To set the stage, let's review a few paragraphs from last week's letter.
"...But more often than not, what we think of as data 'proofs' for a certain viewpoint depend more upon our perceptions than the actual data. What happens is that we develop mental models. We take in information and process it according to our mental models, which are subject to our personal biases. The accuracy of any particular judgment depends almost exclusively upon the accuracy of your mental model, because there is virtually no other basis for our judgment. If the accuracy of our mental model is the key to accurate judgment, it is necessary to consider how this mental model gets tested against reality and how it can be changed so that we can improve the accuracy of our judgment.
"How can we deal with this bias? To get some help, let's look at these paragraphs from an essay by Richards J. Heuer, Jr. entitled "Do You Really Need More Information?" It was published in a book called "Inside CIA's Private World: Declassified Articles from the Agency's Internal Journal 1955-1992."
" 'Information that is consistent with our existing mindset is perceived and processed easily. However, since our mind strives instinctively for consistency, information that is inconsistent with our existing mental image tends to be overlooked, perceived in a distorted manner, or rationalized to fit existing assumptions and beliefs. Thus, new information tends to be perceived and interpreted in a way that reinforces existing beliefs.
" '...If we are to penetrate to the heart and soul of the problem of improving analysis, we must somehow penetrate and affect the mental processes of the individuals who do the analysis. This strategy is to focus on improving the mental models employed by the analyst to interpret his data.
" '...All involve confronting the analyst with alternative ways of thinking. The objective is to identify the most fundamental analytical assumptions, then to make these assumptions explicit so that they may be critiqued and re-evaluated.
"AND THIS IS KEY: '...The analyst should then try to disprove, rather than prove, each of the alternatives. He or she should try to rebut rather than confirm hypotheses...It is especially important for the analyst to seek information that, if found, would disprove rather than bolster his own arguments. One key to identifying the kinds of information that are potentially most valuable is for the analyst to ask himself what it is that could make him change his mind. Adoption of this simple tactic would do much to avoid intelligence surprises.' "
With this as background, let's look at some of the more important macroeconomic premises from which flow my general investment themes. (Yours, of course, may differ.)
Premise #1: A Secular Bear Market
Long time readers (as well as readers of my book) know that I believe we are in a secular bear market, and that we should understand such secular cycles in terms of value. For newer readers, let me briefly define that or review it for long time readers.
I believe that in the very long run, the broad stock market as represented by the DOW or the S&P 500 will deliver 6-7% returns (plus dividends). By long run, I mean 70 plus years. That return corresponds to GDP plus inflation plus dividends, and is roughly the historical average for the last century. However, we know that for shorter periods of time, the markets can deliver much higher returns as it did from 1982-99 and much lower returns as it did from 1966-82.
The research I presented in my book and in this letter shows that future returns from the broad market are highly correlated with market valuations. If you start with any period of low valuations since the recorded beginnings of the stock market, ten years later you would have had a nice return, sometimes in excess of 10% annual returns for the entire period. If you were lucky enough to start investing in 1921, 1950 or 1982, you might see a 10% compound return for 20 years.
However, the research of Professor Robert Shiller of Yale (presented in his excellent book, Irrational Exuberance) shows that if you start in a period where the markets are at peak valuations, then ten years later you would have been better off in a money market fund. Think 1929 or 1966.
The stock market cycles from periods of high valuations (whether in terms of P/E ratios or book values) to low valuations and back to high valuations. The long term P/E average is around 15. By "low valuations" I mean P/E ratios below 10 and by high valuations I mean P/E ratios above 22. In terms of value, the market seems to always want to go to above and below these extremes. These cycles can last anywhere from 8 to 17 years.
From the Latin word secula for an age or period of time, economists call these cycles either a secular bull market (when the market is going up) and secular bear market (when the market is going down).
Looking at the record of history, we see that once a new cycle has begun at one extreme the market will go to the other extreme. While there will be many short term bull and bear markets in between, many stops and lunges, eventually the market has always gone from one extreme valuation to the other. While no one rings a bell at market tops or bottoms, I do believe there is a methodology using valuation that will allow you to time the markets and avoid the long frustration of the secular bear cycles.
Market valuations peaked above 40 in 1999. These were the nosebleed P/E levels of the largest bubble in history. Today we are still above 21 for core earnings for the S&P 500 (for a detailed analysis you can go to www.standardandpoors.com and click on indices).
Jeremy Grantham is a highly respected money manager and analyst, in fact almost a guru in the investment industry. His firm, Grantham, Mayo, Van Otterloo (GMO) Advisors, manages $54 billion. In research done by his firm, he asked the question:
What Will the Stock Market Return over 10 Years?
Grantham breaks down historic P/E ratios into five levels, or quintiles, from level (or quintile) 1, which represents the 20 percent of years with the cheapest values (lowest P/E ratios) in history right on through the fifth quintile, which represents the 20 percent of years with the most expensive values.
What kind of returns can you expect 10 years after these periods, on average? Interestingly, the first two quintiles, or cheapest periods, have identical returns: 11 percent. That means when stocks are cheap, you should get 10 percent over the next 10 years. The last, or most expensive period, sees a return over 10 years of zero percent. Investors who think the long run is 10 years would clearly be disappointed. We are in a period that would easily rank among the most expensive periods.
(For an in-depth analysis of secular bull and bear markets, see chapters 1-6 of Bull's Eye Investing at www.amazon.com/bullseye.)
Looking at history, one could leap to the conclusion that the stock market is not going to deliver returns much better than money market funds over the next ten years, but with a great deal more volatility. While the investment considerations are somewhat obvious (avoid index funds and broad market mutual funds), it is not quite so straightforward.
And when we ask, "What could prove my premise wrong?" we come to some very interesting thoughts.
First, let's look at what would have to happen if we started last year and are now in another secular bull market, rather than just an echo bubble. What would it take for the market to double over the next four or so years from here?
The bulls would argue that continued earnings growth is all that is needed. They correctly point out that earnings have grown over 300% from the second quarter of 2001 through the second quarter of 2004. 300% in three years is not shabby. If earnings were to grow merely 100% over the next four years, would not it be reasonable to believe that the stock market would double? Indeed, many analysts are forecasting such growth
While the proposition that 100% earnings growth should yield a 100% stock market growth might be reasonable, it is not reasonable to think that earnings will grow at such a rate. Going back ten years for the four quarters ended June 30, 2004 we find that (surprise, surprise) earnings in the S&P 500 have grown by a compound 6.33%. You can play with the dates and numbers and get somewhat higher growth in the 7% range. (Again, from the Standard and Poor's web site mentioned earlier.) That is quite close to GDP plus inflation.
(I would have preferred to use core earnings, but we do not have data for the last ten years, so I used as reported earnings, which show dubious pension income and do not account for options expenses.)
The recent super-charged growth has merely served to get us back on historical track. Think about that. We went through a period of supposedly powerful growth in the 90's followed by a quite modest recession and recently have experienced one of the most powerful profit booms in history. All to get back to trend.
Let's chase a little rabbit down the earnings trail. Why do the largest corporations in the broad market indexes tend to grow at GDP plus inflation? Because as an average group, they tend to reflect the economy. You cannot have corporate earnings in the US economy at large growing faster than the economy over long periods of time. There is a limit. And we are close to it.
Profits before tax as a percentage of GDP are close to a 40 year high, and profits after tax are an at all-time high. It is somewhat unreasonable to expect that earnings growth as a percentage of GDP can grow much higher. Possible, but there would need to be some fundamental change in the structure of our free market economy. When profits are high, competition tends to move into high profit areas and bring those profits down.
Smaller companies can certainly grow their earnings faster. That is why over longer periods of time small cap indexes tend to outperform their larger brethren. They can take market share, create brand new products, etc. It is a lot easier for a company with annual revenues of $100 million to grow 50% per year for a few years than for a $10 billion company to grow 10% a year. Yes, there are exceptions, but we are talking about indexes, not individual companies.
When you combine the slow growing dinosaurs with the large but faster growing technology companies, you get that average 6-7%.
That is also why I suggested in my book targeting a portfolio of small and micro cap companies for those of you who want to invest in individual stocks, and gave you ways to go about finding them. (Chapters 16-18)
But let's get back to marker returns. If the market rises any faster than earnings, that means that the valuation of the market, (P/E ratios) will be going up. If earnings were to rise by 25% over the next four years, but the market were to go up 50%, then P/E ratios would climb to a bubble like 26.4.
I ask myself, "How likely are investors, after the last bubble, to allow a return of another bubble?" Anything is possible, but not all things are likely.
If we get the slightest bit of earnings disappointment - if investors start to realize that projections of 20% earnings growth (roughly what S&P projects) will not happen, many of them will begin looking for the exits.
Elections, Recessions and the Economy
And now we come to the question I think is most pertinent. What if we have a recession? Or better, what will happen
On average, the stock market drops 43% during a recession. Sometimes more and sometimes less.
Is it reasonable to assume the market will rise 50-60% before we have the next recession and we suffer a potential 40% loss to take us back to where we are today? More important, do you think earnings will rise 50-60% before the next recession? Do you think we can avoid a recession for 5-6 years? Like Clint Eastwood, I ask, "Do you feel lucky punk? Well, do ya?"
We have had a nice and predictable bear market rally coming off a recession for almost the last two years. Now it has deteriorated into a sideways, trendless market. I look at my upside potential versus my risk. Perhaps the market can move another 10% after the election (assuming Bush wins) in a reflex rally. A Kerry win would mean the elimination of the dividend and capital gains tax cuts, which has been a significant part of the move up in the broad indexes. The markets will not like that, nor increased taxes upon the "rich." I think it is unlikely we will see a significant rally after a Kerry win.
As an aside, whoever wins will have to deal with some real economic structural problems. There are few magic bullets left to deal with the next recession. The next one is going to be more difficult with tougher decisions. I mean, in one sense, Bush had some easy decisions. In the face of an impending implosion as the aftermath of the stock market bubble, the classic solution/answer is tax cuts and deficits, coupled with lower rates. They went overboard on the deficit, but it did soften what should have been the worst recession in 30 years.
There will be no tax cuts available to the next president. Larger deficits will be politically difficult. We already have low rates. The next recession, and there will be one in the next term, is going to present "issues" as my teenagers are wont to say.
I argued last night at a private dinner that if we were just concerned about government deficits, a Kerry win and a grid-locked Congress and Washington would probably be better if the objective is to hold down spending. I have been quite disappointed about the inability of a Republican administration and Congress to hold down spending. Some of the pork is truly horrifying. But, of course, this election is not just about government deficits. There are larger issues. There is the whole civilizations in conflict thing. But that's a topic for another letter. As H. L. Mencken said, "Every decent man is ashamed of the government he lives under." Back to the market.
What should you do today? Conservative money should not be in broad market mutual funds. If you are a trader, you can play for the usual and potential post-election rally. But after that (and assuming we get one), I would be on the sidelines. So what if I miss another rally next year?
Come the next recession, I am going to be able to buy this market significantly lower than it is today. Just like sheets and towels at Wal-Mart in January, stocks are going to be on sale at some point in the future. I prefer to buy when things are cheap and give myself a shot at those 10% annual returns.
A corollary question to this premise is, "Will the next recession mark the real bottom of the market and a return to a secular bull market trend?"
The answer is maybe. (Can I waffle or what?) To answer that question, we would need to know how deep will the recession be? Will it be a mild affair like the last two? If so, it might not cleanse all the imbalances out of the system and we will go into a cycle much like we have seen over the past three years: a plunge in the economy and markets followed by a significant bear market rally. Less pain in the short run, but a lengthening of the secular bear cycle. Since the shortest such cycle is around 8 years, historical analysis would suggest we have a way to go. But there are so few data points that you can really have no confidence in the minimum length of a secular bear cycle.
If it is a deep recession, like 1974, then we could very well see values plunge and the base set up for a new bull run. It would be the shortest such cycle. It would also be quite unpleasant. A generation approaching retirement would see much of its retirement assets destroyed in a significant plunge.
There are those who think we need or deserve such a recession. You should be careful what you wish for, because you might get it "good and hard."
Frankly, I do not want a deep recession. I prefer my pain in smaller measured doses. But what we want makes little difference. What we can do now is get defensive with our retirement portfolios. There are other places for money besides long-only mutual funds. For those of you who do not want to sell for tax reasons, I would remind you that a 15% capital gains tax can be overcome by buying your stocks back at a much lower price.
And that's another reason a Kerry win will be bad for the market. Knowing that capital gain rates will be going back up, wise investors will take advantage of the lower rates offered today should he win.
Let me repeat, I am not against owning stocks. Some stocks will do quite well in the coming years. This is a stock picker's market, and requires research and more hard work than simply buying the latest hot mutual fund. I am against owning index funds and most mutual funds which are really proxies for the market as a whole. If you buy the premise we are in a secular bear market, you should be, too. If you are not, you should do the opposite of what I have done here and that is test your basic assumptions that we are in a new bull run. Without wanting to be pushy, the arguments are laid out in detail for you in the first six chapters of Bull's Eye Investing.
Next week we will look at Premise #2: We are in a Muddle Through Economy. Then on to the dollar, China and other points. Stay tuned.
Living in Memespace, Tahoe and Stanford
The final details are on the web for Telecosm 2004, hosted by George Gilder and Steve Forbes at Lake Tahoe, Nevada on October 20-21 at www.telecosmconference.com. Telecosm 2004 has a pretty powerful line-up of speakers, especially for those interested in technology. If you are going, drop me a note and perhaps we can set up a group meeting.
I have long had people speculate about in which part of the universe my mind resides. I have now been given a clue. I am speaking at a conference on Accelerating Change at Stanford in a few months, and in the press release they said:
"Accelerating Change 2004 features 36 acceleration-aware speakers, including virtual worlds creators, leading edge software designers, innovative venture capitalists, best-selling authors, law enforcement futurists, and other prominent technologists. 'These individuals are all on the cutting edge of the socio-economic meme-space,' says Alvis Brigis, Press Director. "It will be very interesting to see what new concepts and innovative business strategies emerge at this event. The cross-referencing possibilities are endless when it comes to the subjects to be discussed at AC2004."
There you have it. I reside in memespace, and on the cutting edge no less. Now if I just knew where the heck where THAT was I might be able to find my way back to real space.
The conference is November 5-7 at Stanford. You can learn more by going to www.accelerating.org/ac2004/index.html. It looks to be quite fascinating if you are into what the world will look like in a few decades. I am entirely out of my league (there are some really, really smart people speaking), but will have a lot of fun nevertheless. You can still get in for the regular rate if you note that you read about the conference hear.
Today I write from Houston. I went to school here some 30 plus years ago at Rice University. Those were good times. But I had no clue as to what the next 30 years would bring. Cell phones? Personal computers? The internet? Rice itself is a center for nanotechnology research. How many things have changed? I wonder today if I have any more of a clue about what the next 30 will bring. This Accelerating Change conference might be fun, at that. I will report any insights.
Take care and have a great week.
Your looking forward to visiting memespace analyst,
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