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Bread and Circuses
January 2002
Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
See also:
General Index
of all guest columns written by Dennis C. Butler, CFA
A political cartoon that appeared in the newspapers during the immediate post-Viet Nam War period has stuck in our mind ever since. At the time the government of China was picking a fight with the Vietnamese for some forgotten reason -- territorial boundaries, no doubt. The cartoon showed Chinese leaders walking down a path through a Tolkien-like forest and following a sign which read: "'Light At The End Of The Tunnel' This Way." The reference, of course, was to a phrase often used by or about the American military and politicians during that war and the cartoonist was, rightly or wrongly, commenting on the apparent failure of the Chinese to learn from history in dealing with their neighbors to the south.
The foibles of Wall Street never fail to bring the image of this cartoon to mind -- most recently when the resurgence of the NASDAQ market since September lit the fires of enthusiasm for technology shares once again. The NASDAQ index, whose list includes an abundance of technology companies, rose 30.1% during the fourth quarter. One of its leading components and a "bellwether" technology stock, Cisco Systems, rose an even greater 49% for the period (although it still lost 53% of its value for the full year). Why the reversal of Cisco’s market fortunes? It reported earnings of four cents per share in its fiscal first quarter. As often happens with tech companies, these were "pro- forma" results that excluded certain costs -- costs which managements deem not to be relevant when evaluating a company’s business. Even so tainted, the report was not viewed as a disaster in the tech world and, besides, management indicated that things had apparently bottomed for the company: it had enjoyed some market-share gains, and revenues had stabilized after declines in previous quarters. Perhaps some found Cisco’s market valuation of just over 40 times earnings attractive as well. This figure was down considerably from almost 200 times in early 2000. All the same, we find valuations of either magnitude to be exceedingly uninteresting, just as we did in 2000; and we remember that the market’s opinion of this company and its industry at that time was a little too optimistic -- just a little.
But, who are we to say that Cisco or any of the tech favorites will not turn out to have been wonderful stock purchases at this time? Even if this should prove to be the case, we would hesitate to call such purchases investments since their hue is more that of what we understand to be speculations. We also suspect that the old "look over the shoulder" routine is at work here. When the market rises as much as it has in just a few months, professional money managers fear being left out, so they feel obligated to own the issues that are moving, regardless of other, perhaps less attractive attributes. We had thought that 2000 and 2001 would have taught some people to hesitate before letting the market do their thinking for them. After two years of trudging through depressed markets, we guess the temptation to assume the light ahead is the end of the tunnel is just too much to resist.
Panem et Circenses
In Roman times the emperors learned that by keeping the populace fed and entertained (hence the Latin phrase panem et circenses, or "bread and circuses") their subjects would tend to overlook certain indiscretions and excesses on the part of their rulers. Not that the citizens of the empire had much choice in these matters; still, keeping an unruly population under control could be costly and distracting. These lessons have not been lost on politicians down to this very day. It’s also a lesson that has not been lost on Wall Street and the corporations that have learned to play its strings.
The Enron catastrophe was so huge and sudden that it caught the general public’s attention. Vast amounts of wealth simply evaporated, including the entire retirement accumulations of many Enron employees. Yet, had the investment community really done investment work on this company, the calamity could have largely been avoided, at least by outsiders. The company’s aggressive accounting policies had been known about -- and largely ignored -- for years. Analysts knew about the off- balance sheet financing through obscure partnerships, yet chose to suspend judgement when it came to really thinking through the implications of such structures. Why did this happen? Enron’s management knew what kept the Street happy: good reported results that would make for entertaining stories for brokerage clients, and lots of commission and investment banking business with Wall Street firms. Bread and circuses: keep the analysts and their firms happy and they will overlook things you do not want them to focus on.
In addition to the accounting and financing obscurities, one thing overlooked was the company’s arrogance, most vividly revealed in the condescending and even abusive manner in which it treated analysts and investors who did bother to ask questions. This behavior in itself should have been a red flag for an alert investment community. Yet the Enron case is merely a single, albeit extraordinary, instance of ineptitude on the part of Wall Street when it comes to protecting investors. A Massachusetts company, Thermo Electron, for years enthralled the Street with its strategy of starting new businesses in-house and then spinning off pieces of these corporate incubations to the public. Fat investment banking fees had a salubrious effect on investment community opinion until a few years ago, when the stock market became less receptive to the Thermo hatchlings and the game came to an end. Now one seldom hears of this company, except to learn of its progress in restructuring a large basket of subsidiaries. We could point to many more examples.
To be fair, Wall Street was not alone in being lulled to sleep by corporate tomfoolery. The "buy side" of the investment business -- money managers -- also played a role. As one commentator stated in connection with the Enron fiasco: "Not to be with this company was to miss a lot of performance." Enron was a very large concern whose stock was a significant component of the investment universe (at one point its equity market value was over $65 billion). When the price of such a stock advances strongly, people in the money management business, ever concerned with their "relative performance" versus their competitors, have to take notice and participate or risk being left behind by their peers. In other words, the imperatives of the money management business itself virtually force its practitioners to do things that do not always make sense from an economic and risk/return standpoint. This is a primary reason why we maintain that money management, a business, should be clearly distinguished from investing, a profession.
Anni Horribili
In our thinking about investments we incorporate a basic assumption which maintains that there is nothing about the past that necessarily and logically impels a particular future pattern or direction of market values. For example, stock prices have generally risen for several decades, but there is, in our view, nothing that guarantees this pattern will continue. In all likelihood, moreover, the demise of a longstanding pattern will occur without its being recognized until well after the fact. This happened in 1900 after the dollar’s value and bond prices had risen for thirty years. Economists of the day saw this pattern continuing indefinitely. From that moment on the dollar and bond values began a protracted decline that would continue for twenty years. It would seem that all things must pass, sooner or later.
We are aware that most people in the investment business probably do not see things this way and that it is part of Wall Street’s business to keep optimism up and money flowing largely by focusing on recent events and encouraging customers to believe that "momentum," price patterns, or statistical correlations in the markets hold clues to future price behavior. Yet, it is in its forward- looking, soothsaying mode that Wall Street is at its most vocal, but least credible, with the new year’s tea-leaf readings being the least plausible of all. And after two years of rather depressing news from the stock market, it is small wonder that the customary year-end wrap-ups and forecasts have taken on a palpable "keep up a brave front" cast. We find it difficult to believe that people in our business take some of these arguments seriously, but clearly many do. Anyway, here is a sampling of a few traditional favorites that seem to have been emphasized in recent market chatter.
"As January goes, so goes the year." According to this old saw, if the market rises during the initial trading sessions of the New Year, then odds favor positive returns for the entire year. The undeniable strength the markets demonstrated during the last three months of 2001 has made adherents of this creed unusually expectant this time around. The momentum, it is anticipated, will spill over into the New Year and seal the market’s fate for the rest of 2002. Typically, decades of data detailing the supposed accuracy of this forecasting device are presented for our edification. Unfortunately, there is no effort to identify the causative factor involved in the presumed correlations, or deal with the fact that there is nothing in logic or economics that would indicate such patterns, read into the historical record, have any predictive power whatsoever.
Discussion and debate about the possibility of a so-called "January effect" is another annual ritual of the financial media and commentators at this time of year. This darling of the pattern-finding set holds that the abatement of year-end tax selling and new money coming into the markets at the beginning of the new year help cause a lift in stock prices in the year’s opening weeks. Exhaustively studied by academics in the field of finance over the years, there may be something to the idea that regular seasonal money flows in December and January can affect prices in some regular fashion. Nevertheless, the effect is too unpredictable, short-term oriented and, hence, speculative, for our requirements and probably unsuitable for the purposes of most non-professional market participants.
Finally, the fact that 2000 and 2001 were the first consecutive negative years for stock owners since the 1970s has spawned a new fallacy involving market statistics. This year we hear that the odds favor a positive 2002 because the last time a string of three negative years occurred was around 1940! Again, what tries to pass for serious analysis is merely a compilation of statistical patterns that make for interesting stories, but which have no logical significance or predictive power. Proof positive that hope springs eternal on Wall Street and that its ingrained bullishness is a bias that investors have to view with skepticism.
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:
Telephone: 617.441.9695
Email: cscc@world.std.com
URL: www.businessforum.com/cscc.html
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Revised: April 16, 2002 TAF
© Copyright 2002 Dennis C. Butler, All Rights Reserved