Face Reality or Hope for the Best?

Nothing helps focus Wall Street and Main Street on the realities facing investors/managers (or choose not to face, in some cases) like an earnings season. All of us are optimists and want to believe the best is ahead of us. Consequently, stock prices rise as optimism grows. The conundrum all of us face and the question we must answer: “Are our optimistic views based on what is really happening in business and the economy, or what we want to believe is happening?”

While in the midst of the current round of earnings reports we wonder if these company earnings are really true or pro forma. In many cases they barely meet recently reduced earnings targets established last quarter. Real earnings, on a percentage basis, are down substantially year-over-year. In press releases company CEO’s are sugar coating “negative,” or “too hard to judge with certainty,” bankruptcies, lay-offs, further profit shortfalls and a host of other pieces of bad news. Corporate America has found the earnings season the ideal time to spotlight their true conditions, both past and future.

Along with the problems companies are having making money, we have a second and maybe more serious problem – DEBT. As of the end of September of last year, corporations had outstanding debt totaling over $4.9 trillion, up from $2.4 trillion at year-end 1989. During this same period the consumer debt grew from $3.2 trillion to $7.9 trillion. Debt is greater today than when the recession started. The question facing us today is: “How can the economy recover before a cycle of debt liquidation takes place?”

If we are to believe the “reality” above, and we do, how can we be overly optimistic about stock market investing in the near-term? Well, we can’t. It does not mean money cannot be made; it means money will be made, but through a proven discipline that embraces reality. A few other items give us cause to pause. The S&P 500 market basket is “overvalued” at a price-to-earnings ratio, according to Barron’s Magazine, of about 39. This means that investors are willing to pay $39 for something that is only earning $1.00. That is an average. Some investors are willing to pay hundreds of dollars for a company earning only $1.00. Historically, values of 20 are high and 10 are low. In fact, if we were to move back down to the high end of reality at 20, the SP500 Index would have to drop down from the current 1130 to close to 900, which would be a 20% move south. Can any of us stand another market drop of this magnitude? It is in no one’s best interest to see the market down and that is why, as optimists, we do not want to believe it might happen. Are we being overly optimistic and not facing a reality based on history? The market will ultimately lower its gavel and be the final judge. After all the stock market is always right.

Our firm has been defensive for a number of years. We had to stomach single digit returns at times when our peers were generating double-digit returns; and we were reminded of this constantly. The corollary for us is earning positive returns the past few years, while our peers are living with double digits losses. Investing is a balancing act, where hope is our enemy and reality is a friend.

All of us have a decision to make, face reality or hope for the best. The range of emotions that encompasses this bi-polar enigma is what usually gets investors in trouble. After all, what moves the market? Money. What moves money? People. And what moves people? Emotions…greed, fear and uncertainty. Is it any wonder that stock prices move in three directions, up (greed), down (fear) and nowhere (uncertainty)?

Most people reading our comments have lived though the “Roaring ’90’s.” Some of you made money and some lost money. It is a “zero-sum” game and reality dictates we accept losses on occasion. At AAMG we faced the reality of the 1990’s and did not waiver from our discipline – “value” investing, protecting our clients capital, securing dividends and growing our money through capital appreciation, in that order. The thought of “easy” money crossed our minds (normally the case in “boom” times), as we saw each night on the evening news, heard at cocktail parties and read in the news media the fortunes being made in “bubble stocks.” In fact, we saw much of the same back in the mid 1970’s, before the Bear took it away in the 1973-74 bear market. History does repeat itself, maybe not in the exact way, but close. We have survived and prospered since then, and we continue to survive and prosper, going forward in the first bear market of the new century.

Gordon B. Lamb
Carl C. Perthel

February 1, 2002