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Look forward, not back, to invest today
Unique conditions require investors to follow new rules, not old patterns.
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Many investors are reviewing historical data to make investment decisions for today. Historical patterns can teach investors many lessons about the stock markets and investing, but how to invest for today’s markets is not one of them.
Some investors are looking for patterns that occurred during and after previous bear markets, relying on assumptions that historically our markets rebounded by a certain percentage each time the economy emerged from recession. Some are hoping for certain sectors to outperform other sectors in the wake of the bear market. When this data is applied to today’s market, it has not proven successful.
Based on a historical approach for the past year or two, our information tells us to avoid small cap stocks. Small cap stocks have generally proved a bad investment during a bear market. If you look at the bear markets of 1981-82 or 1987 or 1990, small cap stocks fell considerably further than large cap stocks.
Yet for the past 2 years, as our U.S. bull market turned to a bear market and our economy slid toward recession, small cap stocks were about the best place to be invested. From second quarter 2000 through fourth quarter 2001, the Russell 1000 (measuring large cap issues) lost 22.7% while the Russell 2000 (measuring small cap issues) lost only 7.2%.
Industrial cyclical companies have also been strong over this bear market cycle, again deviating from the norm for a bear market historically.
Unique conditions
Conditions in today’s markets are unique to today. They are not simply a repeat of past markets. Never before have we had technology and the opportunities available to our companies. Never before have we had accounting firms such as Arthur Anderson and company officers such as those from Enron or Global Crossing or WorldCom abscond with hundreds of millions of dollars or ignore shareholder interests to better their personal net worth. Never before in history have we had the Federal Reserve trying to limit our markets through interest rate plays. Never before in history have we allowed our judicial system to limit or control our markets through legal ploys such as has happened with Microsoft.
Investors at this time do not have enough signposts to indicate that companies are seeing meaningful increases in sales and order activity, nor are they confident that our economic rebound is long-term or that corporate profits can rebound enough to justify the stock valuation.
Our most recent bear market was driven not by a free-market correction, but by the Federal Reserve tightening interest rates. The Fed was concerned about an expanding economy that might ultimately induce inflation if left untouched. Some analysts also believe the Fed wanted to prick the speculative technology bubble. I believe the dot.com bubble would have burst of its own volatility as investors realized that some of these companies had no real assets behind the high stock prices. Many of the dot.com companies were simply traded among day traders. Few institutional investors owned these dot.coms.
Consumer spending has been surprisingly strong through this economic slowdown, particularly in the automobile and housing sectors. However, as interest rates rose, technology and telecom spending fell dramatically as companies could no longer afford to continue their drive toward automation through new technologies. This has resulted in an industrywide overcapacity that may take years to correct.
Valuation levels are much higher than during past profit recessions. Some of the increase can be explained by lower interest rates, but it is unlikely our markets will experience the kind of valuation expansion investors enjoyed over the past 2 decades.
External factors that have never been a factor in the past are driving stocks. Political pressure on pharmaceuticals and companies such as Microsoft; accounting irregularities; issues relating to balance sheet strength and whether the figures are true; and terrorism concerns now drive our markets. These fears are beyond company control. They have nothing to do with how profitable the company is, but have everything to do with how the company is perceived by investors.
New rules
The investment climate has changed because investors are no longer comfortable obtaining guidance from familiar sources. Confidence has been shaken by questions about analysts’ objectivity, questionable balance sheets and CEO character. Potential legislation in accounting practices can have unforeseeable effects on stock prices.
Some new rules need to be taken into account for today’s investor. Investors should consider earnings prospects as well as valuations. Investors can no longer throw money at small cap and value issues. Relative valuations for these companies have expanded markedly as a consequence of their overperformance.
Stocks must be carefully chosen using sound research, looking carefully at earnings prospects and reasonable valuation analysis. Investors must be realistic as to price-earnings ratios and rates of return they can expect to reap. They must avoid trend chasing.
In our current market environment, trend chasing will equate to buy high and sell low. As the technology sector became increasingly popular and profitable, investors were able to buy into that sector of the market even after the trend had been well-established and still reap profits. They were able to purchase technology stocks in general rather than well-researched companies. In today’s environment, I do not believe it is possible to simply pick a sector that is profitable and make money.