Never have so many wagered so much on so few.
— with apologies to Sir Winston Churchill

Grab the Listerine. This market has bad breadth (a measurement of the ratio of advancing versus declining issues). For the last twelve months, with few significant exceptions (the most notable being a three-week period following the climactic bottom of last October 8), the number of NYSE stocks declining in price on a daily basis has overwhelmingly outnumbered those whose prices are rising. In the face of such a malodorous condition for most stocks, many portfolio managers and investors might be tempted to take a swig of something even more bitter than the mouthwash kids love to hate. Yet if the average stock has continued to slide like Malibu mud into the Pacific, why do the ubiquitous talking heads keep babbling about record highs?

We have previously chronicled the abysmal performance of the average stock over the past several quarters. For the first quarter of 1999, it was déjà vu. Through March 26, almost two-thirds of the stocks on the NYSE were down from their 1998 closing price, and 47% of the S&P 500 and 55% of the NASDAQ followed suit. Diversified US stock mutual funds were up a paltry 0.93% for the first quarter. While the DJIA and the S&P 500 returned 7.0% and 5.0% for the first quarter, the Russell 2000 and the Value Line Composite declined 5.8% and 6.4%. The market is like an inverted pyramid; a few stocks push up the major averages, which mask the performance of the have-nots mired in the quagmire of investor who-caresitis. Indeed, these “averages” are not in fact averages—they are weighted by market capitalization. Thus, the performance impact on the S&P 500 of Microsoft (with $468 billion in capitalization) counts almost one hundred times as much as Tenneco (which has $4.9 billion in capitalization).

BARRON’S relates money manager Peter Cannell’s doleful analysis of the asymmetrical nature of the bull market over the past few years. The ten largest companies of the S&P 500 comprise 20% of its market capitalization, and the ten largest NASDAQ companies comprise 40% of the NASDAQ Composite’s market capitalization. Last year a mere fifteen companies (3% of the Index) tallied one half of the gain in the S&P, while 25 tech stocks accounted for 93% of the gain in the NASDAQ Composite. A full 4,500 of the stocks in the NASDAQ index were down an average of 4% for the year. Since the end of 1994, on average, price/earnings ratios have doubled from 14 to 28. But that is small stuff compared to the clout of the index heavyweights. The ten companies with the largest market cap boast an average P/E of 48. Still, even that pales when compared to the P/E of 70 averaged by the seven stocks among the NASDAQ’s top ten which are currently profitable. The robust expansion of multiples accounted for 80% of the explosive rise in stock prices over the past four years or so.

In the face of such debilitating results for the vast majority of stocks, is there any hope for their return from wandering in an investment wasteland wilderness? We think so. But it may take a new compass to navigate the right path to success.

From the H-bomb, to Sputnik, to glasnost, to a stock in every pot

The quarter-century before the Reagan-launched bull market was both dangerous internationally and frustrating economically. A vignette of mileposts will stir the memories of those who recall their economic and political history: post-Korean War … the Hungarian revolution … Gary Powers and the U-2 incident … the Cold War … the Cuban missile crisis … the Kennedy assassination … the Great Society … the Vietnam War … Watergate … oil embargoes and gas lines … runaway inflation and interest rates … highest unemployment since the Great Depression … corporate America threatened by Japanese and German industrial juggernauts … ad infinitum.

During this period of the Cold War and pre-glasnost, the Fed’s constant tinkering, a repressive tax code, and the economic and political turmoil gave rise to periods of economic expansion and contraction, contributing to approximate four-year economic and stock market cycles. Price/earnings multiples cycled inversely with inflation and interest rates between 9 and 21 times. The Dow Jones Industrial Average, which first hit 1,000 in 1966, languished in no man’s land until 1982.

Now we have come full-circle. The present bull market in stocks and bonds dates from 1982. Federal Reserve Chairman Paul Volcker laid the groundwork for this new era in 1979 when he shifted the Fed’s focus to controlling the money-supply growth. A disciplined Fed, Reagan tax cuts, aggressive defense spending which precipitated the Soviet Union’s throwing in the towel on the Cold War, deregulation of a number of industries, and the revitalization of American industry after years of reorganization, downsizing, and major investments in productivity-enhancing technology, plant, and equipment set the stage for the greatest bull market of the century. The DJIA has increased from an August 1982 low of 777 to 9,786 at the close of March. Today, the United States is the economic envy of the world. The “Evil Empire” challenged by the Reagan administration has disintegrated into a constellation of new nation-states, with the Russian leaders reduced to hat-in-hand pleas for economic assistance. The old-guard politicians of Japan have taken on the appearance of undertakers preparing their own funeral. Germany and Europe find themselves grappling with the wrenching dislocations caused by the integration of their economies and statist policies which have stifled growth. The emerging markets of Asia and Latin America have had to regroup after an extended period of excessive credit expansion and speculation which led to a concomitant debasement of their currencies and the postponement of their economic “miracles.”

In recent years, the growth of the US-led global economy, albeit temporarily stalled in many parts of the world, has been sustained by low interest rates, improving productivity, deregulation (with its attendant boost to disinflationary competition), the benefits of a modern capitalism which continually reinvents itself through creative destruction, a Pax Americana (newly tested by China and Serbia), and the gargantuan growth in international trade and liquidity. All these positive factors have helped to fuel this bull market. The catalysts for this multi-year bull market have in turn supported the explosion of new technology around the world. The explosive growth in technology and telecommunications advancements has benefited from the new international and monetary paradigm of free capital flows, which in turn has helped fuel an acceleration of economic growth in a virtuous circle. Profits of American corporations in particular have grown at a heady pace.

Robinson-Humphrey recently highlighted a June 1997 Forbes article which pointed out that it took fifty years for electricity to reach fifty million people in the United States. The rate of penetration to reach the same level for various technologies has accelerated: radio, 38 years; TV, 13 years; personal computers, 16 years; and the Internet, 4 years. Thus, the Internet is being used by 30% of American households, and that percentage should double in four years. This rapid introduction of technology is producing faster revenue and earnings growth in each succeeding cycle. As firms—especially the highly successful ones—experience such rapid economic and profit growth, their supporters argue, with much validity, that they should be valued at much higher price/earnings multiples. The issue for investors devolves to an age-old argument of how much is too much.

There is no question that we are in uncharted waters. In 1986, Bill Gates brought Microsoft public at a split-adjusted 39¢ per share. At the quarter’s close, Gates’s personal stake in Microsoft was worth approximately $93 billion, and the total market capitalization of his company was $468 billion. Is the sky ever upward for Microsoft, Cisco, Dell Computer, Intel, and their kindred spirits of the new world of technology, the Internet darlings, all of which seem to embody the enthrallment of today’s “investors,” surfers of the ‘Net, and on-line, hyperactive day traders with Dow 10,000 and its siren trappings? Promising, yes. Ever upward, doubtful.

This time, it really is different

Grant’s Interest Rate Observe cites a new-era money manager who opined that “To own a company like AOL you had to throw out traditional measures of valuing companies. We had to say we have to own what we think is the dominant franchise in the Internet. It was a space that as a money manager you simply have to be in.” Perhaps this money manager is right. Maybe things are different today. Surely everyone will eventually be able to quit the drudgery of working for a living and use the ‘Net to day-trade their way to riches at a conservative compound annual return of a mere 20%!

We are a little less sanguine and would echo Grant’s salient take on this “have to be in” mindset: “Here’s a new theory of investment psychology: the compulsion to join a mass movement leads not to tears, but to profits.” A rationalization of the stratospheric multiples for which investors are ponying up to their Nirvana-like window of opportunity usually takes the form of stating that revolutionary technologies command unprecedented valuations. True, but how revolutionary should one be? The table on page 4 might be somewhat discomfiting to today’s “This time it’s different” crowd.

Nevertheless, with those who argue that “This time it’s different,” we would heartily agree. It is always different, and this time it is very, very different. One distinguishing characteristic of the valuation levels of recent market leaders is that which is superimposed on top of the already rather high price/earnings ratios borne by such companies as Microsoft, Dell, and Cisco. What is this even higher benchmark for the pioneers of the Internet that has gained wide acceptance by those who “have to be in”? Having little or no earnings, these companies are valued, not at a ratio of price to earnings, but at a ratio of price to sales. As Grant’s observes, “Unique to this technological revolution is that the revolutionary product is not demonstrably profitable. Amazon.com is famously earnings-free, and Yahoo! and eBay command multiples of price to sales far greater than any price/earnings ratio accorded RCA, Xerox or Apple in their prime . . . What’s different about this technological revolution . . . is that it has revolutionized speculation as well as commerce.” (italics added) We certainly concur, and we cannot help but compare much of today’s investment activity in the chosen few, aka the New Nifty Fifty, and the Internet stocks to a vast electronic casino.

Courtesy: Grant's Interest Rate Observer, March 26, 1999

If indeed speculation has been revolutionized, are the traditional measures of what makes a good investment to be discarded on the trash heap of irrelevant theories? We think not. For those who are perennial optimists, we offer the perspective of 1973-1974, the worst bear market since the Great Depression. The average stock declined 80% (this is no typo), and the DJIA was off 45% from its high. Having only been in the investment business for about five years at that time, one of the saving graces of such a great tutorial was the lack of any significant capital to lose. (Stocks did not rise exponentially in those ancient times.) Lest we unnerve too quickly those who are presently concerned about “the market” and fearful of a sell-off, it is important to note a major distinction between today and 1973-1974. As the advance-decline line on the graph on page 5 suggests, most stocks have been in a bear market, and their declines reflect this fact. This is the reverse of 1973-74. It is the larger much-loved and cherished (or chased?) stocks which could possibly offer greater risk. We think most stocks offer far less risk than those which have heretofore carried the S&P and the Dow to record highs. As one example, the fizz appears to have gone out of Coke, which has had earnings disappointments for the past few quarters, yet still sells at 42 times earnings and may offer growth of only 12% to 15%, if that much. Another laboring giant is Gillette, which saw its stock price slashed due to slowing profit growth, yet which still changes hands at 38 times earnings. Great companies, yes. Great investments, not now. And there are many other S&P stocks which also fit this profile.

Keep on truckin’: destination Dow 15,000

Thus, while eschewing the many obvious excesses permeating today’s investment world, with their potential for earnings disappointments accompanied by negative stock-price movement, we embrace the multiple opportunities which presently exist and which will doubtless blossom in the future. Land mines notwithstanding, our view is that of cautious optimism.

The underpinnings of the US economy which have fostered the historic and dynamic economic growth of the last several years are still largely intact, and they should remain reasonably positive for some time. First, inflation should remain relatively low, particularly when compared to the ‘70s and ‘80s. Asia, Latin America, and Europe will begin to recover and fuel worldwide economic activity. While this may raise inflationary fears in the short term, it should be remembered that there is an excess of raw materials, labor, and productivity capacity around the world. Indeed, there is an excess capacity of everything in the world except brains! Such an environment of excess economic inputs is not conducive to runaway inflation.

Second, low inflation should continue to foster an environment of low real interest rates. The US budget surplus will be even larger than presently forecast. This will result in a new reduction of federal debt which will help keep interest rates in check. Third, technological change has led to an accelerating pace of economic activity and productivity growth. Fourth, productivity improvements have led to improved profit margins for many industries. Finally, demographic factors favor a high level of continuing savings accumulation which will fuel the demand for financial assets. Low inflation and low interest rates combined with productive economic growth should result in higher multiples for stocks being maintained.

In generating this chart, BARRON's subtracts each day's NYSE
composite declines from that day's advances. The total is
added to the next day's total, and so on. When all five days'
numbers are added together, this produces the weekly figure
BARRON's plots. December 31, 1985 = 0.
Courtesy: BARRON's

Abby Joseph Cohen, managing director and chief investment strategist at Goldman, Sachs, continued to display her unflagging optimism in a recent New York Times interview. She pinpoints some of the key reasons a handful of large stocks has left the vast majority plodding along and she suggests a better future.

In the spring of 1997, investors thought all was right with the world. There was a perception the global economy was doing well. . . . [W]e had a broad market, when the small-and mid-caps performed reasonably well and the so-called value stocks were performing better.

That sense lasted for about three months, and then Thailand woke people up to the fact there is risk out there. That made people nervous, and convinced portfolio managers to stay in large liquid names that gave them the chance to get out fairly easily.

In the spring of 1998, small-and mid-cap stocks once again started to do better, and the market started to broaden again. Then came the events of August, when Russia defaulted. Those events pushed investors back into large, liquid names.

This year, if we have an environment in which the US economy is steady and the global economy is getting better, not worse, that may instill investor confidence.

Thus, a restoration of confidence as we move away from the currency turmoil roiling the markets since the fall of 1997 should lead to a broadening of participation from a host of stocks relegated to eating the dust of the herd in front. And as any long-term observer of the markets is aware, it takes far less capital to drive up the price of the average stock than it does that of a widely held mega-cap stock. As leadership begins to spread from beyond the modern “safety havens” of growth and the New Nifty Fifty and the denizens one wag calls the “lemmings.com,” such archaic terms as growth at a reduced price, discount to private-market value, low price/book, and low price/earnings may be rediscovered. In point of fact, many of these dust-covered ideas have been adopted in recent months by some savvy buyers who have taken advantage of the willingness of investors to disgorge their holdings in numerous companies that were not living up to “Street expectations.” After all, why would anyone want to own such companies as Aeroquip-Vickers, AirTouch, American Bankers Insurance, Frontier, MediaOne, Morton International, PLATINUM Technology, and a long list of others whose prices in many cases reflected a lack of good old Wall Street “sponsorship”? Who cares if they were acquired at substantial premiums, or that many more stocks offer the same type of potential? Better to follow the crowd and be comfortable.

Among the tea leaves divining the future are three developments which may portend a more problematic outlook for many stocks one just “has to be in,” along with the simultaneous embracing of the rest of corporate America. Donaldson, Lufkin & Jenrette points out that in 1998, 50% more dollars were placed in money-market funds than flowed into equity mutual funds. This trend continued through the end of February, signaling tremendous investor anxiety. For the five months ended in February, for every dollar that entered equity funds four went into money-market funds. As DLJ states, “Over the past year, there have probably been fifty reasons to motivate investors toward cash and only a handful promoting purchases of stocks.” The assets in money-market funds number in the trillions and are a proxy for fear as well as a reflection of contentment with their relatively attractive current rates of return vis-à-vis longer maturity bonds. Should Ms. Cohen be right, as we think she is, the fear factor will dissipate. Should short-term interest rates move lower as the year progresses, as we think they will, the angst over lower yields will overwhelm complacency. Together, these changes will propel a potential “big shift” of short-term funds into stocks and bonds.

Another development which raised more than a few eyebrows when recently reported in The Wall Street Journal was the slow ooze of money out of S&P index funds through redemptions by major institutional investors. True, the market value of the S&P index funds has increased markedly as their stock holdings escalated in price. But they have been experiencing a net outflow of cash for the past three years from what had been perceived to be a major source of support. At the same time, individuals, enamored of the plethora of index funds, their ready availability, and their recent success, have continued to pour their hard-earned dollars into what must seem like a sure thing. If S&P index-fund assets are going up as their cash flows are decreasing, that is resulting in forced liquidations and the realization of large embedded capital gains. Should the index funds start to slide if their top-heavy stocks totter, it may result in an even faster run for the exits, which will create even more realized gains. Individual investors may find themselves buying the capital gains of an institution which has already cashed out. An ominous warning which investors should heed was uttered by Gus Sauter, managing director at Vanguard, one of the gorillas of the index-fund world: “’We’re only seeing the tip of the iceberg, which is the visible S&P 500 mutual funds. But under the water, large pension plans are lessening their concentration in S&P 500-indexed assets’ out of concern that the huge rally in the S&P 500 has distorted their portfolios.” If one follows the money, the path uncovers some surprising changes in attitude. The Journal observed that

S&P 500 stocks aren’t getting the big boost from new money that investors may have thought. Institutional money that might have been earmarked for the S&P 500 a few years ago now is being diverted to other investments, including bonds, small stocks and foreign stocks. . . . [B]roader market indexes that don’t just represent large-cap stocks are growing increasingly popular among institutional investors.

Another impetus to a broadening participation by more stocks will come from continued and growing high levels of merger and acquisition activity. During the first quarter, 6,949 international merger-and-acquisition transactions totaling $855 billion, the second largest quarter on record, provided powerful fuel for driving up the prices of undervalued assets. AT&T’s acquisition of cable giant Tele-Communications, Inc. and BP Amoco’s wooing of Atlantic Richfield hard on the heels of closing another gigantic transaction highlight the continuing appetite of both domestic and foreign corporations to achieve economies of scale. As companies make acquisitions in an effort to enhance growth and earnings, their activity underscores the often significant disparity between the publicly traded price of a security and its enterprise or private-market value. Industries such as energy, financial services, health care, media and entertainment, technology, and telecommunications (among others) should see a continued high level of merger activity.

When we wrote many years ago in an earlier Decision Maker that the Dow would hit 10,000 before 2000, we were greeted with friendly skepticism. One financial consultant chided us for always being too optimistic. Well, we confess to remaining optimistic, even though cautiously so. Yes, we worry about many of the same things our clients do, and much more. But we see many outstanding opportunities for creating wealth from among companies of all sizes and in many industries. As long as we can keep buying a dollar for fifty cents, we will remain excited about the possibilities for investment. We will leave it to others to try and prolong their acts of financial legerdemain and levitation, who through their tireless efforts continue to persuade both themselves and an all-too-willing, greedy, and gullible public and aggressive money managers that there will always be an endless stream of even greater fools who will be willing to buy the casino paper foisted on those who just “had to be in.” Our admonition of caveat emptor notwithstanding, we go on record as saying that a DJIA of 12,000 to 15,000 could well be achieved in the next five years. Within the context of such a positive prospect, we think future gains recorded by many stocks will be even greater.