Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
of all guest columns written by Dennis C. Butler, CFA
The crows caw
And are city-bound in whirring flight:
Soon it will snow —
Lucky he who now still has a home! 1
It finally seems to be sinking in that the warm and sunny glow of Wall Street’s storybook "Goldilocks Economy" has given way to the cold and dark reality of a wobbly economy and the worst bear market in stocks in over two decades. In a pattern foreign to the experience of most market participants, stocks worldwide have been declining almost daily. Nothing seems attractive to investors, except cash, and billions of that commodity have begun flowing out of equity mutual funds. Investment professionals, always attentive to the latest trends, have been thrown into confusion and everyone hopes that just one more Federal Reserve interest rate cut will turn things around.
"The markets hate uncertainty," as the old saying goes, but they who seek certainty on Wall Street would be better off looking elsewhere. If nothing else, the last three months should have demonstrated once and for all that despite the most intense scrutiny of financial and business affairs, no one really knows what will happen with security prices, or the economy. In fact, the investment community has been taken completely unawares by the severity of the markets’ collapse and the suddenness and depth of the economic challenges facing the U.S. after years of unusual prosperity. Their views shaped by years of rising markets, many observers were led by surprise interest rate cuts and a sharp jump in stocks in early January to predict a "V-shaped" recovery following 2000's downturn, typical of the "buy the dips" experiences of the 1990s. When this happy outcome failed to come to pass, the collective judgement of the Street settled on a "U-shaped" rebound -- not the preferred quick fix, but not too bad. As the declines continued unabated, expectations shifted once again to an "L-shaped" outlook for stock prices: a prolonged slump with no end in sight. So much for forecasting. As usual, Wall Street opinion merely followed the depressing trend of negative corporate earnings announcements lower. There is no reason to believe that the Street’s newfound pessimism will ultimately prove to be any more useful to investors than its now discredited optimism of just a short time ago.
"In Trends We Trust" would be a fitting motto for Wall Street, where "analysts" often do little more than seek out patterns of stock price movements through which they can draw an upwardly sloping line (this is why they so often caution investors to wait for "evidence of a turnaround" before committing funds -- in other words, wait until the stock goes up). Trends provide only the flimsiest basis for committing capital. Essentially the manifestation of an emotional response to what one observes in the markets, trends have only an apparent "momentum" that seems to carry them forward, a fragile momentum subject to disruption by events such as the market turmoil of the past year. When that happens, trend-followers are like cockroaches when the light comes on. Trends are an unreliable compass and no substitute for truly understanding the businesses in which you are investing.
The most unreliable trend of this market cycle has been that associated with the technology sector. Of the action in these stocks that has brought so much agony to their owners over the past year, one could say: "There was a collective ignorance of the earning records that had been compiled by the managers of our industrial corporations. Corporations that had never demonstrated any real earning capacity proceeded with ambitious plans for expansion and their stock offerings were put out by reputable sponsors." Such was actually said -- in 1931 -- of the ancestors of the most recent beneficiaries of speculative greed and thoughtlessness. The stock market darlings of the late 1920s, such as utilities (the "new economy" stocks of that time) and investment trusts, were able to suck in huge amounts of capital, only to see it evaporate when the bubble burst. Substitute "high technology" for "industrial," and "major Wall Street firms" for "reputable sponsors," and voila! -- no difference!
We are amazed at the continuing fascination with all things technology. Whenever the averages have popped up during the long decline, the tech stocks have been responsible. Interviewees on all the business programs are inevitably asked their opinion on the tech sector. The most-active lists are dominated by TMT issues -- technology, media and telecommunications. Elementary economics -- supply/demand -- should have served as a warning that this might not be a good place to put capital, due to the high level of interest among investors of every stripe. Still, the hope of catching the next updraft in tech stocks remains ingrained, showing that speculation of this sort is embedded in the culture of the investment community.
It is interesting to observe the changed mood in these times, when a negative trend is definitely in place. On everyone’s mind, of course, is its possible duration (originally, the first half of 2001; now, maybe until early next year.). Investing’s magic elixir -- indexing -- is being called into question, now that it has produced negative results. Finally a glimmer of hope in a contrarian sense: someone recently recommended investing in something other than stocks -- in this case, rare books. Now, there’s a highly liquid and secure investment which you can count on for retirement!
Imagine for a moment that a Supreme Capital Allocator looks down from on high and passes judgement on the investment activity taking place here below. Nothing escapes this omnipotent Being whose justice is swift and merciless. Not eternal damnation, but financial losses are the punishment meted out at the Allocator’s hands. Judging by the elimination of $5 trillion in stock market value since March of 2000, the Allocator has not been too happy with what has been going on.
Capital allocation is what investing is all about. Whether it is a corporation deciding to buy new productive equipment or an individual contemplating where to put retirement savings, the challenge is approximately the same: how to employ funds in such a manner to produce the greatest return while incurring some understandable amount of risk. To get an idea of the magnitude of the task, picture the individual investor facing a choice of several thousand separate stock issues, as many different mutual funds, plus fixed-income instruments and real estate. Corporations face an equally daunting job of allocating their capital: should it be invested in any number of possible projects, or returned to shareholders?
The importance of the undertaking is demonstrated by the implications of its being done poorly. For the individual, the cost of a poor allocation of resources could be a comfortable retirement. Unwise capital management at corporations can fritter away shareholder wealth. We as a society can suffer, too, if assets are ineffectively used. Those entrusted with the duty of allocating other people’s funds (including those of society as a whole) bear a heavy responsibility. Although never without risk, care must be taken to ensure the preservation of principal as well as a reasonable return. The process should include procedures that are rational and subject to measurement, not just gut feelings. Modern finance has attempted to quantify the process to make it as "scientific" as possible, but, in the end, old- fashioned judgement -- the product of long experience -- probably contributes to successful outcomes as much as any other single factor.
As the losses incurred over the last year indicate, capital is sometimes allocated for the wrong reasons, in apparent disregard for both science and experience. At times the deployment of resources looks to be a deceptively easy task to those who are uninformed, or who are heedless of risk. For example, the prolonged upswing in our equity markets made indexing (investing in funds designed to mimic the movements of market averages) seem like a no-brainer. Likewise, the remarkable rise in the technology sector affected a broad spectrum of market participants, from venture capitalists to Internet day traders, who hoped for an equally amazing -- and quick -- return on their commitments. Telecommunications firms in Europe, flush with excitement from the growth in their industry, spent enormous sums just for the right to operate so-called "G3" networks based on an unproven technology. (The networks must still be built at a cost of additional billions.)
Decisions made because of these essentially emotional reactions to market events are usually poor ones, as subsequent developments have shown. The most rudimentary analysis of market valuation parameters in the late 1990s would have revealed the broad averages (and, hence, index funds) to be uninteresting investment choices. Hence, many investors are rethinking this strategy. Also rethinking strategies are the European telecom giants that are now saddled with debts and sinking credit ratings. The excesses that came to characterize technology are too well known, now, to require further comment.
Too much capital committed to assets at prices too high to give much hope of an adequate return, and too little conservative, hard-headed assessment of market possibilities and cash flows do not bode well for a near-term recovery. The situation confronting those who became seduced by technology looks especially tragic. Much capital has been permanently wiped out, going to line the pockets of early investors and promoters, or simply dissipated by companies with hopelessly faulty business plans. Internet "Incubators" (companies whose business is to place funds with start-up concerns and eventually take them public, reaping big rewards) have experienced horrendous losses. They and other venture capital-type outfits are having to spend money just to keep their ventures alive. We are also coming to appreciate the extent to which even "blue chip" technology companies got into the act. Intel and Cisco Systems, for example, enjoyed large profits from portfolios of technology stock holdings while the sector boomed. (Intel even claimed such gains were part of "normal operations.") These gains have now evaporated, and losses can be expected. We doubt if the Supreme Allocator is done exacting punishment.
1 From Vereinsamt ("In Lonely Isolation"), by Friedrich Nietzshe.
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. 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:
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Revised: July 18, 2001 TAF
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