General Market View

September 18, 2000

Aggregate stock prices remain about twice as high as their long-term average based on PE ratios, replacement costs, and other traditional methods of valuation. However, in recent quarters a series of corrections within specific industries and sectors brought many prices down to either sensible or attractive levels. As a result, the market is becoming progressively more two tiered. Value investors should be more comfortable with the current environment than they have been for quite some time. Not only are the values improving in many areas, the market reaction to news and company performance seems more sensible. It's a welcomed change.

In the early spring I identified the food and property casualty industries as fertile ground for investment.

Since that time a series of mergers in the food group gave some of the stocks a deserved bounce. The prices paid by the acquirers seem very generous to me, but only time will tell if they overpaid. Overall, the group seems mildly attractive to reasonably priced at this point. Competition is tough, pricing power is lacking, and balance sheets are already quite leveraged.

Most of the PC insurance group has also bounced off its most depressed level. Evidence that the insurance cycle is turning in a number of lines continues to mount. I've seen reports of sharp price increases in auto, reinsurance, commercial and specialty lines. The competition in auto remains fierce so the prices of some of those companies remain depressed. Other areas seem fully priced at this point.

Right now I'm finding the best values among small caps and somewhat illiquid stocks. The trend towards indexing and money managers with severe performance pressure is leaving a lot of fine companies ignored and unloved. It's impossible to say when there will be change in the flow of funds towards these better business deals, but I think that patient investors will ultimately be rewarded with huge gains.

I'd like to point out that some areas of the market that "seem" fairly priced may not be. Corporate America is earning higher than average profit margins across many industries. If those margins are sustainable, higher than average prices are justified because of the higher level of free cash that is generated. It's been my view that over the long haul those margins are at risk. Therefore, stocks that fully reflect very high margins as sustainable provide almost no margin of safety.

Certainly, there are individual businesses that have sustainable competitive advantages that explain the margin improvement. But that isn't the case across the economy. I think it might be useful to look at historical data from "The Value Line" or "Standard & Poor's" to see the margin expansion that has occurred in many industries over the last decade or so. Here's an interesting exercise. Apply the historical margins to the current sales or revenues and then calculate the new earnings per share. Then look at what the PE ratio would be if the margins declined to the level of a decade ago. If you can't explain the margin improvement and why it's sustainable you might be on shaky ground.

The rapid rise in oil prices is beginning to feed through to many businesses and consumers. Many companies I follow are missing their earnings estimate because of higher oil based costs. That should either slow down the economy or ultimately lead to higher inflation depending on the future actions of the Federal Reserve. In either case it's a negative for business.

I think part of the reason for this condition is the extremely accommodative monetary policy a couple of years ago when the global financial system was poised on the edge of a precipice. Central bankers managed to inflate asset prices again and keep the global economy going. However, they most likely created downsides that we have yet to experience. In recent years each monetary inflation and bailout has arguably put the system at greater risk and the authorities in a worse position come the next financial hiccup.

I continue to believe that the areas of the market where extreme speculation clearly still resides will ultimately correct. In a free market economy there are relationships between savings, investment, the cost of capital (interest rates and stock prices), the return on capital (interest rates, stock prices, the return on active business investment), productivity, economic growth and other factors. It is those relationships that have produced the general level of stock prices we have seen in the past. Those relationships can and often are temporarily short-circuited by an overly easy or tight monetary policy in combination with the two emotions that rule all of investment - fear and greed.

The 1990s was a period of almost constant easy money, bailouts of reckless vested financial interests, hype, and general wealth transfer from the public to Wall St., options holding executives, and other connected parties. There are surely downsides and heightened risks to all this recklessness and easy credit. It remains to be seen what the ultimate impact will be on the economy and business in general when we get the almost inevitable sharp correction. History suggests that it won't be pleasant for either Wall Street or Main Street. Most periods like this have ended very badly and unexpectedly. For that reason I believe that most investors are still better off holding higher than average cash balances despite the apparent values. A tsunami washes everything out to sea.

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