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The Mathematics of a Market Rally

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Index October 2003 QTD YTD Description
S&P 500 Index* 5.50% 5.50% 19.42% Large-cap stocks
DJIA* 5.67% 5.67% 17.50% Large-cap stocks
Nasdaq Comp.* 8.13% 8.13% 44.68% Large-cap tech stocks
Russell 1000 Growth 5.62% 5.62% 24.11% Large-cap growth stocks
Russell 1000 Value 6.12% 6.12% 20.84% Large-cap value stocks
Russell 2000 Growth 8.64% 8.64% 43.21% Small-cap growth stocks
Russell 2000 Value 8.15% 8.15% 35.72% Small-cap value stocks
MSCI EAFE 6.24% 6.24% 26.25% Europe, Australasia & Far East Index
Lehman Aggregate -0.93% -0.93% 2.81% U.S. Government Bonds
Lehman High Yield 2.02% 2.02% 24.23% High-yield corporate bonds
Carr CTA Index 1.88% 1.88% 12.14% Managed futures
3-month Treasury Bill . . 0.95%
Through October 31, 2003. *Return numbers do not include dividends.

As reported in earlier editions of this newsletter, a plethora of investment gurus, including such luminaries as Berkshire Hathaway’s Warren Buffett and First Quadrant’s Robert Arnott, have stated that equity returns going forward will be significantly lower than the spectacular run of the last two decades. The reasons cited vary, but typically include the present high valuation of the stock market; significantly slower earnings growth; and much lower dividend rates, which have historically been a large portion of the returns of equities.

Most rational investors will find the above argument nearly irrefutable. But if one looks even higher–at the index returns at the top of the page–it’s hard not to find some disconnect between theory and the real world.

Explaining this year’s big run in the stock market is no easy task. William Bernstein, author of The Four Pillars of Investing (McGraw-Hill, 2002), takes aim at this perplexing question in the Fall issue of his online journal The Efficient Frontier ( According to Bernstein, the performance of an asset class is the sum of its fundamental return and its speculative return. The latter, which he calls “noise,” is a function of the standard deviation of the asset class and the effects of short-term trading. In his view, an asset class that is the target of momentum traders (i.e., those who buy the strongest-performing markets and sell the weakest) can deviate significantly from fair value, only to crash back to earth after the fervor subsides.

Another explanation may lie in the strength of the economy. At this point, there’s no question that corporate spending is on the rise. The Philly Fed Survey came in much stronger than anticipated in October. The Empire State Survey of manufacturing activity confirmed a similar pattern. Global semiconductor sales were similarly buoyant.

Another positive factor is the persistence of low short-term rates. With the Fed holding onto its accommodative policy, investors have little choice but to redeploy capital from fixed income to equities. This is especially true for plan sponsors, who find themselves in a considerable hole after three years of negative returns.

Indeed, we see equities rising through year end, more because of friendly asset allocation policies than increases in earnings or other positive fundamental underpinnings. Recent heavy redemptions from scandal-ridden mutual funds will only cause the market to rise in a more orderly fashion, as large institutional players keep adding to their positions at every market drop. In our view, it’s stocks for the short run, and caution for the long run.