Walter D. Pearson-The History Of The Stock Market-Pearson Investment Letter-Sun City-FL

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Back to: Opinions

8/15/2002
THE HISTORY OF THE STOCK MARKET
By Walter Pearson

Many people are worried today about the stock market, and I would be the first one to admit that they have good reason. However, in the field of investments it is important to evaluate the entire situation before coming to any decision. What we are looking at today is a market that was composed of companies that were doing well and stockholders who were very much satisfied with the status quo. Then the roof fell in. What is going on?

One of the problems in the marketplace these days is the way the stock market has been changed to where it very much resembles a slot machine where you pay your money and let the wheel spin. I am convinced that if margin buying were eliminated, prices would seek a normal level and from there on would simply reflect real value as it changed from year to year. I am old enough in this business to remember when stock market swings of the current magnitude were unheard of. I do not expect to ever see the rules change, as this would mean less revenue for brokers. I do not believe in short-selling or margin buying and warn all of our clients against doing either.

We have numerous problems with today's market. From where I sit, I feel that our number one problem is leadership. In the financial field companies are going belly up that were supposed to be solid as a rock. What happened? How could this sort of thing happen, the like of which has never been seen before?

One problem faced by all manufacturing companies is cash flow. This relates to the amount of money you owe to others. It starts with your sales, your rate of collection, cash on hand, and the aging of monies owed to you. Because most manufacturing is very capital intensive, these factors must be monitored at all times by the company CEO. I have examined some rather large firms and I can tell you that Enron, K-Mart, and others were just the tip of the iceberg. I have found scores of companies whose balance sheets indicate a very strong possibility of bankruptcy. If only one or two of these companies go belly up, many others may well follow. Consider Enron: upon declaring bankruptcy, 47 of Enron's business associates came into serious difficulties, and I am only considering a few of the major players.

Inasmuch as there is nothing I can do to correct the blunders put through in Washington, my son and I have put our heads together, and I feel we have come up with a partial solution. After all, we do not run the country, but we do run our clients' investment portfolios. It is our opinion that from here on it is going to be risky to be in stocks, but it will be equally risky to be in bonds. It will be a guaranteed loss to remain in some form of currency, as the inflation rate will bottom-out your value in a few years.

We expect that the market as a whole will be traveling down for some period of time, although stock market averages are one thing, and the stocks the individual investor owns can be something altogether different. It comes down to that story told by one of the leading gurus of yesteryear; it is not a stock market, it is a market of stocks. What he is saying is that the market averages can be going down, but it is possible to find issues that have good potential, are reasonably priced, and come out a winner.

We have had major crashes in the stock market before, and it seems that each is different from the other. Back in 1929 we had one of the most severe ever, but in retrospect it should have been foreseeable. In those days, one could buy $1000 worth of stock for $100 down and owe the rest. This is called margin and though we still have margin buying with us today, the rates have changed. It is now 50-50. In the late 20's people were going overboard with heavy buying because of the 10% down. This caused stocks to rise way beyond their actual worth. When the bubble burst, folks were called upon for more money. Some mortgaged their homes while others jumped from buildings rather than face the financial debacle. Mr. Livingston, one of the heavy players of that day who went quietly broke, went to a bar, had a few drinks, and retired to the men's room where he proceeded to shoot himself. Previously, he had been one of the wealthiest men in the world.

Eventually the market recovered as it always does and, though there were other dips, I believe that the next severe one was in 1970 where even AT&T, which was the pride of the street in those days, dropped more than 50%. Stock prices tumbled, and some very good stocks went down as much as 80% before recovery. One of the things to bear in mind is that there may be values around of that magnitude even in a bear market. I can recall that during that period I had put out Kaiser Steel at prices between 8 and 13 and two years later, at the bottom of that market drop, Kaiser Steel was selling at 42. There was a very good reason for this but it was necessary to understand the situation. The important point to remember is that there are possibilities in the marketplace. One does not purchase the entire market of stocks.

After a couple of years, this market recovered and about 1982 we had the start of a real upturn. The strange thing about these turns is that it is just about impossible to see them even while they are happening. Stocks continued to rise until we hit the computer era in 1987.

As we all know, mutual funds represent the big buyers in this day and age. With the advent of computers, mutual fund managers discovered that they no longer had to watch the stocks themselves; they could have their computers do it for them. I don't remember how many mutual funds there were at the time but probably at least 6,000. Each fund manager would place stop-loss prices on his computer with the order to sell if a stock backed off a certain amount. In actuality this did not work out too well. One day too many sell orders came through and brokers saw prices plummet. The market had never gone down so much before in a single day and probably never will again. The problem was that if the computer was programmed to sell a stock if it backed off to 87, that computer had no brains of its own. If thousands of shares being dumped by other computers had pushed the price down to 60 or 50 or 20, the computer would sell. If a human had been in charge, they would never have let it go at that price. There were so many sell orders that day, the markets were closed early, as there were no buyers. The specialists who usually would pick up any extras ran out of money and credit. Eventually the government came in and saved the situation.

However, that's what happened in 1987 and the one-day drop was followed by a demoralized public which beat prices down for another week before things solidified. The nice thing about that break in the market was that a two-year drop was over in one week. In actuality, in my opinion, there was no valid reason for that break in the market, and I believe that the rapid upturn of the time bears me out.

Today, we have an entirely different story, because prices are regulated by the public. It is they who decide how much they are willing to pay for any given stock. With the decline of manufacturing in this country, it becomes necessary to look elsewhere. We must consider that tens of thousands of our people have been laid off. Their jobs have been terminated in most cases. This should mean a slowing economy. Like Peter Lynch, I have never been one to worry about the economy. I have always felt that with the brainpower we have in our industry most bases can be covered. I lay the blame for our present stock market debacle on the passage of NAFTA and GATT.

There is no logical rhyme or reason for what is going on in today's stock market. It doesn't make any sense at all for stock market prices to move up or down as much as 5% in a single day. As a matter of fact, some issues seem to move even faster than that. In actuality a company has a value and this value is determined each day by those who are dealing in Wall Street. If a company is worth $50 a share one day, how can it possibly be worth $5 more or less the next day when nothing has changed?

My son and I have come up with what I hope will turn out to be THE answer. We have devised a new system for ferreting out companies that we hope will be immune to the coming crisis. We have worked out a schematic that gives us a means of determining the real worth of each company. I think we all understand that no one, nor any system, is or can be perfect, but it is our opinion that over this next period we are going to be able to hold the line for our people, come hell or high water. And, believe me, I don't expect it to be easy. We might suggest a bit of gold for your strong box, just in case.

THE MUTUAL FUND INDUSTRY
5/06/2002

Things are changing all over the world and the mutual fund industry has had some mammoth changes since its inauguration back in the 1920s. It may seem hard to believe, but it has gotten to the point where there are more funds demanding a minimum amount of $1 million up front than those that will start you with $1000. The reason for rising minimums is simple. Fund companies lose money on small accounts. A fund charging a 1.5% expense ratio on a $500 account brings in just $7.50 a year on that money. If there were a $1000 minimum, the expense ratio wouldn’t cover postage and printing for statements and reports. Many funds now charge an account management fee as well. The result has been that smaller investors have had to turn to high cost funds.

AN INTERESTING POINT

From time to time our local paper carries an interesting item on finance. A short while ago they carried a piece by a writer who told about the ups and downs of his mutual fund. He showed how he had chosen a poorly performing mutual fund which gained only 5% for the year, but he actually only gained 3½% because of costs. Then he showed how he was sitting with a loss because he had invested more money later in the year at a high point in the fund’s performance. He intends to hold on, which may be the right thing to do. However, this points out the compelling reason for having a managed account of one’s own. In your own managed account, the new money would be going into one or a few stocks that looked like good buys for you at that particular time. In a mutual fund, new investments are automatically spread over the whole gamut.

STAY ALERT

When selecting stocks for investment, you have two choices; you can do it yourself or you can use a professional. Naturally, the professional should do a better job, but one of the problems in this business is that no one can foresee the future with absolute accuracy. Times change, conditions change, and what was a good investment yesterday may be an absolute no-no today. Before the advent of the automobile one could see the population growing in this country on a regular basis and would think that buggy whips were a sure thing. However, after Mr. Ford had his say, things changed radically.

Similar things are happening today, and it is up to whoever is doing your investing to keep up with the new wrinkles that show up each day. Some of these are negative which, as in the past, would doom buggy whips; but on the positive side for all to see, if only they would recognize, was the tremendous potential in that newfangled invention—the horseless carriage. That monstrosity that some people thought would never take hold swept the country, and other countries, too. Many people today have two cars and some have even more. The important thing for the investor of that time was not to understand automobiles; nor was it necessary to understand the dynamics of how they were put together so they could operate efficiently. No! The important thing was for the investor to recognize the potential.

Today we have a similar phenomenon in the field of computers. There is no doubt that this business is here to stay. The problems in investing are many. Which particular companies are going to make it through to the end, and how about the offshoots of the industry? In the old days we had numerous automobile companies; some made it through and some turned belly-up along the way. Marmon was a great car; Locomobile and Pierce Arrow should have done well, but they are no longer with us. Some of these may have folded, or they may have just been bought out and taken over; however, there is no doubt that many investors got into some of the wrong ones along the way. I think it is easy enough to rationalize here that the investor who was diversified should have done quite well if he was at all capable.

Presently, our computer industry is no longer brand new. Even I spend most of my day working at a computer, although a few years ago I didn’t understand them and wouldn’t touch one. I don’t pretend to understand a computer, but I use it, and it has become absolutely necessary in my work. The fact that this industry has been around for some time and is no longer a novelty doesn’t mean that it is all over investment-wise. There are millions and millions of people who do not have computers. The USA is in pretty good shape but there are other countries that are way behind and will be playing catch-up. There is a tremendous market in China, and our government is doing everything possible to see to it that the Chinese have a better income than they have had heretofore. You may not agree with this philosophy, but the point is that you may as well take advantage of the information that you have.

From time to time you will become the possessor of information that could mean a good bit to you investment-wise. You may or may not recognize the importance of this piece of news. Sometimes the news is something you alone have learned, and at other times it is out there for the whole world to see, such as the computer industry. Either way, it is incumbent upon the investor to stay awake and smell the coffee.

Sent e-mail to: WalterPearson@pearsoncapitalinc.com

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