The Firestorm Effect – April 2000

April 15, 2000 Dow Jones Average: 10,305 S&P 500 Index: 1,356


The Firestorm Effect

Observers of the stock market over the past few months have been astounded by the violent price moves in most stocks. Stock market corrections (drops of 10% or more in the broad indices) are not that common. But in recent months the Dow Jones Average plunged by 18 percent before recouping most of the lost ground. The NASDAQ index, which is dominated by high tech stocks, suffered four separate drops in the past few months that qualify as corrections, with the most recent being a wrenching 34 percent decline.

The defining characteristic of recent market activity has been the inverse correlation between the major market indices. While the Nasdaq index was surging higher in January and February the Dow and S&P 500 indices were plunging by a commensurate amount. In March the situation completely reversed with the Dow stocks regaining 1000 lost points at the same time that many tech stocks lost more than half their value. It seems that for one sector of the market to rise another has to be consumed.   The behavior of the markets is similar to a firestorm where high winds and intense heat create a highly unpredictable, dangerous environment.  The firestorm in the tech area raged through February and then suddenly reversed course during March. Although a reversal of tech stock prices was long overdue, the ferocity of the tech stock decline rivals anything we have seen in the past twenty years.

The extreme price gyrations and one hundred eighty degree turns in sentiment from week to week make absolutely no sense from a business perspective. The forces that are driving the market are greed, fear, and peer pressure. While these basic elements of human nature have always had an impact on the financial markets, they are currently overwhelming all analysis and common sense. The get- rich -quick, winner- take- all mentality that pervades the country and is reflected in tv shows such as “Who wants to be a Millionaire” and “GREED: The Series” encourages people to take inordinate financial risks. While many people are borrowing money against their homes to invest in stocks, others who got in early at low share prices are selling out their positions.

It is unfortunate that the least experienced investors are entrusting their money to mutual fund managers who are perceived to be the experts. There is nothing forcing mutual fund managers to buy ridiculously overvalued stocks. But that is exactly what happens as youthful, inexperienced fund managers become obsessed by their ranking, bonuses, and job security. The fear of missing a hot stock that may be bought by one¹s peers is overwhelming for many managers. Much as in high school, the greatest fear is being different, or out of step with the current fashion. So many fund managers desperately chase the same stocks, fueling the firestorm and the swirling, nonsensical, price swings.   Lost in the entire process is the interests of the fund holders, the people trying to save for college bills or retirement. Mutual fund managers do not even know the names of the people invested in the fund let alone their needs and aspirations. While the fund investors may suffer irreparable financial damage, the fund managers, most with degrees from top colleges, can always find another job.

Current Strategy

We are sticking to our strategy of buying shares in companies that have earnings and a solid position in their respective industries. We trim back on these stocks as they rise and become overpriced. While our brand of investing seems like common sense, few have been practicing it in recent months. Most fund managers and individual investors have been buying companies that have no earnings and weak balance sheets. It has not been easy to maintain our discipline and buy companies such as Justin, 3M, Whole Foods, and Kellogg when everyone else was buying companies. However, in the final analysis we are making substantial long term capital gains on 90% of our selections, while many of the companies are now selling at new 52 week lows.

It is difficult to forecast economic trends at this time, because the meltdown in the tech stocks may or may not have ramifications for the broad economy. Consumer spending has been fueled by a big increase in debt and by gains in the stock market. A sustained drop in stocks, combined with high consumer debt levels and a saturation of demand, could lead to a marked decline in consumer purchases. While a falloff in consumer spending would ease interest rate pressures it would also reduce corporate profits across the board. Investors should be careful as the economy and the stock market are both on a high wire. We have continued to purchase bonds for our clients, preferring the certainty of a seven percent return to the risk of increased stock market exposure.

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