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Commentary:

July 1998

Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel

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    of all guest columns written by Dennis C. Butler, CFA

SpacerDespite some recovery at quarter-end, fears that the Asian financial crisis would worsen and/or spread to new areas of the globe sapped the animal spirits that had been loose in the markets and caused a significant ebbing in the strength of stock prices that we saw in the first quarter of 1998. Even as shares of some of the largest corporations rose to new highs at times during the second quarter, there was a fairly steady leaching away of valuations for the majority of issues. As in 1994, however, the damage was not fully reflected in the market averages. In early June, for example, The Wall Street Journal reported that over half of the companies comprising the S&P 500 index had seen their stock prices decline by 10% or more from their 1998 high points. Taking a broader view, 20% of New York Stock Exchange issues and 51% of those on the NASDAQ market had fallen at least 20% from peak prices. Meanwhile, the Dow Jones Industrial Average was down only 3.4% from its corresponding apex. Later in the month, Barronís reported that the seven largest companies in the S&P 500 Index accounted for fully one-third of the year-to-date results of that market measure. This follows a pattern often seen during the great bull market of the last several years in which the securities favored by the large institutional stock traders -- namely those of the largest, most easily tradable companies -- dominate even the broadest market measures. Needless to say, these are not the issues favored by more discerning investors since they represent some of the most hyped, expensive and, therefore, risky issues in the market.

SpacerNot surprisingly, bond prices rose (to record levels in the case of certain US Treasury issues). Money fleeing Asia and stocks sought refuge in the relative safety of American debt and created a situation, anomalous in the last few decades, in which both stock prices and interest rates were falling (rates move in the opposite direction of bond prices).

SpacerStruggling stocks and the noticeable decline in the level of bullishness on Wall Street coincided nicely with the appearance of the current Market Guru on the cover of Time magazine. Time covers have sometimes proven to be good "contrary indicators," prompting some to proclaim that a peak in stock prices must be at hand. This particular market seer must really know something given the fact that her brokerage firm (the last of the great private Wall Street partnerships) is contemplating doing an initial public offering of stock. Why jinx an opportunity to raise $3 billion from the public?

Rational Behavior

SpacerOur last letter began with a quote from Benjamin Graham in which he advised the reader not to assume that a lack of warning signals indicated the absence of danger. Recently, residents of a town in the state of Washington learned the value of this advice the hard way: heavy rainfalls over the last few years "reactivated" a landslide on which their houses were sitting. After a pause lasting perhaps millions of years, seemingly solid ground resumed its slide into a creek bed, carrying its load of homes and streets -- an entire neighborhood -- with it. Yet the town planners, developers and home buyers had acted rationally; there was simply no reason to suspect that unusual weather patterns would trigger such a disaster.

SpacerWhile the analogy may not be perfect, we think investors can draw valuable lessons from this unfortunate incident. They, too, become accustomed to long-established conditions and act accordingly: a long period of rising security prices has led many to believe that such a trend is an entrenched characteristic of our economic system. Hence, the widespread and basically sound belief that equity securities should be a significant part of any investment plan, especially one for retirement purposes (contrast this view with the one widely held in the late 1970s that maintained equities were a dying security form).

SpacerIt is not bad weather but, paradoxically, what we might call the "sunshine markets" of the last few years that have undermined the foundations of this sound investment practice. Thereís nothing quite like a streak of annual returns in excess of 20% to convert judicious attitudes towards the markets into the mistaken belief that the ownership of a few mutual funds will lead to easy wealth. Financial decision-making based on this sort of logic can lead to unfortunate excesses such as an over-reliance on stocks to fund a comfortable retirement or even (in cases known to us anecdotally) to meet current income needs. Other long-established financial practices have also changed. Recently, The New York Times reported how Americans are turning away from life insurance in order to essentially insure themselves with mutual funds and annuities (a booming economy and abundant jobs have also inspired confidence in the ability to self-insure).

SpacerThe homeowners in Washington had no real reason to suspect trouble underfoot. For stock market participants, on the other hand, ample recorded history affords the ability to judge recent trends as highly unusual. When viewed from the perspective of, say, the last seventy years (geologic time when it comes to Wall Street), it is clear that market expectations widely held among the public today are unrealistic and, furthermore, that there is an alarming level of complacency concerning risk. Having an extended period of above-normal returns such as the one we have experienced produces high valuations, enhances risk, and reduces the margin of safety, leaving us vulnerable to an occasional Asian or Russian crisis. But itís such a nice neighborhood to be in, meanwhile, that we donít notice the danger.

SpacerThe stock market's rather nasty spills during the last few months appear not to have caused any significant change in this state of affairs. With the exception of a few specialized areas such as gold and Asia, stock mutual funds are still attracting new money and we detect no particular signs of nervousness outside the usual Wall Street types who are paid to worry. Still, one has to wonder, given the damage inflicted on a broad range of stocks during this episode of weakness, what would happen if a genuine currency or economic crisis were to occur and the "new lows" list in the daily papers continued to expand.

* * * * * * *

SpacerWithout a doubt the bull market in financial assets has been an unalloyed boon for the corporate citizens of our polity. Strong demand for debt securities has enabled them to retire old obligations and replace them with new ones with lower coupons, lowering interest expense in the process. Pension funds invested in the stock market have risen in value to fully funded status, thereby reducing pension expense. The presence of legions of avid buyers has permitted companies both new and seasoned to issue shares to fund new investments in plant or takeovers of other corporations. Stock awards to executives enable companies to "attract the best management talent," as the saying goes, by giving them the opportunity to become as rich as the King of Cathay in quick order.

SpacerFinance theory maintains that financial markets exist to allocate scarce resources to where they can be most productively put to use. The practices alluded to in the preceding paragraph may very well illustrate this principle at work: the most successful enterprises have rising stock prices that in turn attract more capital. As investors, we have a decidedly different perspective. Companies sell parts of themselves (which is what they do when they issue stock) when there is a good reason: namely, they are getting a good price. Hence, the "cost" of that source of funds is relatively low and corporate finance officers naturally and rightfully gravitate toward it. However, our aim as investors is not to help lower the cost of equity capital for corporations; we seek, instead, to extract value from them. In a sellers market (which is what we have experienced for a few years now), this becomes an increasingly difficult objective to attain.

____________________

Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28).   "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:

Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695

Email: cscc@comcast.net
URL: http://www.businessforum.com/cscc.html


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