April 17, 2001 Dow Jones Average: 10,217 S&P 500 Index: 1,192 Making History The Nasdaq Index, a barometer for technology stocks, fell by a record amount in the first quarter of 2001. The drop came hard on the heels of its historic 39% decline in the year 2000. These reversals followed a record rise for the NASDAQ in 1999. The S&P 500 index gained 20% or more each year during 1995-1999, a string of gains unmatched in U.S. stock market history. Since then the S&P Index and other broad indices have been falling at a rapid pace. The Japanese stock market, once the envy of the world, is down 72 percent to a 16 year low. CEO’s of major companies such as Cisco Systems and Texas Instruments have stated recently that the communications and semiconductor industries are in the steepest and most severe decline in the long history of those industries. We do live in interesting times. Given the extremes of recent years no one is sure what to expect next. One wonders if we, in the U.S., are destined to follow the path that so often leads from great bull markets to economic malaise. The Federal Reserve, fully cognizant of history, is trying to arrest the economic collapse before it becomes unstoppable. The Fed has aggressively cut interest rates three times since January in an effort to bolster consumer confidence and economic activity. In normal times, when the Federal Reserve Board cuts rates three times in rapid succession, the economy does better and the stock market rises 20% on average over the ensuing twelve months. This pattern has repeated 12 out of 13 times, in all instances expect 1929. Investors who are currently optimistic take comfort in statistics that indicate an 92 percent chance of a near term market recovery, and the launch of a new bull market phase. The central question is whether we are in normal times. Roger Haydock, my good friend and stock market historian, has done an exhaustive study of extreme highs in world markets. His conclusion is that large declines, 63 to 84 percent, follow all the historically highest market peaks. By any and all measures, the U.S. market in 1999 was the highest this country has ever seen and one of the highest in world history. On a graph it looks like Mount Everest while other “high” points in U.S. market history are mere bumps and foothills. When Germany experienced a similar market high in 1960, England in 1936, France in 1962, the U.S. in 1929, and Japan in 1989, the aftermath was declines of 66 percent or more in each case. Roger believes that the odds of further substantial market decline in the U.S. are 98 percent. Weak corporate profits, high price/ earnings ratios, and demoralized investors give weight to his argument. It is an interesting dilemma for investors. Two schools of thought, both steeped in market history and compelling statistical analysis, claim that sharply different outcomes are highly probable. It is possible that both could appear right for a period of time. With the broad market indices recently down 35 percent from their March 2000 peak, it is possible to have a 20 percent near term rally in the context of a dominant longer term downtrend. How much exposure investors should have to the market depends a lot on whether gains are a temporary respite in a bear market or the start of a new long term uptrend. We do not believe that a sustained uptrend will begin from the current market level. On the other hand we are not sure that the broad market indices are destined to follow the 70 percent decline experienced by the Nasdaq. It may be that the market will make history rather than repeat it. The Car Lease Fiasco One half of all vehicles sold in America are acquired through a lease. Auto and finance companies have greatly expanded the use of leases in an effort to sell more high priced cars to people of modest means. In a lease the purchaser pays for only part of the car price. The cost to the buyer is the difference between the car price and its residual value, which is what the car company says the car will be worth after the lease is up. Interest payments are also part of the equation. A high residual value, one closer to the car price, favors the buyer because they pay on the difference between the two values. The car companies set the car prices high and the residual values high, because that moved more high priced cars into the hands of average American consumers. It was a great deal for the consumer while it lasted. But now the day of reckoning has come. The car finance divisions and banks own the cars that come off lease. They have to sell them to a second set of buyers for at least the residual value or take a loss. There are few buyers for used cars at these high residual values, so the finance companies and banks are slashing the prices and taking losses. Bank of America, to name just one institution, wrote off 500 million dollars on what they call “impaired car leases” in just the past few months. In their desire to lock in an initial high sale price and receive interest on a large loan balance the car companies and banks became partners in a disastrous arrangement. The car companies have been forced to change their policy. They are now setting residual values at lower levels, keeping car prices high, and moving people to five year loans in an effort to keep monthly payments palatable. It’s another bad solution to car prices that most people can not truly afford. Current Strategy Even with the market off substantially from its highs, there are not many compelling investment opportunities in stocks. Stocks are not much cheaper relative to earnings or growth rates, as both are dropping as fast or faster than stock prices. Larger technology companies, still favored by so many investors, are mired in a deep industry wide slump. These stocks are riding on past glory not current reality. Many other industries, from building materials to consumer products, are also facing sluggish business conditions. Companies are not in particularly good shape to weather a downturn. Corporate debt levels have risen dramatically as companies have used up capital for expansion, acquisitions, and share repurchases. The kind of situations we look for, i.e., strong balance sheets, a growing stream of profits, at a reasonable share price, are just not available in this market environment. We are maintaining positions in a few companies such as NY Times, Nucor, Schwab, FedEx, etc. Companies in advertising, construction, brokerage, auto, shipping, and other economically sensitive sectors usually lead market rallies when the economy emerges from recession. It is probably early to even be in these quality companies as the economy has not gone through the kind of contraction that produces a strong recovery. The other group of companies that traditionally do best coming out of an economic/market slump are small companies with solid niche businesses and good profitability. These companies can be found in technology and non-tech industries. One has to be careful owning too many of these smaller companies, because they are particularly vulnerable to periods of prolonged economic weakness. We still believe that in general this is a time to protect one’s gains from prior years and wait for better buying opportunities.