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Quarterly Newsletter October 2002

Quarterly Newsletter: Where to Now? 
A Rational Assessment
October 2002

An ugly September closed out the worst quarter since the market crash in the fourth quarter of 1987. The damage was widespread, with growth, value, large-cap, small-cap and foreign stocks all experiencing double-digit declines. REITs and high-yield bonds were also hammered though they declined much less than stocks. Bonds, especially Treasuries, did well. But beware, interest rates are at 40 plus year lows and bonds will suffer when interest rates rise. A recent survey revealed that 70% of investors don’t understand that bonds will suffer capital losses when interest rates rise.

As this torturous environment hits the 2½ year mark we know it's trying the patience of most investors. I empathize because my patience is also wearing thin. Our decisions have allowed us to protect substantial capital relative to our benchmarks during this bear market. However, this year the message has been that we've outperformed by losing less. While our clients have been supportive, it is frustrating to deliver good relative performance in a negative investment climate. But at times like this I take great comfort in our research emphasis and the confidence this gives us in making investment decisions. I've spent many hours analyzing the factors at play in this environment, looking at data and talking to other investment professionals I respect. The following Q&A summarizes my thoughts.

Why does the stock market keep dropping?
In my opinion there are three reasons:

  1. Economics and profits: The economic recovery is slow and while we can't predict whether we will return to a recessionary environment, some forward-looking economic measures are deteriorating. The weakness is most apparent in the manufacturing sector. Consumer spending has held up reasonably well but some analysts are concerned that if the trend of increasing layoffs continues, consumer spending will ultimately slow. That would be trouble because consumer spending has been the primary positive in the economy. The weak economy is a problem because businesses are not as profitable when the economy is weak. Though profits have experienced some recovery this year, the rebound has not been strong.
  2. War: The risk of war with Iraq has driven oil prices higher and made investors nervous. The economic relevance of war in this region (as opposed to other conflicts in Afghanistan, and before that, Yugoslavia) is primarily the risk that oil exports out of the region are disrupted. Though this seems to be a low probability, anything that destabilizes the Middle East tends to worry investors. A secondary concern is the possibility that a war with Iraq could have ripple effects in a very unstable region that might fan terrorist flames.
  3. Bubble Aftermath: In the early days of 2000, many investors were unconcerned about valuations, fundamentals, or any sort of rational analysis of risk. The last few years have been one heck of a reality check. Investors are now much more cognizant of risk, so much so that their angst may be causing them to shift to a glass-is-half-empty mindset. There is great concern about the economy and Iraq as mentioned above but it doesn't end there. There is also a general confusion about valuations. It is not unusual after bubbles for the investor sentiment pendulum to swing all the way to irrational paralysis, leaving markets at undervalued levels.

Has the 47% decline in the S&P 500 since March of 2000 resulted in bargain-priced stocks?   

By any method worthy of consideration, the market looks quite undervalued. In fact it is more undervalued relative to interest rates than it has been since before the great bull market that started in 1982. Even if we assume the ten-year Treasury yields 5%, instead of its current level of 3.7%, the model says stocks are selling at a level 37% below their fair value based on valuation metrics that held over the past 20 years. At present I am confident stocks offer a lot of value, and because of that we will eventually be rewarded with good returns. Beyond the valuation analysis itself, my conviction with respect to valuation levels is buttressed by feedback I get from stock fund managers I respect (for their ability and their candor). Many say there are a number of stocks selling at attractive prices.

So the stock market is a long-term bargain but the next several years are unclear…then why own stocks now?

One lesson that has been taught time and time again is that it is dangerous to underestimate the ability of the stock market to surprise investors. Bear markets always bottom at the point of maximum pessimism. This lesson was learned on the heels of the Asian meltdown in 1998, and it was learned when the Gulf War started in January 1991, and there are many other examples. At present, fear and pessimism are much more apparent than greed and optimism. Clearly some of the negatives are already priced into stocks (thus the undervaluation) and a few unexpected positives could turn things around. For example, there is a massive wave of mortgage refinancing happening now. A Fed study suggests that based on past relationships a meaningful amount of the refinancing proceeds will make it back into home improvements and other consumer spending. This could result in an unexpected spike in consumer demand. Events in the Middle East could surprise on the upside just as they could on the downside. Being intellectually honest, even a pessimist must admit that the negative scenarios are not sure things. Positive scenarios are also quite possible. So the point is that with the market at a bargain level on a long-term basis, I don't want to risk missing out on the rebound simply because we can't say for sure when it will come. I recognize that it's possible that a sustained rebound might not come soon and that stock prices could go lower. But if a rebound does come suddenly we will have missed an opportunity to profit from the undervaluation that we believe is now reflected in stock prices.

A related point is that moving more heavily into defensive investments requires knowing when to increase stock allocations again. To say this is tricky is a huge understatement. The indicators that will signal that risk has declined will send stocks surging before we will be able to re-assess the risk/reward trade-offs. For example, in the month after the Gulf War began the stock market rose 17%. It was up 19% in the month after it bottomed in 1998. I’m simply not confident that we can turn on a dime and catch these types of moves. So with the market clearly undervalued based on our analysis, on a long-term basis, it makes sense for long-term investors to be patient and wait for the returns that we expect will be delivered sooner or later.

So What Should We Do?

If you’re feeling anxious, please give me a call.  We can review your portfolio and goals and run projections. These are difficult times for investors and now is the time to be thoughtful and make rational decisions.

Mike Durant, CFP