March 1, 2004
Two Bulls and One Buffett

In ‘Why The Bears are Wrong’ Business Week’s Christopher Farrell says that, “this time, it really is different.”  Mr. Farrell’s assumption is that since Wall Street’s take on corporate earnings are rising (up 28% in 4Q03!) that the outlook for equities is bright.  Moreover, and while referencing a recent paper by three economists, Farrell says that stock prices need not be confined to any historical valuation averages because the US economy is less volatile nowadays than it used to be: 

“There's no denying that valuations are high. But changes in the economy's performance suggest that the stock market should be valued at a higher level than historic norms measured by p-e ratios, earnings-price ratios, dividend yields, and comparable benchmarks.”

Mr. Farrell ends by likening today’s high P/E market to that of yesterday’s high dividend yield market.  In other words, those expecting stock prices to crash lower until P/Es retreat to historically normal levels could be just as wrong as those who previously believed that dividend yields should offer a comparable yield to that of bonds.

Farrell’s Faults

Farrell contradicts himself when he argues that dividend yields are no longer a valuable stock market indicator.  To be sure, although he claims that dividends became a useless indicator of future stock market performance in the 1960s, this does not stop him from suggesting that today’s dividend trends bode well for stocks: “the bubble brief falls short…more and more managements are immediately handing over some of that [earnings] gain to owners through dividend payments.”  Without mentioning current/historical dividend yield averages – also by completing ignoring the fact that div yields did near the yield on government bonds during the late 1970s/early 80s bear market – Farrell concludes that the death of the dividend indicator is one of the “major breaks with history”.

As for Farrell’s opinion that changes in the economy’s performance is what enables stocks to trade at permanently high P/E levels, the regular points of interest – productivity gains and a more efficient market/economy – are noted.  Much like the widespread ‘new economy’ banner held up high during the late 1920s and late 1990s, Farrell’s conclusion could prove to be untimely.  Quite frankly, theories of more predictable markets made by Nobel winning economists previously proved disastrous when extremes in the financial markets ran outside of the bell curve (i.e. LTCM). Rather than refer to these types of anomalous events, Farrell simplifies his actual point in his conclusion:

“A stock market correction? Sure. Months of investor nervousness? O.K., maybe. But a bubble about to pop? The mass mania isn't there. No, it will take a sharp change for the worse in the underlying economic and political fundamentals to send the stock markets spiraling downward. And the economic outlook suggests that day isn't coming anytime soon.”

Not surprisingly, Farrell’s provocative title is backed by little more than ‘the economy is doing great!’  Despite a flurry of ‘this time it is different’ logic, he does not make a sound argument about why P/Es will remain at high levels forever.  

Currier Checks in

In ‘The Bull's Secret…” Bloomberg’s Chet Currier questions that if the ‘smart money’ is always skeptical and contrarian, “how come it doesn't make me rich?”  To arrive at this conclusion – that the smart money is not so smart - Currier uses sleight of hand tactics.

To place Currier’s dig at market bears into a context a couple of paragraphs will suffice:

“Five years ago, smart skeptics everywhere were busy warning us, quite correctly, that the stock market had strayed into Fantasyland. We read, for instance, of an ``Internet insanity index'' published by independent analyst Steve Leuthold, who said, ``This stock market segment has become a mania, one which will likely replace tulip bulbs as the classic example of a speculative market bubble.'

Sure enough, the next five years brought the worst setback for stocks in a generation. Yet over those five years, according to Morningstar Inc., the average bear-market fund that seeks to profit from declining stock prices has produced an average LOSS of 5.3 percent a year.”

To begin with, it has not yet been 5-years since the bull market peaked. In fact, it hasn’t even been 4-years since the Nasdaq’s peak.  With this in mind, Currier’s statistics (LOSS of 5.3% a year!), is based on the assumption that ‘bears’ purchased bear-market funds in early 1999 - a year when the Nasdaq posted the strongest US stock market return on record. 

What Currier fails to point out - not doubt for fear of weakening his point, is that the few bear-market funds that existed in 1999/2000 attracted very little money. Furthermore, what Currier conveniently ignores is that the smartest money* - even while warning of a stock market bubble in the late 1990s – was never stupid enough to simply toss their money into a bear market fund and pray for a meltdown.  .

Suffice it to say, using performance figures dating back 1999 to suggest that being a bear is a losers game is suspect.  Moreover, to assume that bears – who today could be holding TIPS instead of shorting stocks – are always gambling on falling stock prices is simply naive.  Gold/silver has been an extremely contrarian and extremely smart investment choice since 2000. Currier doesn’t seem to care.

Smart Money Not Loading Up On Stocks

Warren Buffett’s investment vehicle, Berkshire Hathaway Inc., recently reported that it had sold or reduced its stake in Great Lakes Chemical, Duke Energy, Dun & Bradstreet, Level 3 Communications, HCA Inc., H&R Block, Gap Inc., and Dover Corp. *If Buffett and the Templeton type investors that avoided being burned by bubbling stock prices in the late 1990s do not represent the ‘smart money’ I don’t know what does.

In rounding out their optimistic bias the Farrell’s and Currier’s spin a web of one sided statistics that ignore the obvious: a company to company investigation unveils few undervalued opportunities in the marketplace today.  Finding undervalued opportunities could be as simple as finding a Wal-Mart that is trading below its 10-year P/E average, a Tyco or Interstate Bakeries that is trading near their breakup value, or a low growth Water Utilities company that is yielding more than the 10-year. However, the simple truth is that these types of opportunities are extremely difficult, if not impossible to find today. 

With this in mind, Farrell argues to throw caution to the wind and use stocks to place a bet on the economy. Similarly, Currier argues that “a bullish point of view at least gives you a chance to go with the flow”.  What enables F&C to ignore valuation considerations is the confidence that has been gained from a rising stock market.

Yes, F&C are right about the world – stocks prices have risen! - but they are only ‘right’ until their flat theories can not be rounded into profits during bear years.

Although Warren Buffett has not been adding many new equity positions to his portfolio, he did add a $73.3 million stake in Cadbury Schweppes PLC during the fourth quarter of 2003.  This tiny stake may not indicate that Buffett is making a long term investment in Cadbury’s turnaround. Rather, since the bear market began Buffett has used many successful short term investments (Williams, Level 3) just to keep some of his money working.

Recent momentum in Cadbury’s stock price may mean that investment is only possible on a pull back.  Nevertheless Cadbury – whose balance sheet is not as attractive as the more highly valued Wrigley’s – is a quality turnaround story. Mr. Farrell should remember that things are not that much different -- Cadbury yields more than its peers.  Mr. Currier should study Buffett’s historical performance and realize that Cadbury is not owned by many bear funds.