28 Jun 2002 The Fever and the Thermometer
As a thermometer, the stock market notifies us of serious problems in our world. It provides an up-to-the-moment measure of the sum of all investors’ views of the financial world’s present condition as well as its near-term future prospects. But, the market is no more to blame for our woes than the thermometer is to blame for the fever. The market has told us for some time that our illnesses go deeper than a hangover after the ‘party’ of the late nineties. Indeed, we have discovered serious diseases in our world and our capitalistic institutions that require attention.
Periods following stock market bubbles are usually marked by a resurgence of morality, both individual and institutional. In the years following the Crash of 1929, the Securities Exchange Commission, the Federal Reserve, and the Commerce Department were formed. These government institutions were equipped with oversight and authority to control the financial market’s prior excesses. But the more important changes occurred among individual Americans who rose to the challenges created by the ‘Great Depression’ and set our country on a new course to strength and prosperity.
Most prolonged periods of expansion and good times are accompanied by abuses and corruption. The Bubble of the late 90’s is proving to be no exception. The most egregious acts are coming to the surface now, but some of the better-camouflaged cases may take longer, months longer. But, corporate managers and those institutions that police them are clearly on notice from governments and investors, at home and abroad, that business-as-usual will no longer be tolerated.
All the while, the stock market does what it does best – it discounts news. The big declines of Wednesday morning were sparked by WorldCom’s disclosure of huge accounting abuses. But the entire market’s steep decline was not due to one company’s fraud. Investors sold most stocks Wednesday morning as they ‘discounted’ the possibility that if managers of WorldCom were capable of conducting such a significant fraud, there must be other company managers similarly motivated and capable. Only in time will we know who they are, but my supposition is that the market will be less ‘surprised’ and react less with each new revelation.
While the market has had to deal with numerous unprecedented revelations, a corporate earnings revival has been quietly taking shape. This time last year companies confessing disappointing earnings news outnumbered those meeting or exceeding expectations by 4 to 1. However, that ratio is down to only 1.1 to 1 with recent reports. Based on this observation and others it looks like corporate earnings may be better than the today’s pessimistic market currently expects or discounts. We are also seeing the acronym GAAP (Generally Accepted Accounting Principals or Procedures) used more often as managers announce their earnings outlooks for the quarter. Recent managers’ reports show a genuine interest in assuring their investors of their reliability and credibility.
We have discussed in previous Briefs the importance of trust. Relationships cannot exist without it, businesses cannot exist without it – capitalism cannot exist without it. A great thing about this country is its ability to rise to a challenge. It seems dark now, but the reality is that most corporate managers are truthful and honest with their shareholders and employees. Governments and regulators will probably overreact with stricter regulations and penalties and managers will likely redouble their efforts to provide every important piece of information. In time the markets will adapt and reach a new equilibrium. For now, the grinding market will continue until enough good news accumulates to counter the bad mood. Earnings season is coming soon, we’ll see.
Our Second Quarter’s Performance
As confessed in earlier briefs, I was slow in recognizing how long this bear market would last. I was recently reminded of Warren Buffett’s confession to his shareholders for the large losses he sustained in General Re following 9/11. He said:
“I violated the Noah rule, predicting rain doesn’t count. Building arks does.”
Facing the reality of a long bear market, we have spent the past several months building arks. We have diversified in both numbers of positions to counter dramatically increased volatility, and among new industries to counter the harsh punishment of unpopular industries. Our efforts are bearing fruit, but the second quarter’s numbers will not show it. We are down equal to, and in some cases, slightly worse than the averages. Our new holdings performed well in the few good markets, but the last three months have been difficult for almost all stocks, even the market favorites. Accounting and management scandals have wrought their havoc on almost all stocks as investors worried about who might be next.
As I commiserate with other money managers, I am reminded of how widespread the destruction to portfolios has been. For instance, the average large-cap, mid-cap, and small-cap growth mutual funds are down 19.2%, 17.2%, and 16.8%, respectively. Our models’ results are similar. Even the most widely respected managers can suffer prolonged down periods. Warren Buffett’s Berkshire Hathaway shares declined over 50% during the months between June 1998 and March of 2000. The results prompted BusinessWeek and other publications to ask questions like, “has the master lost his touch?”
In fact, Mr. Buffett had not lost his touch; his critics were simply focused on too short a timeframe. As you can see by the chart on the right, Warren’s portfolio recovered nicely from its lows. You might notice that his values started advancing when ours started declining. The reason: Buffett owns the kinds of companies that investors flock to during uncertain times. While we were waiting for growth stocks to reassert themselves, value stocks continued to rise to new heights as the bear market trudged on.
Don Hays provided an interesting chart in his morning’s comments that I think sheds some light on market expectations from here. The effects of the technology Bubble of the late 90’s are largely captured by the NASDAQ 100, which is comprised mostly of the large and mid-cap technology darlings of the day. Alternatively, the S&P Midcap index represents those stocks that can be found in most indexes, thereby providing a good indicator of the broader market. As you can see the NASDAQ and the S&P Midcap were in sync until 1995 when the Bubble began taking shape. The NASDAQ peaked in March of 2000 and fell back to meet the Midcap index just recently. That means that the valuations of technology stocks have returned to pre-bubble norms and the excesses have been largely wrung out. The markets are more balanced as a result.
Because pictures are worth so much, the chart below puts it all in perspective. It is the S&P 500 for the past 20 years in logarithmic form (removes the problems of comparing small index levels to larger levels; i.e. a 40% move from 100 to 140, or 40 points, looks just the same on the chart as a 40% move from 750 to 1050, which is 300 points. A point-based chart exaggerates the moves at the higher dollar ranges)
The line running diagonally up the chart represents a long-term trend line of the NASDAQ, which is roughly 14% annually. You can see that the trough formed under the line at the top right is forming a mirror image of the bubble that peaked in March of 2000. In other words, the pessimism has been overdone as much as the optimism was overdone during the Bubble.
The important point here is that the market average always returns to the trend line. And, you mathematicians know that to get there requires a higher rate of growth than the trend line’s 14% rate of growth. History tells us that better performance can be expected. The economy has shown improvement for several months. And most recently corporate earnings are hinting at better times ahead. The best markets historically spring from the toughest times. As the ills of our time are treated and eradicated, the markets will return to health. In the meantime, we’ll do our best to thrive in today’s healthy areas of the economy.