"This is more than a bear market, Mike. Much, much more." I winced as the always-unconventional George Murphy fortified his lemonade with a splash Sauvignon Blanc. One thing about Murph, he doesn't stand on ceremony!
Last Monday, after the Dow plunged 700 points in two days, I called my old friend for perspective and perhaps a little solace. Sensing my need for more than a few minutes of comforting clichés, he graciously invited me for a Saturday afternoon visit to his backyard patio in Ridgewood, N.J., a quiet oasis 30 miles distant from the organized hysteria of Wall Street.
The Closing Chapter
As he made himself comfortable on the flowered chaise lounge, Murph continued thoughtfully. "This is the battle of Hastings, Bull Run, Hiroshima; an inflection point in a global struggle that will grow in significance as it is remembered."
Ever since he read Gerald Loeb's 1935 classic Battle for Investment Survival, war analogies have been Murph's preferred vehicle for explaining his investment insights. "We are witnesses to a raging contest among the competing forces of free-market capitalism, the significance of which is not yet apparent to the combatants. But one day, we will all see it for what it is: the closing chapter of an age of ease and excess, a changing of the guard, a reassertion of values most cherished after they are lost. History has suddenly turned its spotlight on the rich and the powerful, exposing for all to see self-dealing once masked by the cloak of privilege-and the naïve among us, complicit while we rode their wave of irrational exuberance, are suddenly and indignantly aghast at their greed.
"Over the next several years market forces will assert our renewed appreciation for the importance of transparency as the only defense against selfish human instincts. Perhaps we will even experience a resurgence of reason and temperance." I noticed just the slightest grin as Murph raised his glass in a toast to temperance.
"Murph," I said, "I have a friend who grew up overseas in a fairly lawless environment. One day, when he was recounting stories of what passed for commerce in his village, he told me something I will long remember: 'Mikey, (I imitated his gravelly voice) let me tell you sumthin'. Where dere's secrecy, dere's deceit.' So I understand what you mean about transparency as a defense against our base instincts. But do you think we really live in a lawless society? Has the trust factor been that damaged? Is this really a major cause of the stock market's weakness?"
Loss Of Equilibrium
Murph gazed skyward as though absorbing inspiration, then meditatively swirled the ice cubes in his glass before warming again to his dissertation. "Over the last decade or so, the greatest system ever devised by man for allocating material resources has gradually lost the balance of power that is essential to its smooth function."
"Ours is a 'mixed economy' in which government establishes the rules of engagement for our various markets, and government in turn, is ultimately subject to the voters' sense of satisfaction with its work. The real genius of our market system guided by accepted principles of law is that each of the competing forces is free to seek an arrangement that best meets its own interests. Whether this give and take occurs on the floor of the New York Stock Exchange, in the halls of Congress, or on eBay's virtual auction, the nature of every free market is the same-a struggle for personal advantage that is ultimately resolved by the contestants themselves to their mutual satisfaction.
"But when deceit provides one side an unfair advantage over the other, instead of a mutually satisfying conclusion, the result is a scam. The beautiful equilibrium of the whole market process is destroyed. If trust is the lubricant of the market's machinery, fear and skepticism are sand in its gears. You read the same headlines I do. Tyco and Cisco puffed their reported earnings with acquisitions at ludicrous prices paid for with inflated securities. Even Merck! Merck for cryin' out loud, reported as revenues money that never touched their books. Johnson & Johnson, your trusted baby oil people, have guys with badges showing up at their factories. Enron shuffled billions of debt off its balance sheet, and now the Feds are implicating Citigroup and J.P. Morgan. Those are big names! WorldCom pretended away billions of dollars of costs, and now it's bankrupt. We could go on, right? I'll let the lawyers squabble about the details, but do you think investors are feeling a little scammed?
"And a little poorer," I added.
"Sure they feel poorer; trillions of dollars poorer. Do you think that's not gonna make 'em take a good, hard look at where their paycheck's going? Do you think they're not starting to worry about their retirement?" Murph picked a large tortilla chip from the bowl. Noticing that it was blue, he held it up for inspection and wrinkled his nose with displeasure before helping himself to a generous scoop of salsa.
"There's serious sand in the gears, Mike. The market is slowing down for repairs, and the repairs are going to take time. But the longer it takes, and the more corporate hijinks we discover, the worse the skepticism gets and the harder it is to restore a working equilibrium. Fear is waxing and trust is waning." That sounded like an ending, but Murph was on a roll!
"Think about how many different players there are in a market economy, and the complex dynamics. Investors are feeling very anti-business, yet most of them are also employees of businesses, and of course they want their stocks to go up. They want to pressure their government for new rules, but they don't want the economy to slow too much and don't want to lose their jobs. And they don't want interest rates to rise because their mortgages are adjustable, but they are upset that CDs only pay 2%. They end up feeling confused and even helpless. That's a far different market force than the invincible investor who drove Nasdaq to 100 times earnings just a couple years ago.
"Politicians have been quick to get aboard the anti-business bandwagon, but while they're whipping the horses of accounting reform, they've got one eye on their corporate campaign contributions and the other on the federal deficit. Even as they design expanded safety nets for their constituents, they worry about raising the debt ceiling because they know higher interest rates will put the kibosh on homebuilding, the one thing that's been saving our collective bacon.
"And Greenspan, bless his heart, is being pilloried by Alan Abelson for sustaining the market bubble by cutting interest rates and not raising margin requirements. Now that the GDP has slowed, he's getting pressure to cut rates further to stir up the economy instead of trying to boost consumer morale with speeches about how the economy is basically sound, and how people should take a vacation and charge it to their home equity line. If our Wunderkind isn't waffling, at least I'll bet he's losing sleep.
"If you think about it, trying to come up with solutions that will restore balance and growth to our free-market economy is a new kind of market in itself. You see, in the midst of this sort of turmoil, everybody's got an ax to grind. Everybody's got a need. Everybody's got a point of view. If you solve one guy's problem, you gore the other guy's ox. So we're going to have a marketplace for solutions, and we're going to sort through our options. We'll try all sorts of stuff and eventually come to a place that most of us are reasonably comfortable with. Then, and not until then, we'll get on with the greatest show on earth.
Sorting It Out
"In the meantime, all the constituents of our mixed economy are engaged in a sort of struggle to re-establish a comfortable working balance in the market machinery. Washington will pass laws and spend money they haven't got. States will trim budgets because they can't run deficits. Consumers will cut back here and there and start to put a little aside for tomorrow, because tomorrow is not as rosy as it was. Industries with too much capacity and too many weak players will consolidate (think fire sales and bankruptcies). Healthy corporations will trim costs, reduce debt, lay off a few people, hold the line on prices, and be careful about hiring. Investors will ignore analysts, be more skeptical of data and projections, and demand more of their return in cash dividends."
"And what will this struggle mean for the stock market?" I asked the obvious million-dollar question.
"Well," my host sat upright in the chaise lounge, obviously energized by the question. "I think we're working our way back to reality. Yeah, that sums it up best. Back to reality.
"We are beginning to sort through the rubble, the aftermath of the explosion of an historic investment bubble. We have left euphoria far behind and entered the confusion stage where we're not sure what lies ahead or what anything is worth. This is not a good environment for stock prices. It won't feel like we're making much progress for a while. We'll feel alternately encouraged and discouraged by developments. That's where the analogy with famous military conflicts is helpful for me." I was hoping he'd get around to that!
"You see, as we look back on pivotal military contests with the benefit of hindsight, we understand their long-term significance. But in the heat of those battles, the overwhelming experience for the participants was fear and exhaustion. Few held the vision of what the conflicts were ultimately about. In a similar way, our investment markets are churning lower, and investors are distressed, wondering where it will all lead. But eventually we'll look back and see this era as a period of pain we had to endure to restore rational values and the free market equilibrium that nurtures enterprise and innovation. As we're figuring out how to fix the machinery, securities prices reflect our shifting expectations of the future. From day to day, emotions drive prices, but ultimately what is going on is a very rational process. And that gives me comfort.
"The infamous battle of Hastings took place in a single day in 1066. The tide of battle swung violently back and forth, and from hour to hour, the outcome was entirely uncertain. Reminds me of a typical day on the floor of the exchange; down 200 at lunch and rally to close up 30! Finally, King Harold himself fell and the Normans swept in, ending the long era of Anglo-Saxon rule during the final stages of which personal gratification had become the life work of large numbers of the nobility as well as the clergy. Sound a little bit like the scandals of our age? Well that's probably coming to an end, too! Think of the Bear as William the Conqueror ushering in a new era.
"In 1861, Bull Run, as you doubtless know, was the scene of the first great land battle of our terrible Civil War that culminated in the ratification of the 13th amendment; bad war, good fruit. When the crew of the Enola Gay detonated that first A-bomb over Hiroshima in August 1945, the captain wrote in his flight journal, 'My God, what have we done?' But whatever you think of Truman's terrifying decision, history shows that it was effective in bringing to a close that long conflict between tyranny and freedom, to be followed by an age of unprecedented, not to say unblemished, prosperity for a large percentage of the earth's population.
"Today CNBC transmits images of the casualties of capitalism's civil war; the chairman of Adelphia led into a patrol car in handcuffs as the headline at the bottom of our screens inquires, 'Will the chairman of WorldCom be next?' If you remember, the market was up almost 500 points the day we watched that fellow being hauled away by the cops. My read is that American investors are still hoping for an easy resolution to the executive skullduggery that is plaguing our markets. We hope that locking up a few of these curmudgeons will make everything better. But it won't be that simple.
"Transparency is a critical issue for free-market capitalism, but the current contest goes way beyond that. Investors are combatants in a global contest between labor and capital, between east and west, between peaceful societies and terrorists, between regulation and personal freedom. This is not a one-day battle. This is more like the Civil War or, an even more sobering possibility, like Vietnam.
"That's why my advice in this environment is to make preservation of your capital issue No. 1. Settle for safe, modest returns while the market sorts out the issues. Don't worry about missing out on the upside; there will be plenty of time for prosperity. This is history in the making; just let it happen."
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.