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Commentary:
Hindsight Conservatism
October 2001

Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel

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    of all guest columns written by Dennis C. Butler, CFA

SpacerWhen viewed strictly in terms of its immediate impact on investors, 9/11ís events in New York merely served to accelerate a declining trend of stock prices that was firmly in place. Already by September 10, the popular averages were down from 9% to 30% year- to-date, following more weakness that had set in by early August after a couple of rally attempts in July. In the week following the closure of the stock exchanges for the longest period since 1933, prices dropped nearly 15% to their lowest levels in four years, despite frantic efforts by Wall Street and government officials to prop them up. Trends in the fixed income market also accelerated. Short term interest rates continued to collapse to record lows of just over 2%. Corporate debt issuance, which had, by July, already reached a record for any year in history, continued strong, with a least one prominent company borrowing funds on September 17, the day stocks resumed trading, and using the proceeds to buy in its own shares.

          Interest rate cuts and increased government spending have led some to expect a rapid recovery in both the markets and economy in the coming months, such as occurred afer the last recession in the early 1990s, or following the Asian financial crisis a few years ago. We hope such forecasts turn out to be correct, but in all honesty we find it difficult to be so enthusiastic. The catastropheís longer- term effects, while impossible to precisely foretell with any confidence, are potentially quite negative, indeed. The current international tensions appear likely to drive up costs economy-wide, and lower profitability across a broad range of businesses. Fiscal measures to counter an already slowing economy, as well as possibly prolonged military operations to deal with a difficult problem, are also likely to have profound effects that may eventually show up in higher inflation rates, reduced capital investment and more subdued rates of growth in this country and abroad. While we do not make specific predictions, the developments just enumerated reinforce our general view, expressed some time ago, that the average returns on equity investments are unlikely to rebound anytime soon to anywhere near the excessive levels that the public had enjoyed and come to expect just two years ago. Nonetheless, markets began to recover at quarterís end and fears of further terrorist activity began to recede. We question whether the very real risks of further disruptions are being underestimated.

          From our perspective, the current situation presents special difficulties for investors. Speculative stocks have collapsed and carried the market averages down with them, but such businesses seldom hold appeal for us in any case. Other issues are down significantly, but as their prices were exceedingly high to begin with, they remain uninteresting as investments. Bond prices, on the other hand, have risen smartly in the declining rate environment, producing returns of 8-10% for holders so far in 2001, but leaving little to excite newcomers. Unlike in years past when short-term rates averaged around 5%, investors are not getting "paid to wait" while seeking opportunities. Preserving capital has to be a paramount consideration under these circumstances, precluding both "reaching for yield" in an expensive bond market and most certainly aggressively betting on any hope of a rapid recovery in stocks. Meager returns may have to be tolerated for a while.

Event Trading

          "If I could, I would be buying stocks today." Thus spoke a U.S. Cabinet member who, while barred from purchasing shares himself, clearly felt no qualms about encouraging a mass television audience to do so. This was only the worst example of many in an appalling display of stock market boosterism by stock exchange and government officials on the morning of September 17, as the markets prepared to reopen after the monthís extended closure. For those with no personal capital at risk, such as the government official quoted above, it was an easy call. For those of us sensitive to the fiduciary duties we have regarding the management of client funds, it was an irresponsible act by people in positions of authority, with no heed given to the possible consequences for those with less advantaged financial positions than former CEOs of major corporations. With parts of New York in ruins, financial markets world-wide in turmoil and threats of uncertain magnitude still a possibility, why these individuals felt that the average investor was equipped to weigh such risks is beyond us -- even professionals have a mixed record of performing such evaluations. The result of this propaganda barrage was predictable: "I would like to buy something. I donít know what, but I would like to buy something," said one woman interviewed on the streets of New York City that morning. No matter what the circumstances, when it comes to financial matters, patriotism is no excuse for foregoing reason and careful study, and attentiveness to individual circumstances.

          There are groups of players who are capable of evaluating the types of risks confronting investors at this time, and acting on those risks. One of them is the so-called "event traders." Essentially stock market opportunists, event traders look for situations in which the market has responded emotionally to unexpected news, positive or negative, which they deem to be transitory, in the face of fundamentally unchanged business economics and outlook. Such news -- perhaps an earnings report that exceeds expectations or an external shock of some kind (the "event") -- often results in stock prices that are out of whack with what might be expected based on historical valuation measures. The traderís objective in these cases is to purchase or sell, hoping to profit from a relatively quick return to more "normal" valuation parameters once the emotional reaction has worn off.

          While not our cup of tea, the strategy does require an admirable degree of sophistication, at least when it comes to statistical analysis and market watchfulness. Whether it works well or not, we are not equipped to say. Although it bears some similarity to the "buy the dips" maneuver popular during the late and lamented bull market, we doubt if the average investor is ready and willing to make the effort to do the detailed analysis required, or spend the time watching the ticker. Even those who engage in the activity warn that it is difficult to do, often unprofitable, and probably not something most people should contemplate doing. Unlike what the market cheerleaders of September 17 may have hoped, this is probably not a nation of event traders.

Hindsight Conservatism

           We continue to be amused by the continuing stream of free, conservative financial advice being offered by the titans of the American financial establishment through media advertising that presumably mirrors what is being provided by their sales forces. Hence, we are now being reminded of the virtues of diversification and of the necessity of tweaking our portfolios to adjust them for the new market environment. Unfortunately, we do not find much comfort in the fact that the same people now pushing "safe" bond investments, for example, after bonds have advanced sharply in price and when interest rates are at historical lows, were only two years ago urging us to buy Internet stocks. As for diversification: we have never really understood nor have we advocated diversification simply for diversificationís sake, and note that few sectors have escaped the current bear market. Investing internationally would not have been of much help this year either. World-wide stocks are down 20-25%, much like share prices in the U.S. It appears that American and foreign markets are more linked now that ever before.

          Hindsight wisdom is cheap -- thatís why itís offered for free. Yet there appears to be a "phase variation" in the counsel being given to the public nowadays. Since March, 2000, the NASDAQ average is, at this writing, down over 60%. The S&P 500 has declined about 30% over a similar time interval. If anything, hindsight would seem to teach us that the really significant risks existed two years ago in the midst of a flood of optimism, and that those risks are now lessened by the intervening wave of gloom that has deflated valuations and rewarded speculation with its just desserts. In hindsight, putting money into "safe" bonds during the earlier period would not have been such a bad idea. Of course, advocating such a policy two years ago would have been considered lunacy in a Wall Street that was minting money doing technology deals, just as, we suspect, questioning the wisdom of buying bonds now would be ridiculed when Wall Street is selling record amounts of corporate paper. There are two lessons to be learned from this experience, lessons consistent with those gleaned from similar episodes throughout investing history. First, if you are uncertain as to your investment policies and goals before catastrophe strikes, you are apt to be bewildered after the event. Second, investors cannot rely on those whose business is selling securities for insight, and must look to their own informed counsel for protection of their interests.

____________________

Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:

Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695

Email: cscc@world.std.com
URL: www.businessforum.com/cscc.html


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