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Issue VII

April 1996

Sharp Investing

The Big Bad Bear:
Coming soon to a Market near you?

The serious money on Wall Street is made in the aftermath of bear markets. Quick money is made in the chaos of crisis. Occasionally, major declines climax in circumstances of panic, as in 1970 and 1987, and then the limited risk and reflex opportunity is truly remarkable.
However, the public is mostly indifferent and unprepared at such times. It is the long-continued bull episodes such as exist today that draw the greatest public participation. Upside fireworks excite the imagination and spur greedy hopes. Precious little money is made at such times, but the bull mania is contagious. It is precisely at such times that greater fools rush to the marketplace. As dependably as winter follows summer, bear markets will follow bull episodes and inevitable panics will build with shocking speed. The opportunities of such crises will be repeated again and again for those who are prepared.
The beauty of these opportunities is that an investor need have no special knowledge, only the courage, discipline and money to buy when no one else will. Serious market money is made by buying stocks when no one will have them except at distressed prices, just as the profits of panic comes from buying into an overnight collapse.
Courageous investors in periods of crisis and panic are generously rewarded. Paradoxically, the highest market risks have accompanied years of high prosperity and confidence - 1919, 1929, 1937, 1946, 1972, and 1987 to name a few.

Let us differentiate between the two types of market corrections; bear markets and panics. Bear markets always follow bull markets (by definition) and generally last from 6 to 12 months, with an average decline of 34.8%, and are relatively rare with a dozen in the last century of investing. Panics can occur at any point in a bull or bear market, last only for two weeks on average, and have an average decline of 15%. There have been nearly a hundred documented panics in the last century of investing, about one every year. However, there has been only one panic (Kuwait invasion) since the 50 point Dow computer shutdown rule went into effect in 1987. The nearly 6 years since the last panic is a market record.

Dow Crashes 171! Pg 5

Panics are like air pockets, fast, furious and over before you know it. Bear markets are like a bad storm, they seem to go on and on. Panics are characterized by high trading volumes, as investors frantically sell all the way down. Bear markets are characterized by low trading volumes as investors are disinterested and immobilized in the slowly declining stock market and focus their attention elsewhere. The reason for panic is usually widely known, some sort of crisis, always temporary in nature. The reasons for bear markets are less understood, but happen mainly prior to a recession in the economy, although some bears have started

when the economy was strong. Whether the correction is a bear or a panic, there is opportunity for investors to benefit.
Panics provide a narrow window of opportunity, often only a couple of days, but almost always provide a quick and rewarding rebound. The only exception this century was the 14% drop over two weeks in 1990 when Saddam Hussein invaded Kuwait, which was followed by another 7% loss over the next several months. Even in this exceptional case, investors who bought in the panic and lost 7% more over the next several months found their portfolios up 43% by 1993. The other 99 panics this century provided an almost instant rebound, on average regaining that lost 15% in a matter of months. Therefore the best strategy in a panic is to fight human nature and buy, buy, buy when the crisis hits. It takes no special knowledge, excellent companies are available everywhere for a fraction of their previous price. Speed and courage will be amply rewarded regardless of the stocks selected during a panic.

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

A bear market is a different animal entirely. The rewards are not immediate and only long term investors need apply. Judging the bottom of the bear is a difficult task indeed. Just ask those who tried through the worst bear of my lifetime, the 1973-74 bear which lasted 22 months and 26 days, and seemed like a lifetime. Fortunately, there are several advantages to bear markets that make them even better opportunities than panics. First, the buying window of opportunity is ample, with the low often tested for 6 months. Second, a panic or crisis during a bear market often signals the bottom and takes the guesswork out of trying to time the bottom. Third, and most important, the average
gain 12 months after the bottom of a true bear market is a whopping 73%! This compares with an 8% average gain in the last year of a bull market. Yet investors fearlessly throw money at an old bull and shy away from the young bear.
Most fundamental investors such as myself will inevitably start buying into a bear market too soon, as the bargains become too good to pass up. However, good bargains frequently turn to great bargains in bear markets as investor psychology drives prices below reasonable levels the same way it drives prices above reasonable levels in an aging bull market.
The best thing to do then, when you think that prices can't possibly move any lower, is to spread out your buying program over six months. The next best thing to do is to buy quality high dividend yielding stocks (wonderfully abundant in bear markets) to tide you through the rest of the bear if you've bought in before the turning point. Other strategies include buying excellent large companies and small capitalization value companies which historically rebound strongly out of bear markets once it has turned the corner.
The common thread running through all these techniques is that an investor doesn't have to catch the exact bottom to benefit. A 73% rebound is forgiving as long as an investor does some buying within several months of either side of the turning point. The turning point, in retrospect, is invariably that point at which there is the least interest in the stock market and doom and gloom is strongest.
The beauty of the bear is that like a panic, it doesn't take a genius to pick bargains when the whole market is a bargain. The sting of the bull is that it does take a genius to find bargains when very few exist. In fact, I believe that Warren Buffett is the only investor able to still find bargains consistently regardless of market level. Even the great Buffett stayed out of the market from 1969 to 1972 because he could find no bargains, but was fully reinvesting during the 1973-74 bear.
In case you are thinking that your mutual fund manager is level-headed enough to buy into a panic or bear market, let me point out that he or she may recognize the bargains and be completely helpless to do anything about it. Just when the mutual fund manager needs cash to buy bargains the shareholders start redeeming shares in a panic and the manager not only has no excess cash to invest, he or she must sell to meet the heavy redemptions, which only adds to the panic atmosphere. The only

time your mutual fund manager has excess cash is at the end of bull markets when everyone is throwing cash at the mutual fund, there are no bargains to be had (by mere mortals anyway) and they end up forced to buy at the top. Buy high and sell low, one of the reasons why 8 out of 10 mutual funds underperform the market.
Everyone hopes to buy stocks near bear market troughs. But many are unprepared for the opportunity, either psychologically or financially, or through the constraints of institutional investing. Yet the very same investors fearlessly throw money at the market in the preceding bull mania. At Sharp Investments, we will arrive at these moments of opportunity cash-rich and confident. With regard to long term market timing, our motto is "to be fearful when others are greedy, and to be greedy when others are fearful".

Market Update

The only task more difficult than consistently picking winning stocks is predicting turns in the stock market; i.e. market timing. Short term market timing is even more difficult and anyone who purports to be able to provide this information should be viewed with skepticism. Even long term market timing is quite difficult as the future never quite exactly matches up with the past. The best that anyone can do is to compare current conditions against historical standards and make an analysis based on probabilities and the long term reliability of the indicators being used.
The three most reliable market indicators, as determined by research are:
1. Interest rates/Inflation
2. Business Outlook
3. Investor Psychology
We are going to look at each of these indicators and compare them against their historical standards.
1. Interest rates/Inflation
The 30 year treasury bond rate has hovered between 6 and 6.5% for the last year, down from 8% a year earlier. Inflation has averaged between 2 and 3% for the last year, also a bit under the historical average of 3.2%. Mortgage rates have approached 25 year lows in 1993 and 1995. All of these things have been bullish for the stock market this past year, the question is, where are these rates headed in the future?
At Sharp Investments, we use a variety of weekly index futures on interest rates to try and capture
consensus trends and get an idea of where rates may be 12 months from now. The current consensus is that rates and inflation will be flat or slightly lower a year from now compared to current levels. However, the consensus trend is slightly up as rates were predicted to be even lower a couple of months ago. Obviously, there are some mixed signals here but there appear to be no big changes either way on the short term horizon for interest rates. Keep in mind that consensus is only an average of what investors think will happen, the actual direction of interest rates is quite unpredictable. In fact, history shows us that inflation generally rears its ugly head when least expected or worried about.

Interest rates/Inflation are currently a neutral indicator for the stock market.

2. Business Outlook
The most popular indicator for business outlook is corporate earnings. However, taking raw earnings levels into account ignores the creative accounting employed by many corporations. Recently CEO's reported an average salary increase of 23%, mainly due to incentives in their contracts tied to increased stock prices. I believe that this is just one of the reasons why corporations have incentive to inflate earnings during good times.
It also works the other way as corporations like to dump everything bad out at the same time during tough times. This is done so that the subsequent reporting periods won't have any of the negative drag of a problem that can be written off earlier. Therefore I believe that good earnings are often not as good as reported and bad earnings are not often as bad as reported.
1995 saw record level earnings increases that peaked in June, and the trend has reversed and earnings have not only stopped growing at record levels, but have experienced negative growth from the peak ($35.18 for the S&P 500) to the current earnings ($34.1). To expect record earnings growth rates to be sustainable is like expecting to win the lottery twice in a row - unlikely.
Investors can use a normalized dividend yield growth rate to forecast business outlook without the corporate trickery. Dividend growth verifies the slightly bearish trend pointed out by earnings growth. I believe that while the business outlook is

still strong long term, there is a high probability of regression to the mean with corporate growth moving more towards long term averages. The economy has been slowing down and there is a good chance we may already be in a slight recession, although there are no signs of it being a severe contraction.

Therefore the business outlook indicator is slightly bearish.

3. Investor Psychology
There are three indicators of investor psychology which have good long term records of prediction.

A. P/E Ratio - The P/E ratio is an extremely good long term market psychology indicator. Anytime the P/E has been 8 or under the market has experienced a 25% average gain in the subsequent 12 months. Anytime the P/E has been 20 or over the market has experienced a 15% loss in the subsequent 12 months. The average market P/E is around 13. Any P/E in between these extremes has had a lesser degree of predictive power, as indicated by the charts below.

As I noted earlier, earnings have started to move down over the last two months, yet prices have continued to move up. The market P/E has just moved over 20 as March begins. Two months ago the market P/E was 16. What possibly can warrant a 25% rise in the market multiple over the last two months? I'll tell you what: speculation.

B. Dividend Yield - We are currently at the lowest level of dividend yield in the last 100 years, 2.1%. This is a very bearish indicator for the market as the average long term dividend yield is 4%.

However, the dividend yield has been under 3% (considered bearish) for the last couple of years, and has obviously been wrong for the last year. It's not obvious why a previously accurate indicator seems to have lost it's predictive power. Some say that it is because dividends no longer matter to investors, but I can tell you that dividends matter very much to me.

C. Market to Book Ratio - The book value of a company is the amount a company is worth should it have to be liquidated. Because most companies grow over time, they sell at a premium to this book value. If investors are optimistic about a stock's growth prospects, it sells at a high market/book multiple. An aggregate market/book ratio for the market gives an indication of how optimistic investors are about the prospects of the market in general. The average market to book ratio is 1.75, and is cyclical as seen below. The current level just passed 4.0 for only the second time in history. The only other time in history the market/book ratio went above 4 was the year 1929.

The investor psychology indicator is bearish.

When interest rates are stable, business outlook is neutral to slightly bearish, and investor psychology is bearish, the probability of a correction is high. The probability of a continued bull market is low, but still possible. If interest rates move down drastically, or if earnings increase dramatically again, the market will continue to rise. Neither of

these scenarios is very likely. I'm even more certain when you factor in the age of the current bull market, the fact that we are long overdue for a correction, and the wild 100 point swings we've experienced routinely in the market lately, that the odds of a correction are high.
However, we know that upside potential has been drastically limited and risk is high previously at these points in history. A lower risk, high return bear market or panic opportunity may present itself in the near future and I am perfectly content to sit on my hands a while longer waiting for better odds.
Warren Buffet stayed completely out of the market for 4 years from 1969 to 1972 during a long speculative bull market run, but made it all back and then some during the ensuing bear market. Serious money doesn't worry about missing out on the meager returns at the end of bull market runs, knowing that the real opportunity lies in the coming correction.

Late Breaking News

March 9, 1995 - An Opportunity for Serious Money?
This newsletter was written prior to the second largest one day decline in market history (points, not percentage). I decided to delay circulation long enough to add some thoughts about the big move, as I'm assuming most of you have more than a passing interest in this historic event. I am eternally grateful for the market cooperating with me and providing an excellent and timely exclamation point on this quarter's chosen topic. If only I'd been able to have this newsletter at your doorstep Friday morning.
The Dow Jones Industrial Average tumbled 171.24 points yesterday after being down more than 200 points earlier in the day. This was the largest one day percentage move in seven years at a little over 3%. While volume was heavy at more than 400 million shares, it was not of epic proportions. The reason for the big drop: February job creation was considerably higher than expected, i.e. the economy is stronger than expected, i.e. the Federal Reserve will probably not be lowering interest rates, which was not expected. In short, good news for
America was bad news for those speculating that further interest rate cuts were in the future.
As I write this the next day, I am struck by the similarities with Friday, October 17th, 1987, in which a 121 point loss was followed by the more than 500 point loss that was Black Monday. The chances of a 500 point loss or more on this coming Monday are remote at best, but millions of investors are sweating it out this weekend wondering if history will repeat itself.
There are several differences between the current environment and 1987. The Dow computer shutdown rule of 50 points was not in effect in 1987, which allowed computerized program trading to escalate the freefall. We'll never know if this rule limited yesterday's losses, or proved ineffective as the market still fell 150 points within a 2 hour period Friday. The bottom line - while computers may now be programmed to avoid panic, there is nothing to stop humans from panic. I don't believe the computer shutdown will make a big difference in a true panic.
The other difference is that there are currently many avenues for investors to place orders over the weekend, which was not the case in 1987. These orders won't be executed until Monday, but I'm sure that most of them will be sell orders. Therefore the probability of the market opening considerably lower is high. What happens after that is where it gets interesting. We have many new investors in the market that have never experienced anything like this. They stampeded into this market at the top with textbook predictability, and should they follow the historical pattern, will stampede out at the same rate, after considerable donation to the market.

There are three distinct possibilities for the coming days, weeks, or months:

1. The market stabilizes and see-saws its way back up to the 5600 level.
2. The market drops 750 - 1500 points in a short amount of time (panic).
3. The market drops 750 - 2000 points over a considerable period of time (bear).

What does this mean for us? If you are fully invested in this market, you are obviously hoping for the first scenario. If this is the case, at the very least let yesterday provide a wake-up call that the market can move swiftly in directions other than up. If a panic ensues, there is not a lot to be gained by bailing out at this point for those that are fully

invested. In times of panic, the individual investor is the least prepared to get out of the market. Phone lines will be busy, and brokers will be giving priority to their large institutional customers. Resist the panic. Take your lumps and ride it out, don't sell at the bottom - remember the rebound effect discussed in the first part of the newsletter. If the third alternative occurs, the dreaded bear, liquidating the more vulnerable holdings now may stem the losses, but a bear is tough to spot soon enough to do any good. This is why at Sharp Investments we turn conservative prior to a point that requires perfect market timing. The warning signs have been in place for a long time.
If you are in a conservative, cash rich position (as we at Sharp Investments have been for months) the potential for opportunity can be high with the correct strategy. You need to start a shopping list of companies you would like to own at bargain prices. The market stabilizing and creeping back up would be a sign that investors think that prices are bargains, but resist buying under those conditions. A 3% correction is not an indication that the excess risk has been driven out of the market, in spite of the dramatic way it was accomplished.
However, should we get a lovely 10-25% panic in the next several weeks, you can confidently start your buying program, as the risk is limited and the return potential high. If a slow death spiral ensues (the bear), beware buying too soon. We've had a 3% correction, but the average bear move is a 34.8% correction.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

If all this uncertainty makes your head spin, your heart beat too hard, and keeps you up at night, perhaps you might consider professional management. At Sharp Investments, we embrace uncertainty and panic as opportunities to take advantage of temporary market inefficiencies. Fear and greed do not figure in our analytical approach to investing. Unlike most other professional management, we feel no pressure to conform to short term thinking as we always take the long view. By having the flexibility to take advantage of the rare opportunity we put our clients in a position to significantly outperform the market over the long run. This approach has allowed Robert Sharp to extract nearly a 30% return from the stock market over the last 35 years. We can hardly wait for the market to open Monday morning.

There is no time like the present to call us.
Daniel Sharp 503-520-5000
Robert Sharp 360-253-3539

A disciplined approach spread over 6 months will increase your odds of buying near the bottom, putting your portfolio in a position to rebound.
Even if we are moving into a bear market, my opinion is that it won't be prolonged. The economy may be picking up steam again and interest rates are still predicted to remain stable. The most likely culprit for a bear type of correction is a reduction in corporate earnings, which is probable given that the record earning levels of early 1995 leave nowhere to go but down.

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