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Friday, January 22, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

The Bubble's Going to Burst Sometime

There has been a good deal of press coverage lately discussing whether our markets are in a "bubble" phase. I don't know whether that will prove to be the case; we'll have to wait until a pop does or doesn't occur to find out definitively. What I can say is that we are in a market that has seen extraordinary returns over the past 15 years as numerous positive economic influences converged. The current valuations in the market appear to assume that those trends will continue unabated into the future, which is extremely optimistic.

One thing I've learned over the past decade of following various securities markets is that you should always be prepared for the unexpected to happen. Certainly very few folks in 1982 would have projected the kind of bull market that was about to begin. At the start of 1998, many people were skeptical that the major indices would achieve 20%+ returns for the fourth consecutive year because never in history had the market done that. Lo and behold, the S&P 500 created new historical precedence by gaining 28%. Expect the unexpected.

Fortunately, most surprises over the past decade have been extremely positive for investors (such as plunging interest rates, the taming of inflation, and soaring corporate profitability). Many people believe these trends will continue indefinitely, justifying the current stock prices. I have no idea what will happen over the next thirty years, but my guess is that there will be some volatility in these key variables that will not always boost stock prices.

Why do I anticipate these variations will occur? Let's look at the history of some macroeconomic inputs. In the late 1970s and early 1980s, we were faced with outrageous inflation and interest rates. The interest rates on 30-year Treasury bonds soared above 13% as investors feared inflation would continue to run rampant forever. Due to myriad factors, less than 20 years later, newly issued 30-year bonds are providing yields that are more than 60% below that level as investors perceive inflation is permanently under control.

Now, I can add as much insight into specific future interest rate movements as I can about the mating habits of the fruit fly (meaning nothing). It doesn't seem unreasonable, however, to expect that sometime in my lifetime there will be real and perceived threats that interest rates will rise. When that happens, the value of stocks will most likely come down, potentially significantly.

Another example of how quickly (and dramatically) the whims and perceptions of investors change can be found in foreign currency. In the middle of 1995, investors fled the U.S. dollar in favor of the Japanese yen. During this period, a dollar could buy fewer than 80 yen. Five years earlier, the dollar purchased over 150 yen. I can still remember all of "the pros" saying that the dollar was going to continue falling forever. Less than four years later, the dollar has risen over 40% to 114 yen (down from its recent peak over 140 last fall). Macroeconomic variables invariably change over time, impacting stock prices.

I could delve into numerous other examples of dramatic volatility in the financial markets over the years, but you probably get the idea. How do these affect valuation? If inflation stays below 2%, long-term interest rates remain around 5%, and corporate profitability meets forecasts of strong growth, most stock prices probably aren't overvalued. If one of these variables (or the 1,000 others that go into stock prices) do change, we may find that many stocks are overpriced in the short-and intermediate-term. Of course, equities could go much higher for a number of years before these negative surprises show their faces.

With so many fundamental elements of our economy strong, it is understandable that most people aren't too concerned about the future. When things are going so well, it's easy to become complacent. Nonetheless, my imagination doesn't need to be stretched too far to envision a period where inflation rises substantially or profitability growth ebbs for a period of time. Maybe it will be 15 years from now, maybe it will be tomorrow. I certainly can't tell you when. After having unsuccessfully predicted somewhere around eight downturns over the past three years (being right once -- for a month), I no longer play that game.

Instead of focusing on the virtually impossible task of projecting when negative surprises will pop up and impact stock prices, I simply remain mentally and financially prepared for such events to happen. In doing that, I ensure that a "bubble bursting" would not have a cataclysmic effect on my life.

Knowing the historical long-term outperformance of stocks over other investments (even when including such disastrous periods as the Crash and the 1973-74 tumble), I feel very comfortable plowing my long-term investment dollars into stocks. In doing so, I know that this money most likely will be invested in at least one market crash. When the calamity strikes, I plan to keep that money invested in equities and continue putting new dollars into the market as my income allows. This strategy has led to terrific returns for other investors throughout this century.

So, are we in a bubble? I don't know. In my opinion, there are many indications that we are. Does that mean you should stop investing? Absolutely not. Predicting the timing of short-term market moves is extremely tricky and generally unrewarding. Should you be prepared for a bubble to pop? You betcha. It may not be this decade, but it's probably going to happen sometime if you're investing for the next twenty to thirty years.

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