To Our Clients and Friends of Parthenon Capital Management
The date on the calendar changed but the market’s action was undeniably retro in the first quarter as stocks extended the decline of last year. The S&P 500 Index fell 11.9% in the period as the weakness that had been concentrated primarily in technology and internet stocks widened to include more industry sectors. This moved the S&P Index briefly into a “bear market” which is generally defined as a drop of at least 20% from the high. The use of animal allegories to describe significant market moves is a Wall Street tradition whose origin is somewhat shrouded in mystery. Though colorful, we doubt the practice is of any use to an investor in formulating investment strategy, but we would definitely concur that the term “bull” fittingly described the peak prices of many formerly high-flying, and now down trodden, stocks.
As the signs of economic weakness multiplied late last year and early this year, the Federal Reserve cut interest rates three times in the first quarter and once shortly after the start of the second. The cuts totaled 2% and the last came with a clear statement that, if needed, more are on the way. The Fed is fighting a battle against a number of forces including declining capital spending, particularly on information technology and telecommunications equipment, the negative “wealth effect” on consumers of lower stock prices, and rising unemployment. The Federal Reserve ultimately wins these battles but the opposing forces are fairly formidable this time. According to a Fed survey, Americans’ average net worth declined in 2000 for the first time since 1945. In addition, after years of climbing stock prices and investor’s unrealistic expectations for permanent 20% equity returns, the individual savings rate actually declined to zero during the past year. In addition, consumer debt burdens relative to income are at, or near, record levels. We recite these sobering facts not to frighten. In fact, the economy has not entered a recession and there are numerous positive offsets to the negative ones we have enumerated. But capital and consumer spending growth have been at unsustainable levels and lower interest rates, though helpful, are unlikely to overcome all the drag of a return to more sustainable growth rates. This argues for moderate economic growth and hence, lower overall growth in corporate profits. We continue to be conservative in our expectations for the businesses we research and, consequently we are equally conservative in the prices we will pay.
Although the often stunning daily market volatility, with seemingly chaotic and irrational stock price moves, might seem to contradict the point, we believe the overall market has ultimately come to “rest” at a much more rational, though far from undervalued, level. We caution that expectations should be moderate (exceptional returns are rarely gained from rational prices but instead from irrationally low ones) for the intermediate term, but the corrective process of the past year has removed much, but not all, of the excesses from the market. Interestingly, excluding the technology sector, which soared in 1999 and collapsed in 2000, the index was approximately flat in both years. One of the more astute comments we read during the explosive rally that ended last year was that for investors “the only thing we have to fear is the lack of fear itself.” Although we do not detect abject fear and loathing, and stock prices in general do not reflect that sentiment, there is at least a healthier respect for the risk of reckless and unbridled enthusiasm over stocks.
Is This the Time to Buy?
An endless stream of advice can be heard from Wall Street’s market analysts stating that this is the time to buy or alternatively, that now is definitely not the time to buy. Of course, you may also hear that perennial favorite, that this is not the time to buy but wait a couple of months and that will be the time to buy – with the correct date often provided with clairvoyant accuracy. Not
only do we not know if this is the “time to buy,” we think the question is irrelevant and also counterproductive. It is counterproductive if it focuses one’s attention and effort toward attempting to predict the unpredictable. Instead, we recommend that when you hear admonitions in that vein to substitute the query “is this the price to pay?” The former usually implies that there is some way to know that stocks in general are prepared to rise or have further to fall in the immediate future and the prognosticator can discern the direction and timing of such events with a high degree of accuracy. The latter assumes that the investor conservatively estimates that as an owner he/she will receive more cash in the future, discounted at an appropriate rate, than has been invested. There is never a wrong time to make such an investment and never a right time to pay more than a rational estimate of a business’s value. So in a sense it is always the “ time to buy” if the “merchandise” is correctly appraised and available at sale prices.
The best “tonic” for a weak market is an appropriate asset allocation between stocks, bonds, and cash. Of course, when the markets are weak the appropriate exposure to stocks as a percentage of assets can feel like it should be 0%. Conversely, when the market roars ahead any asset other than stocks can seem an unnecessary anchor. But the appropriate allocation for a portfolio is always the proper balance of the probable long-term out-performance of stocks with income needs and the tolerance for volatility. We have detected only a normal and reasonable level of anxiety in our communications with you over the past year and we have suffered only moderately ourselves (we have slept quite well, but we promise not during market hours). We believe this was not only because our preferred investment universe held up better than the averages but also because we have worked diligently with you to insure that all portfolios have the proper balance of assets. The correct balance could be 100% stocks or a minimal equity position, but it should be based on long-term planning not short-term fear or exuberance. Financial assets should ultimately be a source of comfort not anxiety.
Please note that we have enclosed a privacy notice. The Securities and Exchange Commission now requires all registered investment advisors to send clients this notice annually. We have always, and will continue, to treat client information with the utmost confidentiality.