Broker Check

Quarterly Newsletter July 2002

Investment Review and Outlook:A Tough Environment Continues

July 2002                        

It has been more than 60 years since the U.S. stock market experienced three consecutive negative calendar years. With the S&P 500 down 13.1% on the year through June, it will take a 15.1% increase over the next six months to avoid that fate (in terms of the math, remember that it takes a 100% gain to offset a 50% loss—which makes outperforming in a down market such an important pre-requisite to good long-term returns). We’ve managed to outperform the benchmarks during the bear market but we can only feel so good about a relative victory in the face of a weak absolute-return environment. We did this with allocations to value and small cap funds. After three consecutive years of weak market performance, you would think we would be set up for a huge bull market. So how does this decline stack up as a buying opportunity?


Well, as far as market overreactions go I can say that, as I write this, the U.S. stock market has sold off to a level that is looking attractive. From here (with the S&P 500 below 1000) there is a very good chance that stocks will have a decent cyclical rebound. We could see a run that could take stocks 10% to 20% higher from current levels over a period of several months. Valuation models measure stocks as 16% undervalued on 6/30. Interest rates are very low, and it is this low rate level that supports higher prices for stocks.


The onslaught of troubling headlines on corporate management misdeeds will result in significant positive behavioral changes. Regulation, prosecutions, embarrassments and investors generally paying attention (they weren’t during the bubble) will all drive change in behavior and make the corporate governance issue temporary. There may be more surprises, but I believe that management at the vast majority of public companies is honest (my opinion is reinforced by fund managers whose judgment I trust). Still, there is no question that we were in an environment where far too many management teams were “ethically challenged.” Regardless of our expectation that corporate governance will improve, the headlines will be another factor that will contribute to a general lack of confidence that could chip away at the “equity culture” and lead to lower P/E multiples.


·        A related issue is the level of earnings. How much shenanigans has been going on? When we assess valuations we must use an earnings number. Is the number valid or is it in the process of being restated downward? I believe that there will be more surprises but that it is unlikely that, at this point, earnings for the overall market are materially overstated given the huge earnings decline that has already occurred.

·        Then there is the terrorism wildcard. Many potential terrorist acts would probably not have a far-reaching economic impact. However, if the worst-case scenarios involving weapons of mass destruction come to pass a severe economic impact could be felt. This is not priced into the market (nor should it be—it is far too uncertain). Worst-case scenarios rarely happen and we’ve always tended to discount them. But at the very least the risk will lead to more defense and homeland security spending. These are not productivity-enhancing activities.

So Where Does This Leave Us?


First, there are important positives that must not be forgotten. Stocks are generally much cheaper than they were over two years ago and we are very likely to see a decent cyclical earnings rebound over the next year. The statistics say that the economy is clearly recovering and that’s what could drive a cyclical rebound in the stock market. I don’t make short-term bets but I’d put the odds on such a rebound as high. And it could be temporarily powerful. There is a huge amount of cash on the sidelines earning very low returns. Stock returns are still likely to be competitive with the defensive alternatives of cash and bonds.


At two-and-a-quarter years it is worth noting that this period of market weakness is already very long. History and valuations suggest that the odds are heavily stacked toward decent returns over the next few years after such an extended period of lousy performance. These decent returns could very well be front-end loaded with above-average returns over the next six months to a year.  If it is likely that we can capture decent returns, why get defensive and gamble that we can do better? Doing so risks missing out on full participation when the market does rebound. Of course it is possible that stocks could fall more. But, this is unlikely, and if the market does sell off further, then stocks are very likely to be set-up for a very powerful rebound.


I believe we are invested with superior managers who will continue, on average, to provide higher long-term returns than their benchmarks. So while we focus our market assessments on the market averages, we expect our managers to outperform those averages. It’s worth mentioning that the brief love affair with individual stocks at the expense of mutual funds at the latter end of the bull market seems to be reversing. The diversification offered by funds and the realization that good professional management can make a difference has again underscored the common-sense appeal of funds. And while there are only a handful of great funds out there, I believe finding them is one of my strengths.

In Closing

This is the toughest investment environment I’ve experienced. Nevertheless, my confidence in our managers, and the potential to take advantage of volatility give me a high level of confidence that the next several years will be better than the last several years, with reasonably good absolute returns (though our performance has been quite good in light of the market environment).


Looking forward I believe we are continuing a transition to an environment that will be characterized by a return to common sense. Value and good fundamental analysis will be rewarded, as will honesty, integrity and accountability. Our ability to look at a broad spectrum of asset classes, search for the most skilled managers to implement our asset class plays, and to do so absent any conflicts of interest, puts us in a strong position to add value.


Please don’t hesitate to contact me if you have any questions or concerns.



Mike Durant