In the final quarter of 2001, America hosted a remarkable stock market rally in the face of extraordinary economic and political uncertainty. "A public demonstration of the strength of the American way of life," say bullish commentators. "Testimony to the storied resilience of democracy and capitalism."
As citizens, we've all experienced a patriotic surge of strength and optimism, an exhilarating antidote to September's fear and destruction. Hoping for a new dawn of capitalism, investors have opened their wallets in response to Wall Street's beatific vision of a V-shaped recovery, international harmony and a resurgence of global prosperity. I don't know about you, but some days I am sorely tempted to throw caution to the wind, raise my financial fist in defiance of the unseen enemy and ride that promised wave of recovery to unimagined riches. I want to believe.
Actually, I do believe. I believe that good trumps evil. I believe that beneath all the chaos, the world is actually evolving toward democracy and free markets because these work better than any system of social order ever tried. The insurmountable evidence is the "longest enduring society of free men governing themselves without benefit of kings or dictators," as the Wall Street Journal put it in its Thanksgiving day editorial. I believe in America, in freedom and investing in the public securities markets. It's the price of those securities that gives me pause. And I have learned the hard way that it matters what you pay. It matters a great deal.
I am not just a private investor throwing in my lot with the enthusiastic public. What makes my situation different is that someplace along the way I assumed the mantle of personal financial advisor to hard-working, hard-saving retirees who look to me for sober judgment in matters that will significantly influence the quality of their remaining years. Feeling every ounce of this responsibility lately, I have been sifting each morning's fresh economic data, searching for that nugget of truth that will give me permission to join the stock market rally with a clear conscience. Instead, I find myself feeling the way I did two years ago, before the bubble burst. So I do what I often do when I am searching for market truth. I look up my old friend, Murph.
Wisdom At Delmonico's
George Murphy dropped out of St. Mary's Seminary in Cleveland early in the first Eisenhower administration. More accurately, he sneaked out of the dormitory in the middle of the night, bicycled to Union Terminal and caught the 6:02 Sunrise Special to New York City. The rest, as they say, is history.
Murph is not saying, but his friends guess he's past 70. Been on "the street" for half a century and paid attention every blessed day of it. He's a living legend at Delmonico's, an opulent bar and steakhouse just a five-minute walk from the NYSE. Younger traders and portfolio managers can't get enough of his colorful recollections of fortunes won and lost. And Murph never tires of the telling!
It's a little windy as I turn the corner onto Beaver Street. As I push open the heavy, carved door, I am cheered by the glow of holiday lights strung above the mahogany bar, the clink of crystal and china and the buzz of the after-work crowd. Sure enough, I spot George Murphy at a small table in the far corner. He seems to be having a spirited exchange with young Jack Clark.
Jack joined Murphy Advisory about five years ago. He's a Notre Dame undergrad, did a two-year internship at Morgan Stanley, and completed Chicago B School and a stint with Janus. Aside from their Gaelic surnames and Midwestern Catholic roots, Jack is the antithesis of the self-educated Irishman who worked his way up from the back office of Glore Forgan. Murph and Jack come at most issues from very different perspectives. But they enjoy the daily battle, and they both know their clients are better off when they are able to hammer out a consensus. So, when they go at it, they don't hold back. Let's grab a seat at the next table and see what we can learn.
The Market According To Murph
Jack: Murph, I really think we're missing the boat this time. If we get this wrong, you're not going to have a practice to sell me. It's that big. The Dow is up 20% from its low. America's in a new bull market, and we're sitting on the sidelines watching the parade go by! You've gotta get with the program, man; we've gotta go with the flow, be in the game, do whatever works. That's what clients pay us for.
Murph: (Leaning back in his chair, staring at his pilsner glass as he idly turns its base on the linen table cloth.)
Go on, Jack, I'm listening. For a change!
Jack: (Sensing the older man's respect, he also settles back and talks more calmly.)
Number one, as we all know, recessions run two, maybe three quarters, and we're halfway into the second quarter already. Number two, the stock market is a forecasting machine, and it bottoms out three to six months before the economy does. And it has bottomed out, Murph. The bottom is behind us! What are we waiting for?
Murph: C'mon, Kid. You sound like one of those talking heads. Where is it written that recessions are six to nine months, huh? And are we talkin' GDP recessions here, or earnings recessions? Let's look at some history; earnings peaked in 1929, and they didn't get back to that level for almost 20 years, not until 1948. And stocks didn't get back for another six years after that. You want to buy a year and a half after the market peak? OK, middle of 1931 we buy the Dow at 150, down from 381 ... on its way to 41 the next year.
Jack: Don't drag out that 1929 ancient history stuff. It'll never be like that again, all those bank failures, restrictive trade tariffs, bread lines, panic in the streets. The Fed has a grip on money supply and reserve policy today. We've had 450 basis points of rate cuts, and if that's not enough to kick start the economy, we've got tax cuts on the way. And, oh, by the way, consumer spending and leading indicators both rose in October. I'm telling you, Murph, it's recovery time, and we need to raise our stock allocation and stop hunkering down in bonds and value funds.
You're right about the Fed, Jack. Greenspan's been great; my hat's off to the guy. But you know what bothers me? Japan. Eleven years of stock market declines, persistent recession, deflation the past three years and still no sign that consumers are coming back. It bothers me that maybe the Fed is pushing on a string this time. One-half percent interest rates didn't stimulate anything in Japan. Maybe 2% doesn't work here. Maybe 1% doesn't. I think it all depends on the quality of loans that are out, and they worry me. Consumer installment debt is at an all-time high as a percentage of incomes and way above where it usually bottoms in recessions. Personal bankruptcies were high and rising before the recession.
And because of the consumer's long binge, we have the newest car fleet and the most up-to-date housing stock ever. Build me a case for "pent-up demand," go ahead, I dare you. The U.S. consumer can cut spending, work on his balance sheet for years and hardly notice a change in lifestyle. That's two-thirds of the GDP that can easily stop in its tracks. The after-burner in the last bull market was capital spending, but today's businesses are only using 75% of their capacity, and they are choking on debt. Cap spending can go on a long furlough, too. That leaves government spending. I'll give you that one. Post-9/11, those old boys have all the excuses they'll need for years worth of new programs. More government slows the wheels of commerce, son, and don't let anybody from those fancy colleges tell you different.
Jack: Murph, interest rates are the lowest they've been since you were counting paper securities in the vault at Manny Hanny. Last week, I bought Ruth a new minivan for nothing down and no interest on a five-year loan! Not stimulative? Are you kidding? Give the consumer a chance to spend, and voil, you've got a recovery.
Murph: Ever hear of profitless prosperity? Do you think Daimler-Chrysler is making money on the van you bought for 88% of list with an interest-free loan? Believe me, if that's what it takes to sell cars, they'll cut production until they can sell them at a profit. I see more layoffs.
Keep in mind that companies are in business to earn a profit, and business profits ultimately drive stock prices. Over the long haul, earnings grow about the same as GDP. That's all. In the 80 years from 1920 to 2000, GDP grew at a compound rate of 6% a year, and the Dow grew 6% a year. Coincidence? I don't think so.
Sometimes profits grow faster than average for a while, and sometimes slower. Profit margins swing between 3% and 6% of sales. When they get low, the weak competitors get weeded out. When margins get high, new competitors come in and eventually drive margins back down. It's always out of balance and always seeking equilibrium. In 1999 and 2000, margins got to 6%, the high side of the range. I think they've entered a multiyear retreat.
Jack: Well, think about the other aspect of low interest rates. Our bond
portfolio did great for the first 10 months this year; I'll give you that. But now the yield is around 4%. How long will clients pay us to earn them 4%, Murph, come on! And if I'm right and this economy is back, then rates will start inching up, and our total return on bonds will be so bad you'll have to retire.
Murph: Don't think I haven't lost a little sleep over that one, Jack. You know, for years I've been saying that the inflation surprises will be on the downside and that long-term Treasuries will yield 4%. Well, we almost got there last month. I know at some point we need a new game plan. Eventually, I want to load up on stocks, too. You bring me a story with good value, and I'll buy it. But don't ask me to become a momentum guy. Ultimately, you can't win that game. This isn't Las Vegas, Jack, it's Wall Street, where America raises capital for legitimate businesses. It's our job to know the difference between gambling and investing, and God help us when we forget it.
Jack: There's always been a speculative aspect to the markets, Murph, and you know it. If it weren't for the promise of quick riches, we wouldn't have the liquidity that we all enjoy.
Murph: True. But remember who makes all the money in Vegas. The house, not the wide-eyed visitors.
Jack: So now I'm naive, right? And what about you? You cut back on equities in '98 when the Dow was 8,000 on its way to almost 12,000. You left 50% on the table. Was that smart?
Murph: For the last five years, bonds have earned more than stocks, haven't they? Now who's naive? Jack, history is a great teacher, if we'll just pay attention. There's valuable information in the historical data. A couple hundred years of free market transactions show a range within which most commercial activity takes place. When current numbers are near the extremes of a historic range, an opportunity is usually smiling at us from the data.
Stock valuations reflect waves of emotion on the part of the players who are in it for the quick buck. And coming off a heady decade like the nineties, there are more speculators than ever. Even a lot of the pros have become players. If you try to go with the momentum, instead of paying attention to legitimate investment values, then you're a speculator, Jack, and you're gonna end up like the dandies at the blackjack table.
You're worried about the clients not paying us for small returns? This afternoon, Liz Gabriel called me to thank us for earning her 5% this year. She's 75, but she knows the stock market is off. Her friends are crying in their Pouilly FuissÈ, but she feels secure, and she is grateful. If we take good care of our clients, Jack, they will take good care of us.
Murph notices me as I get up to leave and lifts his Guinness in a silent toast. His quiet confidence always calms me. I'm glad I had a chance to introduce you to him.
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.