Where to Put Our Money and Why

November 26, 2012

    When I began preparing this investment news page in the spring of 2008, I had no idea that the U. S. Federal Reserve would lose control of the U. S. economy or that we would still be in the doldrums four years later. But here we are. All of my investment experience was gained through the Post-World-War II period when the Federal Reserve fought inflation and unemployment using primarily the discount rate on overnight intra-bank loans. Add to that computerized high-frequency trading by heavily capitalized hedge funds and .
    Had the conventional election cycle scenario played out, we would have seen a stock market that hit a peak early in 2009, followed by a gradual up-and-down decline to a cyclical low sometime in 2010, and then a rise to another peak right about now. But the key issue is that the Fed still doesn't have enough inflation or a sufficiently robust economy to resume its normal or managing the economy.
    OK. Where do we go from here?
    Let me begin by re-printing what I wrote on this website's index page: "Right now, the S&P 500 and the Nasdaq Composite are lower than they were 13 years ago in 1999. But in 1999, the S&P 500 hit a P/E ratio of 34:1... far higher than it had ever been throughout its previous history. Similarly, in 1999, the Nasdaq Composite topped out at 5,500 compared to its current reading of around 3000. Over the past 13 years, the markets have been working off this once-in-two-centuries excess. The P/E ratio for the S&P 500 is currently around 21:1... reasonable but not cheap. In the meantime, we're ostensibly in a secular bear market that's due to end in the 2028-2030 time frame at P/E ratios in the single-digit range."
    I don't have time tonight to do any kind of justice to the Doug Short's most excellent chart below, but it will give a sneak peek at what I'll try to write up in the next few days.

    For tonight, the message I'd like to convey is that the right end of the blue curve representing where the S&P 500 stands tonight (at around 1400) is as far above the trend line as it was at the market tops in 1901, 1929, and 1966. If it behaves the way it has at the those three past market tops, it might typically take another 16 to 18 years to reach a secular bear market bottom from which it could mount the next super-bull market. Of course, there's nothing that I know about that says that the U. S. stock markets have to follow any particular script, but by historical standards, the S&P 500 is still substantially overpriced.
    So right now, my guess is that we're still mired in a mud-patch that we aren't expected to exit for another 16 to 18 years.
    To return to the question posed above: how should we invest our money over the next 16 to 18 years?   
    My current investment strategy is guided by the State of the Markets investment advisory newsletter. As their table shows, their new "Adaptive" Daily Decision System Aggressive Portfolio sports a simulated annual compound rate of return of about 61% per year over the past 16 years and is up 41% through September 15th for this year versus about 3.6% per year for the S&P 500. But I have two concerns about this. First, the system itself has been selected because of its superior long-term performance on paper, but that means that a selection process process has taken place which optimizes its effectiveness  looking backward but not necessarily looking forward. Will it do as well in the real world going forward as it has on paper in the past? Second, (and this is a far greater concern), whenever a successful system for beating the stock markets shows up in the public domain, it probably won't be successful very long. The reason is that everyone will want to sign up for it or emulate it, and it will grow exponentially until it begins to sway the markets.
    My problems with it so far have revolved around difficulties in keeping up with the emailed trading alerts. A couple of months ago while we were on vacation, an alert came through while we were on the road. The next-to-last time, I learned to my horror that although I thought I had sold on time, I learned later that for some reason, the sale didn't take place. Now I've fallen behind and won't experience the gains that have been made so far this year. 
    For this reason, I'm casting about for other market strategies that could serve as fall-back alternatives if State-of-the-Markets begins to flag.

    This chart begins in 1871, two years after the Golden Spike was driven in Ogden, Utah, signaling the completion of the U. S.' first transcontinental railroad. Prior to its completion 1869, travel between St. Louis and San Francisco relied upon either wagon trains or stagecoaches. It was dangerous, arduous, and typically took months. After the advent of transcontinental railroads, travel rapidly became safe and easy, and travel times were reduced to days.
    Oddly, the price chart doesn't show much reaction to the Panic of 1873 until its short, sharp dip in the latter 1870's. After that, the market indices rise above the trend line and remain there for 38 years from 1879 to 1917. During that 38 years, the United States was an emerging markets country. It was the age of the Second Industrial Revolution, The Gilded Age, the age of the Robber Barons, of sweatshops, of small children toiling 12 hours a day, six days a week in the miserable working conditions of the mills ("The golf links lie so near the mills that almost every day, the laboring children can look out and see the men at play."), of trusts and monopolies, and of a growing gap between the rich and the poor. It ended (I think) with growing public resistance to its exploitation. Teddy Roosevelt became a "trust-buster", breaking up the monopolies that were strangling competition in the U. S. Karl Marx had written that capitalism carries within it the seeds of its own destruction: that monopolies would arise and would coalesce, choking out smaller competitors, until they became the government. But the Western democracies corrected themselves, and the dystopian world that Marx foretold didn't come to pass. But back to the chart.
    If you were plotting the S&P 500's performance during that 38-year period between 1879 and 1917, you would have generated a regression line above the long-term trend line in the chart above, but it would have been parallel to the existing trend line. And I find that a little curious. The trend line depicts the average long-term rate of rise of the S&P 500. I would have expected that as a growth rate "speedometer" for the U. S. emerging-market economy, the S&P 500 would have risen more steeply during this Second Industrial Revolution time frame than it does today, as a reflection of a faster U. S. economic growth rate then than we're experiencing today. But it didn't. Of course, it's worth noting that this stock market chart doesn't include dividends, which would have more than doubled  Mr. Short's 1.73% average annual rate of rise.
    Also, I don't see a secular bear market and a secular bull market pattern in the S&P's 1879-1917 performance.
    Beginning just before World War I, the S&P 500 finally falls back below what in hindsight will become its trend line, bottoming in 1920. Then in the "Roaring Twenties", with a population fresh from the farm, and with minimal regulation of the stock markets (stocks can be leveraged 10:1 by buying on 90% margin), the stock markets soar to a wild peak as naive investors flock into stocks. The bubble bursts with the Crash of '29, ushering in a precipitous and unprecedented decline in the market indices as the Dow goes from a high of 381 in the summer of 1929 to a low of 42 in the summer of 1932. To compound the problem, the market indices staged a series of strong "sucker rallies" on their way down. If the Crash didn't get you, the "sucker rallies" did. Banks failed en masse, taking depositors' life (e. g., retirement) savings with them. There were no social safety nets... no welfare, no Medicaid, no unemployment insurance. The only thing standing in between unemployment and starvation was the soup kitchen.
    But back to the chart.
    For the next 20 years, from 1929 to 1949, the S&P 500 curve exhibits an extremely volatile wedge pattern, exiting from it in 1949 to begin the climb to a secular bull market peak in 1966. From there, it yo-yoes its way down to the 1982 market bottom, rising in the biggest super-bull market (and the biggest excursion from its trend line)

To be continued.