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Issue XII

June 1997

Sharp Investing

Do Trees Really Grow to the Sky?

The stock market has been on a rampage for the last 2½ years, or has it? It seems as though stocks like Microsoft and Coca-Cola are making new highs every other day and big companies are trading at levels not seen since the early 1970's. Earnings have been tremendous for the largest companies in America as the economy has provided a once-in-a-lifetime environment of prosperity. Investor expectations, as a result, are now so high that most expect to see annual returns of 20% or more without as much as a 10% correction in stock prices over the next ten years. Is this expectation based on long term trends or on short-term euphoria?

How should one invest in a climate where stocks only seem to move higher, with no apparent downside risk? Has "Buy high, sell higher" replaced the age-old "Buy low, sell high"? In this issue of Sharp Investing we will examine the pitfalls and opportunities such an environment provides, and put the current investment climate in historical perspective.

A close examination of the last couple of years shows that the current prosperity, for the most part, has been confined to a small percentage of corporate America. For example, the Dow and S&P500 indices were both up over 20% last year, while the average mutual fund for the same period was only up about 10%. Investing in big stocks, which normally provides below average returns, has provided above average returns for the last two or three years.

Market Cycles

Keep in mind the long, long, long term trend of the stock market is, always has been, and always will be up, up, up. Over 50,100, or 300 years, stock markets all over the world have compounded at about 10% because of constant increases in technology and productivity. This is always going on no matter the economic climate or current level of stock popularity.

However, within this very long-term positive bias trend, stock markets follow economic cycles over 5 to 20 year periods. If the economy spends a lot of time in decline (recession) the stock market will do the same, as it did from 1968 to 1982 when the Dow did not make a single new high. When the economy spends a lot of time in expansion, as it has since 1982, the market does well. These are the long-term cycles of the stock market.

Within economic cycles are the shorter-term cycles of popularity. If investors are down on the markets, prices fall even when the economic backdrop is good. Conversely, when investors are high on the market, prices rise beyond what is justified on an economic basis. These shorter cycles take place within the economic cycles and can sometimes last for up to three or four years, though a year or

two is more common. The trouble is, the shorter the cycle, the more difficult it is to predict the inflection points, that is, where the cycle changes from up to down or down to up.

Have Reliable Predictors let us Down?

In years past, there have been several "Old Faithful" indicators that have been very accurate predictors of a change in the popularity cycle from up to down. These include market dividend yields, price/earnings ratios, and market/book ratios.

Dividend yields of less than 3% have usually signaled the end of a bull market run. However, the current dividend yield of the S&P 500 is now 1.7% and has been less than 3% for almost four years. This Old Faithful indicator has not worked this time.

Other indicators such as the Price/Earnings ratio of the market or the Market Value/Book Value ratio of the market have also given false indications of an impending market correction. The Price/Earnings level of the market (currently 21.3) has never been this high at this late stage of an economic cycle (7th year of expansion). Generally, high P/E multiples occur when an economy is coming out of a recession and investors are anticipating vastly improving profits which will bring the P/E of the market down to more normal levels. However, the market is currently pricing stocks as though there will be vastly improved earnings even though companies have provided record level earnings for several years in a row, which is very unlikely to continue. The Market/Book ratio has also provided false alarms, as the market has existed for several years in a state where the Market/Book ratio has been twice as high (5 vs. 2.5) as long term averages.

What these failed indicators show is that popularity or unpopularity of the market trumps economic statistics or figures in the short run.
These indicators simply tell us when the market is under or overvalued, but not how long it will stay that way.

Eventually sanity and market ratios return to more normal levels. And in the longer run, these indicators are always right. The last time the market looked like it does now was the late 1960's and early 70's. From 1968 to 1972 there were four years in which the "Nifty Fifty", a group of fifty large stocks, commanded outrageous multiples with no end in sight. When sanity returned in late 1972, it took another 10 years for the Dow to reach a new high, and twenty-five years later many of these "Nifty Fifty" stocks have not surpassed their 1972 highs.

Investors that bought into the Nifty Fifty in 1968 did very very well for four years, but have done terribly for the ensuing 25 years. Conversely, investors that avoided the popular stocks for those four years did much worse for a few years, but came out far ahead in the longer run. Short-term prosperity seldom holds up long enough to significantly affect long term investment results.

What's Happening to the Risk/Reward Ratio?

There are approximately 7500 stocks that are not members of the S&P 500 that trade on national markets in the U.S., which make up over 93% of all available publicly traded companies. These are generally considered to be medium-sized to small-sized companies and are also referred to as second tier companies. Because these companies are not as large and powerful as the S&P 500 stocks, have less liquidity, less economies of scale, and lower profit margins, investors generally demand higher rates of return to hold these "riskier" investments. Since second tier companies have more risk, they also provide more return. This is why these smaller stocks have traditionally produced 12.6% return over the long haul (the past 70 years), compared to 10.7% for the large stocks.

What has been going on for the last couple of years is an extreme reversal of the natural order of investments; big stocks with less risk have significantly outperformed small stocks which have higher risk. Why? There are several theories, some making more sense than others.

First, earnings of big stocks have been much better than earnings of small stocks. But this is almost always the case as large stocks have typically earned 9.37% versus 7.5% for small stocks. Since this is normal it seems unlikely to be the main reason for the large cap stocks big performance.

The next reason given is that since big companies are much more likely to be in global markets, they benefit more from the increasing globalization of the world's major economies. Again, I would argue that this has always been the case and falls under the category of economies of scale. Since big companies have less risk because of their global diversification, they should pay lower returns than small stocks, rather than higher returns.

The last reason expressed (and the one I believe to be valid) is the increasing popularity of index investing. Index investing is where investors purchase a "passive" mutual fund which is constructed to mimic the returns of an index such as the S&P 500 Index or the Dow Jones Industrial Average. Index investing works great in up markets but does poorly in down markets because there is a cycle to index funds. Following the market performing above average for a number of years (which it has since 1990) investors pour money into index funds to take advantage of the good overall market, which are more heavily weighted in the larger stocks. This causes more money to be automatically shoveled into the larger stocks, driving them to overvalued levels. In addition, mutual fund managers, who have been left behind by trying to invest in all stocks, rather than just big stocks, now pile money into these big stocks hoping to perk up their short term performance.
The end of the cycle comes when the market finally goes through a normal correction and

the big stocks, being most overvalued, correct the most. Index funds then move down more rapidly than the general market causing index investors to pull money from index funds which deepens the losses of the big stocks. This ends the cycle and index funds fall out of popularity until the market has a few good years of performance again.

We are currently at the stage of index investing where many big stocks are wildly overvalued. The same factors that cause the large cap stocks to outperform the overall market will cause them to underperform that market at the corrective phase of the cycle.

Sharp Investing is a quarterly publication focused on investment education. For a subscription contact
Sharp Investments, at:

13160 SW Butner Road
Beaverton, OR 97005
Phone 503-520-5000

Fax 520-0530 email:
Daniel R. Sharp
Registered Investment Advisor

So what does a long-term investor do in the current climate? Knowing that the bigger growth stocks are overvalued but not knowing how long prices will continue to rise makes investing both risky and very difficult at this stage of the cycle. No one knows when the party will be over for the new Nifty Fifty, but when it is everyone will be rushing for the door at the same time. Betting that you can get out that door before everyone else is a

longshot indeed, not a long-term investment strategy. If you are a long term investor you want something that will capture at least some of the current upward momentum of the large growth stocks without having to put up with the potential 10 year hangover that investors in the 70's had to endure once the party was over.

The Answer: Small Value Stocks

Value investing is an all-weather type of strategy that provides superior returns over the long run and holds up much better in declining markets. A small value combination should enjoy upside momentum in the event the party continues, but provide much less risk in the event that the party is over. Small value returns, tracked over the last 45 years, have averaged 21.5% annually.

At Sharp Investments, we are using small cap value stocks to accomplish this goal. Small stocks are not currently as overvalued as their bigger brethren and have underperformed drastically during the last several years of this big bull market run. Anytime this has been the case in the past, small stocks have significantly outperformed the larger stocks for the next five to seven years. However, in the event that the party is over soon for big stocks, some small stocks will decline as much as the big stocks even though they are not as overvalued as the big boys. This is where the value component, combined with small stocks provides a safe haven.

Most investors do not have the expertise to select small value stocks. It's easy to look around in the grocery store and pick Coca-Cola or Proctor & Gamble, but much more difficult to dig out a small, unknown, undervalued company and do the analysis to insure you are investing in a viable business. This is where investment advisors like Sharp Investments come in.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

Investors cannot think they can get something for nothing. Getting high returns from low risk investments has been a temporary fluke in the market, and cannot continue long enough to
significantly affect long term investment results. If investors wish to outperform the market over the long run, it means taking on more risk, that is, small stocks over large cap, value stocks over growth. Although this strategy has underperformed the market over the last 2 or 3 years, it has outperformed the market over every 10-year period in history, including the last 10 years.

If, on a sunny day in Alaska, you are given the choice of wearing shorts or long pants exclusively for the next 10 years, how many of you would base your choice on the current sunny conditions? It may be uncomfortable to be in long pants when you see others around you in shorts, but the long-term benefits of the long pants will prevail. Think of value investing and small cap investing as an all-weather pair of pants, uncomfortable once in a while on the rare sunny day, but far better than being caught in shorts during more normal conditions. Although I can't tell you exactly when the weather will change, my advice is to take care not to get caught with your pants down.
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