23 Aug 2002 The Stock Picker’s Market

Have we seen the bottom or are we in for another cruel joke from old Mr. Market?  As you know, the market is random in the short term, and this bear has lived up to that reputation.  But, there are a lot of signs that point to an improved investment climate in the coming months. 

The Dow Jones Industrials are almost 11% off the lows it reached on July 24^th.  The broader S&P 500 is up 14%, and the beaten-up NASDAQ is up 10.3%.  The buying activity has included more than the technical buying and short covering of earlier rallies as institutional managers have demonstrated an increased willingness to buy under priced companies.

While additional accounting scandals may yet be discovered, investors seem to be saying that the problems of Enron, Tyco, Worldcom, and others are isolated events and represent relatively minor flaws in the integrity of American business.  The August 14^th SEC deadline requiring CEO’s and CFO’s to vouch for the accuracy of their company’s financial reports has passed with little surprise.  Only 16 companies did not sign the certification by the specified date and asked for extensions.  They stated they would sign when specified issues, identified with ongoing audits or company transactions, were adequately settled.

The Federal Reserve last week decided that another interest rate reduction was not necessary, but did change its bias to one of caution.  They signaled that additional rate cuts would occur if further economic weakness warranted.  Three governors speaking this week indicated that they doubted the cuts would be needed.

Uncertainty has gradually given way to better understanding on a number of fronts.  The economic recovery is going to be much more gradual than typical recoveries and less than earlier expected.  Interest rates will likely remain at low levels for months to come, keeping borrowing costs low.  Consumer confidence, while dropping with the market in June and July, has likely stabilized and may improve as unemployment levels stabilize.

We may or may not go to war with Iraq, but the market is better prepared for the news if it happens.  Investors know considerably more about that enemy from our experience in Gulf War I, hopefully reducing the speculation of extreme outcomes this time.  There will undoubtedly be significant anxiety about new terrorist threats as we approach the September 11^th anniversary, but the markets have some experience there as well.  The Memorial Day and Independence Day holidays passed without public awareness of terrorist activity.

There remains a world of worries for investors to dwell on, but lately they seem more interested in the positives.  Companies, on balance, have shown investors that they can deliver earnings results in challenging environments.  Many companies have performed exceptionally well, but with all today’s pressure on honesty and conservatism in reporting, managers have been downright dull in their outlooks for their companies’ near-term outlooks.  Their excellent quarter’s results in so many cases have been wasted on cautious investors who are suspicious of managers’ abilities to continue their good performance, so recently demonstrated.

Nevertheless, stocks prices have gone up.  Since the July 24^th dip, the biggest winners have been in the Utilities sector, up 32%.  Close behind have been broadcasting and cable, office electronics, gas utilities, airlines, insurance, and wireless.  In short, many of the industries pummeled over the past year have bounced from their extreme oversold positions.

Volatility, another major source of fear for investors, is getting better.  The VIX, a measure of market volatility has improved dramatically since it reached a climactic high on July 24^th.  Following each of the prior five climaxes since the index was developed in 1986, were significant market rallies.  We are in the midst of proving the indicator right for a sixth time.

Another indication of the oversold conditions on the 24^th was the number of New York Stock Exchange stocks trading below their 200 day moving average.  That index bottomed at 19% on that day.  In the last decade, levels this low were reached only during the Fed induced slowdown of 1994 and the global currency crisis of late 1998.

Conditions for investing are improving, but very slowly.  We are taking a very cautious and balanced approach.  Wall Street analysts, economists, investors, and government officials are all quite skittish on the near future of the market.  This lack of conviction means a sideways market for some time to come, but there will be opportunities.  Our portfolios have significant allocations of cash, fixed income, and real estate to dampen the still higher-than-usual volatility.  But we are ready to take advantage of opportunities created by hyper short-term traders when they sell indiscriminately.  Our primary focus will remain long-term, but we plan to take advantage, to the extent possible, of short-term opportunities.