14 Jun 2002 Time to Throw in the Towel?

A handful of clients called or emailed this week to discuss the prospects for the market and what actions they should take given its current weakness.  I was as candid as possible with them and will be the same in my remarks today. 

Until the disappointing retail sales report yesterday there were faint indications that markets were finding some footing.  A number of individual stocks were reversing their downward spiral and moving up quite nicely.  Many companies were pre-announcing better-than-expected earnings for the second quarter.  But the few negative pre-announcements more than overcame any rallies that resulted from good news.  For example, on Tuesday Abbott Laboratories stock fell 16% when the company slashed their 2002 profit forecast.  It was Abbott’s biggest stock drop in over 20 years.  The news started a market slide that trounced most stocks, whether they had anything to do with pharmaceutical production or not.

Volatility is on the rise again as world events vacillate between improvement and decline.  As India and Pakistan stand down from war, a bomb blasts near the US Consulate, killing eight.  As the U.S. calls for a Palestinian state suicide bombings continue, making negotiations difficult or impossible.   The dollar is declining as faith in the U.S. recovery wanes abroad.  Accounting issues, insider trading, and analysts’ conflicts of interest continue to erode investor confidence.  It’s not an overstatement to suggest that there is broad investor crisis in confidence going on right now, with few signs of abatement.

The latest fly in the ointment is the size of the unexpected decline in retail sales for the month of May.  The consumer is everything to this recovery.  If confidence and actual spending decline, hope for a sustained economic recovery diminishes considerably.  That the release had such a significant impact on the market provides further evidence of its overly emotional state.  The decline in retail sales was widely expected among economists because May was colder than usual in many parts of the country, which usually puts a damper on sales of summer fashions.

In several of our past Briefs, we’ve discussed the disconnect between the market’s bad mood and the relatively good economic news.  The market is either excessively emotional now due to the considerable uncertainties facing investors, or the market is telling us that the economy is not going to recover with another recession likely.  Both scenarios are likely responsible for explaining the market’s current volatility.  Because investors are so emotional, any sign that the recovery is faltering causes more extreme reactions than might otherwise be the case.  Academics would have us believe that the market is a globally diverse, unemotional, logical calculator of the sum of value of all publicly traded companies.  But, closer to reality, the market is a collection of people, each with emotions pretty much like the other.  It is quite possible for collective fear or greed to drive markets down or up, respectively, much further than logic would indicate.

What to do?

It is never a good idea to make financial decisions out of fear, or greed.  It’s an individual decision that requires analysis of your current financial requirements against the backdrop of your ability to look beyond the current morass with confidence that today’s stock prices represent exceptional values for the long-term investor.  That said, I don’t know how long this ugliness will continue nor how much damage will be wrought.  We may see stock prices decline much more from here or a turn may come soon.  But the markets are oversold by almost any measure and are due for at least a brief rally.  We saw a rally after 9/11, but we have given it back.  As pointed out before, many stocks are near or below their lows of 9/11.

As for management of the models from here, you will see a significant reduction in our activity.  Many of the companies we now own are doing well in the current economic environment.  Their stock prices are relatively stable and rising as today’s investors seek them out.  Companies that require a bit more time for earnings recovery are big names that attract investors as they anticipate earnings recovery.  The country funds provide us with exposure to countries whose markets are faring considerably better than the U.S. markets.  On tactics, our stop-loss selling is currently suspended and will remain so until the panic selling subsides.

As I write this Brief the markets are tumbling with the news of a disappointing University of Michigan confidence number.  While not good news, it’s simply too early to assume the consumer is buckling.  One month does not a trend make.

Remember, you do not own the stock market.  You own a group of companies that make useful products, sell useful items, or deliver valuable services.  Each of those companies is represented in the market by a stock.  During uncertain times like these, investors panic and sell stocks indiscriminately, regardless of their individual merits.

Investors who keep their heads are able take advantage of cheap stock prices resulting from indiscriminate selling.  The challenge they face is time.  How long will the selling continue and will they have the confidence, patience, and fortitude to hold on to their investments in the face of such uncertainty?  To make matters worse, they are a distinct minority.  There are few like-minded INVESTORS from which to seek support.  They certainly don’t expect encouragement from CNBC or other televised market services either.  Fanning fears is what keeps viewers attention between commercial breaks.

While those in panic sell and short-sellers feed on them like sharks in frenzy, stock prices drop.  They reach lows that are just as unsustainable as the highs reached during speculative bubbles.  We have noted dramatic reductions in shares sold short in companies like General Electric, IBM, AT&T and Nortel.  Their shares have become so oversold that hedge funds (a big source of short-sellers) now see value in owning the companies outright.

My advice and my personal decision are to stay the course.  But if your circumstances or emotions dictate otherwise, please call so we can work out a thoughtful solution.  We face extreme conditions right now as investors, but we must not overlook the opportunities they create.  Treasure hunters pay close attention to coastal storms for the currents they create often uncover archeological treasures that might otherwise remain buried.  We will get through this storm, and hopefully, discover treasure along the way.