Bad Breath – October 1999

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.

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