AAMG - Past Market Views - Risk Versus Reward

AAMG's Past Market Views
Risk versus Reward

The stock market is really all about risk and reward. Supposedly the higher the risk the larger the reward. Conversely, the smaller the risk the smaller the reward. At least that is how it has worked in the marketplace over the last 100 years or so.

As managers of other people’s money it is our job to minimize risk and maximize reward within the confines of a reasonable market environment. A glance back at history tells us that the market has returned a historic annual total rate of return of better than 10%.

As we close out the 20^th Century we have to ask ourselves; "Have the rules of market analysis really changed? Have our risk tolerances been altered to the point that 30 to1 price earnings ratio are the norm? Is it more important to have stock buybacks rather than dividends? Does momentum or earnings drive stock prices higher?" These are just a few of the questions managers are asking themselves these days. In recent months the Wall Street "talking heads" have proclaimed that we are in a new era and the old rules no longer count. Companies no longer have to have earnings. Their sales just have to grow at a high annual double digit rate to have their stock price catapult into the next millennium. Add ".com" to the end of your corporate name and watch the volatility as the day traders begin to play your stock. Many of these internet and tech stocks have become ridiculously overvalued to the point that it has become dangerous for the amateur investor, who is using the market as a gambling tool rather than an investment procedure.

Back to risk and reward. We were reminded the other day that some of the members of this firm lived through a period in the 60’s where the exact same rhetoric was taking place. High P/E’s and book values were commonplace and the sky was the limit. Then came the bear market of ‘73-74 and it was back to basic analysis. In fact there are some historians that will tell you that this "new era" thinking comes to the fore about every 30 years or so.

In our last exchange we said that the Dow would close above the 10K mark in the first four months of this year. Well it did it in three and may now be settling in a trading range that brackets a few hundred points each way of the 10K mark. But the Dow and the S&P 500 as proxies for the market have become misleading as true measures of market performance. As of this date two thirds of the stocks traded on the New York Stock Exchange are down for the year - yet the market, as measured the Dow, is up 7%. The same is true for the S&P 500 where half of the stocks are down, while the index is up 5%. A look at the number of stocks that have advanced, less the number that have declined over the past year tells an interesting story. A weekly charting of these numbers would show an almost uninterrupted down trend. In fact the Advance/Decline line peaked on April 3^rd of last year and has been going south ever since. What does this mean as far as risk and reward go? It means that market risk is extremely high at this point and future short-term rewards could become harder to come by.

Earnings are going to be the key over the next two quarters. According to the Department of Commerce, corporate earnings, after tax, topped out in the third quarter of 1997 and saw a 5% decline through the 3^rd quarter of 1998. The 4^th quarter of last year, at best, may show a slight increase over the previous year. For the current year, things are rosy or dull depending on whom you are listening to. According to an article in the March 29^th issue of Barron’s entitled, "A Drag on the Dow," "First Call’s latest consensus forecast of analysts puts the Dow 30’s combined earnings at $432.37, 13% above the 1998 level." This has to be a pipe dream on the past of many analysts. Already earnings estimates in the Dow have been revised downward on an average of 3.5% through March 23rd. In our last piece we predicted an 1999 earnings increase in the 3-5% range. Looking forward we may have been a little optimistic. Earnings are being squeezed from slightly higher labor costs, yet producers are hard pressed to pass these costs along to the consumer. Yes, productivity is improving, but still not enough to increase earnings.

Much has been written and spoken of on the subject of low inflation and interest rates. Let's look at inflation first. We can almost say that there was no inflation during 1998. In past issues we have commented that global deflation should be a major worry for us. This is still true today, especially if China should devalue its currency later this year. In which case all hell could break loose in the Pacific rim. Here at home there is a little noted change taking place. During the last month the Commodity Research Bureau (CRB) index of future commodity prices has tacked on 10 points or 5.5%. Granted, oil prices have increased over this period, but you know that the Fed is watching this index as a clue to a possible increase in the inflation rate. At the end of December 1998, the 30 year Government Bond was yielding 5.17%. Today the same bond is yielding 5.64%. This is about a 9.1% increase in yield. More important from a risk standpoint is the differential between the spendable return of the S&P 500 and 30 year Treasury Bond. As of March 30, 1999, the yield on the bond was 5.64% and 1.29% on the S&P 500. This puts the ratio of bond yield to S&P yield at 4.37 or in other words the 5.64 is 4.37 times the yield on the S&P. Again something to note.

In addition, we are concerned with the internal structure of the market itself. As we have pointed out numerous times there is tremendous vulnerability to a market that is being carried forward by just a few stocks. Fewer and fewer stocks are advancing and the number of new lows has outnumbered the new highs daily for most of the past month. Even on the day that the Dow closed over 10K, for the first time, 60% more new lows than new highs. Not a good sign.

So what does all this mean when looking at market risk? In the short run we are forecasting a correction of 10 to 15%. This would take the Dow back to 8500 – 9000 and cool the speculation and outright gambling that is going on in the market. Later this year we expect the market to resume its upward movement. Our strategy is to continue to use patience and prudence while searching for healthy income-generating equities.

Gordon B. Lamb
Jeffrey M. Campbell
March 30, 1999

For further reading please review "Puff and Stuff - fiction but its market reality."

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