October 18, 1999
Dow Jones Average: 10,116
S & P 500 Index: 1254
Bad Breadth
The stock market has been suffering from a condition known as bad
breadth since April 1998. While the popular market averages are based
on a handful of large stocks, such as GE, Microsoft, Cisco, and IBM,
overall market breadth is a measure of what all stocks are doing. The
average stock peaked in April of 1998 and has been heading lower ever
since. In recent weeks hundreds of stocks have been hitting new twelve
month lows while a small number have reached new highs. Bad market breadth
is a sign that the market is tired and can no longer support most share
prices at high levels. The condition usually worsens, affecting the
stronger stocks over time.
Market breadth tends to deteriorate after a long bull market run.
The money necessary to propel large numbers of stocks ever higher simply
dries up. With savings depleted, retirement plans fully invested, corporate
coffers drained by share repurchases, and foreigners re-investing in
their own markets, the U.S. stock market is short on fuel. At the same
time that capital is less available, more fledgling companies are going
public, riding the last wave of bullish psychology. When new companies
go public there is a diluting effect, as the pool of investment dollars
is spread over more companies.
Bull markets do not end without a struggle. Even when all kinds of
warning signs are flashing, the memory of big profits and the hope for
similar gains keeps bullish enthusiasm alive. The reality of deteriorating
breadth is ignored as investors pile into the few remaining stocks that
are still in up trends. Given a choice of pulling back from the market
or paying extreme prices for a few popular stocks, many investors opt
to stay in the market whatever the risks. A two tiered market develops,
with most stocks declining, and a few becoming ever more overvalued.
The glamour stocks prove to be a temporary haven as they soon join the
broad market decline. For experienced investors who do not want to lose
the gains of prior years, it is the kind of environment that rewards
discipline and patience.
Greenspan's Dilemma
Stock prices are supposed to reflect the fortunes of corporations
and the state of the economy. But long running bull markets take on
a life of their own, influencing rather than reflecting the economy.
The stock market is affecting everything from the national savings rate
to housing prices. The typical savings rate for Americans is five percent
of income. That rate has now gone to zero as people spend everything
they earn, while assuming that stock market gains will more than make
up for a lack of savings.
Seventeen years of generally rising stock portfolios have conditioned
people to believe that old fashioned savings is an unnecessary burden.
Decisions that appear logical in extreme financial times will seem imprudent
when normalcy returns. If the national savings rate returns to historical
norms over a one year time period the impact on consumer spending and
corporate profits will be devastating. Corporations are not preparing
for such a shift, as many continue to spend valuable capital on foolish
share repurchase activity. The high stock market is the common denominator,
giving credence to the decisions of consumers, investors, and corporations.
With a record number of Americans in the stock market, Alan Greenspan
knows that market psychology is a controlling force in the economy.
He doesn't want the market bubble to grow any larger as that would lead
to a more damaging financial dislocation down the road. On the other
hand he is afraid that a market collapse in the near term will quickly
expose all the risky decisions made by investors and corporations. Through
modest interest rate increases and verbal warnings, Alan Greenspan is
trying to slowly deflate the market bubble without triggering an economic
crisis.
Current Strategy
Our current strategy is one of capital preservation. We are cutting
back on stock holdings while building up cash reserves and bond positions.
Our stock evaluation system indicates substantial overvaluation of the
largest companies and modest undervaluation of many smaller and mid-size
firms. Valuation gaps of this magnitude seldom last long. There are
several ways the gap could close, with the most likely being a sharp
decline in the share prices of the larger companies. Even though there
are some interesting longer term buys in the smaller company arena,
we are limiting our clients' overall market exposure in the face of
a potential drop in the major market indices.
We have been adding bonds to our clients' accounts throughout the year.
With interest rates rising, the yield on bonds has moved to a multi
year high. We feel that a 6.5 to 7 percent return on intermediate term
bonds is a worthwhile alternative to money market funds and most stocks.
