Dateline: 9/7/98

It's been a turbulent week in the markets. The DOW had its second highest single day point drop in history Monday. Then it had its second highest ever single day gain on Tuesday. After that it sputtered and....well, it ain't necessarily dead yet! But it may be close.

Meanwhile the Canadian dollar has made a solid comeback rebounding from a low of almost 63 cents to almost 66 cents. The TSE also showed more resilience than the DOW, gaining on days the DOW contuinued to falter.

What can we make from all this? Where are the markets headed? Your scribe has written several times over the last year to be aware of what the bears were saying and to be cautious. Now seems to be an opportune time to revisit this area again.

The Q-Ratio

If you haven't already seen it, I highly recommend the latest issue (Sept. 11, 1998) of Canadian Business with its feature article "How You Can Outsmart a Bear Market".

The article discusses the various factors pointing to a probable bear market - overvalued stocks, shrinking profit margins, the Asian crisis, the Russian meltdown and more, and goes on to discuss what investors can do to prepare and to cope.  But of particular interest is a sidebar piece on something called the Tip of the Iceberg about a concept called the Q-ratio.

This concept was developed by 1981 Nobel Economics Laureate James Tobin. The Yale professor hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs.  So the ratio of all the combined stock market valuations to the combined replacement costs should be around one.

Personally I think this is not correct. The stock market valuation projects future earnings and can increase the market value accordingly. In fact, Tobin himself points out that the ratio does not reflect intellectual assets. Obviously Microsoft is worth a lot more than the sum total of its physical buildings and structures.

That said, though, there is a strong element of common sense in the notion of the Q-ratio. Just as we wouldn't pay more for a chair, a book or a stereo than it would cost to replace it, so it is with stocks. Why would one want to pay more for a company than it would cost to replace it? Whatever the impact of intellectual property in the mix, there is a strong correlation between replacement cost and market valuation.

Looking at markets over the last seventy years, analysts using the Q-ratio have shown that the ratio spiked to levels over 1.5 before each major market crash. In 1929 it spiked to over 2. In 1937 to 1.7. In 1968 to 1.8. And in 1972 to 1.5. Today (or at least before the crash on Monday) the Q-ratio was approaching 2.4, an unprecedented level far surpassing that of 1929.

Analysts Andrew Smithers of London, England's Smithers & Co. Ltd., figures the market had been trading at 2.2 times its real value. Even with the recent 20% drop, it is still trading at excessive valuations today. Smithers admits, though, that he turned bearish in 1993 and missed out on one of the greatest bull runs in history!

Is the market set for a recovery? Is it set to decline further? It's hard to say for sure. In today's technology driven market, intellectual property plays a considerably greater role than before. Some high valuations may well be justified. (See my review of The Gorilla Game, which argues that high market caps are justified for some companies like Microsoft, Intel and Cisco.)

Nevertheless, prudence and caution ought to be the watchwords of investors today.

So What's Good?

The Canadian Business article discusses several options for safe investment in these uncertain times. Basically it's "let's get back to fundamentals", which means look for value. Look for solid undervalued stocks and value-oriented mutual funds. Tim McElvaine, manager of the Cundill Security Fund, recommends Canadian natural resource companies. And events of the last week make him appear prescient.

Gold has leaped forward. Barrick Gold stock shot up 25%. Many analysts say the rebound of the Canadian dollar is based on strengthening of commodities prices. The TSE has certainly been bolstered by the resurgence in gold.

Others cited in the Canadian Business article recommend Segregated Funds for safety, Dividend Reinvestment Plans (DRIPs), and blue chip quality stocks with strong yields.

In the high tech field, avoid concept companies with high P/E ratios and low revenues. Go for the solid well established giants. Canadian Business, in a sidebar, recommends Northern Telecom and CGI Group. Even though they have fairly high P/Es, writer Andrew Wahl argues that they have solid growth potential and are not speculative. He also recommends Hudson's Bay Company, Petro-Canada and Trans-Canada Pipelines.

Here's a suggestion of my own worth considering. If you sold off some investments, particularly mutual funds, before the big dip, start using the cash to re-invest using dollar cost averaging. For example, I sold off a significant chunk of my AIC Advantage holdings at around $75. AIC Advantage is now under $60.

Uncertain whether the market will rise for a while before crashing even lower, or whether it will descend steadily downward for a while to come (the 1973-1974 bear market lasted two years) it would be prudent for me to start re-investing the $5000 I now have sitting in AIC's Money Market Fund into AIC Advantage at the rate of $200-$500 a month. It would take between 10 and 25 months to fully re-invest the money. My inclination is to go long term and only re-invest $200 a month. Over the long term, I'm still keen on AIC Advantage, but it may be in a prolonged slump if a bear market ensues.

The gold bugs, meanwhile, are turning very bullish on the yellow metal right now, and they have good reason. Recently selling at unprecedentedly low levels - $270 an ounce, gold has rebounded to $285. Some analysts like Steven Jon Kaplan predict the gold price will surge to well over $1000.

I have to be skeptical of this. Production costs for the senior gold producers have been plunging. Canaccord Capital reported at the end of July that Placer Dome's average costs have gone down to US $150/ounce from $208/ounce the year before. Costs at their Pipeline mine were an incredibly low US $51/ounce. Placer's costs are even lower than American Barrick's of US $183/ounce.

On top of low production costs, there is still a huge overhang of central bank gold. There are some fears that the worsening crisis in Russia may see the Russians selling gold to bail out their troubled economy.

As a general rule, commodity prices fall over time. This was established empirically by the late economist Julian Simon and he expounded on this in his remarkable book, The Ultimate Resource. In fact, Simon won a notable wager with doom and gloom purveyor Paul Ehrlich in which Simon bet that the price of any five commodities of Ehrlich's choosing would fall over ten years. I believe Simon's thesis is correct and gold is no exception. (Wired Magazine did a superb article on Simon and his work in 1997.)

That said, gold prices are determined by demand as well as supply. With the U.S. dollar faltering, there could be a surge in demand if people no longer regard the greenback as a safe haven. A strong hedge position in gold would not be unreasonable in this time of uncertainty. (I just bought additional shares in Dynamic Precious Metals last week and am considering buying stock in some major gold producers.)

Before a few updates, be sure to check out my Bear Necessities collection of Net Links about bear markets. In particular, please revisit Lowrisk.com's 1998 chart.

Update on previous articles

Those of you who have been following the mutual fund portfolios I started here in December know that two of the portfolios were liquidated for cash before the crash. The third was at 80% cash. The remaining 20% was sold off on Tuesday and it too is now 100% in cash. These portfolios, of course, are based on specific buy and sell criteria that don't accomodate the decisions mentioned above - like buying Precious Metals funds, until those funds really start to take off.

The two billionaire stocks - Microsoft and Berkshire Hathaway, have both suffered declines in the current upheaval. Nevertheless, Microsoft is still well above the $83 price it hit when the feds launched their suit against the company. Berkshire peaked at $2700 this year and has declined to $1990, still up considerably from its January 1 level of $1595. Both are holds in my portfolio. If you have the money, you may consider buying more. (I have the money but it would push me over my 20% foreign content levels in my RRSP). Berkshire Hathaway, incidentally, is about to merge with General Re, which would make it the largest company in the U.S. with a net worth of over $58 billion (June 30 prices). The AGM to approve the merger takes place September 16.

ATI Technologies has taken a hit declining to around $16 from over $20. It is a hold in my portfolio. Expect a solid rebound in the fall and winter when new earnings reports come out. This is not a speculative stock, but a solid producer wih a great track record.

Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions. The author holds interests in a number of the funds mentioned in this article.

Investing (Canada) Notes:

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