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Year four of the Great Decline appeared to be well underway when enthusiasm associated with the ending of uncertainty over the outbreak of war in Iraq rescued the popular stock market averages from a serious rout. Declines in the 5% to 10% range had been registered at times during the quarter, but by the end of March the NASDAQ average was actually up slightly, while the other indexes were down 3.5% to 5% -- indicating a substantial comeback. Still, these results pale in comparison with the achievements of some foreign markets -- such as, for example, Iraq. Offering stunning proof that capital knows no politics, stocks at the Baghdad Stock Exchange posted a gain of 39% year-to-date through the first week of March (the latest figures we have seen). Market "technicians" would probably downplay the significance of the move since it occurred with very low turnover (the equivalent of about $130,000 per day); nevertheless, other markets in the Middle East were also showing sharp gains, apparently in anticipation of profits to be made from reconstruction work after the war. Given that stock movements generally tend to be forward-looking, perhaps better times are ahead for that part of the world.

        Much attention has been recently devoted to attempting to prophesy the future course of stock prices in the aftermath of the current military encounter. Using the history of financial markets during wartime as a backdrop, the emphasis (unsurprisingly, given the suffering of most market participants since 2000) has been on demonstrating the lift that usually accompanies armed conflict, following an initial period of hesitation. The 1991 Gulf War experience in particular has been promoted as a model for what we might expect from the markets during the current middle eastern venture: a drop during the buildup to the battle, followed by sharp gains once the bombing began. There is very little we can add to this discussion, since one person's speculation is as good as another's. We offer only the observation that the consensus view, so often wrong, turned out to be correct in this case. Because the possibility of war had been telegraphed to the markets for several months, one would think that it would have already been reflected in stock prices. Nevertheless, the mere initiation of hostilities has had a positive effect on market psychology, providing the impetus for the strong upward move we have seen since. However, this, the ultimate in "external shocks," provides but a fickle basis for a sustained bullish advance. It is the nature of shocks that they can be, well, shocking -- and unpredictable. Historical patterns are only, after all, historical, and offer no certainty as to what might ultimately be in store.

        Longer-term considerations in fact raise doubts over whether the 1991 conflict is an appropriate archetype. Unlike the earlier war, the current encounter seems destined to entail immediate post-war and "long-tail" responsibilities and obligations of an enormous magnitude whose costs are likely to greatly exceed those of military action itself. Viewed in combination with the on-going mobilization of defenses that we have witnessed in response to the potential of terrorism, we see an impact more alike in character to that of the Cold War aftermath of World War II than the Gulf War, although perhaps to a lesser degree. Missing, however, would appear to be an offsetting stimulus to economic activity of the type provided by heavy government security expenditures during the Cold War. Since the events of 2001, we have felt that with the economy-wide increase in non-productive expenses owing to heightened security concerns (higher insurance premiums are one example), a general compression of margins would seem to be in store for American business. The Iraqi conflict could add to this trend. Reduced future profitability would tend to support the growing belief that returns from stock investments may be subdued in coming years, and certainly well below the inflated results the public had been led to expect just a few years ago.

Speaking Softly

        The old African folk proverb (popularized by Theodore Roosevelt) -- "Speak softly and carry a big stick." -- has always appealed to us. It implies confidence without arrogance and hubris, strength without intimidation. The sentiment it expresses is also quite valuable in fields beyond power politics, including investments. For us as investors it implies the strength of convictions based on sound logic, proven methodology, and facts -- impervious to the vicissitudes of "the battle for investment survival," as one broker and author once put it (military metaphors have long been popular on Wall Street).

        The investment "battle" of the last three years (we celebrated the bear market's third anniversary in March) has sapped the strength of the combatants. We noted recently, for example, that 63% of corporate pension plans are now underfunded due to declines in stock prices, a figure that would have been even higher had it not been for a convenient change in a law governing how pension liabilities are determined (it seems that truth is the first victim in investment battles as well as in military ones). Anecdotally we have heard of severe contractions in the portfolio values of individual investors as well, many of whom have been frightened away from stocks completely. It seems that the remaining enthusiasm for shares resides with hedge fund speculators and program traders who now account for upwards of 40% of a typical day's trading volume on the New York Stock Exchange. Even that interest is wearing thin as poor results have stemmed the flood of money to hedge funds and spelled doom for dozens of the lightly regulated operations.

        One would think that the investment business by its very nature would be a bastion of the "speaking softly" philosophy. Arrogance can be expensive: it is very easy to be proved quickly and embarrassingly wrong and lose a lot of money. Yet responsibility for much of the difficulty that most market participants are experiencing can appropriately be assigned to overweening confidence. Unfortunately, Wall Street is prone to a peculiar form of hubris, born of long bull markets, when every decision seems to be a great one and every market forecast prophetic. If the good times go on long enough, as they did in the 1990s, a false sense of infallibility develops. This is confidence without the big stick -- without the sound basis in logic, methodology, and facts-the kind which gives rise to inflated expectations. It is at such times that pension plans assume unrealistically high returns on their investments, and individuals think that 20% per year is feasible. Even the hedge fund craze might be seen as part of the same phenomenon, or at least its aftermath -- a way to recapture some of the glory of the 1990s, perhaps.

        Careful investors have had an interesting time of it during the last several years, although in a different way than the typical mutual fund manager. Seemingly "impervious to the vicissitudes" of Wall Street, they were shunned in the late 1990s due to their refusal to follow the speculative crowd. In the new decade their results have been exemplary, both in absolute and relative terms. Befitting their character as investors, such people tend to speak softly and are almost never "talking heads."

Lessons Never Learned

        There is a movement afoot to "unleash" fund managers and give them greater leeway in determining how the money under their control is invested. Fund investors would benefit from managers having flexibility and authority to take advantage of more of the kinds of opportunities that the market offers, so the theory goes. We would advise potential investors to be very suspicious of this idea.

        The money management business (including mutual funds) is hemmed in by all sorts of restrictions, many of them of the industry's own making and often driven largely by marketing considerations -- for example, the proliferation of "styles" in investing -- "growth," "value," "large cap," "mid-cap growth," and so on. Managers of such funds must pay close attention to so-called "benchmark" indexes (representing the sliver of the stock market that is the focus of their fund), against which their "performance," and that of their competitors, is measured. Performance relative to benchmarks and competitors is important to the managers, as it determines salary, bonus and job. Deviation from the inventory of stocks included in the style category ("style drift") or holding large amounts of cash are no-nos, as such actions could impact performance, hence salary, bonus, and job. We should also mention that all of this is done on a very short-term basis -- there is little patience for "underperformance" in this business.

        This neat system for managing money had problems enough during good times (we recall that many funds loaded up on technology stocks at the top of the bubble); but since the beginning of 2000, when the market started to tank, it has not worked very well at all. Managers constrained to work with the stocks in their particular universes helplessly watched their funds decline along with their benchmarks. Much to their chagrin, managers found their investors did not appreciate "relative performance" during down markets and began to yank their money out. Suddenly the business wasn't fun anymore. A large number of managers left their fund companies to join or start hedge funds where they would have the flexibility to do more interesting stuff -- such as selling shares short, holding cash, buying bonds, trading in currencies and derivatives and all of the other exotic things hedge funds are wont to do. Hedge funds were also producing better results during the downturn (during the first couple of years, at least), allowing them to attract large amounts of cash from big investors.

        It is in response to these trends that fund companies are considering loosening the reins on their portfolio managers. By doing so they hope to retain talent, improve results and create new product offerings that will attract cash from the investing public. We are skeptical that investors would benefit from such changes over the long run. Some of the activities to be permitted by the new "flexibility" are inherently speculative. Short selling (with exceptions) involves a bet on a stock's or the market's direction. Active asset allocation of the kind being discussed -- moving from stocks to cash to bonds and so on -- is very difficult to do successfully. There is no guarantee that a manager accustomed to buying shares for longer or shorter periods could meet the challenges of a more active trading strategy. Then there is the money management business itself, with its size and rigid competitive structure. Evidence suggests that the industry needs to think twice before so radically altering the way it operates. Several years ago a prominent fund manager tried to employ a "flexible" strategy: in anticipation of a steep stock market decline, he sold a sizable portion of the stocks in his fund and bought bonds. He was about three years early. His fund's relative results suffered and he was out of a job.

        It is an old truism in the investment business that when an opportunity is widely recognized, it is too late to profit. So, any attempt by fund managers to copy hedge funds will probably come at just the wrong time, and when markets improve the funds will likely go back to their old ways. The fund management business has enough fundamental problems as it is. There is no need to complicate matters by engaging in activities that add risk and challenge even the best of traders.

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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
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695

Email: cscc@world.std.com
URL: www.businessforum.com/cscc.html

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