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Commentary:
High and Low Financiers
January 2004
Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
See also:
General Index
of all guest columns written by Dennis C. Butler, CFAGold has defied expectations to record a 20% gain ... strategists expect gold to continue its run this year.
� Financial Times, January 2, 2004
About six years ago we wrote an article that was published in Barron's financial magazine in which we suggested that the gold sector probably represented reasonable value as insurance against financial difficulty � a traditional role for gold. "Gold Coffin," as the piece was called, appeared during a time of extremely negative sentiment towards the metal. Its price had been declining to the lowest levels in decades, and at under $300 per ounce was less than the production costs of many producers. The world had seemingly given up on gold as a store of value, or for any other purpose outside jewelry for that matter. Our skepticism about the "death" of gold proved a little too early for most people, however, and for the next three years the insurance remained cheap.
The situation in the commodity and share markets for gold is now strikingly different. A rekindling of interest has boosted the metal's price to over $400 per ounce, and mining stocks have doubled and tripled. Companies are raising capital for projects to increase production; mutual funds specializing in the area are at the top of the charts; innovative new investment products designed to meet retail demand for gold have come to market; and promoters of far-flung mining schemes are again receiving lots of free press after years of banishment. The radically changed atmosphere, and the highest prices since 1990, indicate to us that gold's insurance value has been superceded by a speculative interest that is beyond analysis. For those who might be attracted by the recent excitement, we advise caution.
Whether it involves gold or anything else, the Financial Times quote above illustrates the imprudence of giving too much credence to the divinations of market prognosticators. It also shows that being wrong in no way diminishes the predictive impulse. Just for fun we pulled up an article from a year ago about a well-known "Elliott-Wave" theorist who claims to discern predictive power in the patterns found in long-term market charts. Our sage made "correct" calls on the stock market's rise after 1982 and its crash in 1987. His fame faded after keeping his followers out of the decade-long bull rise up to 2000, but a couple of prescient moves in 2001 and 2002 brought a renaissance of interest in Elliot Waves and their interpreters (the popularity of seers seems to depend on the fading memory of their past mistakes). Which brings us to the fun part: one year ago our theorist was calling for a dire market crash, in which the Dow Jones Industrial Average would fall to 800 in the midst of a "deflationary depression." Instead, it closed 2003 at 10,500. Perhaps a deflationary debacle will yet occur, but in the soothsaying business you are only as good as your last forecast, and missing a big market run-up such as 2003's does not exactly endear you to your following.
In fact, the markets were surprisingly strong last year, with the averages customarily followed in the press up from 25% to 50%. Few expected such an eager return to stocks, but the liquidity resulting from massive deficit spending and monetary looseness has to go somewhere. We will probably pay the price for the current borrowing spree at some point � one Financial Times columnist said that finding justification for questionable economic policies in the current growth spurt is "like saying it was worth the melanoma to get the sun tan." � but we will leave that for future generations to worry about.
For the money management crowd, for whom the future begins and ends with each day's opening and closing bell on the New York Stock Exchange, 2003 brought a respite after three years of declines and something positive to write about in investment letters. Not to rain on the parade, but the year's gains actually amounted to only a partial recovery from the three-year beating. The Dow Jones average, despite having risen 25.3% in 2003, was still 11% below its record high in early 2000. Likewise, the S&P 500 ended the year up 26.4%, and 27% below its 2000 record. The NASDAQ Composite rose an astounding 50% last year, yet remains 60% under the March, 2000 high mark. Momentum players beware: it takes a long time to recover from paying excessive prices at times when the outlook is rosiest.
Despite the strongest markets in years and increasingly robust economic reports, from our vantage point the investment scene appears curiously subdued and the public disengaged. Some people even seem unaware that stocks have actually risen smartly over the past year. Yet by almost any measure, from P/Es to "Q" ratios, stocks are at the high end of historical valuation ranges. Record trading volumes in tiny "pink sheet" stocks, or the strength in "emerging markets" may bear witness to a speculative binge underlying a calm, possibly far too complacent Wall Street. The 20% rise in gold last year, and the dollar's similarly large decline against the Euro, might be telling us something that no one wants to hear.
High and Low Financiers *
A few remarks on the year's Wall Street scandals seem in order given their prominence in the news. The Street is prone to periodic embarrassments, but the mutual fund industry's involvement in shady dealings caused some shock because it was apparently widely believed that the business of running funds was innocent of such bad behavior. It is indeed shameful that those who are supposed to benefit from fund management � small and unsophisticated investors � have once again suffered at the hands of others positioned to manipulate the system. "Once again" because this is not the first time, nor will it be the last, unfortunately. Even at its birth the mutual fund industry (its precursors were then known as "investment trusts") was enveloped in corruption. Wall Street promoters used the trusts as a tool for issuing new securities and earning fees and commissions, first through the securities issues of the trusts themselves, and then, derivatively, from the scores of flimsy new companies whose securities the trusts would subsequently purchase. This Ponzi scheme came to a halt at the end of the 1920s. With the arrival of the "performance derby" in the 1950s and 1960s, some fund managers turned to illiquid stocks with largely fictitious valuations as a way to produce equally fictitious investment results. This con game faded away with the end of the "Go-Go" years (although variations on the method still crop up occasionally, as the owners of certain bond funds learned last fall). The more recent scams involved offering favored big customers off-hours trading privileges in return for placing assets in the funds.
Insights into why this happens, and why the problem may be intractable, can perhaps be gathered from the following statement by a well-known Wall Street strategist: "Portfolio managers' performance pressures do not allow them the luxury of anything but a short term time frame." Performance pressures: managers depend, for their high-paying jobs, large bonuses, and advancement, on their power to attract assets for their funds and employers � an ability that rests largely on producing short-term investment results that are attractive to the investing public. Fund managers are highly trained and ambitious people who operate in what is perhaps the most competitive of businesses. For the most part, customers (shareholders) can come and go as they please and, having been miseducated about the markets and investing, are inclined to jump ship too often (a recent study showed returns actually achieved by mutual fund investors came to only 2.6% annually from 1984 to 2002 � a pathetic result due largely to ill-advised fund switching). The pressure to maintain competitive performance numbers is, therefore, immense � more than enough to motivate unscrupulous activities. Clearly, there is a lot of blame to go around and everyone involved in these workings, from the investing public to fund managers, is to some degree responsible for the continuation of this vicious cycle. As long as the industry retains its current form of organization, which rewards asset-gathering over investment principles and short-term results over the long-term well-being of investors, ethical problems of one sort or another will crop up from time to time.
Lest anyone believe that what is good for the fund manager is good for the investor, take heed of the following, also from the strategist referred to above: "As a result [of the short term time frame], short term technical analysis has replaced longer term fundamental analysis." If this is indeed the case, it is a bad omen for those who partake of the services of these institutional investment management organizations. Fundamental analysis, which is a rigorous effort to understand security values, is at the heart of successful investing. So-called "technical analysis" is nothing less than an attempt to predict security price changes using the record of past price behavior within an interpretive framework. Unfortunately, the methodology, in any of its varied incarnations (including Elliott Wave theory), has no consistent record of positive results and is considered by many to be little more than hocus-pocus. At its heart, technical analysis is a tool of speculation. People calling themselves "professional investors" should know better. The use of speculative methods corrupts the investment process and represents a dereliction of duty to those who depend for their financial well-being on the safeguarding of their limited resources. Investment management is more than just performance. If fund customers want to engage in speculative operations, that is up to them; individuals have a long history of falling prey to speculative schemes. However, they should at least be aware of what is being done with the money they entrust to others. They should also know that, over the long run, speculators lose money.
� � � Finally, 2003 was a good year for most investors, institutional and individual (excepting those who paid too much attention to certain market technicians). A few figures illustrate why. In addition to producing the best average returns since 1998, the rise in stock prices was very widespread. In the S&P 500 index, 459 companies rose in value-the largest portion in any one year since about 1980. This contrasts with some periods in the late 1990s when as few as two dozen companies accounted for the entire rise in the popular market averages. The spell of three losing years having been so decisively broken, optimism has returned to Wall Street and its fortune tellers are predicting a positive or even a great year for 2004. Our own forecast remains, as always, that the markets will rise or fall. In our case, we will make good use of either move. Our current holdings will increase in value with a rising market, and if prices fall, we will be better able to find new investment opportunities.
* Title of a book on Wall Street swindlers published in 1932.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139Telephone: 617.441.9695
Email: [email protected]
URL: www.businessforum.com/cscc.html
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Revised: April 28, 2004 TAF
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