Dangerous Reactions

Are we in the middle of a secular bear market? You may be tempted to underestimate the significance of the downturn in 2000…and, as John Mauldin implies below, you’d be in good company. But don’t be fooled…what goes up must still come down.

It is my contention that we are in a long-term secular bear market cycle, speaking for the broad market averages that are basically comprised of large companies. In this cycle, I believe, we will see the price to-earnings ratio – the ‘value’ – of these index averages slowly come down.

The P/E ratio of the S&P 500 on March 31, 2000, was 29.41. Today the level is at 29.46. That means the P/E for core earnings (which is accountant speak for cash-in-your-pocket earnings) is somewhere north of 35.

The market is still irrationally high, based upon historic trends. It does not mean it cannot go higher. But it does mean it will go lower eventually. History shows us that valuations will revert to the mean over time and even move significantly below trend. There has never been a time in history when P/E ratios hit a range around 30, as they did in 1999 and again at the end of 2003, that the broad stock market outperformed a money-market fund over the next 10 years. Never.

Yet investors keep running stocks up to nosebleed valuations and somehow expect that this time it will all be different. It never is.

Let’s look at some of the reasons for such behavior. They are rooted not in mathematics and economic foresight, but in psychology.

Economists Michael Kilka and Martin Weber provided a clue to why investors go wrong in a paper called "Home Bias in International Stock Return Expectations." They compare German and U.S. investors. Each group feels more competent about their home markets and stocks. And each group assesses the probable future returns for their "home" stocks to be higher than the foreign stocks. In other words, simply because they are more familiar with a stock, investors think it is more likely to go up than another stock with which they are less familiar.

This is not just a German/U.S. issue. Another study in 1996 shows the exact same response from institutional investors with regards to Japan and the United States. Yet another study shows that the more we know about a stock, the more likely we are to be optimistic and the more likely we judge ourselves competent and to trust our analysis.

Investor Overreaction: Why Does Bear to Bull Take So Long?

Familiarity in stocks does not breed contempt. It breeds confidence. Worse, given enough time, it can breed unreasonable confidence.

Keeping this in mind, I note that it typically takes years for valuations to fall in bear markets to levels from where a new bull market can begin. Why so long?

Because investors overreact to good news and underreact to bad news on stocks they like, and do just the opposite to stocks that are out of favor. Past perception seems to prophesy future performance. And it takes time to change those perceptions.

The power of investor overreaction and underreaction is forcefully borne out by a study in 2000 by David Dreman (one of the brightest lights in investment analysis) and Eric Lufkin in "Investor Overreaction: Evidence That Its Basis Is Psychological."

In any given year, there are stocks that are in favor, as evidenced by high valuations and rising prices. There are also stocks that are just the opposite.

Investor Overreaction: Dreman and Lufkin Study

Dreman and Lufkin (or DL for short) looked at a database for 4,721 companies from 1973 through 1998. Each year, they divided the database into five quintiles, based upon the stocks’ perceived market valuations. They then studied price-to-book value (P/BV), price to cash flow (P/CF) and the traditional price-to-earnings (P/E) results separately. This created three separate ways to analyze stocks by value for any given year, so as to remove the bias that might occur from just using one measure of valuation.

The top and bottom quintile become stock investment "portfolios." You might think of them as a mutual fund created to buy just these stocks. From the time of each portfolio’s mock-creation, they then looked back 10 years and forward five years to measure trends in price and value. There was enough data to create 85 such portfolios or funds.

Let me describe what I think are the more pertinent facts that leap out as we go through their presentation.

Most notably, almost immediately upon creating the portfolio, the price performance comparisons change dramatically. The "in-favor" stocks underperform the market for the next five years, and the out-of-favor (value) stocks outperform the market.

I should point out that other studies, which Dreman does not cite, seem to indicate that the actual experience of many investors is more like these static portfolios than one might first think. That is because investors tend to chase price performance. In fact, the higher the price and more rapid the movement, the more new investors there are who jump in.

Remember the first study I mentioned? Not only do perceptions of the past color the future, but those stocks also become most familiar. And the more we learn about a stock, the more we think we are competent to analyze it and the more convinced we are of the correctness of our judgment.

At five years prior to the formation of a portfolio, the trends of each group were set in place. The next five years just reinforced these trends. This, in turn, reinforces the perceptions about these stocks and increases the level of confidence about the future.

So to the bottom line… How much better did the highly valued stocks do than the low-valued stocks in the 10 years prior to creating the portfolios? The highest P/BV (price-to-book value) stocks outperformed the market by 187% in the 10 years before they were selected as top-quintile portfolio stocks in the DL study. The lowest stocks underperformed the market by -79%, for a differential of 266%! If you look at the P/CF (price to cash flow), the differential between the two is 172%.

But what happened to investors was a different story. In the next five years, the hot stocks underperformed the market by a -26% on a P/BV basis, and -30% on a P/CF basis. The out-of-favor stocks did 33% and 22% better than the market, respectively. This is a HUGE reversal of trend.

Investor Overreaction: Why the Reversal?

So, what happened? Did the trends stop? Did the former outcasts finally get their act together and start to show better fundamentals than the all-stars? The answer is a very curious "no."

In nearly every test DL made, the fundamentals for ‘growth’ (high P/E, etc.) stocks are better than those for ‘value’ (low P/E) stocks both before and after portfolio formation.

"Although there is a major reversal in the returns to the best and worst stocks, there is no corresponding reversal in the fundamentals [valuations]." [Ed note: In this study, "best" means highest P/E, etc.] In fact, in many cases the fundamentals continue to improve for the growth stocks and deteriorate for the value stocks.

And yet, there is a very stark reversal in price. Why, if not based upon the fundamentals?

Dreman and Lufkin conclude that the cause of the price reversal was not, in fact, a change in fundamentals. Nor was it risk. Instead, it was persistent investor overreaction or underreaction.

The overreaction begins in the years prior to the stock reaching lofty heights. As Nobel Laureate Hyman Minsky points out, stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction.

When the correction first comes, we tend to underreact. While we do not like the surprise, we tend to think of it as maybe a one-time thing. Things, we believe, will soon get back to normal. We do not scale back our expectations sufficiently. It apparently takes years for this to work itself out.

As DL note in their conclusion, "The [initial] corrections are sharp and, we suspect, violent. But they do not fully adjust prices to more realistic levels. After this period, we return to a gradual but persistent move to more realistic levels as the underreaction process continues through" the next five years.

Would not, I muse, this apply to overvalued markets as a whole? Might not this explain why bear market cycles take so long?

Thus my contention that we are just in the beginning stages of the current secular bear market. These cycles take lots of time, anywhere from eight to 17 years. We are only in year four, and still at nosebleed valuation levels. The next surprise or disappointment will surely come from out of nowhere. That is why it is called a surprise. When it is followed by the next recession, stocks will drop one more leg on their path to the low valuations that are the hallmark of the bottom of secular bear markets.

Given the level of investor overconfidence in the marketplace, and given the length of the last secular bull, it might take more than one recession and a few more years to find a true bottom to this cycle. It will come, of course.


John Mauldin,
for the Daily Reckoning
March 3, 2004

Editor’s Note: John Mauldin is the author of the weekly e-mail The Millennium Wave Investor, as well a soon-to-appear book from Wiley & Sons: Bullseye Investing. He is also a frequent contributor to The Fleet Street Letter, in which a version of this essay was originally published.

We have only two thoughts this morning – both of them arrogantly humble….and both concerning gold.

We admit that there is more under heaven and earth than is contained in our philosophy…but we give it to you anyway, because it is all we’ve got.

In our humble opinion, the tide is going out on the wet, wild world of American consumer-led global dominance. But don’t worry, dear reader. A tougher, stonier, more difficult world will be revealed…but it will be a better one.

The trouble with consumer-led prosperity is that it is a fraud. You can’t spend your way to prosperity; instead, if you really want to grow rich, you have to avoid spending…and concentrate on saving, training, investing, learning…and all the other things that most people don’t want to do.

After all, if getting rich were easy, everyone would be rich. They’re not.

The vast majority of the world’s population is poor. The Chinese, the Indians, the Nicaraguans and people all over the globe will work for $5 a day and say ‘thank you’ for it. If they had the machines, the capital, the skills, the training, and the luck that Americans have had, there is no reason that their work would be any less valuable to the rest of the world than the work of an American. And guess what – they’re getting all those things.

Meanwhile, our fellow countrymen believe that the key to growth and wealth lies in consumer spending. So, the Feds lower rates and cut taxes to give consumers more wherewithal – to borrow and spend.

The U.S. used to make things and sell them overseas. General Motors was our biggest employer…and our balance of trade was in our favor. When Eisenhower was in the White House and William McChesney Martin was at the Fed, the U.S. had most of the world’s gold…and most of the world’s credit. Foreigners owed us far more than we owed them. This happy state of affairs persisted until the reign of Ronald Reagan and Alan Greenspan…when the U.S. became a net-debtor to the rest of the world and Wal-Mart – a retailer, not a manufacturer – became its biggest employer.

In America’s post-industrial economy, consumer spending is what counts; it is 70% of the GDP. Economists, politicians and TV teleprompt readers give loud huzzahs at the latest GDP figures…but numbers themselves have become an accomplice to fraud. The faster they go up, the faster Americans ruin themselves with more debt and more spending.

Of course, you can fool economists, the press, and the lumpen-voters almost forever. But, in the long run, the splashing waters of the marketplace turn even lies of granite to powdery sand. The erosion began with the bear market in stocks of 2000-2002…the bear market in the dollar of 2001-2004…and the bull market in gold of 1999-2004.

If we’re right, these trends have only just begun. But – and here, dear reader, we would like to reduce expectations – these sorts of multi-year mega-tides in the affairs of men do not lead to fortune easily. There are always counter currents and riptides…whirlpools and eddies…that make us doubt ourselves and abandon our positions.

Gold has gone from $253 in the late ’90s to near $400 today. It would not be surprising to see a correction down to say, $350 or lower before the next advance. The dollar lost 40% against the euro. There, too, a major correction may be underway.

We say this because, yesterday, gold fell $5.80…and the dollar rose to $1.21 per euro. These were major moves and could signal major corrections.

Should you try to trade these moves? Should you sell your positions and wait until the waters calm? We don’t know. We are neither traders nor clairvoyants. But the tide has turned, we think. And for our part, we bought more gold last week. We have set out to sea in our little golden bark…we will stay aboard and wait to see where it takes us.

Over to Addison, in Paris, with more news:


Addison Wiggin, back in the saddle after a week-long journey to and from Mexico…

– One question: What is the hapless market observer to do? Just when we were beginning to enjoy a few macro-trends – gold going up; dollar dropping down; lumps deluding themselves en masse in the stock market – we go on a little junket to Mexico and all hell breaks loose…

– For example, "against all odds, the dollar is rallying," we found ourselves writing this morning. The fundamentals are no different today than they were on February 18 – when the dollar reached an historic low against the euro, at $1.2928. Yet now, the dollar climbs.

– Looking for reasons why, we think we can hear currency traders whispering. "Shorting the dollar is a very ‘crowded trade’ these days," they mutter. "Perhaps its time to buy," one speculates…"The ECB will drop rates when they meet Thursday," another surmises, "sell euros"…"Japanese bonds investors failed to show up at a bond sale yesterday," still another remarks, "they may be losing interest in the Nipponese dollar-buying strategy…sell yen."

– And so the dollar gains ground by default. Suddenly, after sipping a bit of the elixir of success…we’re beginning to feel a little woozy. Gold’s nearly six-buck plunge yesterday came on the heels of a three-dollar rally the day before. What will happen today? Tomorrow? We’re not sure…

– But neither does Mr. Market seem to have a clue. Following Monday’s big rally to a two-week high, the Dow shed 86 points to close at 10,591 – its biggest sell-off since the Fed removed two goofy words from its post-FOMC press release. The S&P and Nasdaq each got the wind knocked out of their sails yesterday, too, selling off 6 and 18 points respectively.

– At this rate, only a healthy dose of bad news could get the markets moving in a comfortable direction again. And this week…we may just get one.

– It’s a big week for economic reports, you see. As Eric reported yesterday, we learned that in January, Americans continued to borrow faster than their pay increased. (That’s not good). Jobless claims come out tomorrow (we’re not holding our breath). Today, the Fed’s "Beige Book" will give us a region-by-region report on the success – or lack thereof – of their current goose-and-pray economic strategy (not likely to be all impressive, but we do expect it to smell pretty). Then on Friday, the doozy…

– Early projections show that non-farm payrolls will climb from 112,000 in January to 128,000 in February. The number will be an improvement, to be sure, but not enough to keep pace with "official" immigration. So the "official" unemployment rate will actually climb a point to 5.7%. That’s a number certain to give pause to those economists prone to repeating the Greenspan-Bernanke mantra – "jobs are on the way, jobs are on the way" – even if only a brief one.

– Last week, on the plane from Paris to Boston – the first leg of our trip to Puerto Vallarta – we had the fortuitous occasion to sit next to one of the faithful: an economics professor from Harvard, whose office is across the hall from Greg Mankiw, chairman of the president’s Council of Economic Advisors, and who is a neighbor of former IMF chief economist Ken Rogoff. He even claims to have been recruited, at one point, by Ben Bernanke to teach at Princeton.

– A diminutive man of French descent, the professor almost immediately set upon "chatting up" the woman sitting on his left. She, it turned out, was an executive with Genzyme, the biotech firm. Having discovered he was an economics professor (a fact he was only too happy to reveal), she wanted to know if "offshoring" was going to pose a serious threat to wages in the biotech business. "Ah, to some extent," he replied, "but I wouldn’t worry about eet…ze recovery iz underway, and ze jobs picture will eemprove dramatically very soon."

– The lesser of your two evil Parisian editors could not resist. "I couldn’t help overhearing your comment," he blurted out, despite his best efforts not to. "Do you really think jobs are going to reappear? Seriously? Even with public and personal debt loads going through the roof?"

– What ensued wasn’t pretty. (Especially since we were taking liberal advantage of Air France’s free wine policy on the flight).

"The currency markets don’t like the federal deficit, so dollar is falling, correct?" we began our circular argument. "Zat is right," came the reply.

"A falling dollar cancels out gains by foreign investors, true?"

"Right again…"

"And foreign investment is needed to finance the trade deficit. So if the dollar continues to fall…interest rates will have to rise in order to keep foreign investors interested?"


"If interest rates rise, won’t that impede job growth?"


"Likewise," we continued, gloriously entertaining visions of Socrates in our head, "if an increasing money supply starts showing up as ‘inflation’ in the CPI, wouldn’t that cause the Fed to raise interest rates?"

"Oui, bien sûr. But eenflation eez still low. And the Fed must steemulate job growth. They have a théorie: it eez called the ‘licopter théorie’…"

"Bernanke’s suggestion to throw money out of helicopters?"

"Yez, that is it…you know ‘im? Becauz I know him…"


"Hee is very smart. The Japaneez could have used the ‘licopter théorie…we don’t need eet…we only need ze jobs…" We could tell he was getting impatient…clearly we just didn’t get it.

Still we persevered: "Aren’t jobs showing up in India, at lower wage rates? Won’t any new jobs in the U.S. have to be competitive with those wages? Effectively mutating the ‘jobless recovery’ into the ‘wageless recovery’?" The Genzyme exec squirmed in her seat a little.

"Besides," we tried again, "at some point, won’t the government, regardless of the party, have to raise taxes – or, better yet, cut spending – in order to deal with the deficit? Both of which could effectively put an end to the stimulus package? And with no stimulus, where will the jobs come from?"

"Meester Wiggin, my work eez mostly on the teoretical end of tingz…"

"Well then, theoretically, where will the jobs come from?"

"Meester Wiggin, I leave the eemplementation to other people. And now, eef you forgive mee, I have a lecture to prepare for…"

– We tried to put on a movie, but our personalized monitor was broken. As we left the plane…after several hours of silence and polite nudges on the arm rest…we scribbled an e-mail on the inside of the French copy of Financial Reckoning Day and pressed it into his hand.

– Curiously, he has yet to respond.


Bill Bonner, back in London…

*** One of the most remarkable market predictions we’ve seen involves a comparison between WWII and the War on Terror. WWII proved to be a good time to buy stocks, writes one benighted forecaster, and the War on Terror will prove to be an investor’s pal, too.

We don’t know. So far, the forecaster has not been far from the mark. But from what we have read, the only real comparison between the two events is the three-letter word people use to describe them: war.

The thought crossed our mind when we read London’s Daily Telegraph this morning. We normally read the obituaries first. But here we found a near-obituary…an account of a the "White Mouse," a WWII heroine who is not dead yet. Nancy Wake, now 91, was awarded the Order of Australia medal…to be added to her collection which includes the George Medal, three Croix de Guerre, the Médaille de la Résistance, the American Medal of Freedom, and the insignia of Chevalier in the Légion d’Honneur. At the age of 28, she "parachuted into occupied France, was machine-gunned by a German aircraft while escaping in a car, cycled 270 miles in three days through numerous enemy checkpoints with vital radio codes, and killed a German guard with her bare hands while sabotaging a factory."

Her French husband, the report continues, "would later die under torture refusing to disclose his wife’s whereabouts to the Germans."

*** Below the item about Ms. Wake is a little note about the War on Terror, from the Afghan front. Seems the spirit of capitalism has returned to the Hindu Kush: "Cut price heroin is expected to flood Britain’s streets after a huge increase in poppy production in Afghanistan, the United Nations says today."

*** And here’s a note from our unpaid correspondent, Byron King, writing from Pittsburgh…and thinking of Mars:

"Does Mars, the God of War, have a sense of humor? Or is he just mean? Viet Nam screwed up the destinies of the two men who would one day compete for the presidency of the nation. Viewed from the very large perspective, Viet Nam created fault lines in every other aspect of American culture and politics. And those fault lines still cause earthquakes.

"…The [single most enduring] legacy of Viet Nam is a mismanaged fiat currency. The three biggest industries in the U.S. today are government, housing and automobiles, which are all forms of internal consumption, financed by cheap dollars. Not to rain on the picnic, but there is no significant export market for government, housing and U.S.-built automobiles. What with a merchandise trade deficit of about $500 billion per year, the nation’s biggest export is U.S. dollars, and these are units of currency now worth but a fraction of their former value. At some point, sooner or later – and I think sooner – the false economy will come to an end.

"My concern is that, when things start to unwind, the nation will be led by one or the other of two men and two political parties for whom Viet Nam was formative. The Viet Nam War will have come full circle, and Mars will be standing at the door, demanding payment in full…and probably in gold."