We were wrong thinking that the last quarter of the year 2000 was the most disastrous for stock markets worldwide. The first quarter of 2001 turned out to be worse: the TSE 300 was down almost 15%, the S&P 500 down 12.11% and the NASDAQ down a whopping 25.5%. The technology sector (especially telecom related) was totally decimated with the so-called blue chips down 70-90% from their high.
Interest rates in North America stayed fairly stable during the quarter. We would like to point out that the yield curve is back to its normal shape, i.e. slightly sloping upward. History shows that an inverted yield curve (the one we have experienced during 1999-2000) is a precursor of a recession (or a slow down) and a normal positively sloped yield curve is a precursor of a recovery. As expected, the Fed slashed interest rates, by another 50 basis points in April. We expect even lower rates going into the summer as the economy continues to show more weakness.
The CDN dollar has deteriorated from $1.4991 to $1.5766 and is now trading around $1.5411. As long as the Canadian government stays with its socialist program, the Canadian dollar will stay weak, albeit undervalued. The Euro has resumed its downtrend and ended the quarter at $0.8767. As far as the Euro is concerned, the problem is much more structural. A recent trip to Europe made us realize how monumental the change has to be before Europe can challenge the U.S. in terms of economic power. For example, the European Central Bank wants Ireland to raise its taxes to match those levied by other countries in the continent in order to level the economic playing field: a strategy that would certainly not strengthen the Euro. As investment managers, we will look for a major catalyst that will eventually reverse this socialist trend. For the time being, we are extremely selective in our European investment choices.
Oil prices traded between US$26.00 and $28.00. As the economy weakens, oil prices will drop. OPEC has been fairly disciplined in terms of controlling their production. Although we have come to respect their relative success in « managing the supply and demand » of oil, we have yet to see how it plans to deal with a global economic slowdown dictated, at least partially, by high energy prices.
Please refer to the portfolio valuation in the next section of the report for a complete list of securities you own. You will find a transaction report that includes descriptions of selected securities that have been purchased.
Now that we are well entrenched into this bear market (defined by the S&P 500 falling more than 20%), we would venture to suggest that it is time to look beyond the bears and see if there is a light at the end of this tunnel. And we are very encouraged by an increasing number of indicators and statistics that we follow:
1. Duration of bear markets
- Statistics show us that bear markets tend to last anywhere from 10 to 18 months with an average of 13 months. This one started in March 2000 and has now passed the average duration. Moreover, the average stock has been in a bear market for an even longer period of time, though the fact was largely masked by the high tech stock mania which continued to boost the NASDAQ and the S&P 500 until early 2000.
2. Monetary conditions
- The Federal Reserve Board has cut rates four times in a row indicating rising liquidity for the stock market. As they say on Wall Street, “Don’t fight the Fed after three cuts”.
3. Cash assets in mutual funds
- Cash is to bull markets as blood is to Dracula. And there is a tremendous amount of cash in investors’ pockets right now. For example, money fund assets now stand at 15.8% of the total market value of the stocks on the New York Stock Exchange – the highest level since the stock market low in 1990. Since 1980, whenever money market assets rose above 13.07% of Big Board capitalizations, the subsequent annual gain in the Dow Jones Industrial has averaged 18.2%.
The bottom line of all this is that with an accommodating Federal Reserve Board and an improved valuation environment, it is likely that the bulk of the decline is behind us. Markets tend to reverse their trend at the most pessimistic time. (You have probably recently heard about layoffs, bankruptcy, recession, no visibility in earnings, analysts suddenly cutting estimates and price targets…).
Given this information, what are we planning to buy? As usual, we are on a constant look out for well-managed companies in an industry with above average growth potential. We would like, however, to share with you several of our thoughts regarding the coming years:
- We have noticed for several months now that although the PE (price earnings ratio) for the S&P 500 is hovering around 24-28, the S&P mid-cap median PE is only 14 times 2001 earnings. It seems to us that many of the mid sized companies are trading at very reasonable valuation multiples whereas most of the large capitalization companies still command ridiculous ones.
- In economics, a classical recession tends to be created by an excess in production capacity and therefore manufactured goods. It takes some time for demand to catch up with supply before the economy can grow again. In the past, demand for goods (i.e. cars, fridges, housing) tended to grow at low single digit rates (i.e. 3-4%) whereas demand for telecom services (i.e. bandwidth, internet access) is growing at double digit rates. Could it be that a technology driven recession will take less time to resolve itself? Given the continued healthy demand, we certainly believe so.
- Over the short term, stock prices have very little to do with the underlying economics whereas over the long term it has everything to do with it. Therefore we ignore the short-term fluctuations of stock prices in our fundamental analysis and concentrate on finding a valuation level for each company that we own or intend to own that makes economic sense to us. We do not pretend that we have found the Holy Grail, but we can say this: we feel very comfortable with our models that have provided us with consistent results over time.
As long term serious investors, in these volatile times, it is quite reassuring to know that we can hang out hats on our dependable company valuation models.
The Claret Team