"It's not about calling market bottoms. It's about identifying levels of attractive valuations."
— Ed Kerschner, Chief Investment Strategist, PaineWebber, October 13, 2000
Economists have been able to develop greater understanding about how people make financial decisions by importing insights from psychology, replacing some of the assumptions of classical economics by descriptions of how people actually behave. Maybe next the economists can round up some cognitive scientists and have them investigate the subject of investors' memory, which seems to differ significantly from the everyday variety.
Our memory provides continuity and context to our daily activities, enabling us to recognize familiar situations, see their similarities and differences, integrate experience into a broader context, draw lessons from the past, and so on. Investment memory, though, seems considerably more short-term, selective, and sub-optimal. Normal memory, though far from perfect, allows us to function reasonably effectively; investment memory often fails just when it is most needed. We don't remember that similar situations have occurred in the recent past; we don't put current events in perspective. The result is sub-optimal investment decisions.
When T.S. Eliot said April was the cruelest month, he wasn't thinking about tech stocks, but during April those stocks collapsed, finally bottoming in early May. Spring has often been a good time to sell technology, just as fall has often been a good time to buy. Securities prices seem to have a habit of dropping in September and October, and the fall has seen many important market bottoms. The market crash in October 1929 provided a nice trade into the spring of 1930. More recently, the bear market of 1973-74 ended in the fall, the October 1987 crash was a low, the bear market of 1990 bottomed in the fall, and the panic of 1998 saw an October bottom.
We have just finished six straight weeks of decline, beginning on the 1st of September and carrying the market down over 12%. This is the second correction of 10% or more this year; the only other years this decade with two 10% drops were 1990 and 1998. In both years we had external and internal sources of market angst. In 1990 it was war in the Middle East, high oil prices, recession, and the impact of Fed tightening. In 1998 it was emerging markets, Russia's default, Long Term Capital Management's collapse, and Fed tightening. Now it is tensions in the Middle East, rising oil prices, earnings warnings, and Fed tightening. There are the rudiments of pattern here. In each case, either the decline in the market itself, or the causes of the decline finally made the front page of the New York Times and other newspapers. By the time market declines (or advances) are front-page news, they usually have run their course.
In the summer of 1983 we had a technology-driven new issue boom that drove the NASDAQ to a peak. Over the ensuing 12 months that index fell about 40% before resuming its advance. In 1987 the S&P 500* peaked in August. It fell 40% in 40 days, bottoming with the crash's 20%, one-day decline. This year the NASDAQ peaked in the spring at 5,000. By the end of last week, its decline reached 40% peak to trough.
There are of course differences between this decline and the others. Previous shifts from decline to advance have often been catalyzed by a change in Fed policy toward risk. No such change is evident today.
October is also when Institutional Investor releases the results of its annual survey of Wall Street analysts, highlighting those voted best in their respective categories. For the first time, Ed Kerschner of Paine Webber was named best strategist, outpolling Abby Joseph Cohen, the justly celebrated Goldman Sachs strategist who has been correctly bullish on the market for the past 10 years. I have long admired Ed's work, which is always quantitatively sound, analytically rigorous, and conceptually interesting. During the tech frenzy this March, he correctly called the top, just as he correctly called the bottom in 1998. This past week, he said the stock market was the most attractive it had been since October 1998. This, like his other market judgments, was not a psychological assessment, nor was it based on his reading of the charts; it was a valuation call. Declining stock prices, positive fundamentals, and a benign macroeconomic environment have combined to produce the best opportunity for excess returns since 1998.
Of course, the market may continue lower, fundamentals may deteriorate, oil may rise further, tensions may escalate, the macro-environment may darken. There are always reasons why the market is down, and those reasons dominate investors' consciousness; but current fears are reflected in current prices. Justice Holmes once said people need to be reminded more than they need to be instructed. Once reminded, we remember October has often been a time to be bullish.
Bill Miller
October 14, 2000
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