The Wrong Lesson

January 4, 2005

Dear Investor:

It wasn’t long ago that the world suffered the greatest market collapse since the Great Depression. Though we are far from the index highs that marked the last peak, markets have rebounded to a point where people seem to trust them again—perhaps a little too much.

It’s remarkable that the new issues market is booming again, and that gamblers, salivating for the next IPO, are once again calling the same brokerage firms that stuck them in Worldcom and Pets.com. Is this human nature at its worst or finest? Then there are those who have foresworn Wall Street altogether, convinced that the problem was equities in general, not their own appetite for speculative stocks. Both those who learned no lesson and those who learned the wrong lesson will be vastly disappointed over the next decades. Markets will continue to suffer setbacks—even collapses—and speculative stocks will get shown the door from time to time. Over time, however, equities will continue to be a superb investment for those who pick well-capitalized companies selling at discounts to their intrinsic value.

In the meantime, the speculative frenzy pouring into certain sectors looks just like 1999. If you ask these people why they are buying a stock that has no earnings and no definitive prospects, they will give a very nineties answer: because it keeps going up. The power (or impotence) of the human mind to convince oneself that this time I’ll get out in time, this time I won’t lose it all just shows that people ultimately believe what they want to believe.

Just as the intense pessimism in the summer of 2002 meant markets would (despite all intuition) soon turn higher, December’s complacent optimism might bode poorly for the near future. In 2005, long-term interest rates should trend higher. The yield curve is starting to flatten as long rates remain artificially suppressed relative to short rates. This cannot continue and is likely to get resolved as long rates surge higher. Such a scenario does not augur well for long-term bonds, the housing market, or for companies that need access to the fixed income market. All are likely to suffer major setbacks as the 10-year bond yield passes 5%. Investors who remain in short-term bonds and well-capitalized stocks are likely to do better than most and will be able to swap into longer term bonds as rates rise. TIPS are starting to look slightly overvalued as investors have bid their prices up in anticipation of inflation. We would not add new money to them at this time. Over the past quarter, we trimmed the overvalued energy and small-cap sectors and have swapped into large-caps. Large-cap stocks, often multinationals, are less dependent on the bond market and can take better advantage of the declining dollar through their exports.