Letter – 2001 Q3

“It’s the dumbest thing in the world to bet against the United States.  It hasn’t worked since 1776.”  –Warren Buffett

The stock market has rarely lost as much ground in an entire year as it lost in this past quarter.  For the year to date (as of Sep 30), the S&P has lost 21.2 percent, the Nasdaq has lost 39.3 percent, and the Dow has lost 18 percent.  Since World War II, only 1974’s loss of 26.5 percent on the S&P 500 was worse.  The worst damage of the year was done in the quarter just ended.  The S&P 500 lost 15.0 percent, the Nasdaq lost 30.6 percent, and the Dow lost 15.8 percent.  Since World War II, only three other quarters (in 1962, ‘74 and ’87) have seen such losses.

Your account declined in value by 6.9 percent during the quarter.  While that is not a happy result in normal times, I hope you will agree that it was pretty good at least in relative terms.

The market was weak even before September 11, with the S&P having already dropped 6.4 percent in August and another 3.6 percent in September before the tragedy.  I raised a fair amount of cash during that decline.  As I have told you, I sell a certain amount of stock during periods of protracted weakness for defensive purposes.  That approach comes with a risk of selling at just the wrong time, and having to buy back into the market at higher prices.  While there are certain trades that I wish I could take back, this approach did in fact help to protect your account during this severe decline. [ I made net sales of nearly $xx in August and another $xx in the first ten days of September.  The portion of your account allocated to stocks was 48% in mid-July, 43% by the end of August, and only 38% just before the terrorist attack on September 11.

Moreover, we did succeed in buying certain stocks back at substantially better prices.  For example:

  • We sold xx Ivax at $29.90, and bought most of it back at $17.82
  • We sold xx American Woodmark at $39.82 and bought half of it back at $33.25
  • We sold xx Flextronics at $21.05 and bought xx at an average price of $15.01
  • We sold xx Lehman at $55.00 and bought it back at $50.05
  • After selling xx Cisco in June at $17.26 and another xx in August at $18.97, we bought xx back at $13.11 and another xx at $12.72

Obviously, these and other trades generated more activity in your account than is normal for a given period in time.  But the frequency of trading was in reaction to abnormally large price movements.   While on balance this approach was successful, certain trades did not work out as well.  For instance, I sold xx Ann Taylor at $23.35 and wound up buying xx back at $24.10.  I bought some Home Depot at $34.80, and decided to risk not more than 12 ½% on half of the position – and wound up getting stopped out of half of the position at $30.40.  While that was very disappointing, it is important to define some ways to limit risk in a declining market and in this case our stop-loss limit was simply in the wrong place.

The other disappointment was that our losses were greater than they might have been because we were somewhat overweighted in consumer cyclical and energy stocks.  In retrospect, the consumer sector has been one of few bright spots in the economy, and I’m not sure anyone could foresee such a sharp and sudden decline in stocks like Chicos.  In recent days, it staged a good comeback rally.  As to oil stocks, I think it is a mistake to sell them on weakness given the potential for instability in the Middle East.  Again, oil prices simply declined by more than I expected and stocks like Ocean Energy fell by more than I anticipated.

The bottom line is that I think we got out of certain stocks pretty well, used the sharp decline to re-establish positions in certain good companies and to initiate positions at good levels in blue chip stocks like GE, Citigroup and AOL which came into attractive valuation levels after having been too expensive for too long.  And we have good positions in high-yielding stocks such as Mack Cali and Thornburg Mortgage, which both have yields that are well over 8 percent.

It is hard enough to make economic forecasts even without all of the geopolitical uncertainty.  But there are some encouraging signs.  Real interest rates have not been this low in many years.  The drop in oil prices should provide a boost to the economy.  Fiscal policy is aggressively stimulative.  And most analysts think that the market is now somewhat undervalued.

Low interest rates in particular should help spur an economic and market rebound.  First, cash earning two percent is not a particularly attractive investment.  Anyone who believes that stocks will generate any positive returns will have to see equities as a better place to be than cash.  Second, low rates generally benefit the financial and housing sectors, and will ultimately make financing purchases more attractive in both the capital goods and consumer sectors.

Some observers say that low rates didn’t help the Japanese economy.  But we’re not Japan.  We may have had a technology bubble, but Japan has spent a decade recovering from a much more comprehensive asset bubble.  In the late 1980s, the Japanese were buying office buildings at a 1% cap rate and Nippon Telephone’s market cap exceeded that of the entire West German stock market.  Their banks are now in deep trouble, with capital adequacy ratios far below international minimum standards.  In contrast, our banking system had the S&L shakeout a decade ago and is now strong.  We have had rolling recessions – with energy, banking, health care and other sectors peaking and then correcting at different times.  Technology might be the most extreme case, but it is simply the most recent.  And some thought that the 1983 sell-off in technology shares marked the end of the tech revolution.  In retrospect, it had barely begun.  We may say the same thing in ten years about this period.

Market history provides further encouragement.  First, each of the three terrible quarters cited above turned out to be a great buying opportunity.  Second, the market has tended to sell off and then rebound after the onset of a political / military crisis – whether the Cuban missile crisis, the Kennedy assassination, or Pearl Harbor.  The Pearl Harbor case was the sharpest drop; the market plunged 7% in the few days after the attack.  Here, the initial reaction was a 14% drop – twice as much.  Based in part on that comparison,  I judged that the initial reaction was probably too much.  So I put a good amount of cash to work while the S&P 500 Index was below 1000.

The market actually did fairly well during both World War II and the Cold War.  The Dow (easier historical data to get) rallied from a low of 105.52 in December 1941 to about 175 by August 1945.  And the market was generally strong during the Cold War years in the 1950s and 1960s, until the Dow hit a wall at the 1000 level.  Arguably, the strain from both the Vietnam escalation and the Great Society spending affected confidence, and helped to put a lid on stock prices.  Today, there is a strong argument that the nation’s defense needs will spur the sectors most in need – capital goods (planes, other military gear, infrastructure spending) and technology (storage, security, smarter and faster devices).  And as previously mentioned, stimulative monetary and fiscal policy may keep the consumer sector strong.

While there are many reasons to be optimistic about the country’s overall economic outlook and the specific stocks that we own, there are still factors that must be constantly re-assessed.  Corporate earnings estimates are still being revised downward, and it would be helpful to start seeing at least some deceleration there.  The market has not moved above its 200 day moving average at all this year, which many analysts believe means that we are in a long-term downtrend until there are clear technical signs indicating otherwise.  The political instability in countries such as Pakistan and perhaps Saudi Arabia, the potential for conflagrations in the Mideast, further terrorism here and other vagaries of war are all major risks.   So far, the market has held above the lows established during the Asian financial crisis of 1998.  A break below that level would be a significant negative event.

I believe that your portfolio well-balanced, with many stocks that are poised to lead the way in an economic rebound and other securities that will do fairly well in almost any economic environment.  **  you should always feel free to call me anytime you have questions or concerns.  Let me close with a timely statement from Warren Buffett: “It’s the dumbest thing in the world to bet against the United States.  It hasn’t worked since 1776.”

I hope all is well with you and your loved ones.


* Past performance is not necessarily indicative of future performance. Results for individual clients may vary. Results are not audited. Byrne Asset numbers reflect the addition of certain dividends and deduction of all fees. S&P numbers are based on the total return of Vanguard’s S&P 500 Index Fund.

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