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Past Commentaries

Current Commentary, 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 record.

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 with age.

Sincerely,