What Surprise?

Returning from dinner on Wednesday night of last week, in Singapore, I was able to catch CNBC’s coverage of the impressive stock market rally that was just then unfolding in New York (Singapore is twelve hours ahead of New York, but the jetlag helps).

The commentators were marveling at the powerful impact of the “surprise” interest rate cut announced by Mr. Greenspan. But, I wondered, where exactly was the surprise?

It certainly was no surprise that the Fed should cut interest rates most aggressively just as the economy shows every sign of entering recession. It has always cut rates at that juncture in the past and it had all but announced further rate cuts a few weeks ago.

The apparent prescience of the stock market in anticipating economic recoveries comes from the very fact that central banks create money most aggressively when economies enter recession. Since most of the new money is not immediately needed by a slowing “real” economy, it flows into the financial markets and boosts the prices of financial assets. This, in turn, generally benefits stocks most because, at that stage, they often have been declining for a while, whereas bonds typically have rallied with the weakening economy.

Nor is it a surprise that Mr. Greenspan, who sees himself as the world’s central banker, should worry about the potential harm to emerging economies from a US recession. In Japan, even zero interest rates can’t seem to boost the economy, so that helping others is not on the Bank of Japan’s front burner. As for the new European Central Bank, it is struggling to establish an identity through somewhat pathetic efforts to show “independence” from the Fed. It too, seems far from taking on global responsibilities.

From all this, I conclude that the only surprise in Mr. Greenspan’s latest rate cut was its timing. And this is irrelevant to all except to the very short-term traders.

My Headlines and Bottom Line of March 26 argued that the economic news was dark enough and stocks had fallen enough to take a more sanguine view of the US stock market, especially in light of aggressive monetary easing and forthcoming tax cuts (See: Are We Happy Yet?). But I stopped short of making a call on timing, for which some readers reproached me.

The reason is that market timing is a futile and doomed game, which only the fool or the lazy play, usually in lieu of real work or serious analysis. To justify my deprecating language, I exhumed a couple of studies. The first one comes from Sanford Bernstein via Train, Smith Counsel. Though it covers only one decade, it is the most striking.

There were 2,528 trading days, returning 17.6%*

If you missed the best 10 days, the return fell to 12.6%

If you missed the best 20 days, the return fell to 9.3%

If you missed the best 30 days, the return fell to 6.5%

If you missed the best 40 days, the return fell to 3.9%

* S&P 500 annualized rate of return. Assumes that assets not invested in stocks earned interest at the average 30-day T-bill rate for the decade.

Another study, from Townley Capital Management and the University of Michigan, covers thirty years. It shows that $100 invested in the stock market in 1963 would have earned $2,333 by 1993. But missing the best 90 days of that period (an average of 3 days a year) would have cut the earnings from $2,333 to just $110.

The “surprise” could have happened earlier or much later, but it was set to happen. When it did, missing the first few days of market reaction could prove expensive. Headlines and Bottom Line is really written for our research department, and made available to our investment clients on the web. “Are We Happy Yet?” was written to remind our analysts and portfolio managers that we had reached a market level where the bulk of the previous two-three years’ speculative follies had been erased, and where brainwork again stood a chance against the madness of crowds. As a result, being out of the market now presented as much risk as being in -- perhaps more from a long-term perspective, as the studies above illustrate.

Some readers also thought I did not pound the table hard enough about how cheap stocks (and tech stocks in particular) had become after the recent stock market decline and the Nasdaq’s 65 percent debacle. The following chart may illustrate my hesitation:

If we assume, as I believe had broadly been the case, that the Nasdaq plodded along more or less apace with its component companies’ earning power until 1997, then it is fairly obvious that 1998-1999 constituted a pricing bubble. But the fact that the bubble has now burst does not make stocks cheap. Unless there has been a radical acceleration in the long-term earnings growth rate of Nasdaq companies, which seems unlikely, then stock prices are only back to their pre-bubble valuations. Unscientific as this reasoning may appear, this is also what we find in our effort to pin buy-price targets on the best technology companies. Much as we try, we find surprisingly few tech stocks where a doubling in price over three years (our general goal) seems possible without another pricing bubble.

Still… we do find some attractive stocks, both tech and non-tech at current levels. That was my whole message. It’s not like a major bear market bottom, where buying value is like shooting fish in a barrel, but the game is at least open and fair again. This is good news for value stock pickers.

^©Tocqueville Asset Management L.P.

April 23, 2001

The information contained herein has been obtained from sources believed reliable, but is not necessarily complete and cannot be guaranteed. Tocqueville Asset Management L.P., their affiliates and their officers, directors, employees, advisors or members of their families as well as the clients for whom they manage portfolios; 1) May have positions in securities or options of issuers mentioned herein and may make purchases or sales of the securities or options while this publication is in circulation; 2) May hold directorships in corporations discussed in this publication. Affiliates of Tocqueville Asset Management L.P. may, in the last three years, have been manager or co-manager in a public offering of securities of issuers discussed in this publication.