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Rising Expected Returns
October 2002

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

SpacerExpected returns on common stock investments rose during the third quarter, continuing at a somewhat accelerated pace the trend that has been in place for over two years. Although as investors we welcome this development, we acknowledge that the process of wringing out excess optimism has caused considerable pain to those who may have had too much faith in the modern "equity culture" so revered in the late 1990s. As happens so often, when something complicated seems easy to so many people -- as did stock trading just a few years ago -- it's probably safe to assume that hazards abound.

        It may strike the reader as odd that we would choose to speak of the possibility of common stock gains at this particular time. Yet with much of the investment community busy working to dampen the public's expectations concerning future returns from stocks (following Warren Buffett's three-year lead), an interesting phenomenon has been occurring seemingly unnoticed: the returns that one can reasonably expect to obtain from investing in stocks have indeed improved considerably from two and three years ago. Although the magnitude of the change is difficult to quantify, the basic principal at work is easily illustrated. Imagine for a moment that a security is available for investment that pays $1.00 per year with certainty. If you pay $20 to purchase this security, your expected return is 5% per annum. Pay $10 and your return rises to 10%. Expected return, therefore, depends to a large extent on the price paid for the investment. Why our security should yield 10% at one time and 5% at another may be due to changing market rates of interest, the presence of attractive alternatives, or fleeting concerns of one sort or another. It is simply the nature of the beast for prices to fluctuate. With stocks as well there is the added consideration that their cash flows are far from certain. Nevertheless, the general rule holds: prices matter. So, as stock prices fall, all other things being equal, the return potential rises.

        Clearly, an increased potential for gains is not something that owners of stocks have appreciated very much lately, as their attention has been distracted by very real and growing losses. Price declines broadened in July to include virtually every economic sector and accelerated to the point where losses of 2-3% daily seemed to be presaging a general market collapse. After an intermission during August, the selling returned with a vengeance in September, and at month-end the popular market averages were sporting declines of 24-40% year-to-date. The cumulative losses on the S&P 500 Index during the last three years, at -42.5%, now exceed the -37.3% total of the last great bear market cycle in 1973-74. Should stocks remain depressed through the end of this year, we will have experienced the most severe downturn since the early 1940s. Such is the damage thus far. Undoubtedly more worrisome to most market participants is the uncertainty over what should be done if the declines persist.

        Market difficulties of this magnitude elicit all sorts of actions in response -- such as panic selling of stocks or the purchase of other assets at high prices -- most of them inappropriate. Among the oddest responses to the current distress has been the booming interest in so-called hedge funds (now beginning to wane, apparently). Such funds are permitted broad leeway in the types of transactions they can engage in, including short sales and trades involving derivative instruments. This flexibility, it is believed, gives such operations the ability to prosper in down, as well as up markets -- an attractive selling point nowadays. In reality, hedge funds are speculative vehicles: they typically engage in highly risky trading schemes that not infrequently entail the risk of total loss; hence, access to them is limited to those with deep pockets. Speculation of this or any sort just does not work in the aggregate. A lucky few may do OK with these aggressive strategies, but, in general, there is just no easy way to avoid the disturbing effects, financial and emotional, of a bear market. The wise investor would do far better to expect to meet a bear market from time to time and plan accordingly, accepting the temporary declines with magnanimity and, more importantly, taking advantage of distress selling by those less prepared for difficult times.

        This last statement is not meant to suggest the investment equivalent of schadenfreude. It is a long-established principle of successful investing to be prepared to profit from the misadventures of the ill-informed. It may ease the moral conscience to note that this has always been surprisingly hard to do. Many years ago a long-forgotten author on investments wrote of the need for a "zone of caution" when markets get to extremes and prices are high, at the same time noting that during such times (think 1999 and early 2000) the forces of greed and the fear of being left behind make it difficult to be cautious and step back from the action. A corresponding "zone of courage," it was argued, is imperative when markets are depressed and prices are low. At such times the fear of loss prevails and risky securities like stocks are avoided: the withdrawal of money from equity mutual funds in recent weeks is indicative of this phenomenon. The lesson for market participants is that successful operations in securities require that one think analytically like an investor (as opposed to behaving emotionally like a speculator or gambler) to avoid trouble and take advantage of opportunity. This is an old lesson that modern investors would do well to revisit.

        As a matter of fact, now might be a good time to revisit those basic principles of sound investing. In an unseemly haste to avoid falling stocks, a lot of money is being directed towards bonds, driving interest rates to the lowest levels in over forty years. Low rates on bonds mean high prices, just as high P/Es mean high prices for stocks. Perhaps we have entered a "zone of caution" with respect to fixed-income instruments. Stocks on the other hand have suffered serious losses in some cases. Might we have reached a "zone of courage" when it comes to equities? The overall valuation of the stock market still does not look particularly compelling, but difficult times tend to jostle things around and create interesting situations. During these periods of uncertainty it often pays to be especially attuned to developments in particular issues.

The Equity Culture

        It seems like only yesterday that bankers and stock shills of all stripes were hailing the growing worldwide interest in equity investments as a cure for economic ailments ranging from underfunded retirement systems to a lack of sufficient financing for exciting businesses of the future. Europe in particular (especially Germany) had been far behind the U.S. in this regard. Europeans have long been more conservative than Americans when it comes to investing their money, preferring the relative security of fixed-income securities and relying heavily on government-sponsored programs for their health and retirement needs. Past inflations, wars, and market collapses had soured the public on the idea of equity ownership; but the improved environment of the 1980s and 1990s seemed to be causing a shift in opinion. Stock investing was becoming more popular, mutual funds were growing and new markets catering to smaller, growing businesses -- typically technology companies -- were established. Governments, too, sought to get in on the action by unloading nationalized industries on the public and encouraging private investment to take the pressure off public pension liabilities. American investment banks invested heavily in Europe in the hopes of cashing in on the flood of American-style industrial restructurings they foresaw. Unfortunately, the equity medicine that was supposed to cure all ills has turned out to be financial snake oil. As of September 30, Europe-wide stock market averages were down 42% so far this year alone. Germany's Neuer Markt (its version of the technology-oriented NASDAQ) is finally shutting down after falling 96% from its 2000 highs. Ill-fated privatizations (mostly in the telecommunications area) are struggling and pension liabilities remain a problem. Once again, equity investments have been discredited in the European public's view, probably for some time to come.

        Although generally more receptive to riskier investments than the Europeans, Americans had developed their own overly optimistic faith in stocks during the 1990s. Americans came to see in the stock market a way to painlessly prepare for retirement and pay for kids' educations. That faith, or, better put, reliance, was not confined to individuals. To a greater extent than perhaps many were aware, public corporations themselves had come to rely on the markets to boost their reported earnings. Taking the growth in pension fund assets invested in stocks into income was probably the most common method, but many companies had invested directly in the markets through the corporate equivalent of venture capital funds. In the recently reported cases of Electronic Data Systems and Dell Computer, we learned that companies had even placed bets on their own stocks -- a losing proposition for both of these companies, so far.

        The equity culture appears far more entrenched in the U.S. than in Europe, but "faith" in such economic systems (or "investor confidence," to employ the usual term) is fragile and can be fractured by prolonged disappointment. In this regard, it might help to remember that in 1980 Americans were largely negative on equity ownership after over a decade of poor returns. With 50% of the U.S. population now exposed to a stock market that has lost about $6.5 trillion in value since 2000, it behooves us to start thinking about some of the potential consequences of a prolonged disenchantment with stocks. Corporate earnings would probably drop as those companies with defined benefit pension plans were forced to accept lower return assumptions for plan investments. Individuals would have to get realistic about the future and not assume the markets will bail out their IRAs and 401Ks. Such a dramatic change in mind-set on the part of consumers could be expected to increase their "propensity to save" and hold down the spending that, as economists so often remind us, is essential to growth in the U.S. economy, not to mention corporate profits. The stock market itself would likely be more modestly valued and businesses would find the cost of the capital needed for expansion higher as a result. Our equity culture truly is entwined with our economic life. How we think about these issues -- the basis for our actions going forward -- will affect our future economic well-being.


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 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
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139

Telephone: 617.441.9695


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