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The Lackluster
Economy
Faith versus History
Secular Bear Markets
Blind Dogs and
Janus Managers
Phony Analysis
Have We Seen the Bottom?
What's in
a Name?
This week we briefly look at a few
choice economic insights, and then I once again will close with a portion
of my book-in-progress about how to successfully invest in secular bear
markets. Despite some non-writing business issues which are eating up a
lot of work time, I am making good progress (finally) on the book, which I
hope to have finished in less than a month and with some hard work on the
part of my publisher available in bookstores and over the internet this
summer. My intention was to call the book Absolute Returns, but it seems
someone has just beaten me to the title. At the end of this letter, I will
initiate a contest to help me find a new title.
The Lackluster Economy
The
Fed issues something called the "Beige Book" each month, describing
economic activity around the country. Yesterday's edition proclaimed the
economy to be "lackluster." Dennis Gartman summed it up best:
"The
Fed's Beige Book yesterday offered little if anything that shall help us
define the nation's future economic prospects. Perhaps the most important
passage from the 'book' said simply that:
'...the pace of economic activity continued to be lackluster
during March and the first two weeks of April. ...Since the last Beige
Book, New York, Philadelphia, Chicago, Minneapolis, and Kansas City noted
that the recent pace of economic activity had been slower than reported
earlier. The onset of the war with Iraq appeared to have some effect on
sales and spending, although it is too early to ascertain the full effect
of the war on both consumer and business
confidence.'
"We are especially 'fond' of and/or
disconcerted by that last statement: that is, the Fed is aware that the
War has had some effect upon the consumer and the economy, but it has
absolutely no idea what that effect is, has been, or shall be. The Fed has
simply admitted that it, like we, is left to flounder from one bit of
economic news to another, hoping to 'ascertain' what direction the economy
shall ultimately settle upon, but not all that confident that it shall do
so soon, despite the legion of PhD's that inhabit the hallowed halls of
the Federal Reserve banks' economic departments."
The economic
data continues to be very mixed. New orders for durable goods -- items
designed to last three years or more -- rose 2.0% after declining 1.5% in
February. It was the second increase in the last three months and a far
better showing than the 0.5% decline economists in a Reuters poll had
forecast.
Earnings for corporations are generally coming in better
than expected, but revenues are typically down. This means the earnings
are coming from cost-cutting, and that means jobs. The unemployment
numbers from yesterday can only be described as ugly.
"The number
of Americans lining up for state unemployment benefits last week rose more
than expected to the highest level in more than a year, the government
said on Thursday in a report showing further labor market erosion.
First-time jobless claims rose by 8,000 to 455,000 for the week ended
April 19. It was the highest level since the week ended March 30, 2002,
and the tenth straight week that claims held above the key 400,000 point,
seen by economists as signaling an unhealthy labor market." (Reuters)
As reported today, the economy grew by 1.6% in the first quarter;
economists had forecasted gains of 2.0%-2.4%, so the number came in 20%
below the lower end of the forecast.
As I have written many times,
and as we will see below, there is no direct correlation between a growing
economy and a rising stock market. One of my favorite analysts, Richard
Russell of the Dow Theory Letter, writes:
"If the Dow can close
above its March 21 high of 8521.97 we'll have what I call a "Dow Theory
all clear" signal in that both the Transports and the Industrials have
closed above preceding peaks.
"But what if the Dow refuses to
close above 8521.97? Can the refusal of the Dow alone reverse the course
of the entire stock market? And my answer is "Yes, a Dow non-confirmation
can reverse the trend." The Dow is still valued at about 25% of the entire
US stock market. The thirty stocks in the Dow are what I term "backbone of
the economy" stocks. What those thirty stocks do or don't do is extremely
important."
Richard, like me, believes we are in a secular bear
market (see more below). That means the long term trend is down, and
probably seriously so. But that is our long term view. In the short run,
both of us would recognize that bear market rallies will occur. It is
quite possible this market will become even more over-valued.
Even
during secular bear market cycles lasting 10-15 years, with very decided
down trends, the market will close up over 50% of the time on an annual
basis, and quite often up over 20%. As we noted last week, while long term
trends can be predicted within some reasonable boundaries, one year market
results are statistically random.
The Nobel prize in economics for
2002 went to a psychologist, Dr. Daniel Kahneman, who helped pioneer the
field of behavioral economics. If I can crudely summarize his brilliant
work, he basically shows that investors are irrational.
There are
many investors who are convinced that some statistic means the market is
headed in a particular direction, either up or down. I would agree there
are some indicators that have proven very reliable over the long term. But
that does not mean the market will immediately respond to your rational
view of the world.
The classic quote from Keynes should be on
every investor's file cabinet: "The market can remain irrational longer
than you can remain solvent."
Let's go back to this bit of wisdom
from Russell; "One of the biggest mistakes you can make in this business
is to assume an emotional position in the stock market. Every seasoned
trader knows that. It is essential that you keep your emotions out of your
market activities. If you can't do that, then you're better off staying
out of the market, because as sure as the sun sets every evening, your
emotions are going to cost you money.
"I'm writing this because
I'm well aware that I have many bullish subscribers who own stocks and
therefore would love the market to go up. At the same time, I have a lot
of bearish subscribers who are either short or out of the stock market,
and this faction would love stocks to go down.
"Both positions are
wrong. In the business of investing, you must learn to take what the
market gives you. If you can't do that, then at least stay out of the
market until the market reaches value extremes. By that I mean that you
should not trade the secondary swings of the market. You should move out
of the market when the market reaches a recognizable bull market top. And
you should stay out of the market until the market reaches a recognizable
bear market bottom, prior to the beginning of the next bull market. That
would be the time for you to load up with good quality stocks.
"This process requires a tremendous amount of patience, probably
more than 95% of investors can muster. But then, as I've said before,
probably 95% of investors lose money in the market over any extended
period of time."
The next segment is from my book. I have chosen
this section because I think it gives us some context for the previous
comments and thoughts on the market.
Faith versus History
In the
17 years from the end of 1964 to the end of 1981, the Dow gained exactly
one-tenth of one percent. In the bull market which followed from 1982 to
the peak in March of 2000, the Dow rose from 875 to 11,723, a spectacular
gain of 1,239% or over 13 times from the starting point.
We all
remember what a difficult time that first period was. You had three
recessions, oil shocks, Viet Nam, stagflation, the collapse of the Nifty
Fifty, Watergate, short term interest rates rising to 18%, gold at $800
and very high inflation.
"Bad news on the doorstep," seemed to be
the theme of the period.
What a contrast with the next period. Tax
cuts and lowering interest rates fueled a boom in the stock market and the
economy. It was Morning in America. Computers invaded our lives, making us
more productive. By the end of the period, even Allan Greenspan was
extolling the virtues of technology led productivity growth. Inflation
became a non-factor, and mortgage rates dropped almost as fast as our
property values rose. The internet promised new ways to prosper. Peace
seemed to be breaking out, and government budgets ran to surplus.
It stands to reason, doesn't it, that the economy did poorly
during the long bear market period and far better during the bull market?
That is what one would think, but the reality is far different.
Gross Domestic Product (GDP) actually grew 374% from 1964 through 1981.
During the period from 1981 until the beginning of 2000, the economy only
grew 197%, or about half of the earlier period.
Even if you take
out the effects of inflation, you find the economy grew exactly 76% in
both periods. Yet, if you factor out inflation, it was not 1982 in which
you finally saw a profit in your buy and hold investment portfolio of Dow
Jones stocks. You had to wait another ten years, until 1992, before you
saw an inflation adjusted return.
Yet, to listen to many advisors
and analysts in the media today, you should be buying stocks because the
US economy is growing, or at least getting ready to grow. "It is always a
bad idea," we are told, "to bet against the US economy."
That
would be correct, if the economy was the main driver of stock market
prices. The economy more than doubled in real terms, from the end of 1930
through 1950. Yet stocks prices were roughly the same, after 20 years!
A reasonable analysis of the connections between stock markets and
the economy shows that stock markets do tend to go down before and during
recessions, but they do not always go back to new highs after recessions.
Investors are told that you should invest for the long run. "It is
impossible to time the market," is the mantra of mutual fund managers
everywhere, even as they buy and sell stocks in a feverish frenzy, trying
to improve their performance. They can trot out studies which show that
long term investors always do better.
I believe these studies are
grossly misleading, and are now doing great damage to the retirement
prospects of entire generations. In fact, the advice that traditional
money managers proffer is precisely the wrong strategy for a secular bear
market.
Secular Bear Markets
The received wisdom is that a bear market
is when stocks go down by 20% or more. It makes for a nice neat media
sound bite. Trying to time bear markets can be a very tough task. In the
recent 18 year bull market, there were several occasions when stock
markets drop by 20% or more, only to spring back quickly to even loftier
heights. Investors were rewarded for being patient, and many became used
to large swings. Their advisors, and the mutual funds they bought, kept
telling them that new highs were around the corner. Each drop in the
market was a buying opportunity. Corporations churned out ever more
glowing earnings projections as a reason for increasingly high valuation
multiples.
Then the music stopped in the first quarter of 2000. It
has been downhill ever since. But you would not know that to hear from the
pronouncements of the "sell-side" investment community. (By "sell-side" I
mean those firms and funds who want you to give them money for their
management. Investors are the buy-side of the transaction.)
Even
as $7 trillion dollars has disappeared from equity valuations over the
last three years, each new low is greeted as the bottom, and the brokers
and mutual fund managers find ever more reasons for you to give them your
money today! Bear markets, we are told, do not last forever. The economy
is out of recession and growing, and thus you should get in the market
today (preferably into whatever they are selling), before the next big
run-up begins.
Staying in the market was precisely the right
strategy for the 80's and 90's. It was the wrong strategy for 1966-1982.
How can we know what strategy is right for today?
Perhaps you have
heard the term, "secular bear market" or "secular bull market." The Latin
word for cycle is "secula," so when economists use the term secular, they
mean cyclical. The term generally is used to indicate time periods of long
length.
Since 1800, there have been seven secular bull markets and
seven secular bear markets. The average real return in a secular bear
market is 0.3% [This is from a study by Michael Alexander in his prescient
book Stock Cycles, which we will discuss later.] (even though the market
was falling, investors still got dividends). The average return during a
bull market cycle is 13.2%.
Not coincidentally, this averages to
the 6.7% (real or inflation adjusted) the Ibbotson study (among many
others) tells us that stock investments return over the long haul. The
average length of bear markets is almost 14 years, and for bull market it
is almost 15 years. But the average complete cycle of a combined secular
bull and bear market is 28 years.
If you invested in a ten year
period contained within a secular bear market in the past, your real
returns were quite likely to be close to zero. And that is with the
historical advantage of dividends averaging 4-5% or more. In today's world
of dividends of less than 2%, if this secular bear market should last
another 10 years, staying even will be a hard row to hoe.
Within
each secular bull and bear markets, there are often intermediate bull and
bear markets. These are shorter term in nature, but still are significant
moves up or down. In a secular bull market, each bear market fails to get
to previous lows and moves on to new highs. In a secular bear, each rally
fails before it gets to the last high mark, and then stumbles down to even
deeper depths.
Blind Dogs and Janus
Managers
In secular bull markets, buy and
hold works, as well as momentum investing, sector rotation and a host of
strategies designed to take advantage of a rising market. Blind dogs and
Janus managers make money in bull markets. That is because the wind is at
the back of the market.
In secular bear markets, making a profit
from these strategies becomes much more difficult, if not impossible.
Money managers, who I track for a living and who made significant and
steady returns in the 90's, now languish with flat or losing returns. In
the 90's, there were many managers with nimble strategies who
significantly beat the market while reducing risk.
Alas, these
same managers are still reducing risk, but they clearly need a bull market
to give investors the returns. The number of managers who are doing well
is a much smaller list.
In secular bull markets, strategies which
emphasize relative returns work well. They are a disaster in secular bear
markets. In secular bear markets, you want your investment portfolio to be
positioned in investment programs which emphasize absolute returns and
have sound risk control policies.
Bonds, dividends, income
producing partnerships, certain types of hedging strategies, and covered
call option selling would be examples of absolute return strategies. Will
these give you 10-15 % a year? Not likely, but they will outperform stock
market investments which are going down or sideways.
Owning stocks
in a secular bear market requires great skill in stock selection. I am
willing to concede that there are hundreds of stocks that will double over
the next few years. The problem is that there will be thousands of stocks
which will drop by 50%. Choose wisely.
How can we know that we are
in a secular bear market? Is there any one indicator that can yield a clue
that we can trust? The answer is a simple no.
To be statistically
significant, there should be a large number of "data points" with a given
indicator that we use to verify its reliability. A poll which interviews
only 10 people has little meaning, while one which has a thousand random
interviews is far more reliable. Since there were only 7 full bull and
bear cycles in the last 200 years, we simply do not have enough data to be
absolutely sure of any one indicator.
But we are not entirely lost
at sea. If you combine the findings of a number of studies, each of which
approaches the problem of predicting the future direction of the market
from a different point, the evidence that we have entered a long term
secular bear is over-whelming, in my opinion.
We will be looking
at these studies and more in the next few chapters: the traditional view
of Price to Earnings value offered by Professor Robert Shiller in "Irrational Exuberance"; the economic growth and
earnings studies by the National Bureau of Economic Research; the long
wave cycle analysis of Michael Alexander in "Stock
Cycles"; the Risk Premium analysis by Robert Arnott; the trend
analysis of Jeremy Grantham; different demographic analysis by both Arnott
and Alexander; the writings of Warren Buffett; and the research on the
dollar and the economy by Stephen Roach and his team at Morgan Stanley.
Most of the above are essentially mainstream analysts. They are
not bears by trade. I should also note that one common denominator is that
none of them make their living selling mutual funds. All these studies
point to conclusion that we are in the beginning of a lengthy period of
time in which US stocks, on average, will under-perform even money market
funds paying only 2%.
Phony Analysis
I am sure you have gotten one of the many
direct mail packages showing you the profits to be made by investing in
the stock market. They show how even if you started just as the secular
bear market began in 1966 or 1974 and invested on the worst day each year,
you would be so much farther ahead than someone who only started to invest
in the stock market in 1982, even if he invested at the best possible time
each year.
Therefore, the reasoning goes, you should not worry
about the ups and down of the markets and invest for the long term. Except
that none of us live in the long term. We live in the here and now, and
those who are retiring certainly do not have 28 years for the long term to
bail them out.
Can you time secular bull and bear markets? I think
the answer is roughly yes. Picking the day or the month would be
impossible, but coming within a year or so is quite reasonable. And that
simple, though imprecise, edge would give an investor a huge advantage
over any buy and hold strategy.
Are
We at the Bottom?
For the rest of this
secular bear market, you are going to see a large variety of studies and
analysis which purports to show that we have reached the bottom of the
bear market, and NOW is the time to buy.
These studies will
largely be built around the potential for the economy to grow, with the
conclusion that profits are going to grow as well, and therefore the stock
market will rebound.
Don't be misled. There is no one-to-one
correlation between rising profits and a growing economy and a rising
stock market. You can have a secular bear market, even as the economy
grows and as profits rise. It has happened many times in the past.
In August of 2000, I wrote extensively about a Fed study which
showed that an inverted yield curve was the single most reliable predictor
of recessions. Recessions appear roughly four quarters after an inverted
yield curve (when short term rates are higher than long term rates).
Since stock markets drop 43% on average during a recession, I
cautioned in that letter that it might be a good time to start getting out
of the stock market. I remember that when the Fed started to cut rates in
January, after the market had dropped only a little, many writers started
to say you had to get back in the market. Study after study appeared that
showed how much stocks went up after the Fed began to cut interest rates.
I caught some grief from readers who were convinced that the bull
market was ready to re-ignite. I wrote a series of articles on the Fed
versus History. If you thought the Fed could keep us out of recession, you
would be a bull. If you thought History would prevail, you should stay out
of the market. I bet on History. Time has shown that History won that
fight. History is a tough opponent. Betting against History is usually a
losing proposition.
Faith versus
History
Today, there is another struggle
going on. I think History clearly shows that we are in for a secular bear
market for at least the next 7-10 years. The shortest secular bear cycle
was 8 years. Coming off the biggest bubble in our history, it is hard to
think we can shake off the effects in just a few years.
Faith is
required to invest in this market. You have to ignore high valuations,
accounting issues, a Muddle Through Economy, and all the myriad issues
surrounding a secular bear market. You have to believe that two centuries
of trends are suddenly of no value. You have to believe that we are in a
New Economic Era. You have to have Faith that this time, things really are
different.
It's not that you can't make money investing in stocks.
Very good stock analysts may do quite well. But the large majority of
investors will get hurt. This includes large pension funds which feel they
must allocate 70-80% of their assets to stocks.
You need to be
really convinced that the stock you are buying can fight upstream. Buying
a stock simply because it looks cheap is not enough. Global Crossing and
WorldCom were cheap one year ago. They are even cheaper today.
Either that, or you have to ignore all of the above. You invest
simply because you hope that you will get back to even. It is not unlike
going to Las Vegas. Some of you will win at the tables, but most of you
will lose. In a secular bear market, just as in Vegas, the odds are
stacked against you.
History tells us one of two things: either
this market has a long way to go on the downside, or it will go sideways
for an even longer period of time, waiting for the valuations to come back
to trend.
And the stock markets always come back to trend. That is
the clear lesson of History. The market is nothing if it is not a lean,
mean, reversion machine. In the past, this has usually meant large drops
in valuations, especially from the highs set during the last bubble. We
will get to see what it does this time.
[In the book, we will]
look at the very diverse studies and analysis which will lead us to the
conclusion we are in a secular bear market. After you learn which way the
wind is blowing, then you will know which way to set your sails. You will
learn how to invest successfully. You will find there are a lot more
investment possibilities than a buy and hold index fund in your future.]
What's in a Name?
I need a title for my book. As I said, I
was going to call it "Absolute Returns" with a sub-title like "How to
Prosper in a Secular Bear Market." The marketing types, who are the
experts about such things, really didn't like the title, as it does not
make people want to take action, and they are not sure how many people
actually know what a secular bear market is. So, since someone else is
using it, it makes sense to find another title. In my quest for the
perfect title, I decided to turn to my rather brilliant readers and put
the question to them. The above section should give you a reasonable idea
of what the book will be about.
Send me your suggestions. If we
use you title, I will send you a serious bottle of wine (or the equivalent
if you do not indulge). Or, as I travel a great deal, I will gladly buy
you that bottle at a dinner when I come to a city near you. Plus, you will
get credit in the book. However, you will not share in the royalties.
Sharing the "fame" does not cost me anything. With three kids in college,
I need the royalties.
I will finish this letter in Tucson, where I
am speaking at a client conference sponsored by Mission Trust and then
back on Saturday. I intend to play golf on Saturday morning for the first
time in a long time (I had stopped since getting serious about finishing
the book), although I must play with rented clubs. It seems someone got
into my garage and stole my clubs. I am not sure what the golf gods are
telling me: either I am such a miserable, no talent golfer (true) that I
should quit golf as I am embarrassment to the game, or that with new clubs
my true talent will arise. The chief concern is that with new clubs I will
still have my old game. Time will tell, I guess.
Your already
dreaming about new clubs analyst,
John Mauldin
johnmauldin@investorsinsight.com
Copyright 2003 John Mauldin. All Rights Reserved
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John Mauldin is president of
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material presented herein is believed to be reliable but we cannot attest
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