Thinking About the Markets
Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
of all guest columns written by Dennis C. Butler, CFA
Amidst the worst December for the markets since 1931, Barron's financial magazine bestowed its "History is Bunk" award on all of those Wall Street sages who, solely because the record of the past supposedly made a third consecutive down year unlikely, a year ago predicted positive results for stocks in 2002. After all, those sages argued, such a thing hadn't happened since 1941. We concur with the spirit in which Barron's awarded this recognition, but maintain that the bunk lies not in history itself, but with those who would abuse it by expecting us to believe that the simple extrapolation of the past into the future represents some form of real analysis, and not merely entertaining speculation. Bunk or no, 2002 is now history, and the stock market averages declined once again, bringing the total losses since the beginning of 2000 to between 22% and 67%, depending on which index you prefer. No "Santa Claus Rally" or early "January Effect" -- or any other financial deus ex machina -- arrived in time to pull this one out. Furthermore, 2002's drop was very broad-based in that few of the economic sectors represented in the market escaped unscathed. As for 2003 -- we are completely agnostic. Anything can happen in this business, including four straight losing years (for the historically challenged: it would be the first such string of losses since 1929-1932). We could even have an up year for a change.
So, here we find ourselves at the beginning of yet another year full of "uncertainty," as the pundits are fond of saying (all years are full of uncertainty -- it just seems otherwise sometimes), and despite some evidence of real fear and resignation abroad in the land, the demand for stocks remains quite strong. It is fairly easy to guess why this is the case. On the one hand there are the money management types (mutual funds and other asset managers) who are always worried about their "performance" and are scared to death of missing a rise; they can always be counted on to pile in when stocks look like they're going up. Then, there are the hedge funds, which account for an increasing portion of stock trading. They are interested in any trend, no matter which way it goes. The activities of such institutions account for pronounced moves in the markets and individual securities. The institutional propensity toward abundant trading also explains why now, when a billion shares of businesses change hands, it's considered a slow day.
If it can't do anything about bad markets and uncertainty, Wall Street at least seems determined to get its own bad behavior behind it and start with a clean slate in 2003. This is our interpretation of the timing of the $1.4 billion settlement with regulators over research and investment banking practices announced in December. While we welcome any steps to curb the self-dealing and conflicts rampant in the industry, we doubt that the arrangements being discussed will save investors much money and trouble in the long run. History suggests that crooks will be crooks, no matter what the legal code or penalties. Furthermore, ending conflicts of interest won't save analysts from themselves; in spite of the more "independent" stances which some of them have taken in this changed environment (the appearance of actual "sell" recommendations, for example), the quality of their advice hasn't changed much from the usual buy high and sell low. We also find the notion that analyst "performance" should be measured based on their recommendations to be misguided (we can't remember the last time we took a Wall Street analyst's recommendation seriously). The value of analysts resides in their often insightful knowledge of industries, companies and managements, information which can be useful in decision-making. Unfortunately, these strengths are unlikely to be of much help to the individual investors for whose benefit prosecutors and regulators claim to be acting. The bottom line will continue to be that if you lack the facility to make independent judgements of Wall Street input, you should probably pay someone else to do investing for you.
Thinking About the Markets
Our history professor in college once opened a discussion on the nature of historical thinking by asking the assembled students, "Do events unfold according to recognizable patterns growing out of the past, or is it just one damn thing after another?" We were reminded of this query by Wall Street's year-end ritual of forecasting and positioning for next year's action. Market strategists (a.k.a. "gurus") have been getting a bad rap this year. As our opening remarks implied, trying to predict the market's direction can be a very humiliating experience, not to mention a costly one, not least for the gurus themselves. Few, if any, of the big guns in the soothsaying business were really of much use in helping people avoid the current downturn in stocks, having overstayed their bullishness long after the declines were underway. Not surprisingly, given Wall Street's low tolerance for not giving customers what they want to hear, heads have been rolling. Of course, this sort of culling activity is not confined to bear markets; during the boom of just a few years ago, it was the bears who were getting axed.
Market forecasting by its very nature tends toward the "recognizable patterns" school of historical thinking. Indeed, much of what gurus do involves extending trends or identifying past market patterns that, so the theory goes, should repeat themselves under similar macro conditions, such as the interest rate environment, money supply growth, and so on. We are skeptical of this theory, even as we readily acknowledge that it occasionally seems to work for a time. Sometimes events just happen to unfold in accordance with a forecast. If this happenstance continues long enough, the resulting "trend" reinforces the forecaster's claim to guru status. (As a general rule, "the trend is your friend" if you are in the prognostication business -- as long as it lasts, at least.)
You can infer from the foregoing that we lean towards the "one damn thing after another" school, although not entirely (as our population and economy grow, and as long as ours remains a capitalist system, stock prices will tend to rise over the years, so, there is an upward bias over time). Actually, we have sometimes wondered what would happen if there were no market analysts or, better yet, if no one approached the market as if it were something other than simply a place to buy and sell securities. We have a sneaking suspicion that things would be pretty much the same -- that, for example, an extraterrestrial observer would have noted the 1990s bull market in stocks just as if Abby Joseph Cohen had been there to cheer it on. The serial popularity of market strategists we alluded to above lends support to this idea: market seers are notoriously poor at predicting turning points and their apparent success at times is really due to their luck in latching on to a trend.
If predicting market moves reliably is a near hopeless task, explaining them afterwards is equally fruitless. We often hear that the market has risen or fallen in response to some new economic data or earnings report from a major company. Who knows if this is indeed the case? Markets are subject to titanic forces often involving events a world away. It is as if market analysts were focusing on ripples on a small patch of water, not noticing that their little universe was part of a wave on a storm-tossed sea. If market moves could be connected with specific news or events, it seems doubtful whether such information would be interesting or useful on anything other than a daily basis. On a larger scale, what caused the crashes of 1987 and 1929 is still a matter of debate. Even when a unanimity of opinion is reached on such issues, the record leads us to question whether we really know what is going on. There are often underlying causative factors at work which become apparent only after some time has elapsed and events are put into proper perspective. To observers in late 1929, for example, the world did not seem like an especially threatening place. They believed that an over extension of credit to brokers for margin loans had caused the unprecedented market crash -- a situation that the crash itself had rectified. Beyond that, the future looked bright still, and market participants expected stock prices to resume their upward trajectory in the immediate future. Serious international financial problems soon proved this happy consensus to be premature.
The lesson to be learned from these ruminations is that treating markets as something other than a meeting place for buyers and sellers is seldom beneficial (except to the firms that publish market commentary, of course). Unfortunately, this provides no comfort for those who have suffered through three years of declines in the value of their savings, and who may be alarmed about their financial future. Unfortunately, as well, it is not the place of investment to provide such comfort. For those who may, perhaps out of desperation, seek to divine the future, hoping to avoid further loss, or even profit from an eventual market rise, we can only point out that if nothing else, history indicates you will need a great deal of luck.
As investors, the experience of the past three years does not perturb us. This is a calm that comes from experience, an understanding of risk, a portfolio constructed -- from the beginning -- with "an eye to calamity," and, not least, from the luxury of a business model that permits a long-term view. You learn to "accept the unalterable with tranquility."
Outlook For 2003
Last year at this time a reader inquired as to why we had provided no outlook for the economy and markets in the coming year, as is customary in the investment business. We explained that we don't engage in or pay much attention to forecasts, but after giving it some thought, we have come up with a perfect solution for those who may hunger for such input. So, it gives us great pleasure to announce the annual...
Doris Day Economic Outlook and Market Forecast
Will the economy prosper in 2003? "Que Sera, Sera."
Will the stock market rise this year? "Perhaps, Perhaps, Perhaps."
The nice thing about these forecasts (and a comfort to those who may be feeling a bit dislodged in these uncertain times) is that they won't change from year to year. Not only that, we will actually be right once in a while!
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:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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