When I was a college intern for the daily Missoulian in Montana, I wrote a couple of editorials that were none too popular with our readers. One took the Indian side in a local dispute over water rights. Another opposed, on First Amendment grounds, efforts to close an adult book store. In short order the paper published dozens of letters questioning my skill as a journalist, my understanding of the West and my ancestry. The experience taught me that someone who wants to spout off in public needs a thick hide. We all are accountable for what we say. After six years of publishing Sentinel, it is time for some more accountability. Many of this newsletter’s articles offer my Delphic pronouncements, because I believe most financial decisions should be guided by our expectations about the future. Enough time has passed to make it worth revisiting some of my old forecasts, in the hope that by looking at what was right and what was wrong, I can improve my own decision making and yours.
Gift and Estate Taxes
May 1993: Much has been made about last year’s abortive effort in Congress to reduce the $600,000 gift/estate tax allowance (the “unified credit” amount) to $200,000. Just this week, another somber-sounding tome crossed my desk warning of attempts to revive the proposal later in 1993 and urging readers to make their big gifts now. (This particular somber-sounding tome came from an insurance company which suggests that the big gift would best be made in the form of an insurance policy.)
....First, the political facts of life. One can never be sure what legislation Congress will pass, but last year’s attempt to gut the unified credit died in committee for good reason: The small business and farm communities went ballistic when they learned of it. First enacted in 1981 (and fully phased in in 1986), the unified credit allows relatively small estates to avoid federal tax, removing the need to borrow against or liquidate a small business when it is passed from parent to child. With the unified credit in place, the estate tax is a problem only for the wealthy; take it away (or significantly reduce it) and the estate tax starts to hit the middle class. The Clinton Administration tax proposals hit the wealthy quite hard, but make no move against the unified credit for obvious reasons.
What happened: Nothing until 1997. Then Congress raised the unified credit amount from $600,000 to $625,000 in 1998 and $650,000 in 1999, with an ultimate increase to $1 million scheduled to be phased in by 2006. When populist rhetoric collides with political reality, reality is the smart bet. The policy trend in this area led me to write in May 1998 that there is a better-than-even chance that estate and gift taxes will be repealed by 2010. Time will tell.
Stock Market Gyrations
February 1994: On Feb. 4 the Federal Reserve Board boosted interest rates for overnight inter-bank loans by one-quarter of a percentage point. Investors immediately dumped stocks and bonds, sending the Dow Jones Industrial Average down 96 points for the day and some interest rates to five-month highs.
....Is the market poised for a 1987-style collapse? Nobody can be sure, unless by the time this reaches you the market already has crashed. (At this writing, it seemed that the recent dip was just a pothole, not a crater.) If things calm down we will be tempted to put the events of Feb. 4 out of our minds. That, however, could be a big mistake. The markets will crash sooner or later; they always do. A good investor should build the downturn into his or her long-term plan so that when it occurs it can either be ignored or used as an opportunity to make some attractive purchases.
How did you react when the news broke that February Friday? Were you tempted to cash in your chips? Did you fret that you had stayed on the roller coaster for one ride too many? Were you worried that there would be a repeat of October 1987, when many who wanted to sell could not get through to their brokers and mutual fund companies?
If the whiff of market panic left you shaken, you are probably in over your head. Despite the attention we pay to pundits who declare that the market is about to go up if it doesn’t first go down, studies have repeatedly shown the futility of trying to time the markets. Except, arguably, for professional traders, the only reliable way to make money in the markets is to invest for the long term and ignore short-term fluctuations.
February 1996: Despite their financial travails, Boomers are probably also largely responsible for the exceptional performance of the U.S. stock market during the past 14 years. This long rally, which has had only a few brief interruptions and no long-term setbacks, began just as many Boomers were beginning to climb the career ladder and earn serious money. Lacking company-funded pension plans that promised a fixed retirement income, Boomers have poured their assets (and, through profit sharing and 401(k) plans, their employers’ as well) into stocks and especially into mutual funds that buy stocks. This money has provided a wonderful base for the stock market expansion. While portfolio managers who worry about quarterly reports are inclined to panic at every market downdraft, individual investors like the Boomers have tended to ride out the storms for the simple reason that there is nowhere else to go.
In other words, what we have seen during the past decade and a half may be as much a structural stock market rally fueled by demographics as a financial rally supported by lower interest rates and greater competitiveness.
But what happens next?
If my theory is correct, there should be a lot of life left in the stock market climb notwithstanding short-term corrections such as the recent technology swoon, or even major craters like the Crash of ’87. Such declines would only be temporary interruptions in the forward march.
January 1997: When the stock market comes off a very strong year, investors naturally worry that the gravy train is about to be sidetracked. It was no surprise when The Wall Street Journal year-end review of mutual funds cautioned that “This year, many fund managers say, the pessimists could be right and the markets could take a dive.”
That article was published last year, on January 5, 1996. The U.S. stock market went on to a second consecutive banner year, with the Standard & Poor’s 500 index up more than 20% on top of 1995’s 34% advance.
So much for taking a dive. This goes to show not the ignorance of the pundits, which remains debatable, but the futility of trying to time the markets. Yet investors from the swashbuckling fund manager to the toe-in-the-water novice persist in this most counterproductive behavior.
I can tell you with 100% certainty that the market will crash, but I can’t tell you when. Nobody else knows, either. What we know is that while the market has advanced at a healthy clip for the past century, it has been an advance punctuated by shocks, stalls and slowdowns, some of which last for years. Meanwhile, the market’s upward moves have often come in brief, sharp rallies that leave behind investors who are prone to be “defensive” when things look bad. The successful investor must accept the bad times with the good.
What happened: How else can we say it? Market timing doesn’t work. Although the jury is still out on our 1996 suggestion that the maturing Baby Boomers are creating a “structural” bull market, the fact remains that the S&P 500 index posted strong gains in 1995, 1996, 1997 and 1998, despite global market turmoil in the two latter years, and reached new highs again in the first half of 1999. Yet many investors who worried about short-term turbulence missed the crucial updrafts that followed brief but sharp market slides. The good news is that many other investors have gotten the message, stayed with their programs and posted fine performance figures. Asset allocation, not stock picking and especially not timing, is the key to investment results.
November 1995: Hungary is supposed to be one of the bright stars of the expanding investment universe. Even in the communist years, a fairly tolerant attitude toward enterprise gave this country a higher living standard than most of its Warsaw Pact partners. Today, with a functioning democracy, a policy of privatization and a society relatively free of ethnic strife, Hungary is widely viewed as one of the safest bets among the former Soviet republics and satellites.
The reality, however, is that Hungary and its peers will soak up investment like a sponge for decades just to reach a level of development that can support modern Western-style commerce. The problem is a lot bigger than the antiquated telephone system that receives so much attention in the West. Decent office space is hard to find in the capital and nonexistent everywhere else. The expressways running out of Budapest in all directions quickly turn into slow and dangerous two-lane roads, clogged periodically by horse-drawn carts and bicycles. Key rail links have just a single track. When you finally get where you are going you find that hotels are scarce and decrepit, except in Budapest where the numerous Western establishments are merely overpriced. Homes and apartment buildings nationwide are literally crumbling after a half-century of neglect. And people reared under communism need to unlearn a lifetime of bad habits before they can prosper, evidenced by the fact that though this country is struggling to lift itself out of poverty, it virtually shuts down through the month of August for a vacation it cannot afford.
May 1997: Its obvious poverty notwithstanding, S√£o Paulo (pronounced SAN POW-loh) is a busy metropolis of 18 million people. The highways leading downtown are jammed with morning rush-hour traffic. True, nearly all the cars are old, tiny and without air conditioning in the tropical heat, but the owners at least can afford to own and drive them. Shining subways deliver still more workers to their jobs.
As we approach my hotel I notice long lines snaking around the block in front of a closed doorway. My host informs me that the crowd is waiting for unemployment and other government benefits to be disbursed later that morning.
Thus I am introduced to the realities of a growing Third World economy, circa 1997. The potential is enormous and the recent progress is encouraging, but these folks have a long, long way to go before their economy and society resemble those of the post-industrialized world. The potential risks of economic failure here are as palpable as the potential rewards of success.
What happened: The Third World financial crisis began in Thailand just a few months after my account from Brazil was published. In August 1998 the crisis culminated in virtual financial meltdown in Russia. Brazil was driven to seek international financial aid three months later. The good news is that small, relatively Westernized and reform-minded economies such as Hungary and Poland held their own despite the turmoil, and even Brazil has stabilized lately. Our warnings about instability in developing markets clearly were timely. Our long-term optimism about Brazil, and our skepticism about politically unstable economies such as Russia, Indonesia and China, are still being tested.
February 1995: Can a business survive by poisoning its customers? Assuming that it can, might it be a good investment?
This is the issue confronting the tobacco company investor. An amazing number of intelligent people treat tobacco stocks as ordinary investment vehicles, to be traded based on the usual criteria of earnings, dividends, market prospects, etc. I believe our grandchildren will regard this the way we view 1920s investors who took stock tips from shoe-shine boys: As the amusing but foolish behavior of people who let their money get in the way of their good sense.
Tobacco companies are in a class by themselves. The normal, ordinary use of their product causes serious and certain physical harm to the customer, and widespread economic damage to the customer’s family, employer and government. As a result, the tobacco business has more in common with a Ponzi scheme or a game of musical chairs than with a normal investment. Eventually, but at an unpredictable time, courts or legislators will reallocate the burdens of tobacco to those who presently reap the benefits. Whoever happens to own the business at that point, loses.
Or, as Philip Morris said in the notes to its 1993 financial statements, “Management believes that the ultimate outcome of all pending litigation matters should not have a material adverse effect on the Company’s financial position. However, management is unable to make a meaningful estimate of the amount or range of loss that could result from an unfavorable outcome of all pending litigation.” In other words, we think we can put off the day of reckoning indefinitely, but there is no telling what will happen if we can’t.
Leaving aside any discussion of ethics or “social investing,” there is no reason for an investor to believe that tobacco companies can forever avoid accountability for the enormous costs their product imposes. The U.S. nuclear power industry is all but extinct as a result of safety and regulatory burdens imposed after the Three Mile Island accident in 1979. If we can kill off nuclear power with nary a second thought, who will cry if the tobacco companies go broke? Only the people who make their living in the industry.
What happened: The tobacco industry has been as well-served as ever by its lawyers, though they are fighting a rear-guard action that cannot go on indefinitely. As the trickle of pending lawsuits in 1995 became a flood, the industry negotiated a comprehensive global settlement that included a ban on future punitive damages. When that failed to pass Congress, the industry made a surprisingly favorable settlement with the states. This settlement may hold back the litigation tide for years, especially if the companies succeed in preventing the states from disclosing damaging documents to other potential claimants, such as employers, insurers and unions.
What about investors in tobacco stocks? If you bought Philip Morris on January 31, 1995 and sold three years later — shortly after the settlement with the states was announced — your annualized return would have been 30.9%, even better than the S&P index’s torrid 26.7% performance. Investors in RJR Nabisco, on the other hand, saw virtually no gain in their investment over the same period. So, was our 1995 article on the money, or just blowing smoke? You decide.