History Rhymes

July 1, 2002

Dear Investor:

The past quarter needs very little introduction and much explanation. This is the worst bear market since the Great Depression and the first time the indices have put in three losing years in a row since those dark days. We appreciate that these are difficult times for you to have your money invested in anything, let alone stocks and bonds. Lest you think, though, that these times are unique, bear with us for the next few paragraphs. As Mark Twain noted, history doesn’t repeat, but it rhymes.

The New York Times says it best: “Unless business behavior improves, the free enterprise system and perhaps freedom itself, could perish.” The trouble is that the Times said that on July 20, 1975, in the wake of the last bear market and just as the market was preparing to rise 60% over the next two years. The favorite resort of the hopeful or fearful is to say “this time it’s different.” Collectively short memories prevent us from realizing that it is never different. What occurs has occurred before. Manias and panics are both as old as time. During 1999, the bulls said: “This time it’s different–it has never been so good.” And in 2002, the bears cry: “This time it’s different-it has never been so horrible.” Of course, both pronouncements are wrong, spoken by those who ignore history at their peril.

In the wake of accounting scandals, terrorism, and all-around bad news, investors are starting to pillory everything from Martha to George. This skepticism is the healthy flagellation that follows a bust; it usually marks a bottom. When investors only issue orders to sell and never buy, the end is near.

Markets are, by design, bent on humiliating the greatest number of people the greatest number of times. When a trend seems cast of iron, it is most ready to crack. Many investors are liquidating or shorting stocks now, when it could not be more dangerous to do so. When stocks appear consigned to the scrapheap, they are most likely to rally, by edict of that cruel intersection of psychology and economics that only a contrarian viewpoint can protect against. The law of demand dictates that massive pessimism is accompanied by the lowest prices. Witness Business Week’s infamous cover story in 1979 trumpeting the “death of equities” just as the great bull market of the past twenty years was poised to begin.

People succumb to the whims of mass behavior because it feels better. It feels good to be out of stocks when they have just plunged, because conventional wisdom says they will plunge again. It feels good to buy stocks when stocks are going up because a greater fool will buy them. All this feeling stands in the way of true riches. That is why the current wealthiest man in the world, Warren Buffett (he recently dethroned Bill Gates due to substantial declines in a stock called Microsoft), got rich by taming his emotions and holding the quality companies he owned for the long run.

How did Warren Buffett, by the way, keep from selling investments during the seventies, when Vietnam was followed by Nixon, which was followed by riots, which were followed by the Pentagon Papers, followed by Watergate, followed by the Yom Kippur War, followed by the Oil Embargo, which was followed by Nixon’s resignation, followed by massive inflation, followed by double-digit interest rates? If you thought that sentence was long, then remember what it was like to live through it-and people say today is bad. Buffett held on by three means: (1) a knowledge that he owned great companies, as pummeled as they may have seemed at the time, (2) a determination to never give in to the temptation of feeling better by selling, and (3) a knowledge of history that protected him from magical thinking.

A little bear market history puts things in perspective: From September 3, 1929 to July 8, 1932 the Dow declined from 381.17 to 41.22, a collapse of 89%. But how many people know that from July 8, 1932 to March 10, 1937, the Dow rose from 41.22 to 194.40, a staggering gain of 372%–during the depths of the Great Depression, no less. It is true that it took until the fifties for it to return to its 1929 high, but this ignores the vast sums of money made by people who had cash on hand and invested near the bottom in 1932. For example, it could take as many as 15 years for the Nasdaq to once again pierce 5000, which is very discouraging for those who bought Priceline at the highs. But it shouldn’t dent the fervor of those who were able to preserve capital to some degree and can now put cash to work.

Many pundits point to average p/e’s of 40 or 20 (depending on trailing or forward earnings) and proclaim that the Bear Market will not be over until the p/e drops to its bear market trailing average of 10-14. This argument does not take into account interest rates, which cannot be excluded in any valuation model. Any economist knows this, but the press, always hell-bent on scaring the masses, ignores this necessary variable.

Stocks compete with bonds for investor attention: putting aside those who sit on mattresses full of bullion, most people choose one or the other for their liquid assets. We know this because the biggest capitalized markets in the world are the equity markets, at approximately $36 trillion in size, and the bond markets at around $31 trillion. Their relative equilibrium shows the highly competitive nature of the asset race. Like Coke and Pepsi, they are always neck in neck. When interest rates rise and hence bond yields, buying bonds look more attractive. Any logical investor, from Buffett on down, compares bond yields to historical equity returns to decide where to allocate money. If 10-year bond yields are at 4.76% (like the present), then future equity returns need not be high to compete, hence a premium placed on forward earnings valuations. Another way of saying this is that more money flows into stocks when bond yields look unappealing, thus boosting the price paid in relation to earnings–the p/e ratio. But if yields rise to 6%, then stocks have to deliver 26% more earnings to justify their ownership: if the earnings don’t rise commensurately, the price will have to shrink, thus contracting the p/e ratio. If interest rates spike to 15%, as they did in the seventies, then very few people will pay up for stocks. After all, who wants a risky return of 10% in stocks when safer bonds are paying double digits? This is why p/e’s at the end of the seventies bear market were so low, and why today’s are not especially high.

Unless monetary policy is grossly incompetent, interest rates should not have to rise to double-digit levels. Rates will climb somewhat to match a recovering economy. Unless inflation, however, grows dangerously high, interest rates should not spiral out of control. The continued deflationary forces of China and the Internet should mitigate the inflationary impact of a weakening dollar. At current interest rates, the average forward p/e of 20 is well-justified, even low.

We will not, of course, return to 20% annualized returns anytime soon. The restricted psyche of a post-bubble hangover will see to that. Stock returns will probably revert back to their historical average, somewhere around 10%. And they should, over time, trump the returns of bonds, bills, gold, copper, sorghum, fine art or real estate-as they always have. The reason for this is simple, unadorned economic reality: investors are always compensated more for taking bigger risks, and it should be clear to anyone at this point that the stock market is a bigger risk. People who bear the risks sensibly (buying quality companies) and not suicidally (buying the next speculative rage) will reap the long-term rewards of their risk-taking as they have without fail over the long history of markets. Some of these statistics were plucked from Triumph of the Optimists: 101 Years of Stock Market Returns. This terrific new book from Princeton University Press, full of excellent research by finance scholars Elroy Dimson, Paul Marsh and Mike Staunton, gives a comprehensive analysis of stock returns over the past century.

Every investor has a story about not having bought X back then, when it was a steal: Citibank stock in 1990, Manhattan real estate in 1975, and so on. Why then doesn’t everyone buy when things are cheap? Why will so many people wring their hands in 10 years and say, “If only I’d bought that stock in 2002″? The reason is that the proposed purchase always looks absurdly perilous at the time. And it doesn’t help that the road to those prices is paved with people who bought too early and lost a fortune. Indeed, the risks of risk-taking cannot be avoided. But those who have the courage to buy quality stocks when it appears hopeless will be rewarded richly.

We know these are difficult times. Our efforts, in conjunction with our fund managers, are focused on daily reviews of the underlying holdings of every portfolio to review credit quality and balance sheet liabilities. Indeed, our managers have always paid attention to such issues.We appreciate your patience during this period and especially welcome all communication. Please feel free to call us with any questions or concerns.