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Quarterly Letter to Clients 

January, 2001

Indices at quarter-end (December 31, 2000):

Dow Jones Industrials:  10,787.99     4thQ'00:   +1.29%   YTD:    -6.16%

Standard & Poor's 500:  1,320.28      4thQ'00:   -8.09%    YTD:    -10.06%

Rather than heralding a new economy, the incredible Internet, high-tech and biotech moves of 1999 proved, in 2000, to be just another bubble.  The NASDAQ, which gained 85% in 1999, has plummeted in 2000 by something near 40%.  Perspective:  a dollar invested in the NASDAQ at the beginning of 1999 would have grown to $1.85 over the ensuing 12 months, but today would be worth only about $1.10, for an average annual gain of 5.5%.  You would have been much better off in bonds, but of course you would have missed the thrills.

For the year 2000 the Dow Jones and Standard & Poor's indices have also declined, though less than their NASDAQ cousins.  The largest falls have been in the above-mentioned technology stocks that led on the way up and which make up such a large portion of that index.  Overall, for stocks, 2000 was a pretty miserable year.

Supply and demand.  Fear and greed.

Someone once said that they could make a parrot into an economist. They only had to teach it to say "supply and demand".  The stock market correlation of this phrase is "fear and greed".

Most of the 1990's was a period of high demand.  Greed created this demand, and demand, in symbiosis, created more greed.  When people believe that stocks are going higher they bid up for shares.  This action in itself causes prices to rise, thus confirming the belief of still higher prices yet to come.  Feeding upon itself, this belief, in turn, causes further price gains, and the move is accelerated, often to unwarranted levels.

Then it turns around.

Fear leads to supply.  People tend to offer stocks for sale when they are afraid:  afraid that the stock will go down, that business is slowing, that the economy is turning down.  Other people notice the trend and offer more stock, carrying the decline ever lower.  The more supply, the lower the price, bringing even more fear and resulting in more selling.

It is very much a psychological game.

But it is also a game of hard numbers.  There are several factors in pricing stocks and bonds.  Principal among them:  earnings growth, interest rates, price-earnings multiples, inflation, and the economic outlook.  In subsets you can find items like money supply, and for individual companies things like new inventions, new markets, drugs, processes, products, appreciated assets, name brands, cash flow, and financial stability, or instability as the case may be.

But as a player of the game, it is the first five factors that loom as most important.  For stagnant earnings, you would be willing to pay the inverse of the prevailing interest rate.  So in an 8% rate environment you would pay $12.50 for a dollar of earnings.  You can see how you might pay a little less for any risks of not earning that dollar, or to account for inflation, or for other unseen items.  But if that dollar of earnings is expected to grow, at say, 20%, you would certainly be willing to pay a little more.  And the further into the future that you can confidently predict that 20% growth, the more you will be willing to pay.

When times are good, people believe that the good times will not end.  They believe that they can see far into an unclouded future, and they make projections of three, four, five years into that future and sometimes more.  They use those projections to justify high price levels.

When, as inevitably happens, business slows down, or inflation heats up, or interest rates rise, or for whatever reason you are no longer comfortable with longer-range guesstimates, you must adjust for the newest forecasts.

Mania then yields to the accountants.

Where do you suppose we are in this repeating cycle?  I am of the opinion that, while there may be more pain to come over the near term, we are much closer to the end than to the beginning.

Historically, the upward moves have been much longer in duration, and much calmer in volatility.  The downward moves have tended to be abrupt and dramatic, often wiping out five years of gains in a matter of weeks or months.

These downdrafts provide opportunities for astute investors, especially so if they have a long-term view.  That describes me.  Thus it is that I am now seeking out those opportunities.  While caution is always warranted, and especially so now, if you buy good-quality companies at reasonable prices you are very likely to be happy with the long-term results.

Jim Pappas

copyright © 2001 JPIC