Anticipating A Trend Reversal: A Time For Opportunistic Investing

NO FEAR!

The main characteristic of a market bubble is a complete disregard for valuation. The key to success during these periods, like now, is to find a stock that is going up and just get on for the ride. Ultimately, an unexpected factor will emerge to bring expectations back to normal. But for now, investors are experiencing the ride of their lives.

Despite the current hoopla, the potential for a major trend reversal is rising. With the environment so bullish for so long, investors have no fear of risk. So when something negative does emerge, investor psychology will probably suffer dramatically. Clearly, the easy money has been made in U.S. equities and a speculative euphoria has taken over. The Federal Reserve Bank, to avoid a financial crisis, is perpetuating the trend by printing dollars and lowering interest rates. Unfortunately, they are only prolonging the inevitable. In time, we will pay the piper for the excesses of this current cycle. This is a time for investors to prepare for the worst, not bask in the glory of the past! It is time to stop playing the game the way it has worked for the past fifteen years and explore alternative, low-risk approaches to invest in U.S. equities.

THE CHANGING SECULAR OUTLOOK

This does not mean that there are zero opportunities to invest in equities but, rather than investing in "the market" via index products and core growth managers, now is a time to be very, very selective. While I believe it is unlikely that we will experience another 16 year bear market like 1966 to 1982, the outlook for "the market" is much less ebullient than the experience of the past 15 years. I expect returns of 5%, not 15%, for the S&P 500 Index. Over the next few years, however, various opportunistic equity approaches should continue to generate returns of 10% or more, just as they did in the bear market of 1966-1982. The main point of this report is that you do have alternative ways to invest in U.S. equities. A combination of these approaches can maintain the same risk level as the market but generate higher returns. While a 5% return for the overall market is not a bad premium if inflation remains steady, it is certainly less than most investors expect and definitely less than what most pension funds need to meet their actuarial assumptions of 8-9%. Many investors could maintain the same average risk profiles in U.S. equities as before but substantially enhance relative returns by acting opportunistically, not in a traditional fashion using index funds and core growth stocks. Stop following the trend, look forward and be proactive, not reactive!

WHY A SECULAR SHIFT?

First, the decline in inflation expectations has run its course. Inflation is now 1%, not 10% of fifteen years ago. More importantly, stocks now discount expectations that inflation will never return. Remember the saying "Never say never!" The easy money in equities has been made. Going forward, stocks must face the realization that inflation will rise. Sometime during the next cycle, rising employee costs and the resumption of commodity price increases, especially oil, should force inflation rates back to 3%. This is not a disaster, but it is not the 1% implied in current share prices.

Second, profit margins have reached levels not seen in a generation. I believe they will not improve much more and will be under attack for a few years because of weakening economic activity and global overcapacity in manufacturing. The profit recession of 1999 should occur even if the economy grows at 2% as is currently expected.

Third, individual investors have more of their net worth in equities today than any time in the last 100 years. More importantly, higher stock values have encouraged consumer spending. Savings rates today are down from 6% in 1990 to a negative 1% today. Some are even borrowing on their credit cards to buy more stocks. There appears to be no need to save as long as stocks keep going up! But what happens if they don't? Returning savings rates to normal would eliminate two years of increases in consumer spending. Clearly, bringing investor expectations toward equities back to earth will constrain future economic growth.

Fourth, valuations for most of the great stocks that weigh most heavily in the market indices overly discount their growth. With many trading at 30 times earnings with growth expected at 10-12%, I see little opportunity for future appreciation. Even one of the great stocks, Johnson and Johnson, may only stabilize at a lofty 25 times earnings three years out because of its 12 percent growth rate. That would take the stock to 92 from 82 today, a compound return of only 3.5 percent over three years!! Also, it is hard for me to see valuations going up for other great stocks when I strongly believe that inflation will accelerate sometime in the next cycle. This is why index funds and core growth stocks look so unappealing, if not risky, today.

Fifth, the huge credit risks that have built up in the past cycle will emerge once a recession unfolds. We had a taste of panic in the financial markets when this became clear in October. Unfortunately, fears about credit quality will not be over until we are on the other side of any recession that emerges over the next 18 months. Alan Greenspan has indicated that he does not want the financial bubble to burst on his watch so he lowered interest rates and helped to bail out a big hedge fund. I believe that he is only postponing the inevitable.

Sixth, if recession does occur in the United States, huge fiscal and monetary stimulus packages will be needed to get the global economy growing again. This, coming on top of unprecedented stimulus in Japan, will certainly lead to much higher inflation expectations.

Seventh, the last two years of our bull market have not been based on fundamentals. It has been driven almost exclusively by a world awash in an ocean of excess liquidity. This was created by the huge monetary stimulus in Japan and is now followed by the actions of the central bankers in Europe and United States. Instead of creating demand for goods (as was hoped) this newly created money floats around the world looking for "returns." The resulting demand for financial assets, instead of goods, has led to speculative increases in the valuation of securities -- higher stock prices, lower bond yields. This "tulip mania" can be seen in valuations of large quality growth stocks and Internet stocks, two areas to avoid when the bubble eventually bursts. For those few investors left who are fearful of risk, now is not the time to play this game. The liquidity driven pseudo-demand for financial assets is providing a sense of security to the markets which is reminiscent of the calm the "nifty-fifty" growth managers felt in 1973, just before those stocks crashed by 70% in 1974. In those days it was the flow of capital into corporate pension funds forced by the ERISA laws which gave bank managers, who all believed in growth stocks, a constant flow of new capital to invest. The firing of these bank managers, once the bubble did burst, paved the way for the emergence of the independent investment advisor, many of whom, not surprisingly, still follow the same investment philosophy of their predecessors.

THE OUTCOME

I am hoping that stock valuations can normalize via a prolonged period of lagging performance rather than a major market correction. The coming profits recession of 1999, however, could very well lead our economy into a recession in 2000 if investors and consumers overreact. The year 2000 issue could compound the problem. More than likely, the market will muddle through the profit disappointments of the next few years, but not without considerable volatility. From current levels (DOW 9600) we see little appreciation potential for the major indices.

When confronted with this possibility, most investors (now conditioned by the bull market to never sell stocks) are at a loss as to what to do. Bond returns look dismal, foreign investments look too risky. With no alternatives, most plan to stay the course and hope that current trends persist forever. There are huge risks today from being complacent, so what do we suggest?

BE OPPORTUNISTIC

Opportunistic investors concentrate on investments that provide attractive absolute return potential but without unreasonable risk. As inflation declined over the past 15 years, the best strategy has been to invest in the indexes (the market) or large cap growth stocks and just hang on. Stock picking and market timing added little value. Neither did global diversification. But during the 1966 to 1982 bear market certain investment strategies did generate positive absolute returns. Typically, they were opportunistic and many did not work throughout the entire 15 year period. For example, technology stocks outperformed significantly from 1974 to 1978 only. It was possible, however, with a combination of stock picking and opportunistic asset allocation to generate positive absolute returns in a declining market that lasted almost two decades. Our solution for the next cycle is to shift away from conventional approaches that worked well during the 1980s and 1990s and minimizing your exposure to index products and core growth holdings in order to focus on opportunistic approaches.

Some rules on how to operate in a market that demands opportunistic approaches:

1. Abhor complacency and conventional wisdom.

2. Develop flexibility to take advantage of any strategic niche investment, no matter how small, that has the potential to generate absolute returns over the market cycle.

3. Stop depending on advice from those who predict the future based on the past.

4. Be proactive, not reactive.

5. Think in terms of market cycles instead of long-term. Focus on real opportunities that are apparent. Do not become dependent on wishful thinking (e.g. hoping that Johnson and Johnson’s price to earnings ratio will go from 30 to 35!)

6. Develop an opportunistic asset allocation model, not one built from past returns. To get started, begin small but plan to shift assets quickly as you gain confidence that this new approach is working.

EXAMPLES OF OPPORTUNISTIC APPROACHES

Opportunistic styles tend to fall into three categories: (a) contrarian stock picking, (b) concentrated sector or niche investments, and (c) world class emerging growth stocks.

(a) Contrarian stock picking

Most growth and value managers are momentum investors. They like to buy stocks that are already going up (value managers have some additional valuation criteria) and hope that they will continue rising. Contrarian value managers, however, start their process with negative psychology, investigating stocks that are down in price and out of favor in hopes of finding ones that have limited downside risk plus a catalyst to return profitability to "normal" within a reasonable period of time. This process of buying low and selling high allows those contrarian managers whose analysis is successful to generate very attractive absolute returns (i.e. 10-15% annually) over a cycle, regardless of what the market does. This trait should prove to be quite valuable in the lackluster market environment we envision. (NOTE: Tocqueville’s large cap product generated returns of 14% annually from 1992 to 1994, a time when the S&P 500 returned only 6% annually. Also, our small cap product has outperformed the Russell 2000 by 45 percentage points over the past four years. Complete performance data will be provided during presentations or upon request.)

(b) Concentrated sectors or niches

Gold. A small movement in the price of gold (e.g. up $50 to$350 per ounce) could prompt a doubling or tripling of these stocks. I believe the distress in global financial markets will cause gold demand to rise over the next few years in spite of the weakening economic climate. Gold prices are at levels today which make 80% of all producers unprofitable, a condition we believe is unlikely to get much worse. (NOTE:Tocqueville’s Gold Fund, started 7/1/98, is the first product introduced in the past five years which addresses this niche.)

Energy. While oil prices have declined because of the weakening global economic climate, the excess capacity to deliver oil has dropped over the past fifteen years from 20 million barrels per day to only 2 million barrels today. Once the global economy recovers and we enter another period of simultaneous economic expansion (2001-2002), the current glut of inventory plus this miniscule reserve of excess capacity will be absorbed quickly. Despite new technology, oil production from old fields is starting to decline rapidly. This will accelerate in the next decade. Hence, we believe that higher prices will be needed to fund the dramatic expansion of capacity that will be needed to sustain global economic growth. The time for energy investments is not at hand today, but I expect to see a low point some time over the next two years at which time energy will become a compelling opportunistic investment.

Real Estate Investment Trusts (REITs). The securities of this new asset class are currently out of favor due to fears about the economy in 1999. Certain sectors, however, possess very attractive total return characteristics with stable cash flows, valuations equal to or less than replacement value, dividend yields of 7% or more and earnings and dividends growing at 3% to 5%. With projected total returns of 10% and limited exposure to a modest economic correction, we believe REITs are very attractive alternatives to bonds for those investors willing to accept modest incremental volatility. We would make commitments to this industry segment gradually over the next six to 12 months.

(c) "World class" emerging growth stocks or "the best defense is a good offense"

Most growth companies, many funded by recent initial public offerings (IPOs), are not really growth stocks. True world class growth stocks are rare and hard to find despite the conventional view of most investment bankers and growth mutual fund managers. Most "growth" companies will not be able to sustain earnings expansion in a more difficult economic environment, and will prove to be very disappointing investments for their new investors. The excess liquidity which we discussed earlier has clearly funded many businesses that should not be entitled to capital. Many of them may disappear over the next two years. The more difficult economic climate will separate the true growth companies from the pseudo-growth wannabes.

In the mature phases of a market correction, the world’s best companies are ultimately thrown out with the rest which typically presents a once in a cycle opportunity to acquire world-class niche growth companies at reasonable valuations. These rarities will never become bargains, just relative values. In a lackluster market environment (i.e. the S&P500 returning 5%), companies that grow at 15% or more over the next decade should provide very attractive absolute returns. Combining a "world class" emerging growth approach with risk averse ones like Tocqueville’s Contrarian Value can generate very attractive absolute returns in a lackluster market environment without increasing the overall risk of the total portfolio.

Within the emerging growth universe, we believe that Health Care is one of the few industry sectors where we can still see opportunity for a decade or more of spectacular growth. Unfortunately, I expect 1999 to be a challenging year for the industry psychologically, if not fundamentally. Anti-drug company attacks as well as legislation will hit the industry from many political circles creating a cloud of uncertainty over future profitability. This will provide a tremendous buying opportunity, the type contrarians love.

Beyond the negative psychology toward the group in 1999, however, I expect to see an explosion of new technology which will accelerate the already bountiful outlook for new products. Surging new product opportunities and technologies will combine with Phase II of the changes to the delivery of health care in our country. The new delivery system will shift the focus to providing quality and generating real efficiency, not just cutting costs by inhibiting utilization. While electronics, technology, software, and services have many unique growth opportunities, health care stands out in our minds as one of the few areas where a portfolio of world class growth companies can be created.

(d) Other opportunities

The above examples represent just a few of the alternatives that exist for investors willing to take an opportunistic approach. Clearly, a superior investment may be emerging in Japan today. The Japanese economy and market has been in a down phase for nearly 15 years. Many small companies are trading today below the value of the cash held in the corporate treasury even though the companies are not merely surviving but thriving. While global diversification has not provided much benefit to U.S. investors over the past cycle, we believe that applying a contrarian value approach to global investing by itself can be another opportunistic investment approach which will complement most of the domestic approaches discussed above. (Note: Tocqueville’s International product is 17% invested in Japan today.)

SUMMARY

This report is not intended to make you fearful of the future. Clearly, risk does exist and it is considerable in some sectors. Rather, I hope it makes you nervous about being complacent and reduces some of the faith you may still have in the strategies that have worked in the past. Conventional wisdom today is extremely dangerous. I urge you to think creatively as you seek innovative solutions for capturing return without increasing risk. Be proactive, not reactive, and get started today before it becomes conventional to be opportunistic. By then, it may be too late! Understand that being opportunistic does not necessarily mean absorbing more security risk. The risk is that you will not conform to the index. But if the index performs poorly, that is what you want!

Drew Rankin