Lakeview Investment Advisors, LLC
Commentary Date: December 2002
by Bill Westhoff, CFA
Did the stock market bottom on October 9?
The following discussion is from a speech given to the Finance Club of the University of Minnesota, Carlson School of Management on October 16, 2002.
Before I answer the question, let’s explore some background. You may have often heard the comment that markets are driven by fear and greed. That is a factor, but the largest determinant of rising stock prices is increasing corporate profits, and a major determining factor in increasing profits is a growing national economy. Fundamental economic forces (such as gross domestic product, corporate profits, interest rates, employment, consumer price inflation, etc.) play a bigger role in explaining the movement of stock prices over economic cycles than market psychology (i.e., fear and greed). However, market sentiment is an important factor that should not be ignored by investors.
There are three broad categories that investors should follow to build a successful investment record: Fundamentals, Sentiment, and Valuation. Good fundamentals and strong market sentiment don’t guarantee that an investor will make money. Often the good news is fully reflected in prices and valuations, making it difficult for the investor to find opportunities. Conversely, weak economic fundamentals and poor market psychology is usually reflected in low stock prices and fair to cheap valuation, providing the investor with many opportunities. A number of successful investors address the interplay of market sentiment and valuations in their writings; including Warren Buffet and Ned Davis.
Warren Buffet has stated that you go into partnership with “Mr. Market” when you invest in a publicly traded company. Mr. Market is often manic/depressive. When times are good and there isn’t a cloud in the sky, Mr. Market places a high value on the company. When times are tough (as they are currently), Mr. Market can only see a cloudy sky and he places a low value on the company. Buffet says that if you pick good companies to own, they will continue to make sales and profits in both good and tough times; and that you should take advantage of Mr. Market and buy when he sets low valuations and sell to Mr. Market when he is placing high valuations on companies.
Ned Davis, the author of Being Right or Making Money, says a successful investor should follow three simple rules:
I will add another thought—it is easier to see the extremes in market psychology after the market has turned (i.e., 20/20 hindsight). For example, in January 2000, the economy was growing very rapidly, corporate profits were expanding at a significant pace, and the S&P 500 Index had just completed an unprecedented fourth year of 20% plus increase in price. The comment in the popular press was that the technology boom was carrying the economy to continued expansion without inflation or recession. In President Clinton’s January 27, 2000 State of the Union message, he stated, “The State of the Union is the strongest it has ever been...” It is now apparent that was near an extreme point in market optimism and market valuations. The market peaked in March 2000 and has turned in negative returns in 2000, 2001, and so far in 2002.
After three years of negative returns, the market appears to be nearing a point of maximum pessimism (if not already there). For the statisticians in the group, I’ll note a number of market statistics to indicate the depth of market sentiment at the market close on October 9, 2002. (The stock market is one game that seems to have more statistics than baseball):
What is the smart money doing in the midst of this pessimism? It is increasing its exposure to stocks. Warren Buffet has made several notable investments in the energy and telecom industries. The telecom investment is noteworthy because this area is considered rife with overcapacity and weak pricing. And it is an area where Buffet has publicly stated reasons for avoiding in the past.
Other market strategists and observers, who previously called the market overvalued in 1999–2000, are now calling the market cheap or fairly valued. Byron Wein of Morgan Stanley uses a dividend discount model recently called the market cheap; Steve Leuthold, who tracks the percentage of times the market has traded at various Price/Earnings ratios, has recently stated that the market is fairly valued. Finally, Ned Davis says to watch for contrary opinion indicators to indicate extremes in market psychology. Popular indicators are newspaper and magazine headlines. “...a market bottom occurs at maximum pessimism; once a majority of nervous investors have sold out of the market, there is no one left to sell.” The run-up to this mid-term election has had many headlines about the poor stock market and economy continuing for an extended period.
In spite of all of the bad news about the market, there are investors who are making money by owning the right asset classes and the right stocks. There is a need for good analysts to find opportunities and manage risk for disciplined investors in all kinds of markets. To demonstrate the opportunities that existed in this market, I looked at ten stocks based in the Twin Cities of Minnesota to see how they performed over the last year (9/1/01–8/31/02). The stocks are a mix of large and small, growth and value, and are in a variety of industries. The results will surprise you.
As you can see, not all of these stocks were up, but the all outperformed the S&P 500 Index. The S&P was down 18% over this same time period. Obviously, hindsight helped pick out these stocks, but the point is that good analysis also helps with foresight.
Is this a good time to invest? Is there hope for graduating students in the investment business? I believe the answer to these two questions is a resounding yes! Has the market bottomed? Time will tell. However, based upon history, there are a number of similarities to previous market bottoms. A disciplined investor with a well diversified portfolio, applying good analysis to specific companies should find attractive returns over the next three to five years.
Since October 9, the market has just completed eight straight up weeks. This is the first time this has occurred since 1998; a pretty good indication that the market has at least found a near term bottom. The market may find new reasons to sell off, such as new news on the economy, another surprising corporate misdeed, the war on terrorism, or the inspections in Iraq. However, a number of significant events have happened in the interim to address the worries of the market in early October. The Federal Reserve lowered the federal funds rate another 50 basis points, the embattled SEC Chairman resigned, Congress passed a resolution supporting President Bush on Iraq, the United Nations’ Security Council unanimously passed a tough resolution on Iraq weapons inspections, the mid-term elections increased the Republican control of the House and gave Republican control to the Senate and the log-jam of legislation has now started to be broken. (Most importantly, the economy has continued to grow and is showing productivity growth, which will allow corporate profits to increase.) These are all significant events that improve market psychology—the tough decision is to buy when the pessimism is at an extreme!
© 2004 Lakeview Investment Advisors, LLC
Any information provided in these materials is believed to be from reliable sources. Lakeview Investment Advisors, LLC makes no representation as to its accuracy or completeness and is not responsible for any damages incurred as a result of your use of these materials. These materials do not constitute a solicitation to sell or offer to sell investment advisory services to residents of any state in which Lakeview Investment Advisors, LLC lacks authority. Part II of Form ADV, which details the business practices, services offered, and management fees charged by Lakeview Investment Advisors, is available upon request.
The Economics and Markets Advisory Board consists of the following members:
Theodore H. Busboom, CFA, President, Prospective Value, formerly Senior Vice President and Portfolio Manager, American Express Financial Advisors
Ray S. Goodner, CFA, Private Investor, formerly Senior Vice President and Portfolio Manager, American Express Financial Advisors
William C. (Bill) Melton, PhD., President, Melton Research, Inc., formerly Chief Economist, American Express Financial Advisors
Jim Walline, CFA, President, Walline Capital Advisors, LLC, formerly Vice President and Portfolio Manager, Thrivent Financial Services
Lakeview Investment Advisors, LLC participates in a Board of Advisors consisting of professionals in the investment field; however, members of that Board who are not employees of Lakeview Investment Advisors, LLC do not participate in providing investment advisory services offered to clients.