General Market View

The 4th quarter market action was simply amazing. Despite some of the most aggressive valuations in financial history the popular high-tech stocks and indices rose in breathtaking fashion. It's hard to know what to make of something like this. I've never seen anything like it. In many cases stock price gains have been outstripping company earnings growth by a significant margin for an extended period of time. Even more startling is that some of the CEOs are encouraging the rise via their public comments. In my view they are doing a serious disservice to their long term shareholders. Virtually all technology companies have very generous stock options plans. Therefore, they are constantly using part of their "supposed" earnings to repurchase exercised options in order to keep dilution to a minimum.

Why encourage a higher price if you are going to be a large buyer of your own stock on an ongoing basis?

I do not buy the "stock as a currency" argument. No matter how high you talk up your stock, it will be of little benefit in an acquisition unless the target company and its board of directors and shareholders are fools. You will generally only receive as much in value as you give up otherwise.

Outside the Nasdaq and S&P500 many other high quality companies continue to languish or get cheaper due to tax selling and general investor neglect. The two tiered nature of this market is opening windows of opportunity for patient long term value investors.

However, I still feel very uncomfortable with the general environment. The overall market is extremely expensive based on all standard measurements of value. The combination of valuation extremes and rising long term interest rates is not exactly a green light to buy stocks. The long term treasury yield has moved from 5.06% at the end of 1998 to 6.4% now. If the bubble bursts, value will mean as little on the way down as it has on the way up. Investors will sell the good, the bad and the ugly. So despite the opportunities, I do not believe a very aggressive stance is prudent at this time. That view is further supported by many telltale signs of a "bubble economy". Money supply and credit growth are very rapid. The personal savings rate remains very low and the current account deficit is huge.

Last quarter I brought up the issue of government statistics. Generally, I believe little if any weight should be placed on macro-economic issues. Investors can usually make informed decisions by looking at industry profitability levels and the business position of the individual players within it. In my personal investing I rarely look beyond credit levels and other very general indicators of economic health.

Unfortunately (or fortunately), the market often swings dramatically based upon the release of GDP, productivity, wage, and inflation data. In fact, in the intellectual debate about current market valuations, more and more attention is being paid to favorable government statistics as a way of justifying the extremely high prices. As a result, I'd like to repeat my concerns about using this information to make investment decisions.

Most government statistics involve very subjective judgments applied to incomplete and sometimes faulty data. Measurement techniques are also constantly changing. Therefore, current statistics often have very little to do with what we are used to. Sometimes they have nothing to do with reality.

The basic point is this.

Investors should ignore government statistics and focus on economic reality - interest rates, current earnings, and probable earnings growth. Leave the statistics to the cheerleaders on Wall St. and in Washington.

Following is an updated table of earnings, PE ratios, and interest rates as of the 3rd quarter of 1999. 3rd quarter earnings rose impressively. However, it should be noted that last year's period was depressed by the effects of the Asian crisis and problems in U.S. capital markets. On a peak to peak basis, earnings growth for the S&P500 has more or less resumed its 6% profit growth trend line. At current interest rates, earnings and profit growth it will take many decades before the S&P500 (dividends reinvested) will be generating as much in earnings as long term treasury bonds with reinvested interest. The comparison is even more difficult against high quality corporates. It's simply impossible to make the case for an investment in the S&P500 unless you have an extremely optimistic view of the future. The S&P500 would have to fall a long way before I would even be tempted to recommend an index fund.

Here are a few definitions.

Operating Earnings - Earnings before one-time charges.

Reported Earnings - Earnings after one-time charges.