Shocking My Socks Off!
(Or Why I'm Barefoot Tonight)

 

    What I’ve been uncovering as I’ve investigated the stock market further has shocked my socks off.

The Nefarious Confusions of Inflation
    Inflation is an insidious instrument for bamfoozling the unwary. It’s very difficult to understand previous financial transactions without correcting them for inflation. For example, in the 1930’s, the mark of the financially successful male was the $10,000-a-year man. Corrected for inflation, $10,000 a year in 1940 equates to about $125,000 a year today.

Shocking Facts Revealed by the Inflation-Adjusted Dow Jones Index
    Figure 1, below, shows a plot of the inflation-corrected Dow Jones Index from its peak in 1929 to its approximate peak at the end of 1999. (All dollars have been adjusted to current dollars.).
   There are two shocking facts about this chart. First, there's the steep straight line at the right, in which the Dow Jones Index, taking off from the top of a normal bull market peak (which was also a super-bull market peak) proceeded to double again in five years ,in defiance of the law of gravity! What happened there? What's going on? At least as plotted here, it's virtually a straight line from 1995 through 1999. If we saw this on a picture of Mars, we'd say, "That's an intelligent artifact." Having only discovered this last night when I plotted the curve of Figure 1, I want to know more about this phenomenon than I do now before I contemplate returning to the stock market.

The Meaning of Dividend Yields
    Figure 2, below, plots the dividend yield over the past 70 years. (This doesn't go back before 1929, but you can examine those numbers by reviewing Harry Rood's CPCUG InvestSIG charts.) As you can see, the dividend yield simply fell out of bed.


    To see what this collapsing dividend yield means, we need to return to Figure1

Virtually No Blue-Chip Capital Gains. You Can't Buy 'Em and Hold 'Em
    The second shocking fact about Figure 1's inflation-corrected Dow Jones Index is that it shows that there has been little, if any, long-term escalation of the DJI (or the S&P 500) since its inception in 1896. Harry Rood arrives at a real rate of rise of about 1.3% to 1.4% per year. He may certainly be right, although it depends upon a judgment call regarding how you draw your trend lines. But the important fact is that, at least for the 30 Dow stocks and the 500 S&P stocks, the average long-term capital gains on those stocks will be no greater than 1.4% per year. What's worse, the values of the 30 Dow stocks fluctuates wildly from one era to another. If you had failed to sell your Westinghouse stock at the peak of the market in 1966, and decided to wait until it recovered its value in inflation-corrected dollars, you would have had to wait until 1996 before the inflation-corrected Dow regained the real value it had in 1966.
    Westinghouse is probably a good example to use. The Dow Index changes its 30 stocks fairly often, as older companies in older industries are replaced by newer competitors. It's quite possible that Westinghouse stock will never sell for as much (in inflation-adjusted dollars) as it did in 1966.
    The bottom line is that there's virtually no long-term capital gain to be had by buying and holding large blue-chip companies. (I realize that this flies in the face of what we're commonly led to believe. I'm not sure at the moment how these two conflicting views are to be reconciled.)

And Now, Back to Dividends
    The other--and main--source of income from stocks is dividends. Dividend rates can be considerably lower than conventional interest rates because dividends can be expected to rise over time to keep up with inflation (or so it is hoped). Excluding the last few years from our dividend calculation, it might be reasonable to guess at a long-term average dividend yield of 4.2% to 4.4% between 1929 and 1995. You can see from Figure 2 what's happened to dividend yields.
    It may be argued that, with inflation running about 3%, and interest rates not much higher than that, dividend yields can afford to be down in the 1.5% - 2% range. However, the next move in interest rates will be up, and as Warren Buffett points out, when interest rates rise, stocks have to fall so that their dividend yields can remain competitive with other sources of income. (This would seem to particularly true when inflation is expected to remain low. When inflation is high, people would probably seek a higher fixed-rate interest premium over dividends than they would in the face of a low-interest-rate outlook. Inflation grows exponentially, and it can rapidly rob you of purchasing power in a high interest rate environment.)

Price-to-Book-Value Ratios Have Gone Around the Bend, Also
    Figure 3, below, shows the average ratio of the stock prices to the book values (liquidation values) of the 30 Dow industrial stocks. As you can see, only twice since 1929 had the price-to-book ratio gone slightly above two, both times at super-bull market peaks. In early 2000, it probably reached nearly seven-to-one.


Could It Be... Say It Isn't So!... "Creative Accounting"?
    Warren Buffett mentions that in 1987, a change in Financial Accounting Standards Board accounting rules allowed companies to add pension income to their reported earnings. GE got 9% of last year's income from pension credit, versus a 20% pension charge in 1982. Mr. Buffett says, "Last year, according to Goldman Sachs, 35 companies in the S&P 500 got more than 10% of their earnings from pension credits, even as, in many cases, the value of their pension investments shrank."
    Somehow, assumptions about future investment rates of return affect the reported pension fund income. Mr. Buffett says,
    "Heroic assumptions do wonders, however, for the bottom line. By embracing those expectation rates shown in the far right column, these companies report much higher earnings--much higher--than if they were using lower rates. And that's certainly not lost on the people who set the rates. The actuaries who have roles in this game know nothing special about future investment returns. What they do know, however, is that their clients desire rates that are high. And a happy client is a continuing client."
    Hm-m-m.

But It's All Just Improved "Return on Equity"
    In a way, I know what caused this sudden surge in stock prices: an unprecedented rise (by a factor of two) in the ROE (Return on Equity). But that's just a buzz word. The question is: what permitted this surge in return-on-equity? It could have been something like the shifting of jobs to third-world nations. Another, more sinister possibility would be a loosening of accounting rules that allowed companies to report fluffy earnings. How substantial are these earnings? Enron and Arthur Anderson have shown us what corporate managements can do. The major question is: are these earnings going to increase at the last five years' heroic rates?

Can Things Pick Up Where They Left Off? Can We Have Even Higher "Returns on Equity"?
Michael Sivy ("Forecast 2002", Money Magazine, January 2002, pg. 63)  reports 2001 earnings that fell 27% below 2000 earnings. He says,
    "Profit gains should pick up in 2002, as GDP (Gross Domestic Product) growth picks up smartly--perhaps to an annual rate of 4% o 5%--near the end of the year. But that sharp rebound won't continue for more than two or three more years. Investors looking out a decade or more should be prepared for a less robust economy--and lower returns. To continue outpacing the market, you'll have to find companies that can maintain their earnings momentum no matter what happens to the broad market."
    Mr. Sivy predicts 2003 earnings that are a little above those of the previous peak (in 2000), and 2004 returns that should exceed prior earnings by, perhaps, 10%. (Note that inflation will be of the order of 12% to 13% between now and 2004.)

What Will Happen Next?
    On fact seems uncomfortably clear: the stock market is at unprecedented price levels. A lot depends upon the legitimacy and sources of its rapidly rising "returns on equity". It stands a lot better chance of falling than it does of rising. There's a general warning that the rate of rise will be slower. Once the Federal Reserve begins raising interest rates, with estimates ranging from this June to this December, the stock market is going to have to respond with lower prices. The old rule regarding interest rate hikes has been "two steps and a stumble". The Fed could make two interest rate hikes without disturbing the market, but the third interest rate hike caused the stock market to stumble. This last time, I seem to remember that it didn't happen this way, perhaps because Alan Greenspan was gentle with rate hikes, and has a good track record of cooling the economy without bringing it to its knees. But he had to keep raising rates to get the market to pay attention, and eventually, it did. Now, he's predicting a strong recovery, which, ironically, might conceivably dampen the stock market recovery somewhat if he has to raise interest rates aggressively..

Is the Stock Market the Only Game in Town?
    My next order of business will be to try to find out more about anomalous explosion in "returns on equity". Beyond that, I'd like to find other decent investments outside the stock market.

What Do the Experts Say About This?
    Nothing I've done here is complicated. I've gotten my Dow Jones data from this table * with backup at this website , and my consumer price index data from this table, with backup at this website. You can run off these calculations if you wish. I divided the current 2002 inflation index, which is 5.37 times the 1967 base level of 1.00, by the inflation index for the year of interest... e. g.,  42.0 for 1940. For 1940, 537/42 = 12.8. It would take $12.80 in today's dollars to buy what one dollar bought in 1940. Then I multiplied the Dow Jones value for 1940 (98.75) in the Dow Jones Table by 12.8 to get its equivalent value (1263) in today's dollars. So what do the experts say about all this? Warren Buffett estimates that investment advice and investment costs are a >$100,000,000,000-a-year industry. I've paid my share of these costs over the years, and I've paid for investment newsletters and other investment advice ad nauseum. and never in these 33 years of seeking guidance, have I encountered these simple explanations of what's going on. It seems to me that these simple lessons would be the first things a fledgling investor would be taught, but that didn't happen to me. Could it be because a $100,000,000,000-a-year industry is riding upon enticing the fledgling investor into supporting all these gurus? If you want an idea about how well some top investment analysts fare when it comes to advising their clients, follow Smartmoney's "Pundit Watch" for awhile. To give a couple of examples, throughout the latter 90's, Abbe "Bullish" Cohen was in first place among the 12 advisors that Smartmoney tracks. She kept insisting that the stock market wasn't overpriced and had room to grow. And until early 2000, those calls were correct. She remained in first place among the 12 advisors. So what would happen when the market turned down? Would she be a "Johnny One-Note" who would lead her flock astray? Or would she anticipate the changing tides and lead her flock to safety?
    She's now in last place, if that tells you anything.
    Another brilliant analyst is Edward Yardeni. His voluminous and insightful Acrobat documents were a beacon in the murky night. Then in 1998 and 1999, Dr. Yardeni fell upon his sword to warn the world about the meltdown over Y2K. (Tommie stockpiled a month's worth of canned goods because of him. We're still eating soups made from those canned vegetables.) Of course. in fairness to Dr. Yardeni, his actions were motivated by an honest concern for others, and for all I know, his publicizing of Y2K may have averted crises that would otherwise have occurred. Left untended...
    I don't mean to say that these experts don't know a lot---only that they don't always agree, and that evidently, they aren't always right. Some experts may be more expert than others. Certainly, I need to check my conclusions with others who are more expert than I in this investment  discipline, and that consists of about everyone from your Aunt Harriet on up.
    And so it goes. Some men who actually make buckets of money will tell you they don't know how to predict the stock market from one day to the next, or even from one year to the next. They concentrate on what they're buying (which they can control), and try to ignore the stock market (which they can't control).
    I'll tell you all about my experiences with stock market advisors and investment services when I quit getting insights and epiphanies.

Two sobering thoughts.
    First, last Monday, at 10,200, the DJI had risen 2000 points above its minimum value of 8200 that it hit last September 19th. When the records are published they'll show a 25% recovery of the Dow from its current cyclic nadir. It wouldn't have far to go from there (1300 points) to reach the same level it held at its last peak. Didn't buy into the stock market when the Dow hit 8200? Neither did I, any more than I knew that the little pullback in 2000 was the beginning of a bear market. There are so many pullbacks as the stock market meanders upward that you can't tell when one is the beginning of a transient setback and when it's the opening chorus of a two-year, 30% bear market..
    Second, because there will be about 12% inflation between the peak of the 2000 bull market and the peak of the 2004 bull market, your investments will have to recover to 112% of what they were in 2000 just to get you back where you were. If your portfolio is still down by 25% (and ours is still down by about 33%), it will have to rise by about 50% just to bring you back where you were.
    To add insult to injury, the S&P 500 index funds are now only down about 11% from their peak year 2000  value (or about 14% as of Friday's close). But we now know, after tonight's discussion , that the major market indices may not be going anywhere anyway.

    As you can see, I've put other activities on the back burner for the moment because I'm pretty excited about these discoveries. It's time to decide what to do about the stock market, since this is probably a good time to buy (if the stock market is valid place to put money). Or there may be a better way to make money than those with which I'm familiar. But I think that it starts with an understanding of what is--and isn't--going on.

(More to come)