The stock market appeared to be rolling along on its way to a fifth straight 20% – plus year by mid-summer, but was derailed in the third quarter. The S&P 500 Index fell 6.24% in the quarter and advanced 5.37% (dividends included) for the nine months through September. Fears of rising inflation, higher interest rates, and the intentions of the Federal Reserve were the ostensible cause of the decline. The 30-year Treasury bond was flat in the quarter but yields are up significantly for the year from 5.09% to 6.05%, resulting in a 6.25% decline in the Lehman long government/corporate index. Although the economy continues to grow at rates that historically have increased inflation, so far there is only scant evidence of higher inflation in the government’s general price statistics.
Perhaps the market is also suffering from “financial vertigo”. We read recently that the earnings of the S&P 500 companies are up collectively about 230% since the market low back in August 1982, which is generally acknowledged as the starting point, allowing for several short if severe downturns, for the current long bull market. The index is up over 1200%. That is a 7.1% annual earnings growth and a 16.3% annual stock price increase. This is an extraordinary divergence and succinctly illustrates that most of the credit for the huge move in stocks is due not to earnings but to a revaluation of those earnings. We would not dispute the logic of much of that revaluation (and we have certainly enjoyed it). It was propelled by much lower interest rates and higher returns on invested capital. Can it continue? If the divergence continued for ten more years the price-to-earnings ratio for the S&P 500 would increase from the current 25 to 57. The 50-year average is about 15. The market is tethered long-term to the earning power of the underlying businesses. The tether can be stretched but it cannot be broken permanently. It looks taut to us and no bold predictions are required to anticipate and plan for returns much closer to earnings growth over the next 5 to 10 years.
A BRIEF TUTORIAL
We often cite the results of the S&P 500 Index, so a short explanation of its characteristics might be helpful. The most significant characteristic is that the index is weighted (by market capitalization not by revenues or earnings). Therefore, the largest companies have a disproportionate influence. Microsoft and General Electric, the largest components at the end of the third quarter, account for about 8% of the entire index. This is over 4.5 times the total size of the smallest 100 stocks in the index. The largest 100 stocks account for over 70% of the weight while the smallest 300 are less than 15%. Consequently it is not surprising that the index can be up for a period when well over half the stocks in the index are down as has occurred so far this year. The stocks are categorized in industry sectors such as consumer staples, financial, technology, and capital goods. When a stock is removed for any reason, typically the replacement is drawn from the same industry sector. So while the index is a cross-section of the economy by industry, the results are clearly dominated by a relative handful of stocks.
AN “INFORMATION” AVALANCHE
We have recently been reflecting on the expanding quantity and accelerating flow of financial and investment commentary and information. New technology and increased media interest and outlets have made the gathering of information cheaper and easier. But the proliferation of sources has also made the filtering of the verbiage both more difficult and more important. Have you ever watched the financial TV networks during market hours? You are provided with minute-by-minute accounts of every blip in the market and every opinion available on its potential direction for the next minute. The shows often seem more like sporting events than sober financial updates, complete with the most recent “winners” and “losers”. Every move in every major stock and stock sector is dissected and scrutinized on an hourly basis. Of course the Internet has opened an entirely new avenue for the dissemination of opinions and prognostications of which there is an endless supply and apparently an insatiable demand. The desire for an edge creates some interesting items. For example, investors and traders are no longer satisfied with analysts’ published earnings estimates. A small industry is springing up to promote and provide the analysts’ so-called “whisper numbers”. These are the estimates supposedly given only to a select group of favored clients in, we presume, very hushed tones – the quieter the better.
Internet sites have been created to list “whisper numbers”. Numerous “chat” rooms exist for most listed stocks to discuss the latest rumors and hype. This cacophony of noise can threaten to overwhelm the search for what we believe really matters – hard, factual data that can aid in the evaluation of business values. We believe the best defense against the overwhelming preoccupation with the immediate is a good offense. Our strategy remains to look further out than the consensus and concentrate our studies and our holdings only where we believe we can add value. There can be little doubt we are not engaged in the same endeavor as those who demand instant gratification. We have no interest in trying to forecast and profit from hoped-for changes in opinions and market psychology and in struggling to uncover short-term trading opportunities. We prefer to hitch a ride on the long-term growth in value of a collection of strong businesses purchased at attractive prices.
Finally, we have wondered if the rapid trading of stocks on the Internet was on its way to becoming the most popular video game. Now comes word that a large Japanese investment firm is working with a video game manufacturer to develop a service that allows “investors” to trade stocks using a video game Joystick. This should increase the excitement, but unlike a video game some of these “investors” may be unable to “re-boot” when they lose. Investing is an imminently enjoyable but serious endeavor to us. Our excitement over the potential long-term rewards is always tempered by our awareness of risk. We will continue to work to achieve your long-term objectives with that balance at the forefront.