceptions of value? In some cases there are developments that are material to the fundamental operations of the companies. But more often it is emotion that impacts those perceptions. When investors are driven by greed they tend to downplay risk. Conversely when investors are driven by fear, risks are overblown and the positives are downplayed.

The last five years have been among the most amazing in financial market history. Not only have we witnessed a greed-driven "bubble" environment on par with any in history, we've also watched its collapse. It is important to understand that the bubble was not simply a reflection of overvalued stocks. The greed that inflated stock prices permeated the economy in a variety of ways. Because rational thinking was not in evidence as the late 1990s moved toward the new millennium, it is not surprising that there were other excesses that developed and are also now being addressed. Corporate governance abuses, debt levels and the excess capacity present in many segments of the global economy are in various stages of reversal.

As I've watched this period unfold, the evolution of investor psychology has been fascinating. Emotion is alive and well and fueled not just by the financial media, but also by the Internet and e-mail. Unsubstantiated stories, rumors and analyses from sources lacking in credibility spread like wildfire. One of the most surprising developments is the psychological swings of people whom I consider to be very financially sophisticated. I’m personally familiar with a number of investors who were not concerned about risk in early 2000 but instead were more concerned about keeping pace with or beating the market averages in a wild bull market. Now these same investors are concerned about risk and are interested in reducing equity exposure. Perhaps their desire to reduce equity exposure will prove to be wise, but the quality of their risk assessment must be questioned given the fact that at the start of the bear market (when risk was highest) they were bullish, and they have now become risk averse after the stock market has lost almost 50% of its value.

In light of the events of the last few years this is a good time for all investors to be intellectually honest by thinking back to their view of risk and return in early 2000. If views were detached from reality back then, what does that suggest about the wisdom of trusting an emotional point of view today? This is exactly why it is so important for investment decisions to be made in the framework of a process that is consistently applied and is as far removed from emotion as possible.

Staying Rational


An investment process should lead to decisions based on rational and realistic analysis. It doesn’t ensure that all decisions will add value but the process provides a framework for being right more than we are wrong, thereby adding value over the long run. The foundation of the process is valuation analysis. However, the truth is that valuation analysis is an uncertain business. Moreover we know that all valuation analysis is a crude tool, not something that has value as a precise prediction of return potential. Nevertheless, despite all this uncertainty, I do have a high level of confidence in the analysis I use. In addition to using various valuation methods, I also consider feedback about the opportunities at a stock-picking level that I hear from stock pickers whom I believe are intellectually honest. However, despite all the research the truth is that we can never be 100% sure about our valuation analysis.

At present, the valuation work suggests that equity-type assets such as stocks, high-yield bonds and REITs all fall into an undervalued range—though none fall into the extremely undervalued range.

Honest Risk Assessment-What Could Make Us Wrong?

Having high conviction isn't the same as being 100% confident in the outcome. One hundred percent certainty does not exist in the investment business. An important part of our investment process is thinking about what could make us wrong. This critical exercise helps us to assess risks and to maintain a high level of intellectual honesty. At any point in time there are many risks present. Again this is the nature of the business. The world is unpredictable and we deal with incomplete information. As part of our job "to stay rational" we must be aware of as many of the potential risks as possible and assess their probability and magnitude and take them into account in our portfolio construction. The objective is to manage, not avoid, risk because avoiding risk also removes return potential.


The problems we have now seem to paint a grim picture. However there are two very important points to keep in mind.

The first point is that there are always risks and worries, though years later it is not easy to remember how troubling they were at the time. As an example, it is somewhat surprising to look at data from the early 1990s and see the similarities between then and now. The Leuthold Group recently pointed this out quite effectively:

  • After first turning up, the Index of Coincident Indicators temporarily weakened after the 1990 recession ended—just as has happened recently.
  • Business confidence was very weak. Corporate executives were very negative well into 1992 (the recession ended in the first quarter of 1991). Sounds like 2003.
  • Consumer confidence didn't bottom until a year after the recession ended—another similarity. (An interesting aside— ow conow low low low consumer confidence has been an indicator of excessive investor pessimism and has strongly correlated with  a                 a good entry point into the stock market).
  • There was a lot of concern about debt levels in the early 1990s and consumers supported that concern as they decreased debt through the end of 1992, almost two years after the recession ended. Yet the economy was able to recover as consumer spending still rose.
  • Employment (payrolls) didn't improve until a year after the end of the recession.

It is also important to point out that there were other concerns in the early 1990s. A major concern was that the U.S. economy was simply not competitive and would continue to give up ground to the Europeans and especially the Japanese, who were viewed as the world's future economic power. That was obviously way off base. There were serious concerns about our budget deficit. And there was the Savings and Loan crisis and what was viewed as a sizable bailout. And as 1991 started we faced a war with Iraq that, in retrospect, was anticipated with a remarkable lack of confidence. Weak stock markets always coincide with multiple worries.

I am concerned about the problems of today and I acknowledge that not everything about 2003 is comparable to the early 1990s. Most disturbing is the unprecedented weakness in the stock market despite a post-recession period of positive (albeit mild) economic growth. But we also must remember that there are powerful positive forces at play which must not be forgotten at a time when the glass seems mostly empty. Low competing returns from non-equity assets, sizable amounts of cash on the sidelines, significantly reduced allocations to stocks, stimulative monetary policy that has been helping (primarily through mortgage refinancings and the housing market) and the potential for more fiscal stimulation are among the positives. Also, the fact that consumer confidence is low, profit margins are near a 50-year low and five-year real earnings growth is also near a 50-year low suggest that upside surprises could be strong. Finally, the magnitude and length of the stock market decline, from a historical standpoint, suggests that it is unwise to bet against stocks looking out over the next few years.

The second point to make is that stocks price in future expectations. It is my view that stocks are undervalued and are pricing in some of the risks, though not the pessimistic scenario of an extended economic malaise and borderline deflationary period.

Portfolio Strategies in an Uncertain World

Because of very low interest rates, investment-grade bond returns, especially treasuries are not very attractive, unless we have sustained deflation (not likely). Given the geopolitical environment, post-bubble risk aversion and vulnerable economy I believe market volatility (upside and downside) is likely to continue for some time.  

Despite the risks I am confident that the odds for at least decent returns relative to inflation are high over the next few years. My confidence in the ability of our investment managers adds to my expectations. I don't expect to re-live the 1990s but I believe the worst of the bear market is behind us.

Please contact me if you have any concerns or would like to review your portfolio. It is also prudent to review projections.  

Mike Durant