A line from a favorite old song by Don Henley goes, "We all know that crap is king, gimme dirty laundry." That song, which took direct aim at television news journalism and its personalities more than twenty years ago, could just as readily be applied to the lead performers of the stock market in 2003. The Nasdaq 100, heavily weighted in technology stocks and dot-coms, shot ahead 49% last year whereas the Standard and Poor's 500 index was up a mere 28.7%, including dividends. In fact, in 2003 the 20% of the Nasdaq 100 stocks with no earnings were up by an average 93%! The lowest ranked stocks in the Value Line universe, Group 5, were up 78% last year. This group comprises those stocks that had been decimated in the prior three years' bear market. As the economy began to improve, speculators rushed into these shares and bid up the prices. Those who held onto these stocks during the 2000-2002 bear market still have suffered huge losses in spite of the recent run up since most of these stocks sell for single digits and they used to sell for triple digits.
Professional investment advisors such as Marc J. Lane Investment Management, Inc., which stayed with stocks that have good fundamental investment characteristics avoided the very sharp drops during the bear market, but they also missed the sharp increase during the last three quarters of 2003. They were prudent to do so.
Monetary policy plays an important role in stock market cycles and in determining which market sectors advance and which lag. When monetary growth is accelerating, as it has been the past year, much of the excess flows into the stock market, particularly into the more speculative sectors. Once the Federal Reserve becomes less obliging, the liquidity phase of the bull market will end and earnings will become the main driver of further market advances. It appears that we will reach such a turning point by mid-year. Just last week as the Fed left interest rates unchanged, but dropped its commitment to keep rates low "for a considerable period," the Nasdaq and the bond markets sold off.
Several factors accounted for the relative underperformance of conservative portfolios last year. First, small capitalization stocks outperformed large capitalization stocks for the fourth year in a row for a four-year cumulative return advantage of approximately 54% since their former peak in March of 2000. Small and mid-cap stocks as measured by the Russell 2000 are approximately even with their early year 2000 peak while the S&P 500 is about 25% below its peak.
Another factor already mentioned was the predominant performance of lower quality companies, those without earnings or dividends. Many of these companies narrowly avoided bankruptcy and, in surviving, their shares did very well as the economy turned up.
And finally, in case no one believes that history repeats itself, we are in the midst of another technology bubble. Last year's market performance, as measured by the S&P 500, was definitely skewed toward the technology sector, where valuations again are stretched to unsustainable levels based upon expectations for profit growth. The handwriting will be on the wall for the speculative stocks once the Fed begins to raise interest rates. Rising rates will not be a death knell for all stock market sectors, however. Since interest rates are well below fair value compared to an anticipated GDP growth rate this year of around 4%, rates have sufficient room to rise before the bull market ends! Bull markets typically do not end until interest rates rise above fair value and we have a way to go yet.
In fact, we think that stocks that show good quality fundamental characteristics will do well this year. Such characteristics include the old-fashioned, tried and true measures that we constantly preach about: low debt/total capital, and consistent growth in earnings and dividends. This last trait is often indicated by the Standard and Poor's Earnings Quality Rank of "B+" or better.
We manage equities to deliver good risk-adjusted performance over a market cycle. We look for mid- and large-cap companies that are dominant in their industries, have good management teams, and good balance sheets. Such companies were definitely out of favor last year. We would caution investors not to count on a repeat performance from the Nasdaq this year, or at least not for much longer. We are confident that the market will reward our patient, conservative style over a complete market cycle while still allowing our clients to sleep soundly.
Kenneth N. Green, C.P.A., B.S. (in Finance, University of Illinois), and M.B.A. (in Finance, University of Michigan), is Senior Vice President and Director of Investments of Marc J. Lane & Company and Marc J. Lane Investment Management, Inc., the investment affiliates of The Law Offices of Marc J. Lane, A Professional Corporation.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.