OCTOBER 2002

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What To Do When The Bear Comes Knocking

Investing in Turbulent Times

by Cy Lynch

Editor's Note: We extend our appreciation to Cy Lynch for sharing this contribution. Mr. Lynch is a highly-sought speaker at NAIC national events and the comments that follow are from the National Congress held during September 2002 in Portland, Oregon. Cy takes us on a review of the current situation in the stock market, takes a look at historical bear markets and closes with an excellent summation of DOs and DON'Ts for strategic long-term investors. We can't duplicate his wonderful southern accent on the Internet, but we will invite you to grab your favorite beverage and curl up with Cy's outlook on bears that refuse to hibernate.

It is a sign of the times that you chose to attend this session. We've certainly seen a down market since January or March of 2000 and we're all feeling some pain.

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This isn't the first time, believe it or not, that stocks have actually gone down in price. I know that some of you, based on the 1990s, think it is. We also thought that Ronald Reagan repealed the business cycle in the 1980s. We found out something different in 1991. Well, in the 1990s the business cycle had not only been repealed but we'd done away with any down cycles for stock prices. In 2000, 2001 and into 2002, we found out again that this isn't the case.

We're going to spend the last half of the class examining some DOs and DONTs that we can learn from during this time.

The State of Business and Our Economy

Let's look real quickly at where we're at with respect to the business environment. Economic growth is slowing. We've reached the point that the economic growth as measured by Gross Domestic Product (GDP) declined in the third quarter of 2001. It does look like we do have a bit of a rebound forming during the first quarter of 2002. We've moved from negative growth. Don't you just love that term? I'd call that a contraction. We moved from this decrease into a slight increase up to an estimate of 6.1 percent in 2002.

Let me just give a real quick lesson in economics. The Bureau of Economic Affairs (BEA) puts out the GDP figures actually give you three figures for each quarter. They give you what they call an initial estimate. Then they give you what's called a final estimate. And then they give you the real figure.

So we end up with three of them. This 6.1 percent that you here was the final estimate for the first quarter of 2000. The actual figure was recently released and was 5.0 percent. Estimates have been going down in recent quarters. The 2nd quarter of 2002 was 1.1 percent. So there's some talk about a double-dip recession. And maybe we're there. I personally think we're gonna flatten out a bit and experience a "deeper U" type of cycle.

The folks who declare recessions declared that one started in the second quarter of 2001 and we're still in it according to them. But also notice that we declare recessions AND renewed growth about 6-9 months after it actually happens. So we're only talking about history.

Nobody really knows where we are today -- there are a few things that we can look at.

Unemployment was at 5.9 percent when I prepared these notes, about an eight-year high. In August it was down to about 5.7 percent. But let me put that in perspective. My undergraduate degree was in economics. That doesn't make me an expert in economics but I do remember a little thing about economic theory and how it was taught some 25 years ago. Back when I learned economics, guess what so-called full employment was? Anybody care to venture a guess?

Several attendees answer, "6 percent."

That's right. I was taught 6-7 percent for full employment. There are some theories that we're drifting down to 5-6 percent. But I just wanted to put that in perspective, where we're at today -- twenty years ago -- would have been called an employment boom.

People saying that we're in a disastrous economic environment with disastrous unemployment are mistaken. Now I won't disagree if you know someone who has lost their job. It's clearly disastrous and it's clearly bad, but what's happening is that we've been moving from a low 5 percent to a low 6 percent level. It's the trend that we feel. We've had so many years of good times and falling unemployment.

The Wall Street Journal keeps an running survey of employment corporate profits. From the survey of 511 companies, comparing first quarter 2002 to first quarter 2001, there was a decline in net income of over 100 percent. Two things to remember about that. What was the last "good quarter?" Right. We began moving from the peak, robust, quarters right at first quarter 2001. In fact, the information that I pulled off the Internet this very morning shows a few more companies are reporting an increase of 72 percent for second quarter comparisons.

Again, be careful with the math and watch the trends versus the quarter to quarter comparisons.

Setting the Environment

Later on the year, we moved on to the accounting scandals and general wariness of management reporting. This certainly has had a huge impact on the market. Several analysts feel that this impact has been bigger than September 11th.

Let's talk about interest rates because they certainly impact the business environment. The Fed Funds rate isn't something to worry about except that when you hear CNBC talking about Greenspan and interest rates, that's what they're talking about. Technically, it is the rate at which banks lend money to each other to cover short-term needs. It is an interest rate that's tracked but only indirectly affects us. The rate was recently at 6.5 percent in January 2001 and we've had 11 rate cuts. The Fed Funds rate is near historical lows, and is at a 30-year low of 1.75 percent.

What will the Feds do next? Who knows? I think the general consensus is stable and bottomed out, and it's my gut level feeling. Realize that the Feds meet and do two things. They tell what they've done to interest. But then they do a second thing. At each Fed Funds meeting, they also tell us what they're thinking. They might suggest that rates may increase at the next meeting. Or maybe we'll keep rates steady. Right now they're staying the same and we think they're staying the same. And it's the "we think" part that drives the market more than the reality. Usually the reality is pretty much known before announced.

Stock Market Environment

Let's talk about where we're at in the stock environment -- as if you all needed a reminder. (Chuckling) Because you probably already know. All major indices are down over the last two years. The chart we displayed at the start shows January 2000 up to recently. The numbers are a little bit more to the downside over the last few months. You didn't need me to tell you that.

Historically, what's the worst month for the stock market?

Several attendees shout "September."

Wow. You guys are pretty sharp. Many people think of October because of the legendary down month. The worst 2-month period is September-October. What's the best 3-month period for stocks?

Yes, historically it's November through January. So if you live through October, you've got the bright side coming down the road. (Audience laughter)

I'm not a technical analysis advocate, leaning instead on solid fundamental NAIC-style analysis, but there are some things we can look at.

Where I'm taking you is into a little bit of hope, that the November-December time frame actually looks pretty good from both a stock AND business standpoint. If the reasoning is sound, it might be time to look for an upturn.

The numbers in a little more detail show the NASDAQ down some 70 percent. But I'm sure none of you own any of "them," companies like Cisco Systems, EMC, Microsoft, Intel or Yahoo. I'm sure you don't own any of these so you missed that decline. (Audience squirms in its seat, audibly) The S&P was down at one time was down about 35 percent... and it's closing at about that same level these days. So we've seen the 500 largest companies, about 75% of total stock market value down significantly.

The Dow has actually held up the best of the widely-followed market indices. The Dow bear market actually started earlier, back in January 2000.

Both the S&P and NASDAQ declines started in March 2000. But the bear started earlier as measured by the Dow.

In 2002, all major markets are still down. I already mentioned a few stocks that many of us didn't own because we knew they were overpriced back in 1999. So we've seen the market and hearing people talk about the market being down and there's some misery.

But hang in there. There's hope coming. Cy isn't all gloom and doom. We're gonna take a look at how we can continue to discover opportunities during down markets. There's still forty minutes of class left.

The farther that we get away from September 11th, some of the impact on the general business environment starts to diminish. We need to talk about insurance costs, security costs and increased government spending. We've had to move to deficit spending, largely because of September 11th, but we're also in the middle one of those "R" words -- recession, and this has a measurable impact on the economy.

I'm not going to politicize here, but some politicians bash the administration and blame tax cuts that cause deficits. Don't believe it for a second, for two reasons. When were the largest deficits incurred in history, at least on a gross basis? The early to mid-1980s. Remember that Ronald Reagan repealing the business cycle. I'm not a full believer that tax reductions lead to a direct increase in business output, but there's evidence to support this. An economist by the name of Arthur Laffer and the Laffer Curve that was in vogue during that time frame. What happened then did support his theory that lower taxes increase output because the general population works harder and generates. I'm not saying that's all that is going on, but history tells us that there's some support for his theories on deficit spending.

Is there anybody here that's not a taxpayer? How much did your taxes go down in 2001? Very little. If you saw your $600 that they sent you as a pre-refund, then you're lucky. The reality is that the tax cuts are DOWN THE ROAD. To the extent that there's going to be any impact, it's DOWN THE ROAD. The tax cuts haven't really happened yet. The deficit is the product of the economy, part of the business environment and it's normal, it always happens -- recessions -- and some is directly related to September 11th.

Let's talk about insurance costs. Anybody's cost for car insurance go up this year? (Audience laughter) And did you live under the World Trade Center? Do you live there now? Would you believe that part of the reason, if not all of the reason that these costs are going up is due to September 11th? Let me explain why.

Companies like All-State, Prudential and CNA manage their business such that they minimize the "hit" from something like September 11th. They're not going to take the "big hit." It's the people like Warren Buffett that absorb the most damage. These are the re-insurers like General Re. The insurance business has three levels -- retail, for consumers like you and me. Commercial, which includes the distributors like AllState, Travelers and State Farm, etc. and the third level is the re-insurers or wholesalers. This is where insurance companies buy their insurance policies. Your auto insurer buys re-insurance from those people. The re-insurers are raising their prices. And this is why your rates for auto insurance are going up. Of course, there are other reasons, but this is a major influence.

Insurance rates also operate in fairly well-defined cycles. In recent years, we've been in one of those down cycles. Even before September 11th, we were into somewhat of an up-cycle.

The Current Challenge

Will you panic and sell? I started giving this talk about 18 months ago and at that time it was a question that I could ask in the present tense, "Will you?" Today, I'm hoping for most of us here that I'm not asking, "Did you sell?" Seriously, "Have you given up on stocks?" "Will you give up on stocks?"

I challenge you to think of this market as a positive test. If you've been "here" before, having invested through 1987 or 1991, and certainly if you'd been involved in 1973-74 -- and you're still "here" -- then you've BEEN THERE, DONE THAT. You worry a whole less than the average investor. This is the first or second time that we've been tested so heavily. This is different than 1991 or 1997, most significantly because it's lasting longer. Think of our situation as an opportunity, a positive test. Some quality companies are on sale.

We could engage all kind of debate on "how much" the overall market is on sale. But I will guarantee you that SOME COMPANIES are on sale. There are good stocks to choose from. I hope you saw Nancy Cray's guest editorial in your October Better Investing. Nancy said, "Stocks are the only thing that we don't get excited about when the prices are down. When we shop for a car, a dress, or a new suit, shoes or stereo, and prices drop... what do we do? We CELEBRATE. When stocks go down in price, what do we do, "Phooey!" and we suddenly no longer want to buy any!

It's not easy. It takes discipline and most of all, it takes patience.

What does history tell us?

I have a little bit of economics background and I'm a bit of a stock picking hobbyist. I've had real money in the stock market since the late 1970s. I have seen a sluggish market and lived through it and went on to experience the boom of the 1980s with real money involved.

I was even playing around with pretend money since the early 1970s. The current situation does seem to feel a whole lot more like the 1973-74 markets and we should talk about this.

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Here's a long-term Dow Jones chart. Everybody talks about the 1929 stock market crash? But when was the real DOWN period for the stock market? 1930-1933 was the real problem. The market lost 80 percent of its value during that period and we've seen that level of damage on the NASDAQ. Note the bad periods of 1973 and 1987 on this chart. The historical long-term trend is clearly UP.

The average bear market lasts about 11 months. Well... everybody likes to exceed and this bear is exceeding expectations. It's worse than an average bear. This market has passed into second place for the all-time longest bear.

But in the end, EVERY BEAR BECOMES A BLIP.

The bear dropped us 40 percent in 1973 and smacked us in 1987. If you lived it, BIG PAIN, but it passes. Bears become blips.

Look at the long-term charts. During the drops, they're painful and when you're "living them", they hurt. But bears become blips, barely noticeable on the long-term charts.

A good reference on this subject is Jeremy Siegel's, Stocks for the Long Run. Basically it shows that the best return over time periods, going back to the early 1800s, belongs to stocks. If you held for 20 years, the worst case after-inflation returns has been one percent, and on average these 20-year periods have produced 9.6 percent returns.

In reality, his research shows that a 17-year holding period virtually guarantees a gain. Ibbotson Associates documents the same expectation from a historical viewpoint.

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Time is on your side. Patience.

Peter Lynch reminds us that it is possible to make money in bad markets and to lose money in good markets. He says this in One Up on Wall Street, and gives examples of 1970s McDonald's and Coca-Cola where he made money when times were though. I bought my first stock in 1984 -- Delights of America -- right before one of the best markets in history. Guess how much money I made. Right. Zip. I lost it all. So it is possible to lose money in a surging market.

There are times when we can almost throw darts and select a stock that will go up. In my case, my dart selected the wrong one. Peter Lynch says actually in this environment, at Congress 1999 with the Dow near 10,000, "I don't know what the next 1000 point move in the market will be, but I know for sure what the next 10,000 point move will be."

And with all of that I have a disclaimer, I have been teaching NAIC methods since 1988. I am going to tell you the same thing that I've been saying since 1988. If you don't want to hear the same story, told perhaps against a different background, then now is the time to find another room.

We look for companies with solid sales growth and profitability track records. Those that lead industries will do better than peers in good times and in bad. Companies will experience temporary problems and we study these when they take shape. We prefer companies that have relatively less debt than their peers -- they tend to weather storms a whole lot better.

I believe that using the NAIC tools is the right way to do this.

We want to seize the moment. What can we do? What do you do when the bear comes knocking? You can either have a feast, or be eaten. "Either you eat the bear or he eats you." So that's we'll close with, we'll take it backwards. We need to examine what we SHOULDN'T be doing. Let's visit the DONTs and proceed with the DOs.

Don't watch stock prices daily. Hopefully you've learned this because your doctor told you that you needed to take Maalox. (Laughter)

So you've decided to start sleeping at night. This is tough to do in today's Internet world. Stock prices are coming at you. Your personal homepage wants to show you your portfolio... and they'll reprice it for you every 15 seconds or so. CNBC is part of your life. They've got the rolling ticker. There are rolling tickers on CNN and a host of channels. You don't have to watch them!

I've been providing investment advice for a few years now. I have been self-employed for about five years now and is it amazing how closely my wife watches OUR stock portfolio now. (Laughter) For a long time, she'd ask, "What's the market going to do TODAY?" And my answer has always been, "I don't care. It doesn't matter... because we're investing for the long term." Of course, we do like to see some declines and buying opportunities. We buy companies, we don't buy markets.

Checking your prices monthly is plenty. This is true for two basic reasons. First of all, you can't react fast enough to do anything when surprises materialize. Raise your hand if you owned Enron. Leave your hands up IF you sold Enron before they announced that first big restatement of earnings? (No hands stay up) You didn't and NEITHER DID the people who are paid to watch stock prices by the hour! You normally can't move fast enough.

Secondly, we need some time to reflect. Is this a temporary problem, which is actually a buying opportunity? Or is it terminal? Many times you'll be thankful that you had that time lag and avoided panic.

DON'T use stop-loss orders. This is one of the biggest temptations in a down market. Many people say the key is protecting against losses. To which I say, "Baloney!" I'm not saying "buy and forget." There are times, based on the business of the company, that you're going to want to sell. But that's completely different from a "trigger" that is based solely on a change in price.

Some Slices of Real Life Stock Experiences

Some real life examples. These are real examples that either I, my club, or my Clients have actually owned. These are personal experiences.

The first is Affiliated Computer Services. I own this stock. When I first bought it, it surged in price and I was a genius. Then it suddenly dropped 20 percent below my buy price. I had a stop-loss in at 20 percent less than my purchase price and sold the stock. At the time, I thought, "Thank goodness that I didn't lose any more money." And then hopefully I went to sleep. Because my choices are 20 percent loss or 125 percent gain. A stop-loss is a guaranteed-loss.

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Let's look at Cardinal Health, a company featured in Better Investing magazine. We were all geniuses, it went up and then plunged. It was down 25 percent or so from the purchase. Thank goodness, if I'd have had a stop-loss, I'd have missed a 80 percent gain that holds even after a RECENT 20 percent drop in price.

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Microsoft has bounced all over the place. Litigation and earnings reports cause some bumps. It had a 10 percent loss while the market dropped 50 percent. Stop-loss orders are guaranteed-loss orders. It's not a loss until you sell it. Guaranteed-loss orders turn paper losses into realized losses.

Don't panic and sell. Price drops are irrelevant if the business is solid. I've talked to a lot of people who talk about stock prices that "haven't done nothing yet and we've owned it for what seems like forever." Price does not matter. We shouldn't care about the price all by itself. One of the best signs that we'll ever see is a stagnant price for a company that has continuously increased earnings.

Trust me. Enron's price drop is RELEVANT. (Laughter) But that's because the business is gone. The same thing is true for Worldcom and others. But is Home Depot's price to be seen in the same context? I doubt it. Probably a solid company to investigate.

Even if the business is weakening or recession-impacted? Are the problems temporary or terminal?

Don't try to time the market. It does not work. There's a zillion studies which document this. Don Philips of Morningstar told us this very thing over lunch today when he said, "We have not discovered a single fund manager who has been successful using exclusively price charts over time." He told us that timing the market does not work. Trying to time price movements has been shown in tons of studies that this doesn't work. Miss the best 50 months over a 62-year period, your average return on the S&P would be negative 11.5 percent. Miss the best 30 months, your return is ZERO! (That's one month out of every two years.) Timing the market doesn't work.

Ibbotson says that missing the best seven years from 1926 through 1998, your return on $1 invested would have diminished from $2351 to $202.

Don't get caught up in the hype. I won't ask for hands again, but here's Cisco Systems and EMC. 80 percent. Here's a solid pharmaceutical, Merck, down almost 50 percent. In 1999, P/Es were running at almost 45. Notice how how the P/Es were on a relative basis. What's a more realistic number? History is closer to 15.0x. We're returning to reality.

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Merck (MRK) - Down over 50 percent.

The Stock Selection Guide provides the tools and guides to judgment.

So what do we do?

Stay the course. Discipline matters. Have reasonable expectations.

Recent years have delivered some record returns. Technology stocks had some great years in 1998 and 1999. Some of you may have been tempted to discard NAIC stocks, and eschew that SSG thing, and buy dot-com stocks. Or if it was one of those Nasdaq-100 stocks, no questions necessary. Not me.

Or what about those QQQs? You can make more money in a year than your parents made during a lifetime of investing. I'm kidding, of course. Reasonable expectations are important.

The average normal expected return from stocks is an annual rate of return of 10-11 percent.

When NAIC members shoot for 15 percent, we're actually being very, very aggressive. You didn't feel like it in 1999 and neither did Warren Buffett. It's kind of like how parents get smarter with the passage of time, time passes and conservative fundamental investors who can build reasonable expectations get smarter. We buy businesses, NOT stocks.

Do they make money? Unlike 1998 and 1999 when we didn't care about profits. Time named Amazon's Jeff Bezos man of the year. Frankly, I wouldn't have touched Amazon stock with a good long pole after hearing him say something. When asked why isn't Amazon showing profits, he said, "That's just marketing. We can show profits any time we wanted." My question would have been, "Then why DON'T you?"

Profits matter. That's one of the bottom lines of an SSG.

We buy effective businesses and we can make money in down markets by doing this.

Let's visit Rehab Care Affiliates, a company I discovered a while back at this very event. I'd encourage you to explore the companies with exhibits here. And this isn't HYPE, I wouldn't do that. There are opportunities in the Expo Hall. The company is UP 50 percent while this market is down 30 percent.

We looked at Affiliated Computer Services. Refer back to the comparison versus the NASDAQ. With the market down 50 percent, ACS is UP in the hundreds of percents.

We also looked at Cardinal Health. Similar to ACS, refer back to the graph and see that the comparison of CAH versus the S&P is pretty favorable.

One of my all-time favorites, Clayton Homes, is one of those stocks that "hasn't done anything." When we bought it, I told my club that we might see technology-type returns but I don't know when. In late 1999 we purchased and we gained some 80-100 percent gain while the market dropped.

This company is also an example of a company persevering through temporary problems. There were some people that questioned whether the problems were terminal and they had some valid points. My club was among many that didn't sell because of the late 1990s price drop and instead chose to believe that the challenges were more temporary.

Value matters. Our club bought 3M, despite the slower growth, because we expected an expansion of P/Es and this has happened.

Management, management, management. Earnings matter. When shopping for companies, try to identify the top 1-3 companies within an industry. Compare sales growth rates and profit margins.

Verify the validity of the income statement. Rely strongly on the SSG and study the 10-K. Do this and you will know more than 95% of all investors and I also believe you'll know more than the vast majority of professional analysts. Study this information carefully.

Go one step further and look at income statements. Compare cash flow from operations to net income. You want to verify that cash flow from operations is at least equal to (or more than) the net income. Look at a multi-year trend on this.

Monitor the debt level trend. There can be COMPLETELY logical and sound reasons for increases in debt. Check Home Depot's debt track record during the 1990s. You'll see that this was a managed situation, done well.

Keep the LONG-TERM PERSPECTIVE. Discover good companies that are selling at good values. Use the Stock Selection Guide and use this wonderful community of investors that we know as NAIC. You have clubs, your chapter and in addition to those environments, you have the community of investors at events like this. Use your Better Investing magazine to see what's on the collective mind of NAIC investors. Perhaps most significantly, use the community and resources available to you at www.better-investing.org and the various places that this Web Site will take you. I also encourage everyone to visit and "digest" I-Club-List.

Thank you all for your wonderful attention. Bear hunting season is now open.

Cy Lynch received his law degree from the University of Michigan. He was active with the Atlanta Chapter and served as its vice president of education. In 1998 he received BetterInvesting's O'Hara Award in recognition of his service to the Atlanta Chapter, and he is a recipient of the Investment Education Institute's Distinguished Service Award in Investment Education. He is a frequent contributor a popular speaker at BetterInvesting's national events and a former advisory board director. He currently runs a financial planning and investment advisory firm.