First, the Bad News...
To me, it seems highly probable that
we're now in the super-bear market that Money Magazine and my own sources have
been predicting. It didn't arrive in 1998 when it was expected, but instead, was
about one-and-a-half years late. But these stock market cycles most assuredly
don't run on railroad time. That's bad news. We all want the super-bull market
to resume. Still, knowing that it may not, and thereby avoiding a round of
financial shrapnel should be worth something in its own right.
It's so counter-intuitive that it's hard to believe, but let
me reiterate what Figure 2 reveals: that the long-term, inflation-corrected
growth rate of the popular U. S. stock indices has been only 1.3%-1.4% per year.
To see it, all you have to realize is that the Dow-Jones peaked at 400 on the
Dow in August, 1929, just before the Crash of '29. The consumer price index has risen by a factor
of almost exactly 10 since 1929, so that 400 translates into about 4000 (Figure
1) in
today's dollars. The January, 2000, stock market peak was about 12,000 in
today's dollars. That works out to an inflation-corrected gain of only about
1.5% per year. And note that the Dow Jones Index in early 2000 reflected a stock
market that had reached its highest overvaluation in history. A peak on the Dow
of 9000 to 10,000 would have been more reasonable number to compare with the 4000 peak
in 1929.) Add in dividends and inflation, and you come up with a number a bit
lower than the 10.5% per year that's bandied about as the average rate of return
on stocks since 1926. But 1926 isn't the proper year to use. In 1926, the stock market was only about half as
high (Figure
1) as it was at its peak in 1929. Using this inappropriate value, the ratio
becomes 12000 to 2000, or about 6-to-1. This boosts the apparent long-term
return on stocks by a factor of 2 over the 71-year period, bringing the average
rate of return to about 2.5% per year. But you're comparing apples to oranges,
since 1926 was a midway point for the market, while the year 2000 saw an
unprecedented in overvaluations. Stock pushers like to quote this 1926 figure
because it adds about 1% to the average rate of return over this time frame.
"Figures don't lie but liars sure can figure.")
Actually, a more representative pair of numbers for the
71-year period might be the current value of the Dow index that would match
either the price-to-dividends ratio or the price-to-book ratio of the Dow at the
time of the 1929 crash. That would probably be between 9000 and 10000, and would
yield a long-term, real rate of rise of the Dow index of perhaps, 1.2% per
year.
Now let's look at the recent stock market between its
super-bear market bottom, when the Dow hit 776 in August of 1982, and its recent
super-bull market peak of 11,800 0n the Dow in January, 2002. The ratio of
the bull market peak of 11800 to the bear-market trough of 776 is about 15.
Spread out over an 18-year period, that implies an average rate of rise of about
15% per year. Part of that rate of rise represents the average rate of
inflation, which I'll guess to be about 4% per year. A small part of it occurs
because of a rising output of goods and services, which during this
favorable economic period, might have been, perhaps, 2% per year. That means
that about 9% per year is attributable to inflation of stock prices to record
levels of inflation.
To say it another way, between 1982 and 2000, investors bid
up the average price of U. S. stocks by a factor of 4.5!
That averages out to an average yearly rate of rise in after-inflation stock prices of about
9% a year due to
competitive bidding among investors. Add in 4% a year for inflation and, perhaps,
4% a
year in average dividends, and you've got a fabulous 19% a year average rate of return on
equities for 18 years! Wow! Now crank in the Crash of '87, which reduced
values from 2700 to 1700 more or less in a few months time, and then consider the
pullback of 1990, and you'll be left with some really impressive 20%, 30% and
even 40% up-years. Meanwhile, behind the scenes, the inflation-corrected
long-term average in this index is going to rise by only 2% a year, which is
well above its super-bear market rates of rise of less than 1% a year. And
starting in 2000, the system will presumably deflate again by a factor of 4.5,
with several heart-warming up markets and some inflation to mask the actual
deflation of value of stocks that are bought and held.
For most investors, the stock market is a shell game, a
socially acceptable form of gambling. That's because we think we're going to
make a killing in the stock market. And we do, only the victim is ourselves. The
problem is that over the short term, we may make a killing, but over the long
haul, we lose it all back again. We're playing against professional gamblers.
(And I've been as guilty of this as anyone.)
When the stock market is on one of its long upward
legs, everybody wins, and some people win big! We all share in this dream of
greed and big money. When the stock market is going up, we don't want to sell
because it may go higher tomorrow, and higher yet next year. We don't want to be
left behind. When the stock market falls, those of us who have invested for
awhile know that we must keep our money on the table. Our losses will become
real only if we sell while the market is down. The market will come back in two
or three years, and that's the time to sell. But then it's hard to sell when
everything is going to the moon.
Most of us haven't been investing long enough to have experienced these
stock market super-cycles more than once I
invested through 13 years of the 16 years (1969 to 1982) of the last
super-bear market without realizing then what was going on.
The stock market conditions us Rubes, "in the sappy
insouciance of our urban indiscrimination", to march blindly off its cliffs
like lemmings. It's notable that the legends of Wall Street--men like Peter
Lynch, John Templeton and Warren Buffet, the "sage of Omaha"--all
admit that they can't time the market. These men invest in companies, without
regard to the vagaries of the stock market as a whole. If the company prospers
and grows, its prosperity will sooner or later be reflected in its stock price,
especially when Wall Street "discovers" it.
At the same time, times change. AI computer programs are
being pressed into service by the largest investors, making it ever more
difficult for the small investor (and themselves) to outwit the market. Of
course, these big investors are playing against each other, like rival chess
masters, and they must all scramble to keep ahead of their competition.
In Wall Street, once a winning strategy becomes
moderately well known, it will no longer work. Investing is a zero-sum game
where somebody wins and somebody else loses. If there are successful strategies
for beating the market, their practitioners can profit from them only if their
practitioners exercise them in secret. They must remain the exception rather
than the rule.
I once read an article written by a commodities trader who
quit the game with $5,000,000. Afterward, he revealed some of his secrets. One
of them was that had he stayed on as a commodities trader, he would have
lost all his money back again. He said that the news that came over the wires
was rigged.
Several times in 1982, I had the experience of seeing my
stocks drop 20%-30% within an hour, while I haunted a terminal at a brokerage
house. Then the bad news would come over the wire after the stock had hit
bottom. I soon learned that New York brokerage firms such as Merrill Lynch and
Salomon Brothers notify their big institutional customers first, so that these
behemoths can dump their stocks before the scuttling little investors get wind
of what's coming. Beyond that, the institutional investors have computers that
are monitoring their stock prices in real time, together with analysts who are
monitoring the computers. The computers will automatically trigger a sale if
stock prices fall below a certain threshold. (After all, the big investors pay
practically zero in commissions on their purchases and sales.) It was this
program trading that was blamed for the meltdown that occurred in October, 1987,
when the Dow dropped 18% in one day.
One way out of this dilemma is to buy mutual funds.
Another topic of interest is that of mutual funds. There have
been a few classic mutual funds that have turned in good performances year after
year in good markets and in bad markets. One example during the last super-bear
market (from 1966 to 1982) was the Templeton Fund at 14% per year. John Templeton pulled this
off by investing abroad at a time when the U. S. was on the ropes. Mutual Shares
also did relatively well (15% per Year) during this period. And in the latter part of the
period, the Magellan Fund (Peter Lynch, Proprietor) outpaced almost all other
funds.
Now these funds can do well because they're small funds
that can buy moderate numbers of shares in undiscovered small companies whose
stocks don't fully reflect their future earnings---yet.. Successful small
companies tend to grow faster than large companies just as small trees tend to
grow faster than large trees. But it's a tricky business for the fund manager,
because once Wall Street discovers this small, prospering and promising company,
they'll bid up the price of the stock until it's no longer a bargain. That's the
time the fund manager has to sell, and to try to find another undiscovered,
promising small company. (That's getting harder and harder to do, with computers
watching every mouse hole.)
A somewhat similar situation exists with respect to the
mutual funds themselves. As long as successful mutual funds are small and
undiscovered, they can continue to do well, bearing in mind that the successful
mutual fund manager is liable to be wooed away by another company. However, once
word gets out that such-and such a fund is showing a good five- or ten-year
track record, everybody and his brother wants to buy shares of the fund. Pretty
soon, the fund gets too big to invest in small companies, and it turns into a
dancing elephant. The classic example of this is the Fidelity Magellan Fund.
Peter lynch managed to keep up his remarkable rates of return until the fund's
assets got to, I believe, *+ billion dollars. Then he wisely retired before it
killed him. He quit while he was ahead.
Another way to operate is to close
the fund when it gets too large. Companies will sometimes do that to enhance
their reputations. However, it's important to remember that mutual fund
companies are in business to make money for themselves and not for their
customers. The more money they have in a fund, the more money they make in
management fees. Obviously, for them, maximizing their management income is the
bottom line.
I've tried to beat this system by investing in mutual funds
that are about to close. Some of them, like Harbor International, have done very
well over a 15-year period. One problem is that they tend to open up later. And
of course, none of these funds will do well if the stock market in general
deflates over the next 13 or 14 years.
(To Be Continued)