Review and Outlook
September 28th, 1999
To My Clients, Friends & Observers:
There is a chill in the air as the sun sets. The leaves on the trees
and the stock symbols on my screen are turning from green to red.
We are doing our chores, getting our house in order, getting ready
for the fall. And, blessedly, all these things are seasonal.
The chart for the DJIA shows a big, round, topping pattern from late
spring to date - cresting the end of July, dipping on the Fed rate
hike, cresting again to the August 25th highs, then coming down the
mountain a full 10%. Welcome to the correction.
We’ve been discussing the effects of higher oil prices here for the
last several commentaries. And we’ve been warning our business clients,
particularly those who are leveraged, to be wary of energy costs and
interest rates. Last week we participated in a conference call with
Raymond James’ energy analysts who are prognosticating natural gas
shortages and oil priced at mid-to-high $20’s by mid-2000.
Sure enough, consumer confidence, released this morning, has dropped
to a six-month low. And- poof! -almost as quickly as we got the bad
news, the president of Venezuela’s state oil company announced that
OPEC will probably agree to increase oil production in March. And
just as quickly, oil stocks and oil service stocks are down. A lot.
But then what isn’t lately? Every attempt at a buying rally has been
deluged by too-willing sellers. Advance/declines (breadth) continues
to be atrocious (negative). The dollar is off over 20% vs. the yen,
and off over 5% on the J.P. Morgan Index vs. 19 Currencies, which
is what happens when the Fed grows the money supply at double the
rate of GDP.
And then there’s gold, breaking through $309, up from its low of
$253. No comment other than to repeat what I’ve said for years, everyone
should own a little gold.
The worst outcome of bad news and fear would be a snowball effect
leading to a change in market psychology. As much oversupply of stocks
as there is, at high valuations, in the face of waning, or at least
skittish, demand, there is still a strong economy which will generate
just under 4% growth this year, and perhaps 2.9% in 2000. Even though
interest rates have risen the yield curve remains positive and that
confirms healthy economic growth.
Perhaps the most flagrant evidence of some sort of a top in the market
comes from an article in the August edition of the venerable Atlantic
Monthly. Right at the top of this years record indexes two scholars,
Glassman and Hassett, produced a wonderfully entertaining hypothesis
that the "Perfectly Reasonable Price" (PRP) for the Dow isn’t the
11,300 it was in mid-July, or the 10,200 it is today. No, the PRP
should really be 36,000. O.K…What else can you tell me?
Let us, the Perfectly Reasonable Investors, recall the words of a
true American hero, Cmdr. James Stockdale (Ross Perot’s VP running
mate) and ask, "Who are we and why are we here?" To help answer that
I reproduce here my letter to the Atlantic Monthly in response to
the vapors of Messrs. Glassman and Hassett.
To The Atlantic Monthly:
The Glassman/Hassett theory on the Perfectly Reasonable Price (PRP)
for stocks is an entertaining and provocative exercise in discounting
cash flows. There has long been a compelling and overwhelming rationale
for equity investments, however the PRP study contains some assumptions
suitable only to an academic exercise and really should include some
caveats. The PRP exercise considers (1) U.S. market prices
in isolation and uses the last 200 years as forecast for the next
200, (2) assumes the market to be very inefficient, (3)
does not address the simplest issue of supply and demand - that something
is only worth what somebody is willing to pay for it, (4) ignores
statistical probabilities defined by market valuations to date, and
(5) does not examine incremental shifts in the forces of supply
and demand, which I would recommend requires careful demographic study
supported by fundamental economic analysis.
Item (1) Examining another equity index, the Japanese Nikkei
was valued over 40,000 in 1988 at a P/E of over 90. The Nikkei is
18,500 today, having staged a strong comeback in the last few months,
with a P/E of about 60. This while Japanese interest rates are near
zero. If present value is determined by the assumption of sustainable
cash flow then the question becomes how far out are you willing to
discount and how much risk might that entail? How far out was the
Nikkei discounted to merit support of a 90 P/E? Will the P/E be 90
or 30 in 2009?
Item (2) If 36,000 Dow were the PRP, it would already be there
in an efficient market.
Item (3) In financial analysis the two preferred methods are
net present value and internal rate of return, which account for compounding
of cash flows. The weakest method is the payback method which simply
shows how long until invested capital gets paid back. For an individual
investor the payback method is the acid test. Use the payback method
first and consider all dividends and interest as repayments of principal,
then consider whatever is left over after principal repayment as equity.
Then you can sweeten the picture with NPV or IRR with some reasonable
assumptions as to a discount and a time period.
Item (4) Using the historical sample data for P/E, E/P, and
Dividend Yield, even considering that the longer we remain at these
levels the more the mean will adjust, we are at the outer edges of
the bell curve and it is statistically improbable to sustain. Fundamental
economic analysis would support this statistical scenario. Corporate
earnings are driven by U.S. consumers, whose balance sheets are substantially
leveraged. Oil prices have doubled from their inflation-adjusted all-time
lows of last fall. This will diminish consumer expenditures on manufactured
goods and discretionary investment. A sustained market contraction
would hurt household balance sheets. Shrinkage in balance sheets and
income statements may degenerate consumer confidence and contract
consumer spending. Worst outcome would be a shift in investor psychology,
an issue unaddressed in the PRP theory.
Item (5) Indexes and statistics are beautiful things on paper
but the function of money is expenditure, and money is predicated
on investment liquidity. If a 60 year old widow started drawing 8%
a year from a $100,000 investment in the S&P 500 in 1971 she would
have nothing left in 1998, and she would be 87 years old. Of course
those were different times. What if they were our times?
Rising equity prices can be self-stimulated, i.e., stocks are bought
because they are going up. A stock breaks through its resistance level
on a chart and triggers a technical buy signal. Short sellers eventually
have to buy stock to cover and create upward price pressure, the reason
a big "short interest" statistic is bullish. Eventually trends become
exhausted as incremental changes in supply and demand, buying and
selling, accumulation and distribution occur. Look at momentum, the
rate of change of the rate of change, to identify the change. Support
it with other observation. New mutual fund cash flows from January
through April, reflecting retirement fund flows, increased at record
rates for four years until this year, when they failed to set a new
It is a commonplace that risk is mitigated by diversification and
time. There are studies that suggest that extraordinary risk increases
with time - more than just a semantic exercise. Risk to an individual
investor can also increase with time, as needs and circumstances change