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Quarterly Letter to Clients
Indices at quarter-end (June 30, 2002):
Dow Jones Industrials: 9,243.26 2nd Q'02 -11.16% YTD: -7.77%
Standard & Poor's 500: 989.82 2nd Q'02 -13.73% YTD: -13.78%
Last quarter I said that I felt that Enron’s accounting fraud was an isolated incident. Apparently, there have been many more such incidents than I imagined.
A recent cartoon in the Wall Street Journal depicts a blind man carrying a briefcase labeled “Stock Analyst”. He is being led by a seeing-eye dog labeled “Earnings Guidance”.
It should not be a surprise to anyone that analysts employed by brokerage firms issue favorable reports on companies with which the firms wish to do business. These analysts are known as “sell-side” because that is what they do. “Buy-side” people, that is, those who might actually end up owning the securities, have always viewed such reports with a measure of skepticism.
Perhaps it is because we are no longer certain that we can trust the accountants or the top brass of our public companies that this issue is now being raised. But it should not be a shock to anyone that brokers research reports often serve the brokers at least as much as they serve the investor.
The stock market was a miserable place to be this past quarter, and there was only slight refuge in bonds. Accounting changes and accounting irregularities, valuation questions, and terrorism fears were among the things affecting the markets. But we cannot dismiss the psychology of the day: It’s no fun anymore, so investors shun the market. The lack of buyers adds fuel to the decline.
It is no longer a momentum market, at least not of the upward type, which is all anyone really cares about. The path of least resistance is certainly down. Stock picking and stock selection is now all-important.
The pundits and prognosticators are turning over rocks, looking for any sign that the market has bottomed and the economy has turned. But that is something impossible to know until after the fact. When they stop asking where the bottom is, it will have passed. Don’t hold your breath. Every market participant now knows fear.
Markets tend to carry to extremes. That is, they move far beyond reason or logic. This applies to the downside just as it does to the upside. When ebullient, the upward move feeds upon itself, and, as with the tech and internet bubble of the late 90’s, runs past all previous measures of valuation. Similarly, on the downside, you can expect levels of apathy that will push stock prices to bargain-basement lows that would earlier have seemed unbelievable.
Either situation creates opportunity. The S&P 500 is down 33% over the last two-and-a-half years. The Dow’s drop has been more muted, at minus 20%, but the NASDAQ has retreated by 64% from its close at the end of 1999. From the highs, the carnage has been even worse.
Contrast this with the 1973-74 bear market, when over an eighteen-month period the Dow Jones lost 45%. From that period to this, the intervening down markets have been tame by comparison, and mercifully short.
Thus we have, for the first time in a generation, an extended bear market. Many of the players today do not know how to react. Some are pulling money out of stocks and buying real estate; some are shifting into bonds; others are frozen in the headlights, afraid to act in any direction. Perhaps all of them will come out OK. Time, after all, is the great healer.
I can recall some years back when Barron’s published an interview with a famed market seer. To paraphrase, he said “Selling Chrysler short (at the then-current price of $4) is like shooting fish in a barrel.” And remember when Citicorp sold around $8? I have little doubt that today’s prices on stocks like Lucent and Corning and any number of major companies will prove to be equally attractive in the coming years.
Depending on your age, emotional makeup, and needs, the formula for success remains relatively simple. Select good-quality stocks that are selling at prices cheap in relation to earnings, sales, and asset values. Balance your stock holdings with bonds to preserve your capital and provide cash flow. Utilize convertible securities for their blend of these characteristics.
We can never tell what will happen in the shorter run, or in the longer run for that matter, but this is a strategy that has worked for over two hundred years. I expect it will continue to be valid.
copyright © 2002 JPIC