Creating Your Own Bull Market, 2003

“Wealth is another word for change.”

– Paul Romer, New Growth Theorist

War with Iraq. Terrorism. Bankruptcies. Corporate Scandals. Crisis in South America. Uncertainties about the economy. Nuclear Brinkmanship by North Korea. Skyrocketing oil prices. A faltering dollar. Developments during 2002 and early 2003 have done little to satisfy hope for a sustained rebound from three years of declining stock prices, much less ignite a stampede to a new bull market.

The blue-chip S&P 500 lost 23% during 2002 (which closely matched the drop experienced by the average mutual fund investor, who was down 22%). This continued the painful decline that began with a 10% S&P drop in 2000, followed by a 13% decline in 2001. It was the first time since Hitler, Mussolini and Tojo were on the march – 60 years ago – that U.S. markets declined for three consecutive years. This abysmal trend has continued through the first three months of 2003. Now, more than ever, one of the crucial mysteries for you to decipher as an investor is, “What is the prospect for economic growth in the months and years ahead?” And “How can I prosper no matter whether an environment of growth or retraction unfolds?”

Your editors at The Daily Reckoning, observers of the Old School, think the prospects of economic expansion are negligible because of heavy debt and a moral requirement that investors be punished for the “excess returns” of the 1990s by a “regression towards the mean.”

Classical Growth Theory: Variable Rate of Return

In other words, they think it is impossible for the returns on investment to increase substantially over time. In effect, they posit a kind of “steady state” of economic potential, as if some law of physics with the potency of gravity ordained that profits wear lead boots. But I know of no such law of physics. To the contrary. The possible rate of return on investment is clearly variable. It is a function of the rate of economic growth.

In that respect, I am by no means persuaded that the prospects are bleak. “If the Information Revolution increases the underlying rate of economic growth as much as the Industrial Revolution did,” I wrote over a year ago, “the economy could grow by 18% per year. I don’t expect that. But the upsurge in the secular trend of growth could surprise almost everyone. Part of that surprise could be a much more rapid recovery from the downturn than would be expected in a standard business cycle.”

I am intrigued by the expansive views of MIT computer scientist Ray Kurzweil. Kurzweil believes that the rate of technological progress is ponderable. Due to the exponential growth of computational power (up an astonishing 40 billionfold over the past 40 years), technological progress is also expanding on an exponential curve. He calls this “the law of accelerating returns”. Kurzweil is not talking about investment returns, but his argument amounts to the same thing. He believes that the rate of technological innovation will double in every decade of the 21st century, resulting in the equivalent of 20,000 years of technological progress before the year 2100.

Paul Romer, quoted above, is an economist, not a high-tech genius. He makes no claims at all about his ability to foresee technological change. But his analysis of the dynamics of economic growth, for which he is touted to win the Nobel Prize, points to a vastly greater potential for growth in the Information Economy than ever existed in the Old Economy of material objects. The crux of Romer’s argument is that the old, classical analysis of economic growth, which viewed economic inputs as limited to “labor, capital, and total factor productivity” (a vague proxy for technological progress), was unduly pessimistic.

Classical growth Theory: Overlooking Ideas

Although the older models acknowledged that technological progress was an important long-run contributor to economic growth, they were mum about exactly what was at work. Where his predecessors were silent, Romer is articulate. He believes that the so-called “classical growth theory” overlooked the most potent source of economic growth – ideas. By contrast, Romer’s new model of economic growth embraces technological progress, claiming that ideas, rather than labor or capital, are the main drivers of growth.

“Ideas are different. Ideas have special properties,” Romer says.

While things such as land, machinery and capital are scarce, Romer argues that ideas and knowledge build on each other and can be reproduced cheaply or at no cost at all. In other words, ideas don’t obey the law of diminishing returns – where adding more inputs like labor, machinery or money eventually results in the trailing away of additional output.

An important confirmation of Romer’s perspective has been evident in the market for information technology over the past quarter century, where rapidly falling prices have not resulted in a falloff in demand. Skeptics may gripe that most people buying computers have more computational capacity than they know what do with. But new applications are constantly being invented, creating markets that the skeptics never imagined.

This has sweeping implications for investment. Because ideas are limitless, the prospect for long-run growth at accelerating rates are much better than proponents of the old growth models would have you believe. They enshrined the concept of diminishing marginal returns, which led them to brood about “the limits to growth”. The law of diminishing returns states that as a firm uses more of a variable input, with the quantity of fixed inputs constant, its marginal product must eventually diminish.

Classical Growth Theory: The Digital Economy

Diminishing returns challenge the logic of the growth style of investment, implying that growing firms cannot continue to make profits indefinitely. However, as Kevin Kelly points out, “this law only holds true when applied to physical assets and traditional industry, not to the digital economy, where intangible assets such as Wired editor knowledge are so important. In fact, for certain key components of the digital economy, such as technological advancement and an emerging information society, the opposite is true: increasing returns are commonplace. For example, the costs of developing a new piece of software or an operating system like Microsoft Windows are huge, but once the first unit of the product has been sold, each subsequent unit sold costs relatively little to produce. By the same token, firms selling information-based products also exhibit increasing returns: the costs of reproducing an information-based product are practically nonexistent.”

One of my objectives as an entrepreneur, investor and investment analyst is to harness the power of increasing returns in our portfolios. Software and biotechnology are particularly well suited to increasing returns. These are areas that stand to redefine an industry and spawn new industries, and transform our way of living. If you can identify and invest in technologies and businesses that offer the potential of “transformational” change, you can grow very wealthy. Cases in point are Bill Gates and Steve Case. They did not found the Internet, the origins of which date back to 1958, but they recognized the potential for transformational change that the Internet could bring about and began developing and investing in it early. Of course, they became billionaires…and made thousands of other investors into millionaires along the way.

In the somewhat depressing and uncertain climate I outlined in the first paragraph of this article, it is easy (and natural) for investors to be lured by the illusion of the security of shifting their portfolios into well-known and more liquid names. While eventually your blue-chip holdings may rebound with the return of a bull market (whenever that may occur), you don’t want to wait that long. You can create your own bull market by focusing your investment resources on building wealth now rather than waiting for a collective change of heart to confirm that investing in the stock market is once again “the thing to do”.

In even the worst market, there are always fortune-making companies for sale while they are cheap. There are always some sectors that enjoy special conditions, which can lead to “bull” markets for them – even while better known companies suffer.


Jim Davidson,
for The Daily Reckoning
March 18, 2003

P.S. I don’t pretend that finding your own bull market is an easy thing to accomplish. The stocks you select must have the advantage of potential leverage for creating wealth. The first hurdle is to identify that transformational idea with the management and structure in place to make it fly. The second hurdle is to time your investment to the early stages of development before it has become widely known and priced up. (And it never hurts to take advantage of a temporary negative aberration that clouds the long-term opportunity for the bulk of the investment community and prices it down for you.) The third hurdle is to have the staying power and commitment to ride the ups and down of some of these volatile emerging companies to realize the huge gains that are in the picture if your first analysis was on target.

These are the ways to create your own bull market in even the most negative environment. It is not a path easily followed by the faint of heart. But for the bold and visionary investor, it is perhaps the only way to build real wealth.


Well, Saddam has 48 hours to get out of his own town. Or else.

Investors, like gamblers at a back-alley fistfight, are betting on how long it takes the man to go down.

The smart money is probably still on the sidelines. But the average investor seems to want a piece of the Saddam bashing. The Dow rose sharply yesterday; buyers believed that the Butcher of Baghdad will be felled quickly and happily.

God bless ’em.

What impresses us about these people is not their optimism; it’s their unadulterated immodesty. Warren Buffett can’t seem to find decent values on the stock market, but they think they can!

Stocks are far from cheap, says the Sage of Omaha. The P/E for the S&P has run about 18, on average, for the last 50 years. Now, it’s 29…and if you use ‘core earnings’ as a measure (that is, earnings without a lot of financial hankey-pankey in them), they’re over 40.

Buffett points out that the stock market is a giant ‘voting machine’ in the short run. It gives investors the outcomes they choose, just as an election gives voters the sordid louts they select.

But in the long run, Buffett explains, the stock market is a ‘weighing machine’. It measures out a kind of rough justice…based on what stocks are really worth and what investors really deserve.

Investors cannot guarantee success, of course. But at least they can deserve it. Ben Graham, from whom Buffett learned his trade, once described the kind of stocks that were likely to reward deserving investors. They had to meet a number of tests, he suggested, such as having 20 years of uninterrupted dividend payments, a P/E no higher than 15 and a ratio of price to book value no higher than 1.5:1.

Thus can investors figure out if a stock market is expensive or cheap: simply by looking at how many stocks meet Graham’s tests. In October of ’74…when the Dow hit a major bottom…85 of the S&P 500 would have qualified, notes Grant’s Interest Rate Observer. At the August ’82 low, the number was 62.

What about the pre-war low of Feb. ’03? Moms and Pops think a major bottom is at hand. They’re buying stocks as if they were masking tape and plastic sheeting. But how many stocks really deserve their money? Only two, according to Grant’s figures: Limited Brands and Scientific Atlanta.

We’ll take a wild guess: investors gambling on the Saddam bout are not buying either of these companies.

More from Eric…and then, more below…


Eric Fry back in the city…

– The long-anticipated “Invasion Rally” kicked into high gear yesterday, as the Dow raced ahead 282 points to 8,142 and the Nasdaq sprinted nearly 4% to 1,392. As regular readers may recall, the New York office of the Daily Reckoning has issued a few fleetingly bullish musings of late – emphasis on “fleetingly”. Yesterday’s spectacular rally satisfied our bullish urges. We return now to our habitual agnosticism-tinged-with-skepticism.

– The Invasion Rally seems a bit too pat and tidy to be the beginning of a new bull market. More than likely, we are witnessing nothing more than a textbook bear market rally – swift, sharp and short-lived. Just like all the prior bear market rallies that have punctuated the market’s three-year decline, the latest advance sprung to life from the mire of pervasive bearish sentiment. The problem with these bear market rallies is that they wither and fade back into the mire as suddenly as they first appeared. This rally will likely be no different…

– As noted in yesterday’s Daily Reckoning, your co-editor has been hanging out in the Bahamas for the past few days. So he’s much better prepared to discuss rum drinks than Rumsfeld…or President Bush and his new 48-hour ultimatum. But don’t worry; your co-editor will re-acquaint himself with the dismal headlines of the New York Times, well before the shooting starts in Iraq…

– The Bahamas was the site of the latest meeting of the Supper Club – a membership-only investment club dedicated to examining venture capital opportunities. “Venture capital” is a scary term that conjures up images of self- important MBAs throwing hundreds of millions of dollars at preposterously high-risk technology companies. Certainly, some of the deals presented to the Supper Club are plenty scary, and there is ample opportunity to lose money. But the Supper Club is a somewhat different breed of venture capital. For one thing, the club examines a broad range of opportunities that are far from the type your editor finds around these parts [NYC]. Besides, it’s a great time…and worth a word or two of commentary.

– The Bahamas Supper Club meeting, for example, featured opportunities to invest in ventures ranging from an L.A.- based pizza chain to an innovative electric motor to a Northern California commercial land development to a special widget for securing wireless PC networks.

– After each of the venture companies pitches their story to the members, the fun really begins. It is at that point when the members begin to candidly – sometimes ruthlessly – – assess the opportunities that have been presented to them. This free and open exchange enables all of the members to make a more informed assessment about whether to invest in a given deal. The Supper Club – whose three-year existence makes it a mere infant in “VC years” – cannot yet point to any “10-baggers” or other eye-popping successes. But a couple of deals appear to be close to producing some measurable success. As the saying goes, however, “Close only counts in horseshoes and hand grenades”. So let’s wait for conclusive success before planting the victory flag.

– Of particular interest to this observer – as one who keeps an eye out for intriguing macro-economic phenomenon – is that the quality of the Supper Club opportunities seems to be steadily improving, meeting by meeting. Apparently, the lower the stock market falls, the more frightened the traditional institutional VC investors become. Frightened VC investors beget hungry entrepreneurs, which beget better deals – and better investment terms on those deals – for members to consider.

– If you look on the bright side of things, like we do here at the Daily Reckoning, you might notice that this bear market isn’t all bad. Not only is it easier to get a reservation in an expensive New York restaurant, but it’s also easier for investors with the right amount of capital to locate more attractive – and more attractively priced – venture capital deals…and potentially profitable investment ideas – outside of the stock market.

– [Editor’s note: If you’re interested in learning more about the deals being presented at the Supper Club, or where the next meeting will be held, we encourage you to send an e-mail to Vickie Beard, the club’s coordinator:]


Back in Paris…

*** “There are two panaceas for a mismanaged government,” Hemingway noticed. “The first is inflation of the currency. The second is war. Both bring temporary prosperity. Both bring a more permanent ruin.”

We are not Hemingway admirers. In our opinion, his whole oeuvre could be condensed into a single line: ‘Damn, I feel awful; let’s have a drink.’ But if you write enough, you’re bound to say something that makes sense (oops, we have given away our Daily Reckoning secret).

After mismanaging the economy into the biggest bubble in history, the Greenspan Fed has been blowing as much inflation into the currency as it could get away with. Fed credit has been increasing at nearly 19% (annual rate) for the last 3 months. The money supply, as measured by money of zero maturity, rose nearly 12% – or about 5 times faster than the economy, again in the most recent 3 months.

But inflation is not always the panacea that Hemingway thought it would be. There are times when people are reluctant to borrow and spend…and times when rising capacity (in this case, from overseas) drives down consumer prices. Despite heroic efforts from the Fed, the economy still seems to be in a slump – 3 years after the stock market peaked out.

Yesterday brought more evidence that the ‘soft patch’ Greenspan described a few months ago is getting even softer. The National Association of Home Builders, for example, just reported the biggest drop in its index since it was begun in 1985. Likewise, consumer sentiment is at a 10-year low, judging from recent poll results.

What can the Fed do? Most likely, it will continue to try to inflate. Look for another rate cut.

But investors have lost confidence in rate cuts. Now, they’re pinning their hopes on war.

God bless ’em, we say again.

*** A reader wrote to complain about our approving quote from George Soros. The reader is right; typically, we only quote Soros to show what a fool he is. But that is the trouble with fools like Hemingway and Soros, dear reader; you can’t count on them. Sometimes they say something you agree with.

*** Another reader wrote to say the Daily Reckoning would still be a good deal “at twice the price”.

Other reader comments:

“I have appreciated the intelligent and restrained, cynical approach to the coming war taken by the DR. Perhaps you let J.C. Amberger’s comments [“With Friends Like These…” 03/13/03] through just to give some time to the America, right or wrong crowd. Yet, he didn’t defend the war, just attacked the critics’ motives, not their arguments.

“As you have accurately dubbed Bush as a Napoleon, here is a quote from Christian writer Alexander Campbell’s ‘Address on War’ in 1848.

“‘Napoleon, on his death-bed, declared that he had never engaged, during his whole career, in an aggressive war – that all his wars were defensive. Yet all Europe regarded him as the most aggressive warrior of any age.’

“And another quote, ‘Kings cannot grow in America. But under our free and liberal institutions, we can impart more than kingly power under a less offensive name.'”

God Bless, C.

“Sirs: The biggest problem in America the past 75 years has been poor problem solving skills. It’s the common denominator to all our other problems. Today, for example, we honestly mistake our personal opinions for actual fact.

“Sigh! And while Caesar’s fascism was ‘bad’, our own empirical manifest destiny still lives, and is somehow ‘good’. Hail Caesar! So stick by your guns, boys…you are right on target!

“For whatever its worth, I do suspect that:

1.) Bush’s Mission is the democratization of Chaostan, and the first Objective of that Mission is the ousting of Saddam. Can you say “Armageddon”?

2.) We will uncover (literally) desert military stockpiles of WMD, thereby justifying everything (in our eyes only).

3.) But don’t worry about the dollar cost of this war… with a U.S. governor – it will all be paid for by Russia and China, and especially Germany, and most especially by France…out of Iraqi oil perks, of course.

“‘Don’t give up the ship!'” R.E.M.

“Dear DR,

“Don’t pay attention to the fools who confuse patriotism with loyalty to the current gang of politicos who currently infest Wash. D.C. “The tradition of our Constitutional Republic calls for making money from foreigners – not bombing them. “From a strictly economic perspective the fools who call for pre-emptive war will wind up making a ‘pre-emptive’ strike on our economic well being. Their military adventures will accomplish nothing but huge future deficits and a sickly dollar. “I wonder how ‘gung ho’ the current crop of Baby Boomer Bombers and aging chickenhawks will be when they discover they are exchanging Social Security checks for rebuilding Iraq’s infrastructure and paying the salaries of Iraqi civil servants salaries rather then funding Medicare…

“In the not-too-distant future, when the Gung Ho Geezers wake up every 2 hours to pee because they are too poor to buy prescription drugs since their pension funds have lost 90% of their value and Medicare is bankrupt. “Waking up in the quiet solitude of night is a good time to reminisce over the glories of Empire.” Regards, F.L.W.

“Dear Daily Reckoning Editors,

“It makes sense that quite a few people would be sending negative comment your way since people living within the U.S. and accessing U.S. media exclusively are often completely out of touch with the opinions and information available in other countries. My Australian brother and I see the world very differently from our brother and parents that almost never leave the U.S. and are looked upon almost as Martians when we share an opinion.

“I tend to agree with Le Carré that the U.S. has gone mad.”

R. Germano

The Daily Reckoning