Investors' Long and Winding Road
by Bill Bonner
“I look at the world and I notice it’s turning
while my guitar gently weeps
With every mistake we must surely be learning
While my guitar gently weeps…
George Harrison, R.I.P.
“The mere fact that share prices were rising so quickly became the main impetus for people to rush into stocks,” says Warren Buffett of the last century’s first great bubble market, but also describing its last. “What the few bought for the right reason in 1925, the many bought for the wrong reason in 1929.”
Both groups of investors – those who bought when stocks were cheap in ’25, and those who bought when they were expensive in ’29 – got what they deserved. The first group got to sell high after buying low. The second got to sell low after buying high. Both patience and greed were rewarded.
Today, many investors bought when the chips were up in the late ’90s. Most of those investors still buy, and hold, stocks – expecting the chips to rise further. Perhaps they will. And people who follow our Daily Reckoning advice – to stay away from expensive shares – may curse us for the next two weeks or the next two years. We don’t have a clue what will happen in the short run…and we’re not sure about the long run either.
But the world’s greatest investor – Warren Buffett – thinks “it is very easy to see what is likely to happen over the long term.”
“Ben Graham told us why,” he explains. “‘Though the stock market functions as a voting machine in the short run,’ wrote Graham, ‘it acts as a weighing machine in the long run.'”
“Fear and greed play important roles when votes are being cast,” Buffett adds, “but they don’t register on the scale.”
The voters hope to elect a new bull market. In the near term, as the votes are counted, investors – like Democrats – could get any fool result they want…But in the longer term, the scales of providence will almost certainly tip towards lower equity prices and surely give them what they deserve…
The December 10, 2001 issue of Fortune Magazine provides an “Investor’s Guide” to the year ahead. Included is a long article by Warren Buffett.
Buffett begins by describing two periods of time leading up to the end of the century – 1964 to 1981 and, then, 1981 to 1998. The first 17-year period was a time of strong economic growth – with the nation’s GDP up 373%. The second period saw economic growth fall to less than half the previous rate, with total GDP up 177% over the 17-years.
Investors may have a different recollection of the two periods, however. For it was in the second that their fortunes rose, and not in the first. Dow Industrials began the year 1964 at 874.12 and finished not a single point higher. But by the late summer of 1982, here comes the sun. Dow stocks began an epochal rise…From 875 on December 31, 1981, the Dow rose to 9,181 by the close of business on December 31, 1998.
Buffet points out that economic growth has been fairly sure and fairly steady throughout the entire 20th century. In 9 of the 10 decades of the century, per capital GNP, measured in constant dollars, grew by double digit rates. And in every decade GNP growth/capital was positive, with an average of 24.6% growth in each decade since 1950. From 1901 to 1999, per capita output grew by more than 7 times.
Though the economy grew steadily, investors received wildly different results from their stocks. In the first 20 years of the century, for example, stocks went nowhere. Then, in the 1920’s, the Dow jumped 430%. The 1920s were, by coincidence, the least prosperous decade of the entire century – with a growth of GNP/capita of only 1%.
After the crash of ’29, “We go 19 years – 19 years -” Buffett says, “and there is the Dow at 177, half the level where it began. That’s true even though the 1940s displayed by far the largest gain in per capital GDP (50%) of any 20th-century decade.”
Buffett describes the century: “We had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points. And we have three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points.”
If economic growth bears little resemblance to stock market performance – even over long periods of time – what does drive stock prices?
Buffett identifies 3 things. Interest rates determine how much a given stream of income is worth – compared to other uses of your money. Low interest rates require larger amounts of capital to produce the same yields. So, a dollar’s worth of dividend yield will be worth a lot more in a world of 2% interest rates than it will bein a world of 10% rates.
That helps explain why stocks did poorly from ’64 to ’81 and well thereafter. Long-term government bond rates were low in ’64 and rising. They rose from 4.20% at the end of 1964 to 13.65% at the end of 1981. Then, they fell – to 5.08% at the end of 1998.
Another important variable, says Buffett, is company earnings. When earnings are rising, investors naturally look ahead to higher returns from their investments. Profits rose in the last two decades of the century, which – along with declining interest rates – led to a huge increase in confidence…Not only were companies expected to earn more in the future than they did in the past, but those future earnings were expected to be worth more in a lower-interest rate world. The economy was actually growing much less strongly than it did in the preceding period, but investors were willing to pay far more for America’s businesses.
The third variable is the herd psychology of investors. Taken as a group, investors – including the most sophisticated professionals who run pension funds – can be counted on to do precisely the wrong thing at precisely the wrong time. Instead of looking ahead, they continue to do whatever recently proved profitable, long after the justification for it has disappeared.
Pension fund managers put 91% of their cash flow into equities in 1971, for example, just before a major bear market. Then, three years later, when stocks were cheap again, they wanted nothing to do with them, only allotting 13% of cash flow to equities. More recently, since cheap stocks in 1982 proved very profitable…they continued to buy them in 1998…and 2001…long after they’d ceased to be cheap.
What can they expect now? In the short term, the votes will be counted – including the big blocks of votes from the fund managers – and who knows what they will give us. But, eventually, the fundamentals weigh in…and the return on stocks will decline.
At your service,
November 30, 2001
Today, we pose the question again: is the rally over?
The chips were up yesterday, recovering Wednesday’s loss. Where will they be tomorrow and the next day? Who can say? And who really cares? Something not worth buying does not become attractive just become its price rises.
But deflation is back in the news as bonds rose yesterday along with stocks. While stock buyers thought they saw clear sailing, bond buyers saw clouds, and lower rates:
Unemployment claims rose last week, after falling 4 weeks in a row…
“Economic activity edged lower,” reported the Richmond Fed bank in the “beige book” survey of regional trends.
And the White House said it expects at least 3 years of budget deficits. Goodbye surplus…we hardly knew ye.
Eric Fry from New York…
– Hey all you folks singing songs and telling tales around the fire in Bill’s deflation camp, DR Blue Team member Greg Weldon has got a story your gonna love! Have you heard the one about the deflationary Asian economy? “Japan is imploding, and it ain’t no joking matter,” Weldon proclaims.
– He points out that the plunge in Japanese retail sales from September’s -0.7% year-over-year rate of decline to October’s -7.1% year-over-year rate signals an “implosion” in the consumer sector. It is the steepest pace of decline in the retail sector in more than two years.
– Likewise, Weldon asserts that the depression-like 41.2% year-over-year contraction in total orders signals an “implosion” in the industrial sector.
– In response to some of these trends, Standard and Poor’s downgraded Japan’s credit rating this week. Ominously, S&P also said, “There is more than a 60% chance the rating will be lowered again. The fact that we have kept the outlook negative means this is not the end. We expect further significant weakening of both the economy and the government’s fiscal position before more radical action (reform) is taken.”
– Returning to the Stateside economic data, the recent confidence readings from the Conference Board offer additional grist for the deflation mill. The current conditions index has now dropped a harrowing 50% from its cyclical peak in July 2000.
– The “jobs hard to get” reading continues its inexorable rise as well.
– Along with the millions of unemployed are the unspecified millions more of “underemployed.”
– “While tucking into the steaming spinach and chickpea dishes and hot tea that offer comfort in the deli, [taxicab] drivers like Sultan Khan and Abdul Majeed fret about the psychological fallout from Sept. 11 that has hurt their trade,” Reuters reports. “Khan, an immigrant from Pakistan who leases his taxi, begins his day at 5 a.m. and ends it at 5 p.m., and his taxi tip sheet offers an idea of just how sharply demand for cab rides has fallen.
– “Before Sept. 11, Khan’s sheet showed earnings of $110 to $120 by midday. These days, he’s lucky if he clears much more than $60 by that time. Much of the decline in earnings is due to the plunge in airport traffic… Bundled in with the tip sheets are Khan’s credit card bills, some of them delinquent. Nor is he alone in his struggle to pay bills.”
– Reuters continues: “According to U.S. credit rating agency Standard & Poor’s, Americans could default on credit card debt in record numbers because of mounting job losses. Analysts at the rating agency said the loss rate for credit card companies could rise to heights not seen since the firm started tracking the performance of credit cards.” Ouch!
– Credit card giant Capital One’s new TV ads end with the question, “What’s in your wallet?” Unfortunately for the economy and in particular for Capital One, the answer increasingly seems to be, “Not enough cash to pay the credit card bill.”
– The worsening labor market does not bode well for confidence going forward, says Weldon, but the housing market may pose an even larger threat to consumer confidence. “Within the allegedly healthy Existing Home Sales data,” he notes, “the Median Sales price plunged by a massive $9,500, to $138,600, thus representing a steep one-month deflation of 6.4% (There’s that word again!). Annualized, that equals a whopping 77% rate of home price depreciation.
– But Mr. Market couldn’t care less. Taking a page from the book of 1980s pop diva Cyndi Lauper, this boy just wants to have fun. He can’t be bothered with worries about imploding foreign economies or falling corporate profits or rich stock valuations. Let the grown-ups furrow their brows over that boring stuff.
– The only thing Mr. Market cares about is partying 24/7. Yesterday the Dow boogied ahead 117 points to 9,829. Meanwhile, the Nasdaq was “freakin” to a 2.4% advance.
– But this particular party may be short-lived, as Alan Abelson soberly reminds us: “[The] current market- valuation measures – twenty-five or something times earnings, close to seven times book and 1/2 times sales – [are] respectively, twice, more than quadruple in nearly triple what P/Es, price-to-book and price-to- sales averaged at previous bear market bottoms. Or, somewhere between absurd and ludicrous. Pretty shaky stuff to serve as the springboard for a new bull market.”
Back in the City of Light…
*** Not much more to say…George Harrison’s guitar gently wept yesterday…
*** And I had dinner with Maria last night. Tall and elegant, Maria turns heads wherever she goes. And she was in a particularly cheerful mood last night. But she is still just a little girl.
*** “Daddy, I told Sophia (her 19-year-old sister) that I would like to have a boyfriend. And Sophia said, ‘don’t bother. Boys are all scum bags at that age.’…I told Sophia that I was sure she was right. But I’d still kind of like to have a boyfriend…what do you think, Daddy?”
*** “I agree with Sophia,” I replied without much thought. “The last thing you need is a boyfriend. You’re too busy already…”
*** “But you weren’t a scum bag when you were young, were you Dad?”
*** “No, of course not…,” I responded, lamely, “but I was an exception…”