Thoughts from the Frontline

Rules of Engagement

October 4, 2001

Today begins a two part series on a framework for investing when the economy starts to recover. It is my belief that investors need to have a consistent philosophy of investing when choosing investments, otherwise your portfolio looks like the local dog pound: a few lonely purebreds mixed in with a lot of mutts. Some of the mutts end up becoming your best friend, but mostly they just mess up the place.

Within my suggested framework, you will have lots of latitude to tailor your portfolio to your specific needs, but what I will be suggesting is that the times are changing, and you need to change with them. (And yes, I cover that important economic report in detail, as promised last week.)

As far as the economy this week, not much has changed. Japan just gets worse and Europe is getting weaker, which means the US will have to lead the world out of a global recession. But our consumers are saving dramatically more and spending less, manufacturing is down, as is capacity utilization etc. etc. Long bonds are back to new highs. Same old, same old.

But the cavalry is on the way. The Fed cuts again and again and pumps $100,000,000,000 into the economy in a few weeks; Congress is likely to provide significant fiscal stimulus, and travel and business is starting to pick up again. I can hear the bugles, but I don't see the troops yet. It is still not safe to get out of the fort, but it is time to make plans for the future.

So, let's sit by the fire or on the porch, and think about what we will do when the good times return, as they always do. (See, Allen, I am not always gloomy!)

First, three quick seemingly random thoughts to set the stage and then we dive in.

1. Earlier this summer, I wrote about coming from a conference of market timers and noting that, almost without exception, market timers who have been using systems based upon some historical relationship (or multiple relationships) between whatever variables they deemed significant and the stock market were having trouble getting the results out of their systems they had in the past (translation: they were getting their heads handed to them). As I began to explore this phenomena, I saw it in other markets and systems as well. This has caused a major review of my own investment philosophy.

Things were, and are, clearly different. Relationships which had existed in the past now seem tenuous or, even worse, reversed.

2. Investors have been taught a philosophy of investment called Modern Portfolio Theory which has seemed to work quite well for decades. It is belief in this theory that lets Charles Schwab tell us to take a deep breath and to remain calm while our portfolios are down 40%. It is this theory, or a twisted version of it, that allows brokers to tell you to buy and hold large cap stocks with high P/E ratios (or whatever investment they are pushing), even as they tumble. It works well for large institutions. There is much to be learned from this philosophy, but I think it is at the root of much of the pain individual investors have been feeling these last few years. Like watermelon, we need to eat the good part and spit out the seeds.

3. We are now in a new type of War. The enemy is a few thousand individuals in 60 countries hidden in communities of millions, unknown to 99% of their neighbors, sympathized with and supported by nations and peoples who hate us for reasons most of America does not comprehend. They intend to first destabilize us, then demoralize us and finally provoke attacks upon various countries and groups within the Islamic world. They will try to tell the poor of these countries that an attack upon Muslim terrorists is an attack upon all Muslims, turning their terror into a religious war. They hope to stir the Islamic masses to overthrow any moderate governments and install governments based upon the terrorists' radical religious beliefs.

Faced with an enemy which is both deadly and disperse, with goals which do not value lives of either their enemies or themselves, and with a methodology of war which is unlike anything we have experienced in this country, we are now having to develop new strategies for conducting this war.

The Rules of Engagement for warfare have changed. I think it is fair to say that our nation, if not much of the world, has realized that. What would have been unthinkable only a few weeks ago, is now promoted as necessary and wise by (almost) all parts of the political equation. It is clear that our military leaders are hoping to avoid the most costly and typical of all military mistakes: using the tactics of the last war to fight the current war.

All's Turbulent on the Investment Front

I am going to suggest that the Rules of Engagement, as it were, for investing are changing as well. The advent of this war is going to accelerate that change. What has worked for the last 20 years is now going to frustrate those who want to use the old investing rules to fight the next investment war. If you do not see and adjust to these changes, in my opinion you will not be happy with your investment returns over the next decade.

So, first, let's look at the old rules, then survey the new territory and see if we can begin to identify some new guidelines to help us during this new era.

It all started with Dr. Alfred Markowitz in 1952. He began to write a series of brilliant books for which he received the Nobel Prize in Economics. His work is the foundation for Modern Portfolio Theory (MPT), which has since come to be the dominant model for investment professionals.

Markowitz demonstrated how it was possible for you to combine diverse types of assets which, in and of themselves, could be quite risky and volatile, and the combination portfolio would have lower a volatility and better returns than the individual investments.

Current thought at that time was that investors picked stocks because of the expectations of future returns. However, if investors could truly know what those future returns would be, they would only buy the one stock or investment which would deliver the highest return.

Of course, we don't know the future, so we diversify. MPT says if we diversify into different asset classes with different risk characteristics which do not have a statistical correlation with each other, and which have shown to be good investments over long periods of time, that total portfolio return would be smoother.

By that, if we diversify into bonds, stocks, real estate, timber, oil, etc. that over time our portfolio will grow and grow more smoothly than if we concentrated in one market. The key words are "over time".

Markowitz and his followers, who have also won lots of Nobel prizes, created a Greek alphabet soup of statistics to describe risk. Alpha, beta and their statistical cousins help analysts determine the past risk of an investment. MPT then shows professionals how to combine these investments into one portfolio with desired risk/reward characteristics.

All of these analytical tools are very useful, and I and millions of investors use them every day to analyze our investments. Modern Portfolio Theory has become the sine qua non, the gold standard of investing, especially for large institutions. No one gets fired for properly using MPT as the basis for managing large institutional money.

For the last 50 or so years it has demonstrably worked, more or less. There are hundreds of studies which demonstrate its superiority.

But there is one catch to Modern Portfolio Theory. You have to give it time. Lots of time. Decades of time.

If you invested in the S&P 500 in 1966 it was 16 years before you saw a gain, and 26 years before you had inflation adjusted gains. If you invested in the 50s or in 1973 your gains came more quickly. If you invested in 1982 or late 1987 your gains in only a few years were spectacular. And let's not forget 1999. However, 2001 has not been so kind.

You could make the same type of risk/reward analysis for every market: bonds, stocks, international markets, real estate, oil, etc. They all have ups and downs, and over time, they come back. Betting on America has been good.

If you are an institution with a 25-30 year time horizon, the ups and downs are annoying, but you can deal with them. You are diversified, and usually part of your portfolio is doing well when other parts aren't. In recessions, you play with your asset mix, maybe take a slightly higher percentage of bonds, but you NEVER get 100% out of stocks, as you are not attempting to time the market.

Positively, Absolutely Relative

This is a relative value game. If the market (stocks, bonds, real estate, etc.) goes down 15%, and your portfolio is only down 12%, you have beaten the market and done your job. You tell your investors that they should stay with you and that in fact you deserve more of their money. If your clients are institutions, they are likely to do so.

This thinking permeates all of Wall Street. It is one reason why you constantly hear buy and hold from investment professionals. It is why they want you to have a high percentage of stocks in your investment portfolio. They can trot out all sorts of studies which show that stocks are the best investment over the long term. Typically, the long term begins with a good year, but with a long enough time frame you can make a case beginning with almost any year.

In the long run, said Keynes, we are all dead.

What works for institutions may not work for individuals. Most individuals do not have 25-30 year time frames for an investment to come back. How many of you are willing to let a mutual fund or an asset class go for years and years with poor performance? How many years will you stick with a technology fund that has been going down for several years? Those managers will always tell you now is the best time to buy, just as they did 6 months ago, one year ago and two years ago. There is never a time to sell a fund. Every "dip" is just a prelude to a new high. Modern Portfolio Theory says so. Just give me time.

But study after study say investors do not give them time. With remarkable consistency over many decades, investors get frustrated and buy high and sell low. Study after study shows investors only make a small percentage of what mutual funds actually make, buying and selling in an attempt to boost their returns.

The plain fact is that individuals have different time frames and different needs than institutions, but have been talked into using a strategy that is psychologically opposite of their instincts. I cannot tell you how many investors I talk to who tell me they wish they had followed their intuition or their research to exit the markets last year but were talked out of it by their broker or advisor.

Using an investment philosophy which requires a 25 year time frame when your personal time frame is only a few years is a losing game. Investing with a philosophy that is built upon relative returns, rather than the absolute returns your instinct says you want, is a prescription for lousy and even disastrous results.

If you are following the Wall Street cheerleaders you have, whether you know it or not, bought into Modern Portfolio Theory. The problem develops in that you don't know the entire game plan and end up taking the worst parts at the wrong time. You end up eating the seeds and missing the sweet juicy fruit.

Mean Lean Reversion Machine

50% of all doctors graduated in the bottom half of their classes. 2 + 2 is 4. Trees do not grow to the sky. And markets always come back to the trend.

In previous e-letters I have mentioned Yale professor Robert Shiller's book, Irrational Exuberance. Shiller clearly demonstrates that when broad market indexes go above P/E ratios of 23 or so, that investors essentially get no return over the next ten years. The markets return to trend. Three weeks or so ago, I cited a study by Jeremy Grantham's firm which shows that of 28 bubbles they looked at, they all returned to trend.

Now, as promised last week, I want to delve into the analysis and implications of a remarkable study for the National Bureau of Economic Research by three economics professors (Chan, Karceski and Lakonishok).

First, these gentleman looked at a large number of public companies over 50 years. They were interested in two things: "How plausible are investors' and analysts' expectations that many stocks will be able to sustain high growth rates over prolonged periods? Are firms that can consistently achieve such high growth rates identifiable in advance?"

The answer to the first question is not very. Let me run through a number of their conclusions (mostly quotes with some editing for clarity) with a few comments. Warning: these can be a little dry but are very important if you are going to understand the nature of the markets in coming years. Stay with me here, team.

"Our median estimate of the growth rate of operating performance corresponds closely to the growth rate of gross domestic product over the sample period....the growth in real income before extraordinary items is roughly 3.5% per year" (after inflation and dividends. Before them it is about 10%.) "This is consistent with the historical growth rate in real gross domestic product, which has averaged about 3.4 percent per year over 1950-98. It is difficult to see how over the long term profitability of the business sector can grow much faster than overall gross domestic product."

Although there are instances where firms achieve spectacular growth, they are fairly rare. For instance, only about 10% of firms grow at a rate in excess of 18% per year over ten years. An average of only 4 firms a year (or 0.3%) pull off simply above average (the top 50%) growth for ten years in a row. The patterns in the more recent years do not deviate markedly from the averages across the entire sample period. The number of firms who grow faster than the median for several years in a row is not different from what is expected by chance."

Comment: This is why large institutions diversify into different classes of stocks such as large-, mid- and small-cap growth; large-, mid- and small-cap value; numerous sectors, etc. Morningstar has dozens of categories. If you are an institutional manager, your job is to decide how much to allocate to each category and then find a manager who can hopefully beat the market in that category by sifting out the real dogs.

You see, you read the above and got depressed. The average stock only does about as well as the economy? I have to do better than 3% growth to retire. The institutional manager knows that if he is steady, he will get real returns of 3% plus dividends plus whatever bonus returns his managers can give him. Over the long term, this compounds quite nicely. Throw in inflation and you can show some nice numbers to your investors.

If you are not prepared to live with institutional returns, then perhaps you should consider an investing methodology somewhat different than Modern Portfolio Theory. Unless you are Warren Buffet or John Templeton, you are not likely to beat the market. 80% of mutual funds do not beat their benchmarks. Yet investors optimistically think they can do better than the pros. While some can, there are not many, in my experience.

Back to the report: "...security analysts' long-term estimates ...are over-optimistic and do poorly in predicting realized growth over longer horizons. To sum up, analysts and investors seem to believe that many firms' earnings can consistently grow at high rates for several years.....The evidence suggests instead that the number of [firms growing at high rates]is not much different from what might be expected from sheer luck. The lack of consistency in earnings growth agrees with the notion that in competitive markets abnormal profits tend to be dissipated over time.....Investors may think that there is more consistency in growth than actually exists, so they extrapolate glamour stocks' past good fortunes (and value stocks' past disappointments) too far into the future.

Comment: Besides producing a devastating critique of analysts, this study suggest to me a few interesting opportunities. You have to look at the scores of tables they create to see what I mean, but they sure show up to me. For investors who are really looking for growth, one possible area to delve into is small cap value stocks, which other studies I have read seem to confirm. In April of 2000, I wrote that investors should switch from growth stock funds into value funds, which did well last year. Later in the year, I grew negative on all stocks because of the yield curve. (Repeat: stocks go down in recessions.) Up until last month, there were more than a few small cap funds which were above water, although they have now taken big hits along with everyone else. This is to be expected.

When our Three Amigos tell us to get back into the market, one of the areas I will be most keenly interested in is small and mid-cap value funds. Aggressive investors should search for individual companies. This study deals with mostly larger stocks. Logic suggests that the larger you are, the harder it is to grow. I know, there are a few exceptions, but as the study shows, they ARE few. Hindsight is 20-20, and few of us pick them in advance.

Back to the report: "In summary, analysts' forecasts as well as investors' valuations reflect a widespread belief in the investment community that many firms can achieve streaks of high growth in earnings. Perhaps this belief is akin to the notion that there are "hot hands" in basketball or mutual funds....there is no evidence of persistence in terms of growth in the bottom-line. Instead, the number of firms delivering sustained high growth in profits is not much different from what is expected by chance.

The results for subsets of firms [like technology or pharmaceuticals], and under a variety of definitions of what constitutes consistently superior growth, deliver the same verdict. Put more bluntly, the chances of being able to identify the next Microsoft are about the same as the odds of winning the lottery.

Comment: what they mean by this is that simply investing randomly is not likely to give you the 100 to 1 return and even with a lot of effort and research there is still a great deal of luck involved. There are thousands of small companies with great stories who all think they will be big someday.

More report: "This finding is what would be expected from economic theory: competitive pressures ultimately dissipate excess earnings, so profitability growth reverts to a normal rate. Analysts predicted a five-year growth for the top 20% of companies to be 22.4% which turned out to be only 9.5%.(They also pointed out the actual return rate should be lower because many companies actually failed over that period.)

They created sample portfolios based upon analysts' forecasts. Predictably, the top portion of the portfolios actually returned only about half of what the analysts predicted: 11% actual versus 22% predicted. "These results suggest that in general caution should be exercised before relying too heavily on long-term forecasts as estimates of expected growth in valuation studies."

Finally, this very sobering conclusion:

"On a broader note, our results suggest that investors should be wary of stocks that trade at very high multiples. Very few firms are able to live up to the high hopes for consistent growth that are built into such stellar valuations. Historically, some firms have achieved such dazzling growth. These instances are quite rare, however. Going by the historical record, only about five percent of surviving firms do better than a growth rate of 29% per year over ten years. In the case of large firms, less than one percent would meet this cutoff.

On this basis, historical patterns raise strong doubts about the sustainability of such valuations. For example, on average 3% of firms manage to have streaks in growth above the median for five years in a row. This matches what is expected by chance."

Conclusions, class? Yes, I see that hand.

1. Evidently the brightest minds on Wall Street are verifiably (as a group) really, really, really bad at estimating the future potential earnings and growth of stocks.

2. Broad stock market indexes over long periods of time do not grow faster than the economy. Therefore, if they have grown substantially in the recent past, either they will fall in value until they revert to the average growth trend, or they will go sideways for long periods until growth catches up with them. Either way, investors will be frustrated.

So, am I telling you that you cannot beat the market over time by buying and holding index funds? You cannot beat the market by buying and holding momentum and growth stocks. Buying and holding, like Modern Portfolio Theory says, is going to give you the long term average of the market. That is, if you stick with it and don't leave after you are down 40%. Or if you don't concentrate your investments in one area like tech where you get power growth and then power losses. Especially not if you wait until 1998 to enter the tech market.

I am saying that buying index funds or stocks with high valuations today and holding is going to be a low percentage play for the next ten years. If picking a poor stock is bad luck, then why are we geniuses when we pick good stocks?

Now, we are coming to the end of this e-letter. Next week, in Part 2, I will tell you what I think you can do to achieve returns over the next decade that will give you returns you can live with. You see, I do think there will be some good opportunities. I will also give you some broad indicators that you can use to avoid some of the pitfalls of bear markets.

I will also show you an alternative (or maybe better to say a variation) on Modern Portfolio Theory that I think will work for individual investors.

Instead of looking for relative returns like institutions, we will look for investments which offer absolute returns. Instead of riding the markets up and down, let's try to find ways to make some money in all markets.

If I do not stop, this letter will be twice as long. This whole topic will eventually be a few chapters in my book on alternative investments and hedge funds, and I think to treat it adequately it will be 40 pages or more, so I am really summarizing here. I expect to do these chapters early, and plan to start writing in November. I will post these chapters on my web site.

Speaking of web sites, we are changing web hosts this week. We should be operational again. Next week, I will be announcing some big changes for Millennium Wave Online.

But for now, I will hit the send button and dash to the airport. It is my birthday and my wife is taking me off for some well deserved (at least I think so) R & R. My main goals this weekend are to break 100 and to spend some real quality time with the love of my life, not necessarily in that order. (And no, the love of my life is NOT my putter.)

Thanks for the tremendous response to the Afghan food appeal. So far, we have about $10,000 from your fellow readers. The guys will be leaving soon, and will send us frontline reports back.

Have a great weekend and remember that Life is Good.

Your wishing I could hit 'em as straight as I write analyst,

John Mauldin

 

Get a Bird’s-Eye View of the Economy with
John Mauldin’s Thoughts from the Frontline

Discuss This

We welcome your comments. Please comply with our Community Rules.

Comments

There are no comments at this time.