The Lazy Investor's Reward
Is being lazy the secret key to riches? Can you grow your portfolio by 2,000% with just one decision? John Mauldin investigates…
There is a concept thrown around in hedge fund circles called second derivative investing. Allow me to explain…
In physics, we are taught to think of speed as the first derivative. The second derivative would be acceleration. If you are asked the classic question, "A car is going 50 miles per hour. How long will it take to get to Hoboken from Miami?" it is pretty simple math. But if they throw in the curveball that the car is accelerating at 10 miles per hour, the answer involves a much more complex equation. That would be the second derivative. But what if we add a third derivative and state that the acceleration is increasing at 10% every 39 minutes?
Don’t even think about fuel consumption, highway construction, kids in the back seat, the age of the drivers, caffeine consumption and other effects from the space-time continuum. It can get complex.
In this case, the first derivative is simply the price of the stock market or mutual fund. First derivative thinking would be simply projecting past price performance into the future. And that is what buy-and-hold proponents do. Now, admittedly, they may not all promise you a 12% compound rate. But they imply the market, over long periods of time, will grow as fast as it has in the past. You cannot beat the market, so you might as well invest in the lowest-cost fund that represents the market. They contend that any other choices than index funds are simply wasting your time and losing you money.
Second Derivative Investing: Active Management will Outperform
I might agree with that view for investors with few choices – as in many 401(k) plans – if we could make the long period of time 126 years rather than a mere 26 years. But even then I would have to admit there are some very major exceptions in which active management, especially if it is value-focused, will outperform.
The average P/E ratio for the S&P 500 since 1926 is around 15. Typically, 21-22 is in the upper end of the range with 8-11 being the lower end of the range. Over long periods of time (secular bull and bear markets), the market fluctuates around the mean. I think it is quite possible that in 2030 we may be at the end of the next bull market. Valuations, after dropping into the low teens (or lower) this decade, will turn around and a long bull run will commence. What will the S&P 500 be in 2030 if we are once again at a P/E of 21?
Somewhere in the neighborhood of 4,800, give or take a dime. That 4,800 is less than 25% of what it would be at a 12% compound rate. At 3% inflation, a dollar will only be worth 46 cents. It will take $2.15 to buy what is worth a dollar today. That is a compound growth rate of (surprise, surprise) 5.7%. But "objective" profits in that rearview mirror may be smaller than they appear.
Your return will be less than that, because you have to pay taxes. The S&P 500, if past is prologue, will change 250-300 companies through mergers and through dropping and adding companies due to growth. As the dropped and added companies are bought and sold, that will create taxes due. And don’t forget dividend distributions and capital gains, for which you will have to pay taxes in the meantime.
Second Derivative Investing: A Big Difference in Lifestyle
Not to mention that even though the average return for the S&P 500 for the last century was 7.2%, the compounded return was a far more modest 4.8%. That is because when the market drops 20%, it must climb 25% to get back to break-even. So assuming 5.7% may be aggressive if we experience a few recessions and a bear market or two in the coming decades.
I should note that this makes a very big difference in retirement lifestyles. At a 5% return, we are talking about the difference between $2,400 per year and $11,000 per year on that original $10,000.
The real reasons the S&P 500 compounded at 12% the last 26 years are twofold. First, we started with a P/E ratio of 10 at the end of 1975. Over the ensuing years, we simply valued a dollar’s worth of earnings at a much higher rate. Perhaps not as high as the bubble levels of 1999 (over 40), but still historically quite high. As has been shown through research, 80% of the growth of the S&P 500 was simply due to increased valuations and not to earnings growth.
Second, we had the highest period of inflation in the last century in that period. An inflation calculator shows 326% inflation for the entire period. For just the first six years alone, it was 70%.
Are these two items likely to be repeated in the next 26 years? Anything is possible, but not all things are likely. It is doubtful we aspire to a P/E of 40, let alone 97, once again in our lifetimes, and if we do, it will prove to be just as ephemeral. Say what negative things you will about the Fed; does anyone really think we will ever see sustained 10% inflation again?
And let’s not forget the Reagan tax cuts and the coming of the Digital Age, which drove the markets. There was more going on than simple market action that made for the largest and longest period of sustained results in U.S. history.
Second Derivative Investing: The Third and Fourth Derivatives
And that does not even take into account the third and fourth derivatives of demographics and international trade. Can we talk Muddle Through Economy? Investing is far more complex than simply buying the S&P 500 and hoping you can retire on 12% compound growth. Anyone relying upon such a fantasy will find he is working an extra 10 years after his hoped-for retirement date.
One day in the future, I will also become a believer in buying and holding the Vanguard 500 as part of a reasonable asset allocation program. But that is not this day. I think one day in the future that 8-10% compound returns (or more) will be possible. But that is not this day. It is not part of my DNA to mindlessly chase some fantasy by trading peripatetically. I do hope to beat the markets over time – that I will readily admit. And I think I lay out a reasonable road map in my book, Bull’s Eye Investing.
I believe that by using a few facts, some logic and an eye to history, it is in fact possible to do well. But it takes more than being a lazy investor. Let’s be clear on one thing. If you are a lazy investor, you will earn the rewards of being a lazy investor. In secular bull cycles, when values are rising, when a rising tide lifts all boats, those rewards are a good thing.
But when you are on the wrong side of the value curve, it is a prescription for working long past your retirement. Assuming the next few decades will be like the last few violates the first rule of investing: Past performance is not indicative of future results. It is first derivative investing in a multidimensional world.
"A little sleep, a little slumber, a little folding of the hands to sleep – so shall your poverty come on you like a prowler, and your need like an armed man." (Proverbs 6:10-11.)
Words to the wise, indeed.
for The Daily Reckoning
September 9, 2004
Editor’s Note: 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), which is currently on The New York Times business best-seller 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 road map if you want to avoid the pitfalls of the modern investing landscape…
O Lord, it comes this. The fate of the world as we know it rests in the feeble hands of the American consumer.
"After a year of revising growth forecasts higher," said an economist at Deutsche Asset Management on the eve of the Fed’s meeting at the J-hole a few weeks back, "we may have leapfrogged too far."
"It is a global cycle that has never really got to self-sustaining, cumulative recovery mode," added Stephen Roach. "There is nothing mature about [the recovery] except the imbalances. How strong will the recovery be when the stimulus steroids wear off?"
In his report on the Morgan Stanley Web site this week, the excellent Mr. Roach shows that between the two of them, the U.S. and Chinese economies share a disproportionate amount of blame for world economic growth over the past decade. In fact, from 1996 to 2003, U.S. demand and Chinese production account for nearly half of the world’s GDP growth.
For his part, the U.S. consumer consumed at a rate 75% faster than anywhere else in the developed world. "It is hardly an exaggeration," concludes Mr. Roach, "to conclude that the American consumer has been the engine on the demand side of the global growth equation since 1995."
And yet, wages for those same consumers have failed to keep pace with inflation. How can they continue to be the engine of the "demand side of the global growth equation," we ask, with the redundancy of a 4-year-old asking for candy at the checkout line of a grocery store. And answer with the irritable repetition of said child’s parent: "Dddddeebbbbttt!"
"Consumer borrowing up sharply in July," reads a headline in this morning’s L.A. Times, as if to punctuate the irritation with tedious facts. "I have been expecting the savings-short, overly indebted and income constrained U.S. consumer to slow down for some time now," says Roach. "A slowdown in the United States [demand] and China [production]…have raised the risk of a global recession in 2005."
We Daily Reckoners might have said something similar ourselves, had anyone bothered to ask.
Perhaps the greatest disproportion growing in the world today is in the Chinese economy itself. In an attempt to feed the enormous maw at the center of the Western Hemisphere, the Chinese have spent 46% of their GDP on their export industry.
That figure dwarfs the eerily similar export-driven bubble that crushed the Japanese economy in the late ’80s. More on this staggering factoid from Tom Dyson, below…
Tom Dyson, from just across the room…
– Here’s yesterday’s word of the day: "traction." Greenspan said it. He was delivering a testimony to the House Budget Committee.
– "The most recent data suggest that, on the whole, the expansion has regained some traction," said the sheriff of E-Z County. Greenspan maintains the weak performance in June, economically speaking, was just a soft spot. Now he thinks we’re back on the path. He suggested to the House that consumer spending and housing starts had rebounded significantly in July and August, as had business investment.
– But what’s this – maybe he’s not quite the optimist we had him marked as: "If it weren’t for oil prices, I would be very optimistic about where the economy is going," said he. Oil prices have receded over the last couple of weeks. From a high of $49.40 achieved on August 20, they have fallen over 13% to $42.77 at close yesterday. Yesterday the black goo declined another 54 cents.
– Here at The Daily Reckoning, we detect a hint of newly injected caution in the maestro’s speech. It wasn’t just his comment on oil, either. He spent a large proportion of his speech criticizing budget deficits. Long-term prospects "remain troubling," he warned. "Short of an outsized acceleration of structural productivity or a major expansion in immigration, the state of relative tranquility will end soon."
– The markets must have detected his hesitancy, too – or maybe the "regained traction" comment caused traders to fret about another 25-basis-point hike in interest rates at the next FOMC meeting. Either way, Mr. Market humped off in a sulk. The Dow dipped 29 points, down to 10,313, while the Nasdaq lost 8. The S&P ended the session at 1,116, about 5 points lower for the session.
– "Former Fed chief Paul Volker once declared, ‘Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong.’ Good luck, Mr. Greenspan. Dr. Richebächer has a much stronger track record for being right about the economy than you," writes good friend of The Daily Reckoning and International Man Thom Hickling in a missive sent yesterday.
– Thom was at the Gare du Lyon in Paris when he e-mailed us. He was just about to board the TGV to Cannes. Thom is on a mission to track down world-famous economist Dr. Richebächer at his house on the French Riviera.
– "In just the few minutes that I was on the phone with Kurt to set up our meeting," Hickling states, "he was already shocking me with crystal-clear perceptions on the global economy." Readers might conclude the good doctor doesn’t believe in small talk; they’d be wrong. This is Richebächer’s version of small talk. You see, with an inhuman tolerance for minute statistical detail and the patience and thoroughness to pick through reports and data releases, Dr. R. finds things the other lazy economists overlook.
– For instance, this comes from a sneak preview of October’s Richebächer Letter: "During 2003, no less than 58% of China’s imports of goods and services came from Asia, as against 8% from the United States and 13% from the European Union. In short, China is running a big trade deficit within the region.
– "But China’s trade deficit with the Asian countries has been more than matched by trade surpluses earned in the United States ($88 billion in 2003) and in the European Union ($29 billion). During the first half of 2004, China’s U.S. surplus was up to $137 billion when presented as an annual rate. Overall, China had, in 2003, a trade surplus of about $29.6 billion."
– And what’s the Chinese government doing with all these earnings? Dr. Richebächer answers this for us, too…an amount equal to 46% of China’s 2003 GDP was invested in the export industry, he calculates. "That’s insanely high," exclaims Thom. "It’s more than double the equivalent rate in Japan."
– The conclusion is obvious…but we’ll spell it out anyway. Dollars are flowing from the United States to China and then into the rest of Asia. China has made an extraordinarily large bet – 47% of 2003’s entire GDP – on the American consumer perpetuating this dynamic. Malinvestment on this scale reminds us of Japanese government policies in 1988 – but unlike back then, the rest of Asia has been pulled irreversibly into the fray.
– "This could be the mother of all Asian crises!" concludes Thom. [Ed. Note: As we noted above, Richebächer is a masterful number cruncher and goes beyond the boundaries of most other idle analysts. Now he has pounced on the payroll statistics produced by the BLS.
Addison Wiggin, still in Baltimore…
*** What Americans do, the Chinese do bigger… a lot bigger.
In 1864, the death toll as the Union sought to put down the "Southern Rebellion" crested 600,000…a figure so high it nearly destroyed the country. That same year, the Taiping rebellion in China drew to a close. Souls lost? Thirty million.
According to recent census reports, there are somewhere between 1.2 and 1.5 billion Chinese living today. Which is to say, some 300 million Chinese may or may not exist. Total population of the United States as of 11:40 a.m. this morning? 294 million.
And this from Dennis Gartman, in his requisite daily read, The Gartman Letter: "There is a huge…and absolutely stunning large…migration of people from China’s impoverished western provinces to her far more modern, far wealthier, and far more economically sound provinces along the Pacific coast…The movement of the ‘Okies,’ so wonderfully detailed in Steinbeck’s ‘Grapes of Wrath’ was perhaps 2-3 million people. The movement in China is of at least 200 million people thus far. And will almost certainly be 400-500 million by 2020. This is a tidal shift of breathtaking proportions."
U.S. consumer demand for geegaws built in Chinese factories is, at least, a significant contributing factor to the largest migration of people in the history of the world.
*** Our Pittsburgh correspondent, Byron King, on a critical juncture in the War Between the States…
"A few years ago, during a trip to the National Battlefield at Gettysburg, Pa., I walked the route of Pickett’s Charge (an event that occurred on July 3, 1863).
"I had always envisioned Pickett’s Charge as a line of Southern soldiers running across an open field and being systematically mowed down by a line of Union soldiers. The fundamentals of the tactical maneuver seemed so suicidal that I wondered why anyone in his right mind would follow the order to attack and subject himself to that type of fate.
"The answer to my question came when I walked the battlefield, step by step. The march from the Southern positions toward the Union lines covered about 3,000 yards. The first 90% of the advance was remarkable for its use of terrain masking. That is, for most of the soldiers in the advance, Pickett chose the route that was shielded from the line of sight of the Union boys and their guns by hills and lines of rises. Casualties in Pickett’s division were relatively low for that part of the maneuver.
"The last 300 yards or so, the closing phase of the engagement, well…that is another story.
"That last maneuver of the advance was supposed to be a fast run, up a gently sloping hill against the Union barricades. This type of rapid charge under fire was similar to so many other engagements, of so many other battles that occurred during the Civil War. The tactic was not remarkable for the era, but the outcome has shaped the national destiny ever since the fateful day.
"The Southern advance encountered an unanticipated problem. There was a 5-foot-tall wooden rail fence down the slope from the Union positions. The fence had not been knocked down by artillery or taken out by advanced units or sappers. The fence was of relatively solid construction, and its presence halted the advance by Pickett’s men.
"The Union troops rained gunfire and cannon shot down the hill and into the mass of Southerners. By the time the Southerners moved over and past the fence, their momentum of attack had been broken. A very few Southerners struggled their way to the Union lines and beyond, but the energy of the moment shifted to the Boys in Blue. The rest, as they say, is history. And myth. And legend.
"People say that the Civil War was central to the history and political evolution of the United States. And they say that the Battle of Gettysburg was central to the outcome of the Civil War. And they say that Pickett’s Charge was the key engagement of that battle. And the fence at the bottom of the hill is what broke the momentum of advance of the Southerners.
"So that damn fence must be the single thing that decided the fate of a nation."