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of all guest columns written by Dennis C. Butler, CFA
A warning shot? The media’s shrill reaction to February 27’s 416-point drop in the Dow Jones Industrial Average was enough to instill fear for the future of Western capitalism. In reality the 3.5% hit represented little more than a return to normal market volatility. But, because it contrasted so sharply with the unusual calm of recent years, the “rout” attracted undue attention (A well-known tendency among financial pundits to either ignore or welcome volatility to the upside also played a role, one suspects). However, what made the event really interesting and instructive was the ostensible source of the nervousness — a sharp decline in the value of stocks in China, an emerging capital market.
For years academicians and Wall Street have pushed the ownership of foreign securities as a way to diversify holdings, possibly improve returns, and reduce volatility or “risk.” There was a sound basis for recommending such a policy; statistical analyses of historical data had shown that foreign securities markets had never been highly “correlated” with those in the U.S. In other words, stock prices overseas might rise when those in the U.S. fell, and vice-versa. Foreign markets — particularly certain less-developed ones — had in many cases offered higher returns as well. That was history, however, and as often happens when a good thing becomes well-known and broadly promoted, conditions changed. Correlation among markets is now higher, meaning they tend to move more in unison than was previously the case. So, when China got the sniffles several weeks ago, the rest of the world feared catching a cold. Curiously, the same thing is often said of the U.S., the world’s dominant economy. Clearly, the nexus of international economic power and influence is undergoing transition.
In the larger scheme of things, all of these price gyrations reflect underlying worldwide economic connectivity and capital flows. A variety of factors, including the growing complexity and obscurity of the mechanisms of some of these capital flows, have led us to suspect for quite a while that some sort of market dislocation — perhaps a serious one — may be brewing. We felt it would likely emanate from somewhere in the increasingly intricate web of credit market creations, but, if recent events are indicative of anything, it is perhaps that a disruption could come from anywhere. As for the warning shot, we have no idea what it may portend, if anything, for the equity markets in the near term. Obviously, a lot of money rests on a hair-trigger in a market priced for perfection. Further ups and downs would not be surprising — nor should the careful investor fear them.
Turning to the bond market, the following quote from a corporate treasurer says it all: “The overall market’s tightening has played to our advantage.” It is still a sellers’ market: rates remain historically low, spreads “tight,” and borrowers are locking in low costs like never before. The first quarter saw corporate debt issuance increase 16% over the same period in 2006. The flight from risk associated with the stock market hiccup proved to be fleeting; junk bonds increased as a percentage of all debt issuance, with some of the biggest junk deals in history closing during the quarter (and after the plunge in stocks). Merger and acquisition activity, which relies heavily on the debt trough, proceeded at record levels, with over $1 trillion in deals announced so far in 2007. In a real sign of benign conditions and complacency, Wall Street deal-makers and private equity types are encouraging “leveraged recapitalizations”: improving corporate balance sheet “efficiency” by selling bonds and buying in shares. Financial liquidity — the magic potion that makes all of this possible — remains incredibly abundant. Ironically, due to problems in the “subprime” loan segment, practically the only would-be borrowers now finding access to credit limited are those with poor credit histories. In the old days this kind of selectivity on the part of lenders was called “banking.”
When market averages slide over three percent in one day, fear rises, and cries of woe are heard on Wall Street, we admit to a certain hopeful feeling, and a lightness of step. After all, lower prices mean higher returns can be expected; when the going gets tough, it’s time to get greedy. However, stock valuations have become so extended in the last few years that it would take a string of 416-point down days to make things really interesting. As it turned out, despite all the sturm und drang, the popular stock averages were essentially flat for the quarter— — up or down a little, depending on the index. Bond returns were positive by a percent or two, reflecting a modest rise in prices since the end of last year. Nothing to get excited about — a “normal” state of affairs. We remain hopeful.
Youth and Experience
Time can be the investor’s best friend. Years ago an author on investments estimated that if the Medicis of Renaissance Florence had invested the equivalent of $100,000 and earned only a 5% return over the intervening centuries, the family would own much of the planet by now (that such a thing has never happened is due to a little thing called risk — the wars, mismanagement and mistakes that are part of the vicissitudes of human existence). Turning from the hypothetical to the concrete, a great investor like Warren Buffett, while possessed of truly unique talents, has had the benefit of five decades of activity to augment his fortune. In a similar vein, in the mid-1990s the press made much of the story of a woman who invested about $20,000 in the 1940s, and bequeathed a $22 million portfolio to a university in New York City fifty years later. Closer to home for the average person, real estate, while not being quite the bonanza many seem to think it is, has nevertheless boosted the net worth of countless people who did nothing more than own a house for a few decades.
Astonishing results are possible when time, low turnover, and the power of compound interest are permitted to do their work. On the other hand, for those who attempt to mix investing with impatience, time is the enemy. Here we enter the world of speculation, where options and futures contracts expire worthless; stop-loss orders are executed on momentary price dips; and expenses and taxes consume gains. We have seen no evidence to convince us that these short-term trading strategies offer a consistent path to wealth, excepting for those who charge fees for advising others making the attempt.
Recently we talked investments with a soon-to-be graduate of a top law school, who is looking forward to a brilliant career in law and business. As a graduate of a top professional school, our young interlocutor could accumulate considerable wealth if he handles his affairs wisely. Pointing to some of the examples noted above, we explained to him that, with decades of earning power before him and the foresight to commit funds wisely and productively over a longer period of time, while avoiding the costs of trial and error, he could achieve impressive results.
While we trust that the student found our conversation beneficial, we found it to be an instructive experience also. While it was clear that he was fully deserving of a successful career, it was also obvious that, through the timing of birth, he lacked a certain perspective. With regard to the economic themes that were the focus of our conversation, never in his 28 years had he experienced difficult times. The last truly disruptive financial market dislocation occurred before he was born. During his lifetime real estate has been a healthy source of wealth for those fortunate to have been long-term owners. The quality — in terms of caliber and character — of goods and services has changed and often improved considerably (think automobiles and computers). In general, the U.S. for the most part has enjoyed a period of prosperity and economic calm.
He is not alone, of course: anyone born in the U.S. after the mid-1970s has only known good times, economically speaking. So, at a time when Wall Street banks and law firms are expanding, transactions and trading volumes are regularly setting records, private equity and hedge funds are sprouting up all over, and the economy in general is doing reasonably well, it is understandable how today’s prospective young professionals may expect a good reception in the job market, and immediate and continued prosperity.
We were reminded of our own introduction to the investment profession, under conditions very different from those prevailing today. Indeed, we now feel fortunate that our initial foray into Wall Street (in 1982) occurred at a time of layoffs, hiring freezes, depressed markets, and, importantly, depressed outlooks; the general mood was that of expectation of worse things to come. In the midst of that gloom began one of the greatest bull markets in history — an advance which continues to affect market psychology today. Because we had the opportunity to observe such dramatic changes, we are aware of how deceptive the conditions and psychological atmosphere of the present can be, and how differently things can turn out from what we expect.
One needs to be repeatedly reminded of these truisms on Wall Street, which tends to have a very short institutional memory, and where lack of perspective is not confined to the inexperience of youth. Although not appreciated at the time, experienced operators kept a lot of people out of trouble in the late 1990s; the appreciation came when many of those same people enjoyed handsome profits in the years thereafter. And recently, a news story proclaiming “Cheapest Stocks in Two Decades Signal Bull Market” took our thoughts back to those long-ago days of the summer of 1982, when interest rates of 14% led many to think treasury bills a great investment, and stocks were “unattractive.” Today’s well-below-average rates of under 5% have seemingly seduced reputable investment professionals into thinking stocks are cheap, just as well-above-average yields drew money away from equities twenty-five years ago. As it did in the earlier period, the bond market will eventually return to more normal conditions, and probably take equities with it. While it is not in our character to predict such things, we hardly think a “bull market” of major proportions is in order. Stocks today are just not as attractive as they actually were in 1982.
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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.
"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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