Investor Mettle Put to the Test as the Bull No Longer Rages

“So when the market plummets, as it will from time to time, neither panic nor mourn. . . . A depressed stock market is likely to present us with significant advantages.”

--Legendary investor Warren Buffett, in a recent report to his shareholders

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We may be on the verge of finding out just how many Warren Buffett disciples there really are in the world.

The U.S. stock market is in the midst of a serious pullback--that much everyone agrees on. And this downtrend didn’t just start last week. The Dow Jones industrials topped out at 5,778.00 points on May 22. With last week’s 1.4% decline, to 5,510.56, the Dow now has dropped 4.6% from its peak.

Most investors also know that the selling has been a lot more violent in the market for smaller stocks, which had enjoyed a spectacular rally in spring. The Nasdaq composite index of mostly smaller issues peaked at 1,249.15 points on June 5 and now has lost a not-insignificant 11.7% of its value.

When stock prices were rising seemingly nonstop a few months ago, a key argument advanced by the bulls was that “this time is different.” The 1990s stock rally, they said, could go on and on because of a unique confluence of factors: lean, highly profitable corporations, low inflation, the global spread of capitalism and a serious savings mind-set on the part of graying baby boomers.

By last week, the bulls were forced to concede some doubts about their happy confluence. Do surprisingly weak second-quarter corporate earnings reports--the handful that are in so far--signal that many U.S. companies’ profit growth is waning? Is inflation a growing problem or isn’t it? And did the 38% decline in net stock mutual fund purchases in June suggest that baby boomers have had their fill of stocks for now?

Suddenly the market faces too many hard questions, and conviction is in short supply. The easiest decision becomes the sell decision--which is what more investors opted for last week.

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This is not the first challenge the 5 1/2-year-old bull market has faced, of course. Recall that in 1994 the Federal Reserve Board doubled short-term interest rates to slow the economy. When the process began that winter, stocks plummeted, and the Dow index gave up nearly 10% of its value before stabilizing.

Does this market feel worse than that one? Interest rates aren’t up nearly as much as in 1994, and the Fed hasn’t even officially tightened credit yet. The Dow is off only half as much.

But to steal the bulls’ own phrase, this time is different in some unpleasant ways: Corporate profit growth was roaring in 1994, while it is almost certainly slowing this year, any way you measure it. And stock prices are a lot higher than they were two years ago. The Dow is up 50% since mid-1994.

In one important respect, Wall Street has to hope that this time is not different. Investors have become conditioned since 1987 to buy aggressively whenever the market has dropped sharply. And they have been rewarded every time, as stocks overall have advanced with remarkable consistency, especially in the ‘90s.

The fervent wish of every bitter market bear out there is that “buying on dips” will stop working--that stocks will drop, then drop some more, then drop some more, demoralizing each wave of buyers to the point where they swear off stocks forever. That’s the story in Japan so far this decade, with that market still off 44% from its 1989 record high.

But to see the beginning of something that horrendous in the current U.S. market setback, you’d have to bet on a tidal wave of bad news ahead: sharply higher inflation and interest rates and/or an economic recession and/or a collapse of corporate profitability.

All or some of the above are possible. But the prudent investor also should leave room for the possibility that things will work out OK over the next year--no recession, lower interest rates and quite decent earnings growth for many companies.

There’s another possibility too: We just get a normal (and overdue) bear market here, temporarily cutting 20% to 40% off the price of the average stock, before another up-trend begins.

If the bear is at the door, Buffett will be gleeful, because that master investor likes nothing better than to buy assets on the cheap. If you’re really in the market for the long haul, bear market declines present the kind of opportunity you pray for--the only way, really, to “buy low and sell high,” which is what smart investing is all about.

The problem, of course, is that it’s virtually impossible to know in advance how cheap the market can get in a downturn. If you wait for the Dow index to fall 20%, it may never get there. But in the meantime many individual stocks (and stock mutual funds) may lose far more of their value, becoming sensational bargains.

In fact, bear markets are happening all the time on Wall Street to individual stocks. Already, Ford Motor shares, at $30.75, are down 17% from their record high of $37.25 earlier this year.

That’s enough to convince Gail Bardin, co-manager of the Hotchkis & Wiley Equity Income fund in Los Angeles, to want to add to her Ford stake. With a 5% dividend yield on the stock, and the potential for an earnings surge from the company’s European operations if that economy picks up speed next year, Bardin said, Ford fits the profile of the kind of stock her firm was buying last week as others sold.

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Discipline is the key in a market that turns frightening, Bardin noted: If you have done your homework on an investment, and decide that it would represent true value at a given price, you have to be willing to step up if your price is reached. Last week, she said, “We were just doing some things that we had planned on doing, if we got the opportunity.”

Similarly, Denis Laplaige, manager of the MainStay Value stock fund in New York, said he was invigorated by the panic with which some investors unloaded stocks last week. “In some ways I’m really enjoying this,” he said.

He considers insurance giant Aetna Life to be a “screaming buy” with the price at $62.875 by Friday, down 20% from its recent peak. Aetna, Laplaige said, should earn $5.50 a share next year, giving the stock a price-to-earnings ratio of 11 in a market where the average stock is closer to 14 or 15 times estimated 1997 earnings.

Likewise, paper company Bowater’s shares have plunged from $54.375 last year to $37.25 now, as paper inventories have ballooned worldwide and prices have tumbled. But Laplaige is willing to bet that the paper business won’t be down forever. In fact, he said, “We think commodity [businesses] are going to do well” over the next few years, buoyed by growing demand in the developing world.

The caveat from “value” investors such as Bardin and Laplaige is that you have to have a solid reason for buying any battered stock in a market like this one. Buying depressed stocks is not like shooting fish in a barrel.

Or as Joel Dobberpuhl, co-manager of the AIM Value fund in Houston puts it: “Cheap is relative. Without earnings [underlying a stock] there is no value.”

That is why he is content to wait to buy many hammered technology stocks, he said. Just because the stocks have plunged doesn’t mean they can’t fall far more, given weakened computer demand amid excess inventories. “There are going to be a lot of good high-tech stories over the next five years, but we think we will get a better opportunity to buy them,” Dobberpuhl said. “With technology, we need to get to a time when we can see how the companies might surprise us with earnings on the upside.”

The lesson here is that even if this aged bull market resumes, the game is likely to get much tougher. Coolheaded, rational and intelligent stock picking will surely win the day.

But for the emotional, ill-informed or just downright clueless investor, the risks have perhaps never been higher.