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The S&P 500 declined by 13.2% in the June quarter
and 18% over the past year. NASDAQ's respective declines of 20.6%
and 31.9% were even more devastating.
Investors are beginning to feel the pain. Since following the stock
market's progress became a dawn to dusk preoccupation in the late-1990's,
large numbers of investors have gleaned their market information
from financial television. Recently one of the better young announcers
asked with incredulity in his voice: "We're going back to the prices
of 1998 and 1997-is that possible?" It's understandable that someone
who cut his market teeth on the quarter century long greatest bull
market in U.S. history would fail to understand prices falling back
to their levels of five years earlier.
Unfortunately, that lack of a longer perspective hides from most
investors the recognition that past major bear markets have wiped
away far more than five years of investment profits. The first great
U.S. stock market overvaluation peaked in September of 1929. When
that market bottomed in July of 1932 it had wiped out all price
gains since 1914, an eighteen-year span. When the country's second
serious overvaluation topped in the mid-1960's, stock prices traversed
a series of mini-bear and mini-bull markets to their bottom at the
end of 1974. At the trough, prices had dropped to their levels of
1958, a sixteen-year retreat. All the price gains of two of the
past century's most productive decades (the 1920's and 1960's) were
completely eliminated by the bear markets that followed them. Before
the declines began in 1929 and 1966, it was virtually inconceivable
that any serious damage could be done to fruits of those "new era"
bull markets that had rewarded investors magnificently for so many
years.
To put the current bear market into perspective, it is important
to recognize that levels of stock market overvaluation became far
more severe in this cycle than at the top of either of the prior
great bull markets. Consequently, it would not be unreasonable for
the market to repeat its patterns of the past. There is no necessity
that this bear market wipe out the gains of the entire 1990's, but
it would be foolhardy not to recognize that possibility. Should
that unfold, the bulk of the declines lie ahead.
Just as investors in 1929 or 1966 could not possibly have known
what economic, political, or societal conditions were about to unfold,
we are equally ill equipped to see even our relatively near-term
future with clarity. A wildcard in the current situation, unlike
either of its predecessors, is the existence of organized terrorists
with the avowed intention of killing large numbers of Americans
in their homeland, a destabilizing influence at the very least.
Countering the optimistic forecasts of virtually all brokerage firm
analysts, Warren Buffet casts a dark shadow. He has indicated, according
to Business Week, that the "hangover effect" from the excesses of
the late 1990's may lead to economic stagnation through most of
this decade.
Another phenomenon familiar to today's financial television viewer
is the analyst or commentator who marvels at the apparent disconnect
between the falling stock market and the improving economic and
monetary fundamentals. It's the "Gee whiz, how can this be happening?"
phenomenon. After all, the Federal Reserve has aggressively done
its part by promoting very loose monetary conditions. Manufacturing
is expanding. Jobless claims have dropped to their lowest levels
in more than a year. Factory orders are rising, albeit slowly. Interest
rates are near thirty-year lows.
The problem is a failure to recognize an even more important fundamental:
price matters. Consider the following extreme example. Due to a
severe shortage, the price of hamburger has risen to $1,000 a pound.
Over time the price declines to $500 a pound, and your butcher substitutes
prime filet mignon. Clearly the second situation is far preferable
to the first, but it hardly represents good value. Despite the far
improved "fundamentals," the price still makes no sense.
The market experience of the vast majority of today's analysts,
consultants and portfolio managers consists of the recent portion
of a 25 year bull market followed by two down years. Prior to the
past two years, virtually every risk taken was rewarded. That longstanding,
consistent record of success progressively emboldened consultants
and portfolio managers to become increasingly aggressive. By the
end of the 1990's, stock valuations like price-to-earnings, price-to-dividends
and price-to-book value reached levels far beyond anything ever
experienced before. For reasons that we may never understand, except
perhaps as the madness of crowds, such valuation levels lasted for
years, and all but the most experienced investors came to accept
them as somewhat normal, eventually even justifiable. So as not
to be left out of the game, read "fired," as stock prices marched
higher and higher, consultants and portfolio managers suspended
belief in principles that have stood the test of time. They substituted
the newfound "metrics" that justified purchases of companies destined
to live their short lives without ever sniffing anything as heady
as profits.
Obviously the market of the past two years has applied a strong
dose of discipline to investors who forgot, or perhaps never knew,
the principles of value. Unfortunately, despite the sharp stock
price declines since 2000, corporate profits have similarly collapsed
in the worst decline since the 1929-32 introduction to the Great
Depression. As this is written, the S&P 500 is still selling at
over 34 times its most recent twelve-month earnings. Never before
the late 1990's had the S&P 500 sold at a multiple above the mid-twenties,
and those higher numbers came only at market peaks from which significant
market declines began. In other words, the market is selling today
still far above the valuations reached only at history's bull market
peaks. The declines that followed typically brought price-to-earnings
ratios down to single digits before a new bull market would begin.
While rallies, sometimes even significant, lengthy ones, can begin
from any level, no bull market in U.S. history has ever begun anywhere
close to current valuations. It is likely that the ultimate bottom
of this decline will be at far lower levels, very probably a few
years from now. Even if fundamental conditions continue to improve--and
that is far from certain--today's market prices still make no sense.
They resemble our example's $500 a pound, and this is hardly prime
filet mignon yet.
At this year's client conference, I applauded the work of Professors
Ruben C. Trevino and Fiona Robertson of Seattle University. Their
article in the February 2002 issue of the Journal of Financial Planning
demonstrated for the periods from 1929 to 1997 a very clear reverse
correlation between price-to-earnings level at the time of a stock
market investment and the subsequent long-term performance of the
investment. Purchases at low price-to-earnings (PE) levels led to
well above average subsequent long-term returns, while purchases
at high PE levels produced far below average returns.
We expanded the Trevino-Robertson study, adding to the time period
analyzed, and confirmed their findings over time periods ranging
from three to fifteen years. The regression equation derived from
the observation of 76 years of data would indicate the expected
average return for common stocks over the next ten years from the
end of the June quarter to be a negative return per year. It makes
the point that, rallies notwithstanding, this is not a level at
which to simply buy and hold common stocks.
The investment consulting industry, like the vast majority of both
institutional and individual investors, has grown up in a bull market
environment. Not having seen the consequences of even one historically
normal bear market, they have developed investment program designs
built to succeed in the 1980's and 1990's. The basic construct is
to set an asset allocation and periodically rebalance to it. Unfortunately,
if common stocks perform far below average over the next decade,
the consultants' advice will prove counterproductive. Over the next
several years we expect that a great many institutional investment
programs will move away from a fixed asset allocation approach to
one alternately overweighting asset categories that have a probability
of outperforming others based on historical valuation criteria.
We expect that large numbers of individual investors will tire of
the high costs of similarly structured brokerage wrap fee programs
in an era of low returns.
We are very pleased to have saved our clients' assets from the declines
of the past two years. We anticipate downwardly biased markets will
continue to be a problem over the next few years. As prices of equities
decline, we expect to find more opportunities to add reasonably
valued stocks that have the potential for growth when the economy
expands. We will remain disciplined, however, and patient, waiting
for significant equity expansion until more attractive valuations
appear.
Thomas J. Feeney
Managing Director and Chief Investment Officer
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