Letter – 2002 Q4

The stock market just completed its worst showing in 28 years.  The S&P 500’s decline of 23.4% in 2002 came close to the 26.5% decline in 1974.  The Nasdaq Composite Index fell 31.5% this past year.  We did [considerably] better than the overall market this year, but your account still lost xx for the year.  This figure includes all dividends credited to your account, and reflects all fees deducted from it.  It is worth noting that this return was even better on a risk-adjusted basis because your portfolio was [considerably] less volatile than the overall market.

Our outperformance was due to very good results in the first half of the year.  But many stocks that did well in the first half of the year, such as Michaels Stores, gave back a lot of ground in the second half.  And entire sectors that had done reasonably well in the first half of the year, such as housing and related financial services stocks, did poorly in the second half.  So in retrospect, there were very few good places to put money in the second half of the year.  And my stock selection was subpar in the last quarter.  We had a few winners such as Storage Technology, Brown Shoe, and Crown Cork & Seal.  But the selections from my quantitative model this past quarter lagged the overall market for the first time since the second quarter of 2001.  Thus your account gained only   xx  % in the fourth quarter versus 7.9 % for the S&P 500.

We navigated the worst market in a generation better than most.  Having stocks like Thornburg Mortgage and Mack Cali, which pay high dividends and ended the year near where they began it, helped us.  But we can’t just have stocks like that, because they are likely to lag considerably in an up market.  Use of stop-loss orders also helped to conserve cash, but contributed to more than normal portfolio turnover.  That was largely a function of the most volatile market in at least 20 years, as measured by the absolute daily percent change in the S&P 500.  I expect the turnover level to decline in 2003.  And we did move from a very defensive posture to a more aggressive one pretty quickly in early October, so our timing was good even if our stock selection wasn’t the best.

Usually I discuss the performance of individual portfolio holdings in some detail, but I think we’d all rather look forward than back.  And while I generally focus on finding excellent stocks, it is a good time to make some observations about the overall state of the market.

There seems to be a building consensus that, absent any horrible consequences from war or terrorism, the market should finally produce modest gains.  A survey of ten market strategists from leading brokerage houses published in Barrons has the S&P 500 finishing in 2003 at anywhere from 1150 (+30%) to 750 (-15%).  The average comes out to 980, or a gain of 11%.  But we’ll see; brokerage house investment strategists were too optimistic with respect to 2002.

Even in the Great Depression, the market only went down for three straight years, from the summer of 1929 to the summer of 1932.  We’ve matched that time span.  The Nasdaq had been tracking the decline in the Dow from 1929-32 with uncanny similarity until October, when it departed from that pattern very suddenly.  And the economy seems to be in a lot better shape than it’s been after other bear markets.  (You may hear reports of four straight losing years during the Depression.  The market did post four years of negative returns in 1929-32, because the rebound that began in mid-1932 did not wipe out all of the losses from early in that year.  But the downtrend itself lasted 34 months).

Let’s turn to three barometers I use to gauge the condition of the overall market:  (i) valuation, (ii) earnings momentum, and (iii) the 200 day moving average as an indicator of long term price trend.

Valuation.  The S&P 500 (SPX) ended the year at 879.82.  The latest consensus among analysts is for earnings in 2003 of $48.30 to $50 for the SPX (versus a likely $47.94 in 2002).  Even using the lower figure, that means the SPX began the year with a “forward” P/E of 18.2 (ie, the price-earnings ratio based on today’s price and projected earnings over the next 12 months).  That translates to an earnings yield (reciprocal of the P/E ratio) for the SPX of 5.5%.

Some people say that PE ratio is still high by historical standards.  But you can’t look at that in a vacuum.  The PE ratio strikes me as quite reasonable when viewed relative to interest rates.  If you buy stocks with a five year time horizon, it is reasonable to measure them against yields on five year Treasury securities.  Let’s do so at some market bottoms:

Period PE Ratio SPX
Earnings
Spread
5-Year
Treasury
Stock
Yield
Advantage
Oct 74 5.1 19.61 8.10 11.5
Mar 80 6.4 15.63 13.75 1.9
Aug 82 7.5 13.33 13.50 -0.2
Oct 87 10.6 9.43 8.85 0.6
Sep 90 10.2 9.80 8.55 1.3
Oct 02 14.1 7.09 2.65 4.4
* But rates were dropping rapidly.

This yield advantage for stocks is greater than at any market bottom since 1974.  The PE ratios were taken from Value Line, which may differ slightly from measures based on the SPX.

I consider Value Line to be an unbiased source of market data.  They publish a figure called “Estimated Median Price Appreciation 3 to 5 years hence”.  Here are those percentage figures at these same market lows:

Lows VL Appr
Oct 74 240
Mar 80 135
Aug 82 185
Oct 87 120
Sep 90 125
Oct 02 115

The appreciation figure is less robust than at other market lows.  This is consistent with the consensus outlook for a modest rebound rather than a return to the outsized returns of the late 1990s.

Despite this reasonably good valuation backdrop, some would argue that quality of earnings has deteriorated and that “real” earnings for the SPX are closer to $35, making the PE more like 25.  But I think that in this atmosphere of heightened scrutiny, corporations will not fudge earnings in ways that have occurred in recent years.  Beyond that, some bears say that option expenses and other costs should be deducted from the earnings estimates.  While there is validity in that point, it is difficult to establish a  common denominator for comparing those costs in earlier years.

Finally, some bears argue that dividend yields are still too low.  Just as with PE ratios, it depends if you measure only relative to past levels or relative to interest rates.  Moreover, it is likely that dividends will be treated more favorably under the new Bush tax package.  That should be a bullish influence on the stock market.  I’ve enclosed a recent op-ed of mine published in the Star Ledger that elaborates on this point.

All in all, stock valuations seem reasonable if not compelling.  If the market should decline, I don’t think that current valuations will be to blame.  However, just as low or even zero percent interest rates don’t necessarily make people buy cars, low interest rates won’t necessarily make them buy stocks.  And low rates could contribute to weakness in the dollar, which could be a negative for stocks.  So reasonable valuation does not necessarily assure rising stock prices.

Finally, although the overall market seems reasonably valued, I do think that many individual stocks remain richly valued.  Thus stock selection will remain very important.  There are many stocks with solid earnings growth that are good buys.  In fact, my model projects compound annual returns in excess of 20% on many such stocks.

Earnings Momentum.  I have said before that the bear market was simply the painful process of prices and earnings coming back into line.  Beyond that, as prices declined, so did confidence, and earnings declines followed.  That vicious cycle ended some months ago, and earnings are rising again.  Even so, earnings gains for the year are expected to be only in the low single digits, which is anemic for a recovery phase.  But at least the tide appears to have turned back toward rising earnings.  Yet analysts tend to be too bullish, and earnings estimates tend to decline as a year progresses.  We closely monitor aggregate estimates and those for individual stocks.

200 Day Moving Average.   I don’t suggest that there is any predictive value in the 200 day moving average, but it is a widely watched indicator of long term trend.  I do believe in respecting prices themselves, largely because one cannot anticipate every influence that might contribute to the continuation of a price trend.

As the enclosed chart shows, the S&P 500 has not been able to sustain a move above its 200 day moving average in three years.  A move above that average (now at about 957) would be a signal to some that the primary trend has finally changed.  Just for the record, the SPX closed above its 200 day moving average once in January 2002 and then for 13 consecutive days in March ’02 before falling back and resuming the downtrend.  As I’ve said in earlier letters, I’ve been inclined to maintain a fairly defensive posture as long as the market remained in a downtrend as indicated by this average.

Stocks are by nature risky.  But I think we’ve reached a stage where there is more risk being out of stocks than being in them.  My hope is that even if the S&P 500 has only a modest return this year, we can again outperform and deliver a very satisfactory overall return in 2003.  I am happy to discuss these matters in more detail with you at any time; please do not hesitate to call or email with any questions or concerns.

Here’s to a Happy New Year!


* 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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