Lost At Sea

When we left off yesterday, the “gray-haired pinkos” were still adrift in the Caribbean…and I had revealed my secret weapon to you:


Most of the big mistakes made in this world are made by people who refuse to give ignorance its due.

It is not necessarily what they don’t know that hurts them…but what they think they know that ain’t so, as someone artfully put it.

Thus, The Nation subscribers at the floating blab-fest have convinced themselves that they know the planet is warming up…and they know why…and they know what to do about it. The scientific evidence is inconclusive. The supposed remedy is even less sure. Nevertheless, on the basis of this “wissen” – the pretense of knowledge they get from big, abstract ideas – these people are willing to force the entire world population to do as they command. They not only organize their own lives (assuming it is not too inconvenient or uncomfortable), but those of billions of other people, according to the latest fad in collective thinking.

Meanwhile, investors over the last 10 years found another big idea they liked: the Efficient Market Hypothesis. It told them that all they had to do was buy and hold stocks…regardless of how expensive they became.

Today, I return to the q ratio (the price of stocks divided by their book value or replacement costs) – and what it can tell us.

“There is no such thing as a free lunch,” says Milton Friedman. And yet investors might have thought they were getting breakfast, lunch and dinner – all at no expense – over the past 18 years. Stocks went up. They went up so much that no other investment class came close. What’s more, the EMH told investors that the returns were virtually without risk.

Since it was thought that stock price movements could not be predicted, there was no reason to try. Buy and hold. That was all you needed to know.

What a wonderful world it was for investors! They knew that stocks always go up…and that no other asset class can do as well…and that there is no long-term risk, only short- term volatility.

And yet…it ain’t so.

Usually, there is no way to know whether stocks will rise or fall. Prices move around – like genetic variations – apparently at random. But that is not the whole story.

When investors feel like they have a ticket for a free lunch, they take advantage of it. They buy stocks. Why not? They always go up. And there is supposedly no risk.

But how is this possible? How could the stock market provide higher rates of return than other investments, forever, with no further risk of loss?

The answer: it couldn’t. Risk varies inversely with the perception of it. The less risk investors saw in owning stocks, the more stocks they bought, the higher prices went, and the greater the actual risk of loss became.

The higher rates of return in the stock market are only possible because, periodically, the stock market corrects – bringing the longer-term rates of return down to levels that are competitive with other asset classes. Over the very long run – since the beginning of the 20th century – the real return on stocks has only been about 5% per year. But it has been nearly 17% for the last two decades of the century.

“The quality that makes the stock market such a good place to invest, most of the time,” write Smithers and Wright in “Valuing Wall Street,” “means that it has to be a lousy place to invest occasionally. One of those times is now.”

You may recall that a careful study of stock price movements found them almost random. I hope you recall…because I have forgotten the details. But it seems to me that I reported this to you last year – when describing Peter Bernstein’s book, “Against the Gods.”

Academic researchers had discovered a wrinkle in the random price fluctuation hypothesis. When prices were extremely high or extremely low, the odds increased that they would revert to the mean.

Hmmm…this is exactly the common sense observation confirmed by Smithers & Wright in their examination of the q ratio.

“Most of the time,” they write, “when markets are neither extremely over or undervalued, q is not very important, since it cannot be used to make strong predictions about future returns. It is only in times of extremes that it provides vital information. The end of the 20th century is such a time. Q tells you that you are running huge risks if you remain in stocks.”

Stocks provide handsome returns for long periods of time. This is only possible because, for other also fairly long periods of time, stock market investors give back their extraordinary gains.

“The key point to remember…” observe the Smithers team, “is that for over one-third of the 20th century, we have been living in bear markets and that each bear market followed a peak in q…investors who lived through these periods would have found that these bear markets had a large negative impact on their living standards.”

So brace yourself, dear reader.

Bill Bonner Baltimore, Maryland December 15, 2000

*** I have been expecting Mr. Bear to take a little end-of- the-year holiday break. So far, he seems reluctant to leave his work on Wall Street.

*** The Dow dropped 119 points yesterday. J.P. Morgan and Chase Manhattan Bank announced that fourth quarter earnings would be well below expectations. Chase’s venture capital arm, Chase Capital Partners, reported losses of $300 million. The Street didn’t like the news.

*** Yesterday, 1,183 stocks advanced; 1,695 retreated; 105 hit new high; 77 hit new lows.

*** GE – a stock with a long way to go (down) – fell 3%.

*** The Nasdaq did even worse – losing 3.3% of its value, or 94 points. This brings the Nasdaq to a loss of 32% for the year…compared to a 7% loss for the Dow. TheStreet’s Internet index fell 4.5% yesterday – leaving the dot-coms with a loss of 66.5% for the year.

*** I will resist the temptation to say, “I told you so.” Oops, I said it.

*** The Wall Street Journal’s latest stockpicking contest illustrates what kind of success investors are having this year. The professionals’ picks lost 32% over the last six months. So did the public’s choices. Random selections – ‘the dartboard’ approach – did better. They only lost 19%.

*** The WSJ also provides a clue as to why holiday shopping seems subdued. Half of the families polled said they expected a recession next year.

*** The dreaded Winter of Woe begins next week. People are losing their confidence. They know something is wrong. They’re hoping that Alan Greenspan will make things right again. But they’re not sure. Abby Cohen and other cheerleaders are still shaking their pompoms…but, somehow, the thrill seems to be gone. Cohen says stocks are 15% undervalued, by the way.

*** We are entering a period of major readjustment and re- evaluation. It won’t be easy…but at least it might be amusing. The bad ideas, bad loans and bad investments of the late ’90s have to be cleared away before new growth can take root. Before it is over, people are not going to want to hear about stocks. And few people…sniff, sniff…will want to read the Daily Reckoning.

*** The Bank of England joined in warning about the risk of major defaults by telecom lenders. And Bloomberg reports a Moody’s estimate that corporate bond defaults in the next 12 months will be 3 times as great as those in the last 12 months.

*** “Credit risks have increased across the ratings spectrum,” said a Moody’s official. “Every day commercial paper costs creep higher,” says another Bloomberg headline. Commercial paper outstanding – short-term lending to business – is at its highest level ever…$1.624 trillion.

*** The PPI came out yesterday. The annual rate of price increases at the wholesale level were unchanged – at 3.6%.

*** Could it be that inflation has topped out? Gold and gold shares seem unable to advance. And bond investors are paying less and less of a premium to buy inflation-adjusted bonds. The difference between the 10-year TIPS (inflation adjusted) and the regular 10-year treasuries is just 1.45%.

*** The dollar seems to be at the beginnings of its own bear market. The euro rose again yesterday…with March futures at 89 cents. A guess: The Winter of Woe (and the next phase of the Great Bear Market of 1999-?) will get off to a rousing start with a sharp decline in the dollar.

*** Yesterday, the European Central Bank announced that it would not change rates…and the U.S. disclosed another record current account deficit – $113.77 billion for the third quarter.

*** But maybe the news today will be better. Not likely; Wall Street starts business this morning with 3 strikes against it. Oracle announced last night that it missed its revenue targets. A key executive from Cisco resigned. And MSFT, mighty Microsoft, for the first time ever, warned that its numbers may not measure up to expectations.

*** So today should be interesting.

*** And the latest news from home: Maria, 14, wants to be an actress. Her career got a major boost yesterday, she believes, when she tried out for a part on a French TV show. Also, she reports that a man came up to her on the Champs- Elysee and asked her if she would like to work for his modeling agency.

*** “Maria,” I warned, “I hope you didn’t fall for that line.”

*** “Oh no,” she replied cheerfully, “I told him to get lost…but he gave me his card. It’s Madison Agency on Avenue Hoche…the one that Laetitia Casta works for!”

The Daily Reckoning