For the Cautiously Optimistic
In the face of a decade of slogging returns on Wall Street, what should the individual investor do? Addison Wiggin has a suggestion…
Great bear markets take their time. In 1929, we started a 17-year bear market, succeeded by a 20-year bull market, followed in 1965 by another 17-year bear market, then an 18-year bull. Now we’re going to have a one-year bear market? It doesn’t seem very symmetrical.
– Jeremy Grantham, 2001
From time to time, we like to remind readers that markets, like all natural beasts, have a tendency to get out of whack. And, that nature, never too shy, likes to force them back into whack.
In a 2001 Barron’s interview Jeremy Grantham unveiled the conclusions he had drawn following an extensive study of market bubbles, including stocks, bonds, commodities and currencies – 28 bubbles in all. Grantham and his associates defined a bubble as "a 40-year event in which statistics went well beyond the norm, a two-standard-deviation event."
"Every one of the 28 [bubbles] went back to trend," Grantham noted, "no exceptions, no new eras, not a single one that we can find in history." It will come as no great surprise to Daily Reckoning pedants that we are prone to Mr. Grantham’s influence. In fact, if you were a bully and you pressed our backs tightly up against a chain link fence, you’d sooner hear us squeal "Dow 3000" than 13000… or even 12…
Bull’s Eye Investing: Secular Bear Market
What may come as more of a surprise, in today’s essay, however, is a nod to optimism, albeit a cautious one. We have just put down friend and colleague John Mauldin’s new book: "Bull’s Eye Investing: Targeting Real Returns in a Smoke and Mirrors Market," and would like to recommend that you buy a copy and read it. Today.
Firstly, Mr. Mauldin argues forcefully, for six chapters, that we are in the early stages of a secular bear market in U.S. stocks. The comprehensive coverage in those chapters alone makes us – purveyors of the longest daily e-mail in recorded e-history – feel like slackers.
Mauldin shows – citing studies that would make any market historian swoon – that when valuations reach the levels they are at today, investors have always been better off investing in money market funds over the following ten years. But what fun is that? After Mauldin gets done thoroughly discouraging his readers…he offers many a ray of hope. Cautiously, of course.
For example, John cites an article from the 2001 Academy of Sciences Journal of Financial Intermediation, in which a researcher by the name of Albert Wang found that neither "under-confident" investors nor perma-bearish sentiment could survive in the market. Massively "over-confident" or bullish investors likewise lead themselves to the slaughterhouse. Only the investors who are cautiously optimistic were able to, not only survive, but also win.
Bull’s Eye Investing: Overconfidence Will Get You Killed
"In the world of our ancestors," Mauldin writes, "overconfidence will get you killed. Lack of confidence will mean you sit around and starve. Cautious optimism is the right approach. What Wang is showing is that the same is true in the new world of investments. It should be self-evident that it is necessary to play if you are going to win. Further, a willingness to accept some level of volatility and risk is characteristic of successful investing. But taking too much risk will soon get you sent to the sidelines."
But the wrong type of "confidence" will get you killed just as quickly. As an example, let’s look at another study Mauldin has unearthed:
"First, a researcher takes a deck of 52 cards and holds one card up. Watchers pay a dollar for the chance to win $100 if that card is picked out of the deck. Keep in mind the expected payout is 1/52 × 100 = 1.92. Las Vegas would quickly go broke with such odds.
"Then they are asked if they would like to sell their chances: roughly 80 percent would sell if they could, asking for an average price of $1.86. If you could get such a price, it would be a reasonable purchase. For someone who could buy all 52 chances, it would be a good investment or arbitrage. He would make a quick 3.18 percent.
"Now it gets interesting. The next time, someone is allowed to pick a card out of the deck and offered the same chance, but now he has a personal attachment to the card because he touched it. Only about 60 percent of those who picked cards were willing to sell their chances, and they wanted an average price of just over $6. And when this same trick was performed at MBA schools the average sale price has been over $9.
"’I know this card. I have studied it. I have a personal involvement with the card; therefore it is worth more,’ thinks the investor. Of course, it is worth no more than in the first case, but the psychology of ‘owning’ the card makes investors value it more."
Bull’s Eye Investing: Familiarity Is No Substitute
Investors, Mauldin suggests, continually make that same mistake, substituting familiarity for value-based research and reason, basing their investments and their future on false confidence that, in the end, leads to disaster. You could substitute fund, market, country, currency, or metal for stock. Just because we know a lot about an investment does not mean it is a good one.
But where then, does Mr. Mauldin find the right kind of confidence? In a true sense, that search is the unstated theme of his book…and it comes from several sources.
First, it is the steady march of history. Mauldin sees the stock market, currencies, commodities, bonds, interest rates – in short, everything – as subject to historical, economic and fundamental forces. Finding these forces and investing with the trend – rather than against it – is the key to confidence. Where some might see the continued decline of the dollar as a reason to despair, John simply sees another trend from which to profit. If the economy grows slower than in the past – something Daily Reckoning readers will recognize as Mauldin’s ‘Muddle Through Economy’ – again it is not a problem, but an opportunity.
When the Fed wants to manipulate interest rates – they may theoretically be wrong – but astute investors recognize it as a gift of potential personal profit. Every chapter of Mauldin’s book is grounded in history…yet he steps out on occasion and deigns to predict the future.
If you’re a regular reader of the Daily Reckoning, you know Mauldin believes that value is the driver of market cycles. In Bulls Eye Investing, he offers numerous ways that small investors – which he demonstrates have an inherent advantage over institutions in today’s market – can invest with confidence in today’s market. His chapters on value investing may be considered as essential reading for the individual investor. Mauldin’s data mining on "behavioral investing" is worth an entire book of its own.
How can you be in the top 10% of all investors over the next ten years? Simple. Just be above average for each of the next ten years. You don’t have to shoot for the moon or take great risks. If you can beat the average – each and every year – in the end you will be among the most successful of investors on the planet.
for the Daily Reckoning
June 17, 2004
P.S. If you’ve read our book you know there are, quite frankly, few occasions upon which we agree with George Gilder. But when he writes: "Mauldin is the Ben Graham of the new millennium, but unlike Graham, he combines investment savvy with a sense of humor and a gift of style," we are tempted to do just that.
Editor’s Note: Addison Wiggin is the executive publisher of Agora Financial Publishing and editorial director of the Daily Reckoning.
John Mauldin is the creative force behind the Millennium Wave investment theory and author of the weekly economic e-mail "Thoughts from the Frontline." As well as being a frequent contributor to The Daily Reckoning, Mr. Mauldin is the author of Bull’s Eye Investing (John Wiley & Sons, 2004 London NY), which is currently tracking on the NY Times business bestseller list.
In his easy-to-read, straightforward style, Mauldin spots the big market trends – and shows you how to profit from them. "Bull’s Eye Investing" is a must-read roadmap if you want to avoid the pitfalls of the modern investing landscape…
Yesterday, the Dow went nowhere. It has gone mostly nowhere this year. And mostly nowhere for the last 6 years.
There are a lot of days in a year…and a lot of years in a lifetime. On most of them, nothing is likely to happen.
But that doesn’t mean you should not prepare for something. Alan Greenspan has created bubble after bubble…there are now major bubbles in consumer debt, housing, stocks (a bubble that began in the late ’90s and still has not deflated)…imports…and a capital spending bubble in China (the Chinese are feverishly trying to keep up with American consumer demand).
Anatole Kaletsky, writing in today’s Times, argues, "Bust does not have to follow boom."
"Consumption," he quotes Adam Smith, "is the sole end and purpose" of all economic activity. So what if Brits and Americans are consuming their heads off, he says…it is just "a natural and desirable consequence of…improving economic performance."
"The unsustainable orgy of government spending, personal borrowing and consumption which Britain has enjoyed…is a sign that the British economy has gradually transformed itself from the sick man of Europe into one of the strongest and healthiest economies in the world."
Consumption may be the end of economic activity; the trouble for Britain and America is that it is not the beginning. It is not consumption that creates wealth; instead, consumption extinguishes it. Of course, the healthier the economy, the more wealth it produces that may be consumed.
But a society that consumes more than it produces is headed for trouble. Yesterday, we reported that, in May, America’s balance of trade dipped to its lowest level ever – a negative $48 billion. This is a rough measure of how far consumption outpaces production…and another milestone on the road to ruin.
How many miles are left? Will tomorrow be the day we ‘get there?’
Most likely, no. There are a lot of days…and only one day on which the biggest bubbles in history begin to explode.
Still, Daily Reckoning sufferers are advised to consider the gravity along with the likelihood. You may put a bullet in a revolver, spin the chamber, and put the barrel to your head. There will be only a 1-in-6 chance the gun will blow your brain out. Nonetheless, it would not be a good idea to pull the trigger.
Likewise, the end of Alan’s bubbles is not likely to come along today or tomorrow. Still, readers are cautioned to invest as if they happened yesterday.
Over to Eric for more news:
Eric Fry, from New York, New York…
– Here in Manhattan, the weather has turned sultry…and your New York editor is grateful. The local fauna have shed their thick winter coats and may now be seen ambling along the sidewalks in tank tops, shorts, and sandals…The warm weather seems to flush attractive women out of their apartments like a Springer Spaniel flushes pheasant from a hedgerow – not that your New York editor pays any attention to attractive women…other than the one who routinely hangs on his arm, of course.
– No, your Wall Street correspondent never averts his eyes – or his mind – from the financial markets, except to eat or sleep. Yesterday, however, he nearly nodded off during market hours, as the stock market refused to commit to any particular direction. It fell a little, then rose a little, then continued to alternate between the two activities for the next 6 hours until the closing bell mercifully sounded the end of trading. The Dow slipped less than one point to 10,380, while the Nasdaq added three points to 1,998.
– Depending upon one’s perspective, the stock market’s behavior was either impressive or disappointing. On the one hand, a steep sell-off in the bond market failed to drag stocks lower. On the other hand, news of the biggest jump in industrial production in nearly six years failed to drive them higher.
– The dollar, however, relished this fresh indication of economic growth by rallying more than 1% against the euro to $1.202. The dollar’s rally sapped buying interest from the gold market, pulling the safe-haven metal down $4.40 to $384.65 an ounce. Curiously, the XAU Index of gold shares ROSE yesterday – up more than half a percent. We’d like to imagine that the sellers of gold shares have exhausted themselves, but we are too timorous to declare the sell-off complete. We’ll be watching today’s action very closely for additional clues…
– Returning now to the kinds of things that bore most normal folks, the Federal Reserve says we’re producing more stuff than before and that we’re starting to use up some of our spare production capacity. According to the Fed’s reports yesterday, industrial output climbed 1.1% in May to a record high, while capacity utilization rose to 77.8% – the highest level in three years. The utilization rate has advanced by over 5% since setting a 20-year low in June 2003. So clearly, somebody’s producing more of something.
– Usually, but not always, rising production and factory utilization portend rising inflation. And traditionally, rising inflation produces higher interest rates. But Wall Street tells us not to worry. Sure, the overall inflation rate seems a bit high, but the "core" rate is just as tame as can be.
– Tuesday, the Labor Department reported a ghastly 0.6% jump in consumer prices for the month of May. But the experts on Wall Street urged investors to focus on the "core" rate, which only rose 0.2%. The lower "core" rate is, naturally, the one championed by Wall Street as the "real" number…if there’s a way to shade the truth – particularly a negative truth – the folks on Wall Street will find a way. They create more shade than a cabana boy.
– So far this year, consumer prices have increased as a 5.1% annual rate, while "core" prices have increased by "only" 2.9% annualized, or more than twice the 1.3% rate recorded in the first five months of last year.
– Would it be wise to ignore the headline inflation readings and focus only on "core" rates? Let’s respond to the question by imagining that the mutual fund industry reported two sets of performance numbers – "overall" returns and "core" returns. And let’s imagine a year-end portfolio review that would read: "Dear shareholder, we are pleased to report another successful year. While it’s true that your fund’s overall portfolio value tumbled 26%, its "core" portfolio soared 87%, handily beating the S&P 500 for the 13th consecutive year…"
– Embrace the core number if you wish, dear reader, but the core of the truth probably resides in the overall number.
– "Inflationary pressures are not likely to be a serious concern in the period ahead," Alan Greenspan calmly advised the Senate Banking Committee on Tuesday. The chairman’s assertion seems a bit disingenuous because it ignores the inflationary pressures that already inhabit the U.S. economy. Even the toned-down, core consumer price index is tracking at nearly triple the Fed funds rate, while the overall CPI is five times the Fed funds rate! In other words, based upon the government’s own data, Greenspan is asleep on the job – like a kind of Homer Simpson of central banking. The keeper of the currency is snoozing while the inflation rate doubles.
– "If I am a bondholder," says James Paulsen, Chief Investment Strategist at Wells Capital Management, "I want a massively aggressive, inflation-fighting Fed. The last thing I want is a Fed that is timid, touchy-feely, slow and communicative. The Fed has said we’re going to be slow in our response so we don’t scare anybody. But I think that approach is exactly what is going to scare everybody."
– Your New York editor has chills up his spine already.
Bill Bonner, back in London:
*** We watch gold…and bonds. Everyone knows inflation and higher interest rates are coming. But yesterday, bonds eased off – but just a little; they do not seem to have gotten the message. Likewise, gold fell $3.50. If inflation really were increasing…why wouldn’t gold rise?
Our guess is that Mr. Market is fooling nearly everyone. The long bull market in bonds…that began in 1981…may not be over yet.
After WWII, stocks bottomed out in 1949. Then, they rose for 17 years until ’66. A bear market began in ’66, with a confusing second peak in ’68…but then continued going down, a total of 16 years, until ’82. Then began the great bull market that lasted another 17 years.
That last bull market peaked out in the first quarter of 2000. Most likely, stocks are in a major bear trend again. Most likely, it will last at least another 10 years.
Bonds follow even longer trends. Government bond yields rose from 1946 until 1981… a period of 35 years. Since 1981, bond yields, interest rates and consumer price inflation have all trended down. The end of the trend is widely believed to have come almost exactly a year ago this week – when the 10-year Treasury yield slipped to 3.11%. Yields have risen since then. Most observers believe it will be a long time before they drop back.
We’re not so sure. Which is not to say that we want to pull the trigger on U.S. bond purchases. The bull market in bonds may not be over, but the risk of owning them probably far outweighs the potential reward. Some day, bonds will fall. Maybe tomorrow. Maybe next month. That would be a bad day to have the pistol pointed at your head.
*** A reader writes:
"Your vacation concerns and determination are both right on, but frankly, I can’t think of anything that would support your style of thinking and writing better than a trip around the U.S.
"The very things that make kids hate it are so incredibly important from an adult’s point of view. It is just so damned big and hot with so much distance between the points of interest, so much incredibly indifferent food, and so many strip malls that all have the same stuff.
"And that completely leaves out the people. You definitely won’t see many attractive young ladies with flowers in their hats and white pants on their escorts. They make less money than you can believe. They don’t read and they have never met anyone who is gay. (Well, they think they haven’t.) The most polite ones will just smile indulgently if you talk about things that interest, concern, or worry you and me. And yet, most of them are happy, smiling, well adjusted and while they might marvel at someone else’s travels, income, or thoughts, they wouldn’t really consider trading places.
"I’ve never met anyone who wasn’t surprised at the effect the Grand Canyon had on them, or the Grand Coulee Dam in Washington, or the hot springs in Thermopolis, Wyoming that must be free to the public because some smart old Indian saw the white man clearly enough to write that into the treaty which took the land away.
"If the rest of your family doesn’t mutiny, the rest of us will be treated to stories and metaphors that explain the markets in new and interesting ways from things that happen on that trip.