E-Letter To Black Enterprise.com And Derek T. Dingle Re: Market Uncertainty

We always look forward to reading your Money Matters column. However, your July 10th column caused us to raise an eyebrow for the strength of its embrace of the stock market, in this deflationary environment.

We have been writing for the bulk of this year about how the stock market will not be able to break out of its recent bout with volatility, as long as the Federal Reserve continues to deflate the U.S dollar relative to gold. That is the real reason why investors, as you put it, have "yawned" at the Fed's 6 interest rate cuts. As we wrote to Dr. Irwin Kellner earlier in the year, lowering the Fed Funds rate does not inject liquidity into the marketplace, and at times a rate cut can even remove liquidity. I hope that you will consider this argument.

As long as the monetary deflation continues, it not only dampens investment sentiment, but also begins to pull down nominal corporate earnings. Some analysts are erroneously labeling falling nominal earnings as a "profits recession". They have accurately identified the effect but not the cause. As a result they are not recognizing that in a deflation, bonds outperform stocks. This is a historical fact. We wrote about this last Thursday in an analytical commentary, Deflation Has Bonds Looking Sweet.

We agree with Black Enterprise's wealth-building goals and your statement in your recent Money Matters column:

"These recent developments should serve as the impetus for you to redouble your wealth-building efforts. As we mentioned last year, African Americans must realize that the decision to save and invest discretionary income versus embracing compulsive spending is a zero-sum game"

However, we disagree with the lack of a qualification in your efforts to encourage Blacks to jump into the stock market, when prices are at all-time highs, in an effort to obtain long-term gains. You wrote:

"I believe the stock market will continue to provide investors with significant gains for the long term. History bears out this assertion: Between 1926 and 2000--taking into account the Great Depression, recessions, bear markets, and corrections--large-cap and small-cap stocks have produced returns of 11% and 12.4%, respectively, compared to such "safe" investments as U.S. Treasury bills, which produced a return of 3.8%. The rate of inflation during this 74-year period was 3.1%."

This is a common rationale for jumping into the stock-market and it is generally true. But general truths don't guarantee specific profits for individual investors. While we admire what Warren Buffet, as the premier example, has been able to do by holding on to stocks for decades and watching them grow, we absolutely do not feel that most Blacks share his investment profile, nor are they aware of the periods of volatility that one must weather in order to reap the returns that Buffet has, through long-term investment in the stock market.

While the long-term strategy sounds nice on paper, it glosses over the fact that in the short-term, stocks can be very risky. And it also does not spend sufficient attention to the fact that in the time frame that you refer to – 1926 to 2000 – the stock market has often produced negative returns and in some periods, it has taken investors 30 years to get back to "even" in constant dollar terms.

In just the past 40 years alone, there have been 11 major stock market declines that have lasted an average of just under 12 months, causing the Dow to drop an average of 30 percent. And since 1881, the stock market has declined an average of four out of ten years.

Again, we agree with your opinion about the stock market in the long-term, generally speaking, but think that it is important to convey to first-time investors that in times of deflationary-induced stock market volatility, there exist less expensive, and more lucrative investment strategies than "patient equity investing". Quite often an investor should consider U.S. Treasury Securities in climates like that which exist today. With Treasury securities, in an era of equity instability, the investor does not only receive the coupon payment, but also the capital gain that results as the price of bonds moves up in the opposite direction of its yield. This combination produces a greater return than that which is possible by simply holding onto to equities that are moving down or sideways. Another advantage that bonds have over equities in times like these, is that, during a deflation, idle dollars become more valuable each day. With bonds, in a deflation, principal is never eroded. This is not the case with equities.

We are with you in the long-term equities boat and have identified several great equity investments, but we think that you need to show investors how to paddle during storms and choppy waters.

Telling them to just have faith in historical patterns isn't enough, especially when the capital they have invested is so small and unlike with Warren Buffet – easily destroyed in short-term volatility.

Sincerely,

Cedric Muhammad
Publisher
BlackElectorate.com
August 14, 2001

Disclaimer: The above does not constitute a financial investment advisory. All readers are strongly encouraged to seek the advice of a financial adviser or licensed investment professional prior to making any investment in either the domestic or international stock or bond markets.

Tuesday, August 14, 2001