Review and Outlook
My Clients, Friends & Observers:
April 8th, 2002
For the quarter ended March 31 the DJIA was up 3.8%, the S&P
500 was flat and the NASDAQ Composite was down 5.4%. Brae Head composites
are compiled by an independent service and will be posted on the site
by month end. They will be up as indicated by our end of quarter billings
for managed accounts.
Dumbing down or dumbing up?
A common recipe for no-sweat success in academic publishing is to
take a newsworthy event or trend, gather some material facts, and
perform some analysis, drawing suppositions, conclusions, or predictions.
Or take something that’s already been said and say it differently.
Veracity is enhanced if one can affiliate with the name of a major
university. This academic exercise isn’t meaningless yet often the
net result is, "You see? It happened just the way I said it happened"
or "Here’s what happened and it might have happened this way." It’s
not very constructive to the investor for whom the research is a little
Now come Harvard professors Baker and Stein cited in Business Week,
April 8. "High volumes of trading, narrow bid-ask spreads, and other
measures of liquidity are generally seen as signs of a healthy stock
market," according to the BW article. "But evidence has mounted…that
(these) periods…are usually followed by…poor returns." Writing for
the National Bureau of Economic Research (NBER), which declared we
were in a recession last year (we weren’t), the professors have coined
the term "dumb investor effect" to help explain periods of
market boom and bust. "Dumb investors," the professors are quoted
as saying, "irrationally provide the extra liquidity that drives prices
to unsustainable heights while ignoring subtle market signals that
other investors heed. The dumb investors tend to be overly pessimistic
as well, eventually withdrawing from the market, reducing liquidity."
Who could disagree?
Baker and Stein calculate that when share turnover is 12% higher
than the long-term average, stock returns will lag long-term returns
by 4% the following year, a calculation worth testing but not compelling.
There is a plethora of good technical analysis available (historical
price and volume chart patterns). The professors go on to use "dumb
investor" theory to explain why a company’s stock price tends to underperform
after an offering. "Standard explanation," according to the article,
is that corporate managers have inside information that enables them
to time issuance for when prices are high. But, they add, managers
are simply trying to minimize the impact of new shares on the market
price, picking periods of high liquidity, which in turn are followed
by periods of underperformance.
This is moot. Let’s strip the veneer of scholarship from the common
sense. Corporations don’t need insider information to decide on an
offering. Outside information will suffice, i.e., when the market
is hot, issue shares and maximize the return from the offering. A
hot market, more than anything else, will minimize the impact of new
shares on the market price. You best dilute in an up market, not a
But consider the term "dumb investor." We have made the caricatures
of bull and bear anthropomorphic - taken dumb brutes and given them
a human face. The "dumb investor" is no more enlightened than the
bull or the bear, driven by base instinct. The bathos here, dear reader,
is that the "dumb investors" referred to by Professors Baker and Stein,
are almost all professional money managers, the experts running
mutual funds, qualified plans, and private client portfolios. The
consensus estimate, this date, is that at least 90% of all securitized
assets are professionally managed. It begs the question: for what
has the public been paying? Perhaps it’s time for the "pros"
to "dummy up."
About five years ago our local chapter of The World Affairs Council
co-sponsored, with a mutual fund salesman, a presentation by the engaging
Mr. Harry S. Dent, Jr., another Harvard scholar and author of The
Great Boom Ahead, the sum and substance of which is the projection
of a stratospheric stock market driven by baby-boom demographics.
As president of the WAC, I vehemently objected to our participation
in an event that was likely to be inflammatory, rapacious, tawdry
and completely out of our character and mission. My objections, unfortunately,
were unpersuasive and the program was reportedly a big draw. The tragedy
of investment theatrics is that a lot of well-intentioned people can
get hurt. The best money made in the giddiness of the gold rush was
from selling the picks and shovels. Caveat emptor.
Hiring an investment manager is a lot like hiring a pilot. You don’t
want one with too much imagination. My instructor used to aptly describe
flying as "long stretches of tedium punctuated by moments of sheer
terror." The two most important things a pilot does is take off and
land – as necessary. In the air the plane pretty much flies itself,
straight and level. There’s an analogy here.
Time and Tide
Volume across all indexes has been declining, at prices lower than
over two years ago. There is simply less participation. We’ve screened
thousands of stocks since last September and only positioned five
new ones since. We are forced into picking through mid and small caps,
searching for earnings, growth and value (a fair price) at the risk
of less liquidity. Bloomberg television announced last Thursday that
the S&P 500 Index was trading at 61 times existing, quarterly
earnings. The good news is that the P/E has to come down from 61.
The bad news is that improving corporate earnings won’t drive it down
to 20 or 25 any time soon. Valuations are just high. Net income for
the S&P 500 for 2001 is less than 2%. Tripling earnings, and they
won’t triple this year, would take us to a multiple of 30 or so.
If valuations of the broader indexes are high it does not mean that
we have nowhere to shop. According to the theory just described, the
"dumb investors" have left the market. They have left us their shares
at lower prices, thank you very much. Using our system we initiated
or repositioned the following companies in the first quarter and we
illustrate the share prices from January to date.
Timken $16 -$25 Questar $22 -$28
Lawson Prod’s 25 – 29 Superior Ind. 36 - 51
Anheuser Busch 46 – 52 PPG 45 – 54
That represents an average 29% gain from companies that met our criteria
at the time we positioned them. We await the return of the "dumb investors"
to take them higher.
Without specific attribution, it’s estimated that oil prices between
$30 and $35 a barrel would shave just .4% off GDP in today’s economy,
far less punishing than it would have been in 1980. The price rise
in oil is not seen as a significant threat to the economy. Of greater
relevance is the effect on corporate profits. Every penny saved on
oil goes right to the bottom line of industry. We are right back at
$27 today from $20 at year-end. Profitability isn’t coming from raising
prices. There is precious little pricing power. Profitability will
continue to come from cutting costs and raising productivity. We’re
wary of industries significantly exposed to petrochemicals.
I would not expect to see a Fed rate hike until the fourth quarter,
if at all this year. With rising oil prices, however, will come rising
rates in the bond market. Brae Head fixed income paradigm currently
is 30% of portfolios maturing in three years or less, 30% at seven,
the balance at nine to ten. For the more aggressive there is reasonable
speculation in corporates wearing BAA or even BBB credits that should
see an upgrade or two with economic recovery and thence a price hike.
Our emphasis continues to be getting cash flow in portfolios. Our
attention is focused on stocks that are good dividend achievers and
structuring fixed income portfolios for positive returns in a rising
Corporate earnings will expand at a rate well ahead of reported GDP
growth. The yield curve is very positive, indicative of the healthy
economy. The Fed is flexible and benign. Housing and consumer spending
are sanguine. If the indexes trade sideways for another quarter or
two it only brings us closer to a breakout. The lows were in place
September 29, 2001. A portfolio is best positioned after a selloff,
not after a breakout. Now is the time to prepare for the next run-up,
the next bull.
Wall Street Week Without Louis Rukeyser
For the last few years Brae Head has sponsored WSW with Louis Rukeyser
every Friday night at 8:30 on our local PBS affiliate. In a ham-fisted
display of management at its worst, Maryland Public Television summarily
dismissed Mr. Rukeyser last month after he rightly refused to accept
a diminishing role on the show. What a shameful way to end such a
long and rewarding relationship. Obviously there were egos involved.
Lou was entitled to his. He was the star. He invented the show, nurtured
it and maintained a staunchly loyal audience. Most folks I know who
watched it planned their Friday evenings around the show. I watched
it last week and it is not the same. We’ve had to cancel our sponsorship.
Lou was witty, charming and intelligent. He catered to his audience
by forcing his guests to speak plain English, never tolerating investment
jargon. He was ever optimistic about the American free-market economy
and he was a soothing voice in turbulent market times. He was good
for the individual investor and good for the markets by defusing the
periodic inclinations to panic. He exercised a lot of leadership in
a graceful, friendly fashion. I sincerely hope he’s back in front
of the public somewhere, sometime soon.
When I was first made a manager twenty years ago a dear friend told
me, "You can make mistakes but you can’t make any big mistakes." Losing
Louis Rukeyser was a big mistake.
As of July 1 the minimum Brae Head account size will be $250,000.