The Pendulum Principle – January 2003

January 22, 2003

Dow Jones Average: 8,319
S&P 500 Index: 878


The Pendulum Principle


Three years of stock market losses totalling over seven trillion dollars have left investors searching for direction. Those seeking clarity are faced with a bewildering array of factors that might impact the economy and the financial markets. Daily market gyrations have become more intense as investors grapple with numerous geo-political crises, potential tax cuts and expanding budget deficits, a falling U.S. dollar, signs of inflation and deflation, record low interest rates, SEC investigations of corporate corruption, ebbing consumer confidence, and guarded forecasts by companies. One is left wondering what kind of economic trends will develop given the confluence of potentially offsetting forces.

There is a natural human inclination to seek simple, comforting answers to confusing situations. As the great market bubble of the late 1990¹s burst and the economy became ever more problematic, investors found solace in theories that promised a quick return to bull market conditions. Perhaps the most widely followed theory was the one that claimed investors should buy stocks as the Federal Reserve Board lowers interest rates. A great deal of money was lost in the past three years by those who believed with utter certainty that markets always go up after three interest rate cuts by the Federal Reserve Board. Those who thought that the historic long-term return from stocks would somehow protect them in the short term remained over committed as well. And there were still others who were overly convinced that the economy and financial markets automatically recover from slumps after a short, designated time period. The past three years undermined the many truisms that investors had come to rely on too heavily.

There is one theory that we think best explains market action over the past few years. It is a simple concept, but not a comforting one for those heavily committed to stocks. This theory holds that investor attitude toward stock investments moves as a pendulum, swinging between states of euphoria and pessimism. During periods of euphoria stock prices appear to have no limit. Information sent out by corporate PR departments triggers buying stampedes, all news is received in a positive light. When stocks eventually fall, jilting the investors who love them, negativity and disgust replace euphoria. Investors come to hate stocks, and company announcements are either ignored or treated with suspicion. At the moment we believe that the pendulum of investor emotions is about half way between the euphoria of the late 1990¹s and the abject pessimism still to come. There is no precedent for the pendulum swinging from extreme optimism to a neutral position and directly back to optimism. From a mathematical perspective, stock valuations are also close to a mid point. The neutrality of both investor emotions and valuation ratios may explain why the market has been flat for six months.

Current Strategy

It seems unlikely that stocks will rally significantly from neutral valuations. There are still plenty of buyers in the market as evidenced by the relatively high volume of shares traded. But the buyers are more cautious, not wanting to repeat the mistake of overpaying for stocks. Wall Street brokerage firms have converted to the new religion, putting sells recommendations on stocks that move even a few points higher. After missing so many great sale prices at the height of the mania, brokerage firms want to show that they are capable of taking a profit. The combination of timid buyers and eager sellers results in a range bound market.

Even though we do not think the overall market has reached its ultimate low we are finding many more stocks that may be close to their individual bottoms. Our stock evaluation system indicates that these stocks are buyable IF their earnings stabilize and then improve from current levels. That is a big assumption given the current state of the economy. We are planning to modestly increase our clients¹ exposure to stocks at current price levels and are prepared to add more holdings if prices really tumble.

Bonds present an even bigger challenge than stocks right now. While there are some stocks selling at reasonable valuations, bonds are uniformly expensive. We are holding onto current bond holdings and purchasing an occasional municipal bond. For the first time in memory the municipal, fully tax-free bonds yield slightly more than taxable government bonds. The yield on most government bonds barely covers taxes and the current 2.4 percent inflation rate. We do not think it is wise to lock money up in such low yield paper.

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