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)