Summer 2001
"The best of times....the worst of times...
or "Thank you Jack Welch!! Goodbye bull market??".
Summer Greetings:
July 31, 2001
(Tyler Bud's birthday)
...the markets
We ended the quarter maintaining our 20% gain in The Model Portfolio
for the year. Coupled with our 1% gain last year and 42% gain in
1999, the Model Portfolio has out performed the S & P 500 by
60% over the past three years ended June 30, 2001. For the year
ended June 30, 2001 the Model Portfolio had a return of +22% and
the S & P 500 for that same period of time returned -14%. For
the 3 year period ended June 30, 2001 the Model Portfolio had a
annual rate of return of 20% and the S & P 500 for that same
period had an annual rate of return of 4%. For the 5 year period
ended June 30, 2001 the Model Portfolio had an annual rate of return
of 18% and the S & P 500 for that same period of time returned
14%. Past performance does not indicate future performance.
The collapse of the internet and tech stock bubble was predicted
by many but acted upon by few. We were one of the few. In November
1986, nine months before the 1987 Crash, our late partner, Don Yarling,
said in The Lemley Letter, "The last leg of a bull market
is always the most exciting and the most dangerous." History
has shown that when markets run to excess and when stock ownership
exceeds fifty percent of the population it's time to raise cash.
We may have overdone that by being 90% cash, but until we are convinced
that this is only a correction and not the end of a twenty-year
bull market we plan on remaining cautious.
Truth be told, it is professionally gratifying to know we are fulfilling
our responsibilities to our clients. Almost all accounts have outperformed
the S & P 500 by at least 30% during the last 3 years. Our philosophy
has always been to take gains as they present themselves, to try
to hit singles, and to take the home runs when we get lucky. Our
main goal has been and remains preservation of capital. While we
are not yet "masters of the universe" we want our clients
to know that we have delivered the goods. And we also want to thank
them for their confidence in us over the years. We take great satisfaction
in rewarding that confidence with the recent performance in client
accounts in a very difficult time.
...bull market?
With most accounts at 90% cash, we are making a strong statement
that the markets have much more downside risk than upside potential.
The bull market of the last 18 years started right after Jack Welch
took over as CEO of General Electric. GE has been the bell weather
big cap stock of this twenty-year bull market, replacing General
Motors and IBM for that honor. GE has earned this honor and numerous
accolades for Welch by showing consistent earnings, excluding special
charges, and sales growth for the past 20 years. Jack Welch is retiring
on September 7, 2001.
Both the NASDAQ, which is down an astounding 60% from its high of
just fifteen months ago and the S & P 500, which is down over
20% in that same time, are obviously in bear markets. But the DJIA
has only dropped a little more than 10% from its high. If past performance
of the DJIA versus the S & P 500 holds true, the Dow would fall
to the 7800 level to match the drop in the S & P 500.
...why we are bearish
We realize that our view is more bearish than most. We are bearish
because stocks are not cheap. Even after the precipitous drop over
the last year in tech stock prices. Because of numerous rapid-fire
splits over the past few years, stocks such as Motorola and Lucent,
et al, all have total market values well in excess of historical
norms. Excess valuations are never justified, but they may be explainable
if sales and earnings are growing at exponential rates. Over the
last few years we have often questioned whether reported earnings
represented real earnings. We have also questioned sales growth
figures resulting from takeovers at ridiculously high p/e multiples.
And we have been wary of sales growth resulting from vendor financing.
Vendor financing is a topic we mentioned two years ago in relation
to Lucent. Vendor financing means that the company selling the product
also loans the money to pay for the product sold to the company
buying the product. Since most of those companies being financed
were new companies with no track records the sales recorded were
not really sales until the companies paid off the debt to the vendor
financier. Those new companies are now defaulting on their debts
as they file bankruptcy, and that's why Cisco and Nortel et al are
taking multiple billion dollar write downs.
Rising home sales and a 40 billion dollar Treasury tax rebate suggest
continued economic stimulus. But our gut feeling is that the consumer-spending
boom is slowing and that by autumn when third quarter earnings season
arrives the numbers will not be good. Land prices are rising at
an astounding rate. We attribute this to the punk stock market and
the leverage possible on real estate purchases where one can buy
with only a ten percent down payment and thirty years to pay. The
land boom coupled with the rise in oil prices is similar to the
late 1970s. We don't have the commodity boom in gold & silver
prices we had then courtesy of the Hunt brothers. We think the comatose
bullion markets are more a function of illiquidity than lack of
inflation pressure. The new commodity play is electricity and that
commodity is showing enough inflation to satisfy any interest rate
hawk. In liquid markets such as oil, price inflation has been and
is present. Treasury bonds don't reflect this inflation because
the supply of Treasury bonds has been constrained by redemption
from the rapidly evaporating surplus. In reality, there is serious
inflation in food, energy, and housing prices, the three areas that
matter to most consumers and the three areas that most economic
experts ignore when discussing inflation.
The recent billion dollar write down by American Express in its
junk bond portfolio is also a good indication of the current fragility
of the interest rate market outside of Treasuries and high grade
corporate bonds. The Fed rate cuts over the last eight months have
the same purpose as they did in the late 1980s. That purpose is
to help the banks absorb the cost of writing off bad loans made
in the past ten years. The financial press keeps talking about the
drop in rates stimulating consumer spending as credit card rates
come down. Under what rock do those writers live? Credit card rates
never come down. Only the banks' cost of money drops, which increase
the banks' profit margin. The increase in the interest rate spread
helps the banks absorb bad loan special item write-offs. And the
lower rates lower savers income, forcing them to seek other more
risky investment to maintain their standard of living. Once again,
as in the early 1980s and early 1990s, the saving public pays for
the profligacy of Wall Street and the multinational banking cabal.
Do we detect a pattern here?
The present tax rebate debate and the corresponding passing of one
of the most convoluted tax cut packages in history may also have
marked the end of the twenty year rally in bond prices and corresponding
drop in yields. The last two FED discount rate cuts have had no
effect on the yields of ten-year and thirty-year Treasury bonds.
In fact, yields have risen over the past few months. In our view
this price action portends the return of budget deficits and higher
long-term interest rates. It is amusing to hear Congressional leaders
who favor larger tax cuts say that deficit spending is fine since
such deficit spending will stimulate the economy. Think we've heard
that line before but not from the lips of conservative economists.
The continuing discussion of changing Social Security is also a
negative. The markets abhor uncertainty. Allowing individuals to
control what are essentially premium payments is ludicrous. Those
folks favoring private control of a portion of funds to invest in
the stock market ignore the reality that the majority of folks don't
have the expertise to invest prudently. Heck, the vast majority
of stock market experts have also been totally imprudent in their
investment advice for the last few years. Why not have the Social
Security adminstration invest 5% to 20% of Social Security receipts
in a broad index like the Russell 5000, if it's determined that
some equity investment by the Social Security Trust Funds would
yield a better return. Social Security is a social insurance program
and if the powers that be determine that stock investment is warranted
then all should share the risks and the hoped for rewards. Investment
by the Social Security Administration would be cheap and efficient.
The reality of allowing individuals to invest Social Security funds
in the stock market is that if there isn't any profit for Wall Street
and the Multinational banks in whatever action is taken the whole
concept will fade away. Which is what we hope it does. The simplest
solution to the run out of money in 2050 scenario is to quit adjusting
for inflation. BY DROPPING THE INFLATION ADJUSTER IN HALF AND
CAPPING THE MAXIMUM PAYOUT AT $2500 PER MONTH, SOCIAL SECURITY BECOMES
SOLVENT. But that is too simple. Much better to create an unworkable
plan to save Social Security similar to the present ten year tax
cut fiasco.
There are two famous Wall Street sayings. The first is: "The
markets abhor uncertainty." The second is: "Bull markets
climb a wall of worry." Uncertainty refers to a lack of
confidence in an expected outcome because of lack of trust in those
who are implementing policy. Worry refers to fear of losing hard-earned
gains. The reason the "wall of worry" scenario
works is that worry of loss of gains encourages weaker stockholders
to sell and so stocks continually move into stronger hands at higher
prices. On the contrary, uncertainty encourages folks who
have no confidence in economic or political forecasts to move to
the sidelines by selling stock. In this case stock usually passes
to weaker hands i.e., those looking for trading profits, creating
the potential for further price erosion if the trading scenario
forces selling.
Model Portfolio Transactions
We tried a few trades over the past three months. Most accounts
gained five to ten percent but then we gave most of those gains
back. It's getting pretty late for a summer rally, and in our memory
autumn rallies don't usually start till after a significant correction.
So we may keep trying one or two trades like the Schering Plough
trades of the past two months but our main goal is to keep our powder
dry. We hope to be able to sell most of our Gymboree position over
the next few months as we would like to have those funds for higher
quality depressed stocks at year-end. Since inception in 1983, the
Model Portfolio has grown from $50,000 to $425,000. Thank you bull
market.
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