13 Sep 2002 Market Stability Gradually Improving

You know from your July and August statements just how badly the markets mistreated long-term investors.  A few statistics from Credit Suisse First Boston help put the period into even better perspective.  A record $29 billion was removed from mutual funds in July 2002.  Stock funds experienced record outflows, while bond funds enjoyed record inflows.  Net outflows from equity funds in July 2002 were almost twice as large as those during September 2001, and more than five times larger than those during August 1998.  Every style of equity funds was affected by investors’ withdrawals in July. 

CSFB adds that households are often accused of chasing performance.  While past performance is no guarantee of future results, the facts remain that households were selling stocks on the way down while buying bonds at multi-decade low yields.  While during the 90’s individual investors were praised for stubbornly holding to a proven long-term strategy of buying on dips, this bear market has caused many to abandon their strategy and run for cover.  Individual investors may now have succumbed to the age-old characteristic of selling low and buying high.

History tells us that markets go through prolonged periods of shakeout after bubbles.  The process may be woefully inefficient and painful, but it is a necessary and fundamental component of innovation and capital formation.  The process actually leads to stronger companies and markets in the long run.  Please read Michael Mauboussin’s excellent parallel of brain development and the phenomenon of market bubbles Pruned for Performance on our website.  It is a brief but informative piece.

September and October are traditionally volatile months for the market as companies release news of any shortfalls in results.  During October the actual results for the third quarter are released.  Our expectation is that all but the largest of surprises are factored into stock prices.  Stock volatility has been declining for the past several weeks and will likely continue, after we get beyond the next few weeks.

The markets endured a barrage of economic and global news during this emotional week, including major speeches from President Bush and Chairman Greenspan.  The speeches contained no major revelations or surprises, but the market was considerably weakened in the hours following.  Prices were likely returning to where investors thought they should be given today’s realities.  They had likely drifted higher on Tuesday and Wednesday due to 9/11 emotions and light volume.

We expect certain retailers to see significant improvement in the coming months.  This past August saw a huge number of mortgage refinancings.  As homeowners receive cash equity from their homes and their monthly cash flow improves from lower mortgage payments, they will likely increase their spending.  We expect they will increase their major purchases, such as cars, appliances, and electronics, benefiting companies like Best Buy, Superior Industries (major auto parts producer), Electronic Arts, and eBay.  Additionally, they will likely pay down credit card debts, further improving monthly cash flows and consumption.

Better retail sales should spark inventory demand and boost corporate cash flow, which should finally lead to a sustainable pickup in capital spending.  We look for better results from companies like GE, Nucor, Ebay, Nautilus, as well as technology stalwarts like Cisco and Microsoft as capital investment builds momentum nest year.

Consumer confidence remains a primary focus.  Since its pullback in July and August from a peak of 96.9 to 87.6 investors have worried about a ‘double dip’ recession.  Today’s release unfortunately does little to allay fears that the consumer is pulling back.  But, remember, it is what the consumer DOES that is important, not what he says in surveys.  Mr. Greenspan stressed this point in this summer’s congressional testimony.  And as you can see in the economic releases chart above, retail sales are doing quite well, both with and without autos.  Home and auto sales continue at near record rates.  These are not purchases that consumers enter into without careful consideration of their employment and income expectations.

Consumer surveys are useful in gauging future spending, but we must identify those influences affecting survey respondents and determine whether they are likely to effect real change in his spending habits.  The past couple of months have been rife with significant revelations of corporate wrongdoings, potential war with Iraq, terror, and the host of other global concerns.  The duration of these influences is impossible to predict, but a closer look at the confidence numbers indicates that the consumer is adapting to the stress.  The relative decline of the confidence indicator was very small this month and its absolute level of 86.2 was five points above its low reached this time last year.  Consumers aren’t running for cover, and as stated before, we think they will come back stronger in the coming months.  If experts expect that investors will demand proof of economic recovery this time, it’s doubtful they will wait long when that proof starts coming in.  Many signs are already here.