Out Of Wack
“Nature is a shrewd banker,” writes Lawrence Ford and
Thomas Roman in January’s “Scientific American, “and always calls in its debts.”
Ford and Roman were discussing an effect known as “quantum interest.” It was too technical for me. But I took one thing from the discussion — the balance between negative and positive energy is never allowed to get too far out of balance. “If negative energy is thought of as an energy loan,” say the scientists, “the loan must be repaid with interest.”
As I look around the financial world, there are a lot of loans to be repaid — with interest. A lot of things are out of whack. Expect them to get back in whack sometime.
Corporate earnings rose 61%, in real terms, between 1981 and 1999. But the stock market grew from 50% of GDP to 150%. One way or another, they will come closer together.
The Japanese have been in an off-and-on slump for the last decade. Tokyo’s stock market is still down nearly 50% from its high 10 years ago. Consumer spending has fallen every year since 1993, and everyone thinks the Japanese must be idiots. But in America, it is as if we were on the opposite side of the earth. Except for value-minded fuddy-duddies like me, Americans are all geniuses. For every negative sentiment about Japan’s economy, there are at least two positives ones for the United States’. I expect the Japanese to look smarter as time goes by…
The major U.S. indexes — Dow, Nasdaq, S&P — are in or near record highs. But the average stock has been going down since April 3, 1998. This is the greatest disparity between the indexes and market breadth in history. Somehow, the average stock and the major indexes have to get reacquainted.
Last year, stocks hit record after record — while the bond market had one of its worst years in history. Expect convergence here, too.
While Wall Street has gotten rich, Main Street can barely pay its bills. People work more, but earn only slightly more than they did 20 years ago. Household balance sheets improve — thanks to increases in stock and real estate values. But families have less in savings…and a lot more debt. Somewhere, Wall Street and Main Street will come closer together.
The New Economy has been bid up to lunatic levels. New Economy stocks have sold for as much as 18,000 times sales. Almost everyone loves the New Economy and is confident that it will produce nearly infinite riches.
The Old Economy, meanwhile, includes rusty, terminal companies such as GM, Philip Morris, Owens Corning and thousands of others you never heard about. At cocktail parties, people who work in the Old Economy are silent, embarrassed…humbled by bargain prices and the belief that they — – like Warren Buffett — are already dinosaurs…on their way to extinction.
But guess what? Almost certainly, the Old Economy and the new one will reach some form of rapprochement in the year ahead. And most likely, the Old Economy will prove the better investment.
GE, an Old Economy company, has benefited from an extraordinary faith in its CEO and its ability to maintain growth and profits. GM, meanwhile, is thought to be hopeless. I don’t know what will happen to either, but I would expect investors’ attitudes to converge. Sell GE. Buy GM.
My guesses about the future are based on the most simple-minded observation: regression to the mean.
If a man is unusually drunk — chances are good he will be more commonly drunk the next time you see him. If a stock reaches an absurdly high price, chances are good that it will be less absurd in the future.
A study done in England a long time ago sought to show that extraordinary people were likely to have extraordinary children. Exceptionally successful musicians, it was thought, were more likely to have children who were also exceptional. While the study did show some correlation — it turned out to be a weak one. Most of the children of exceptional parents were rather ordinary. Even with the genetic tailwind, most of the children sailed through life like everyone else. They regressed to the mean.
In the investment world, regression to the mean is not merely a quirk of natural law like the Golden Constant or the relationship of the radius of a circle to its circumference. It is the product of individual investors seeking to make the highest possible profit. When a particular investment is excessively productive, investors rush in — like lions after a herd of fat Christians. They quickly devour the opportunities — bidding up prices to the point where the investments are no more profitable than other potential uses of money. In other words, the good investment opportunities are quickly arbitraged away.
Then, there is another factor that comes into play — mob psychology. Whatever direction it moves, the great mass of investors pushes up prices. This success leads to the illusion of genius. As the “Great Winfield” said of his “rent-a-kids” in Adam Smith’s account of the “Garbage Market of 1968” — “The strength of my kids is that they are too young to remember anything bad, and they are making so much money they feel invincible.”
Exceptional opportunities soon become grotesque and dangerous — as prices are pushed up to absurd levels. Team spirit and the same mob sentiment that leads voters to believe that they can get something for nothing focuses the herd of investors on impossible situations and builds expectations to fantastic levels. Not only do they think they are smart — emotionally they become convinced that nothing can stand in their way. They are like Hitler, who told Gen. Paulus, trapped in Stalingrad with neither food nor ammunition, that he would win if he only had the Fuhrer’s “will to victory.”
The effect of mob psychology has been amplified in the 1990s by the participation of millions of new investors. Past eras have seen amateurs in the market, too. But Wall Street was always dominated by pros — most of whom had some idea of what a dangerous place stocks could be. Now, thanks to the Internet, hairdressers and burger flippers have become day traders. The number of fools getting rich in the market has never been higher. Likewise, the prices for favored sectors have never been higher.
Wall Street has become like a huge game show — the greatest show on earth, in which anyone can play, whether or not they have experience, money or any clue how the stock market really works.
Mutual fund managers and Internet geeks have become celebrities. Box office stars, such as Barbra Streisand, pull strings in order to get in on the next hot IPO…just as Wall Street partners used to try to get opening night tickets for the next hot movie or Broadway play.
Venture capital players act like the Hollywood magnates of the `30s and `40s. “What’s the story?” they ask of new start-ups. They know a good story will sell — regardless of whether there are profits in the last act. They just have to be sure to get out before the curtain falls.
The insight of contrarianism is not that the other people are always wrong. Most people step out of the way of a passing bus, for example. It would hardly pay to do otherwise. Nor is it merely to always do the opposite of what most people do in their investments. Sometimes the majority is right — for long periods of time. But there’s a catch — the majority can never earn more than the market as a whole can earn. And the upward limit over the long haul is determined by corporate profits…which grow at 4% to 8% annually. If you want more than that — you cannot do what everyone else does.
The trick is to recognize that people will react to situations in an emotional and episodic way. For those who cannot look into the future, it is this pattern of human behavior that gives us a chance to make above- market gains. The idea is simple: sell the investments that have been the objects of so much mob affection and buy those that have been the objects of scorn. Count on the fact that the patterns of human nature will continue — and that extraordinary sentiments will regress to more common ones. The world will not allow things to stay out of whack forever. Whack balance has to be preserved.
Bill BonnerOuzilly, France February 10, 2000
*** Whoa…the earth turned yesterday. The Dow dropped 258 points…while its counterpart in Tokyo rose above 20,000.
*** There were 1,020 stocks making progress on the NYSE exchange, while 1,969 fell back. Ninety-nine stocks posted new highs; 188 hit new lows.
*** Even the Nasdaq fell yesterday — by 63.5 points. The Nasdaq has performed spectacularly. But it rests on a very slim foundation. Seven stocks make up half the Nasdaq’s total capitalization.
*** The Internets were down yesterday — but not decisively. GE was down, too. So was MSFT.
*** But the big news on Wall Street is the Dow — which Richard Russell believes has completed a “major head and shoulders top.” The right shoulder appears to have broken down — suggesting more losses in the near future.
*** Meanwhile, the bigger news comes from Geneva, where scientists say they have done something that hasn’t been done in a very long time — 12 billion years, in fact. They’ve recreated the “big bang” that is thought to mark the origin of the universe. They smashed lead particles together at nearly the speed of light and produced an explosion that sent temperatures to billions of degrees and gave off gluons and quarks.
*** John Myers reports that women are working twice as many hours out of the home today as they did 20 years ago. But the real incomes of families only increased from $42,469 in 1976 to $44,568 in 1996.
*** Meanwhile, consumer credit grew at $20 billion a year for the 20 years from ’66 to ’86. Now it’s growing at $20 billion per month.
*** I see Steve Forbes has dropped out of the race for president. It’s a shame people confuse democracy with liberty. Liberty is a good thing, they reason…so any product of its twin, democracy, must also be good. Yet elections have the effect of reducing liberty. The politicians who promise to redistribute the most income usually get elected.
*** The mathematics of this are pretty simple. The top 10% of Americans own 68.3% of all the wealth. And they’re getting wealthier. Is it any wonder that the other 90% will try to vote itself some of the money? And is there any democratic way to stop them?
*** A DR reader sent me a quote attributed to Alexander Tyler in 1750: “A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largesse…from the public treasury… The average age of the world’s greatest civilizations has been 200 years. These nations have progressed through this sequence: from bondage to spiritual faith; from spiritual faith to great courage; from courage to liberty; from liberty to abundance; from abundance to complacency; from complacency to apathy; from apathy to dependency; from dependence back again into bondage.”
*** I’m taking a little vacation. We’re driving down to the area near Toulouse — the region of the Cathar heresy and the Albigensian crusade. I’m not sure I’ll be able to get out tomorrow’s DR…but I’ll try. And I’ll let you know what the Cathar heresy was all about as soon as I find out.