MARKET WATCH | 10.2002
by George Gasson, Assistant Vice President/Portfolio Officer, Mellon Private Wealth Management
george@miaminightout.com

EQUITY PERFORMANCE OCTOBER 2002

AN UP MONTH!!!
 
The U.S. equity market moved sharply higher in October as the S&P 500 Index increased 8.79%. The Dow had its best month in the 15 years since January 1987, and put an end to six consecutive monthly declines. Good news included the fact that after six consecutive quarterly declines, corporate profits reversed direction and increased an estimated 6.7% in 3Q 2002. Also, company managements had guided earnings expectations down so far that 60% of the first 400 companies in the S&P 500 to report results were able to exceed the lower expectations. It wasn’t that all the news was good, because it wasn’t, but it was enough for the market to stage a relief rally. Interestingly, the Dow has recorded a positive return in the fourth quarter 71% of the time in the past 82 years. As has been true in recent years, strong fourth quarters have often followed weak returns in September and the S&P 500 was down 10.86% in September 2002.
 
As shown below, the main sources of strength in October were in the previously beaten down sectors of technology, internet and utilities. All S&P 500 sectors registered positive returns for the month, but year- to-date, nine sectors were down and two were unchanged.

While bad news today can be quickly disseminated to both investors and those in the path of a tornado, investors' warning time is quite different. Investors' awareness of trouble is more comparable to the tornado warning time of thirty years ago, which was about one minute. A twister hits investors with little detectable warning before a stock's price implodes.

Investors believe that economic recovery remains fragile and that uncertainty persists regarding a possible war with Iraq. On November 6th, the Fed reduced rates by 50 bpts to 1.25%, a 41 year low. The U.S. consumer has been a bright spot in the economy year-to-date, but two measures of consumer sentiment have plunged. The University of Michigan index of consumer sentiment fell six points to 80.6% in September, its lowest level since 1993. The Conference Board index of consumer confidence dropped 14 points to 79.4% in October, also a nine year low. What consumers have said is that the outlook is gloomy. What consumers do regarding Christmas spending will be even more important. The consumer has money from record refinancings, but how much of that will be saved and how much will be spent? RELATIVE PERFORMANCE TRAILED AS PRIOR LOSERS WERE UP BIG
 
In the first nine months of 2002, a large number of stocks had suffered massive declines and we were pleased to have avoided most of them. Wireless stocks were down 77% year-to-date through October 9th, but moved up 80% the next three weeks. Troubled telecom, internet and airline stocks also suffered year-to-date through early October but made major moves up by month end. Rich Bernstein at Merrill Lynch measures performance by S&P ranked “Quality” and determined that the “lowest quality C & D stocks” outperformed the “highest quality A+ stocks” by 270 bpts in October. At month end, the A+ stocks were trading at an average P/E of 16x 2003 EPS which compared favorably to the average C & D stock P/E of 33x 2003 EPS. Our relative performance suffered in October from not owning the low quality stocks that made huge upward price moves during the month.

Investment Outlook December 2002

Blow-ups

The volatility of individual stocks has increased dramatically in the last couple of years. A company announces a seemingly modest change in its outlook, but its stock collapses almost instantly by 20% to 50%. Virtually every week, the stocks of several large, highly regarded companies suffer substantial declines. A few examples from late October included: Tenet Healthcare's stock losing 26% of its value in a day, Albertson's, the supermarket chain, dropping 19% after lowering its quarterly profit forecast by about 10%, and Tommy Hilfiger declining 20% after tempering its forecast for the second half of its fiscal year. During the bear market, I suspect that investment managers have heard no line of questioning from clients more frequently than why are these sudden crashes occurring and how can they be avoided?

The research of Strategic Economic Decisions indicates that a given earnings surprise for a company precipitates a price change today three to five times greater than a similar surprise four decades ago. Never before has the price change per bit of news been greater than today.

Morgan Stanley research shows that the odds of a stock "blowing up" in the last two years are about six times higher than the average since 1980. "Blowing up" is the label Morgan Stanley gives to a stock that underperformed the Russell 1000 Index by 30 percentage points or more in a given month. During most years, only 3 or 4 stocks a month out of the largest 1000 in market value have experienced a decline in excess of 30%. While the number having such a decline in the last two years has bounced around, the average has been about 40 stocks of the 1000 during each month. At this rate, nearly one-half of the largest companies "blew up" during a 12-month period. For an equity investment manager not to have held a number of these stocks would have been highly unlikely.

Noted Princeton economist Burton Malkiel indicates that while the volatility of the total market has been virtually trendless, when examined over the last several decades, the volatility of individual stocks has risen steadily, even before the severe amplitude of the past few years. For example, the daily volatility of individual stocks was about four times higher in 1998 than in the mid 1960s.

Of course, volatility of the total market has increased substantially since 1999. Thus far in 2002, the daily percentage change in the S&P 500 has exceeded 1% during about 50% of the trading days. Over the last fifty years, the Leuthold Group reports that a median of only 16% of trading days have exceeded this rate of volatility. Day-to-day changes greater than 2% have occurred in about 20% of the S&P's trading days in 2002, compared to a median over the past fifty years of less than 5 days per year. Volatility during the major bear markets of the 1930s and 1970s, while not as high as presently, also rose well above the long-term trend.

Fruit flies and tornadoes

Why have individual stocks become so volatile? One major reason involves individual company fundamentals and another relates to the information flow available to investors. The pace of change in the economy and technological innovation has reduced the time that the average company can sustain its competitive advantage. New technologies have increased dramatically the speed with which innovations can be employed to impact competitors. Companies' life cycles for growth have been shortened. Many new companies, launched by initial public offerings, have an evolutionary cycle that resembles the fruit fly's two weeks from embryo to death.

A second major reason for individual company volatility is the instantaneous dissemination of company news. All investors are capable of accessing investment analysts' earnings estimates for companies. Everyone can instantly know the degree to which companies have exceeded or lagged expectations. Companies previously may have hinted about a change in their forecast to a few selected analysts. As the word seeped around, the new information was rather slowly incorporated into the stock price. Stocks had time to gradually find their appropriate level. Regulation Fair Disclosure has changed former practices. Now, companies are careful to publicly announce changes in expectations. Thus, new information is broadly disseminated. With the Internet and CNBC, individual investors can become aware of new information as quickly as the most plugged-in institutional investor. Everyone can react to the news simultaneously, dramatically driving stock prices up or down and frequently overshooting reasonable price levels.

The acceleration in stock market reaction time to a corporate warning is analogous to the experience in Van Wert, Ohio on November 10, when eighty-eight devastating tornadoes swept through states from Alabama to Ohio. At the Van Wert Cinemas, a tornado left roofs missing on three of the five theaters, walls down and three automobiles in the front rows of seats where The Santa Clause 2 was playing. Yet, no one who had been in the theater was seriously hurt. The initial radar detection of Van Wert county's tornado came at 3:13 p.m. Ten minutes later news came that the twister had developed winds of over 200 miles an hour. The theater manager hustled people into the more protected hallways and restrooms prior to the tornado striking at 3:28 p.m. Even though 48 homes were destroyed and 23 sustained major damage in Van Wert, miraculously only two people were killed. The fast dissemination of information about the tornado allowed a scramble for cover by nearly everyone at the same time. Similar to the swift response in Van Wert, instantaneous communication of a severe corporate storm leads many investors to head simultaneously for an exit. The improvements in communication technologies are "killing" more stocks, but individuals losing their lives in tornadoes are being reduced, falling from 1,420 victims in the 1950s to 580 in the 1990s.

Greater diversification required

To combat the problem of rising individual stock volatility, portfolios should be broadly diversified. Malkiel says that "To eliminate idiosyncratic [company-specific] risk in today's market, a portfolio must hold many more stocks than the 20 stocks that in the 1960s achieved sufficient diversification." Malkiel believes that individual stock volatility will remain high and may even increase because of the CNBC effect, Regulation Fair Disclosure, and technology allowing rapid news dissemination. He also believes that 200 stocks are required to provide the diversification that 20 stocks did forty years ago.
But, what about Warren Buffett, who advocates holding only a handfull of stocks? He is unique and his capabilities relative to other managers lie at the extreme tail of a distribution of investment managers' ability to add value to a portfolio. Virtually everyone else is required to consider appropriate diversification and risk management policies.
Most of the leaders in the investment management business were taught that as few as 12 to 15 stocks were sufficient to diversify away company-specific risk, that is, the risk of a tornado inflicting severe damage. This thinking has led many investment firms to hold a maximum of 20 to 30 stocks in their portfolios for individual clients. During the nearly 20 years that its equity investment process has been used, Mellon has advocated much greater diversification. In fact, we regularly receive questions as to why we believe a portfolio should hold so many stocks. A major reason we recommend more diversified portfolios than many equity managers is to reduce the impact of unexpected tornadoes, so the power of our investment process can be realized. To use a sports analogy, the batting average of a great baseball hitter after four games could be quite low compared to an entire season. With only 20 attempted at bats, the average could be low because of great pitching or a temporary problem with batting technique. But, given a season of batting attempts, the skill of the good hitter will be apparent. If a portfolio holds few stocks, perhaps some poor selections are made or a tornado strikes a stock or two. With a more broadly diversified portfolio, skilled analysts are more likely to reach their normal batting average and the impact of a couple of tornadoes would be diminished.

Summary of implications

• Broad diversification within stock portfolios will assist in offsetting the impact of sudden, inevitable, and dramatic price declines as investors rush for the exits in a response to an announced change in outlook.

• Portfolios holding 20 or 30 stocks will experience a wide range in outcomes. Even portfolios with 60 to 80 stocks, being managed under the same investment style, will not have the tight fit in relative performance that may have been characteristic before 2000.

• Holding concentrated positions in one or even a few stocks is riskier than ever. Even Buffett has not been able to avoid companies that have developed unexpected problems.

• The volatility and fruit fly effect will make it more difficult simply to hold a basket of stocks for years and years. Higher portfolio turnover will be required for some investors. The average equity mutual fund turnover recently has been at well above 100% annually. Turnover at such a tax-unfriendly level for individuals is not required.

• Consistent quarterly and annual performance relative to benchmarks, even with the best of managers, has become more difficult to achieve.

Article courtesy of George Gasson, Assistant Vice President/Portfolio Officer,
Mellon Private Wealth Management
george@miaminightout.com