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The Friendless Trend

This will be an unusual e-letter in that I am going to focus on some recent interviews with well respected investment analysts or economists. I believe you will find them as instructive and thought-provoking as I did. I will quote them directly and then make comments.

The first is from Barron's with Jeremy Grantham. Grantham is a very highly respected money manager and analyst. His firm manages $22 billion. There are many in the investment industry who hold Grantham in almost guru status. He has earned it.

The Trend is Your Friend

His basic investment theory as that over time investment classes come back to the average. When asset classes are well above trend he avoids them, and when they are well below trend he buys them. While it can take a long time for some classes to revert to the trend, if you have time and are patient, this style has been successful. Grantham has been very successful at simply investing for the long term using History as his guide.

As a student of History, I like his approach. It let's you get on the right side of long-term trends. You will miss bubble tops and get in too soon on irrational bottoms, but patience and time will see you rewarded.

The interview is nine pages. It re-enforces some of my recent themes, yet does so from a very different approach. (For information junkies, I tell you how to get it later, and suggest you do so, if you have the time). I reproduce various parts of it and will make comments. Warning: he is negative on the stock market, but he does give us some asset classes to be interested in.

After making a point that value stocks are still under-valued relative to growth stocks, he makes these comments:

"...And tech and growth will overrun on the downside to become cheaper than normal."

Q: Then the worst for those stocks is not behind us?

A: The Internet-telecom-tech bubble was the biggest by far in American history. Bigger than the railroads, bigger than anything. To put it in perspective, the S&P peaked at 21 times earnings in 1929. In 1965, in the other great cycle, the post-war cycle, it again peaked at 21 times earnings. Both cycles were built on incredibly strong earnings and productivity gains. In this cycle the index peaked at 33 times earnings, and as we sit here the S&P's P/E is at 26 times earnings.

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"So, how can you believe that there is going to be a permanent low at a P/E higher than the previous highs? There isn't much hope. My colleague Ben Inker has looked at every bubble for which we have data. His research goes back years and years and includes stocks, bonds, commodities and currencies. We found 28 bubbles. We define a bubble as a 40-year event in which statistics went well beyond the norm, a two-standard- deviation event. Every one of the 28 went back to trend, no exceptions, no new eras, not a single one that we can find in history. The broad U.S. market today is still in bubble territory at 26 times earnings."

Comment: Almost one year ago, I predicted a recession based upon the historical trends associated with a negative yield curve. In the average recession, I told you, the stock market drops about 43%. I suggested that the risk of holding stocks in the face of this historical relationship was high.

Over the past year, I have detailed a number of historical relationships which told us we were headed for recession, and constantly made the linkage to the performance of the stock market during a recession.

Here we have one more historical trend. With no exceptions, bubbles and markets will come back to trend.

"Q: What P/E represents the old trend- line for the S&P?

A: The long-term average is 14. I believe the P/E will come back to 17 1/2 sometime in the next 10 years. A level of 17 1/2 recognizes the world is a better, safer place and therefore we can pay more for it. We think the P/E will trend down gracefully. If it happens more quickly, it will be a lot more painful. If it happens in 10 years, there will only be a modest negative return."

Comment: Ouch. Today a P/E of 17 1/2 would be about 800-850 for the S&P 500, or 300 points lower than where we are currently.

If the P/E trends down gracefully, as Grantham asserts, then that means the market will essentially be where it is today ten years from now. There are clear historical precedents for this.

In fact, that is exactly what Professor Robert Shiller asserts in his book, Irrational Exuberance. He points out that no stock market at the P/E levels we are today has ever returned anything to buy and hold index investors after ten years. Period.

Typically, what happens is not ten years of sideways, or a graceful slide, but a serious correction and a long and painful climb back to break-even.

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"Q: Is the Nasdaq overvalued?

A: The Nasdaq is not any more materially overpriced than the S&P. We think 1250 is fair value for Nasdaq. That said, we have been buying some tech stocks in our large-cap value portfolios."

Comment: That would mean another 30% drop for the tech sector dominated NASDAQ. However, with many stocks at P/E ratios of 100+ and with earnings dropping, one does wonder how long investors will continue to believe that companies which are priced for perfection and 30% growth are either perfect or will achieve 30% growth.

"Q: You say we're still in a bubble. Everyone else thinks this is a bear market.

A: The peak was March 2000 and the market has come down a lot, but it has a whole lot further to fall. Great bear markets take their time. In 1929, we started a 17-year bear market, succeeded by a 20-year bull market, followed in 1965 by a 17-year bear market, then an 18-year bull. Now we are going to have a one-year bear market? It doesn't sound very symmetrical. It is going to take years. We think the 10-year return from this point is negative 50 basis points [a basis point is one one-hundredth of a percentage point] after inflation. We take inflation out to make everything consistent."

"Q: Your outlook is not pretty. Yet, investors appear to be hanging tough. Do you expect that to continue?

A: When a cycle or bubble breaks it so crushes people's euphoria that they become absolutely prudent for the balance of their careers. I've been talking to older people who went through a wipeout and my best guess is about 95% of the people who have been through a bubble breaking never speculate in that asset class again."

Comment: Ben Stein puts it another way: "Philip DeMuth, the noted investment psychologist, puts it in a thought-provoking way. As DeMuth sees it, investors who lost big in the tech debacle often cannot bring themselves to sell because that would mean final recognition of their folly in getting in on the wrong side of that bubble. Not only that, but if they sold after colossal losses and the stocks did by some miracle rebound, they would be suicidal. Thus, they refrain from selling because of a combination of fear that they will be wrong again and denial of the finality of the end of the bubble. Through the prisms of fear or just plain self-delusion, investors see hope and keep on buying -- a hold is the same as a buy, as Roy Ash taught me long ago -- and the market stays at startlingly high levels relative to historic norms. Unless the law of reversion to the mean has been repealed -- always a risky bet -- these investors, myself included, are likely to feel more pain."

Further down:

"Q: What's your near-term forecast?

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A: My forecast is the market rallies on an economic recovery. Anytime now, there will be a fairly decent broad pickup, led by the consumer because of the tax cuts and because of the many interest-rate cuts. It probably will be a decent recovery. In this kind of knee-jerk stock market, at the first sign of a healthy economy the stock market will kick up 10% at minimum, 20% at best. That's the good news."

Q: And you're expecting this by the end of the year?

A: It could start any time, any day, you know, because even if the first good quarter is the first quarter of 2002, it should be anticipated any day. If it is the fourth quarter it should have been anticipated yesterday. The bad news is that there is almost no way this could flow through to earnings. Earnings themselves are a lagging indicator. The capital spending cycle is very important to profits, and it is in full-scale retreat. However low interest rates go, who is going to build a plant that they don't need? No one. So capital spending continues down and corporate earnings are still under pressure.

"If the market were to rally to the top end of my range -- up 20% on a knee-jerk, oh-it-is-all-over, whoopee! -- reaction, the best that would happen to earnings is they'd be flat to slightly off. The market would approach its old high with a substantially higher P/E, because earnings would still be down more than 20%. So instead of 33 times earnings, you'd see the S&P priced in the high 30s or 40 times earnings. The economic recovery will be quite short, two or three quarters, and weak. And then people will get a whiff of the fact that GNP is going to settle back down into a 1.5% range again, because of the capital-spending bust. Finally the negative savings rate will begin to move up, and that will impact top-line growth. The market is no longer in its old game. But this will not destroy the economy. I am not a big bear on the economy at all."

"Q: You could have fooled us.

A: Earnings will be weak and sometime in the middle of next year, or even earlier, we'll get a whiff that things aren't as strong as we thought. With the market at 40 times earnings, the next leg will be more vicious. That's what I consider the bull case. But the great thing about that bull case, if it happens, is that it will be one last great opportunity to lower your risk and move into asset classes with higher implicit returns, of which there are, happily, plenty."

Comment: The interesting thing is that he thinks we see a market rally later this year and THEN a return to a bear market. Some would look at 1929 and 1966 and see similarities: a drop, followed by a series of rallies before a truly serious drop.

But if he is right, and the market reverts to trend, then we have a lot longer to go in this bear cycle.

I include the following on productivity because it is so well thought out.

Q: But what about all the talk of productivity gains?

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A: People say productivity justified higher P/Es through higher profits. But I'll give you a simple thought experiment because thought experiments are incredibly useful. Say you come out with a seed corn that is twice as productive -- that is, for every dollar of seed it will grow twice as much corn in an acre. Give it to everybody at the same price as the old seed. Productivity will double. But what will happen to the price of corn and what will happen to the profits of the farmers in the following year? I think it is fairly obvious to everybody that they will be drowning in red ink and there will be corn coming out of every silo. Productivity does not necessarily equate with profit.

However, let us give it only to a farmer in Illinois. What will happen to his profits? They will go through the roof. He will grow twice as much corn per cost as everyone else and he will get rich and famous. Productivity gains are fine if there is a monopoly. If productivity is shared by everybody it flows right through to the consumer. We get fat and happy because the price of semiconductors comes crashing down, the power of the machines goes up, everybody has it, it flows through. It is not a competitive advantage and profits are completely unaffected by it. The whole productivity argument was interesting but it has no relevance to how much money the system makes and how high a P/E you should pay for it."

For those interested, he believes that there are some good opportunities available. He likes bonds, REITS, timber, hedge funds, value stocks and emerging markets. I respect his thinking, but believe that using trends to value foreign emerging markets may be dangerous in the short run as the world trade economy is clearly in recession, with no signs of imminent recovery.

You can read the entire article by going to www.barrons.comand getting a free two week subscription, and then search the web site for Jeremy Grantham. You can also look at the August 6th Barron's. (There is no free direct link I can give you. Sorry. They want me to pay $.50 cents a hit. That is a 4 bits over budget. They should pay me to send potential customers to their site.)

De-Valuing Japan, or Where the Sun Doesn't Rise and Shine

Finally, he weighs in on Japan.

"Q: What's the swing factor for Japan?

A: I am not a professional economist, but I'm a fan of Andrew Smithers in London. He has lived in Japan for years, he has followed it for years. Ten years ago he said it would be an absolutely bloodcurdling disaster and it would go on for years and years and years. It was the best call I have ever seen anyone make in my career. All the way down he said they haven't solved a thing. His view and a few other people's view is that they need to dramatically devalue the currency and dramatically increase their exports...... On the one hand, Japan has certain aspects of scrap-metal value, but its fundamental problems are so uniquely bad and so obviously unresolved that it is capable of making a huge rally if it gets lucky, stumbles on the right strategy. But basically the stock market has no material value at all. If you mark down their asset base by 25%, you'll find they are so leveraged there is no asset base. Under the worst scenario, the entire corporate sector may have no value. These kinds of thoughts are way off the radar screen. If they get it right they can have a huge rally and be the strongest market in the world. If they get it wrong they can basically evaporate."

Comment: Speaking of Japan in terms of scrap-metal value is harsh. I have been discussing Japanese woes for some time, but this is the most negative assessment I have ever read. I am well aware of the cross-holdings and over-stated valuations their accounting system allows. But if a 25% further drop implodes their markets, then we are talking of a global economic crisis of serious proportions. The deflationary implications for the world are huge.

Japan is the world's second largest economy. They have been the engine for Asian growth. Yet every week we learn of yet more woes in the Land of the Sinking Nikkei. Last week it was their bond auction. Today we hear that it could take years for the banks to disgorge themselves of their bad debts. Tomorrow it will be something else. Their banking sector is collapsing, and taking their stock index, the Nikkei, down to levels not seen since 1984.

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Note the prescription above for Japan: devalue their currency. I ask, "Against what?" Grantham, as do numerous commentators, notes elsewhere that the dollar is over-valued. He feels it is likely to come down, as it has been doing. This plays into my long the Euro, short Asia premise.

Japanese officials are publicly telling us they want to devalue their currency. If they do so, other Asian currencies will have to respond likewise in defense to remain competitive in the chase for international trade and the American consumer.

Competitive devaluation is not good. Direct government manipulation of currencies generally ends very badly for the citizens of a country and for the world economy at large.

Milton Friedman

As space comes to and end, I will summarize the next article from an interview with Dr. Milton Friedman in an Italian paper. He said he expects a recession to be lengthier but less deep than in previous cases, with growth likely to return next year. He said the Fed's policy to cut interest rates is correct as an instrument to boost growth but will be too inflationary in the long run. He also thinks the Euro will come to be seen as a big mistake, but there is no turning back now.

So, two famous analysts tell us that the economy will recover next year, but one warns us the markets will only appear to before disappointing us once again.

Ben Stein's Money

Ben Stein, of quasi-TV and movie fame, is actually a closet and very bright financial analyst. He recently did an article for the which you can access. (

He attacks the notion that long-term stocks out-perform bonds. Clearly, bonds have out-performed stocks for the last three years. There have been numerous lengthy periods where bonds out-performed stocks, unless you took into consideration stock dividends, which of course you should. But now, dividends, except for value stocks, are small or non-existent. Any returns from stocks will largely have to be in the forms of capital gains.

Grantham and Shiller (above) basically tell us not to expect any broad market capital gains for ten years on a buy and hold basis. In theory, "This Coming Disenchantment" (hmm, a good book title) will drive investors to the safe returns of bonds.

The above, and many other readings keep me bullish on bonds. Interest rates on 30 year bonds are at their lowest levels in years. The Target 2025 fund (BTTRX) is up over 14% for the last 3 months, and is (finally) returning to its five year average of 13.76% (Morningstar). Please note: this is a volatile fund. When interest rates are falling, it is typically the #1 performing bond fund. When interest rates are rising, it is typically the worst bond performing bond fund. This fund is a pure and aggressive bet on interest rates. Conservative investors should use shorter term government bond funds for less volatility and still have some capital gain potential.

I know I keep looking like a one trick pony. Bonds. Bonds. Bonds. But they are being good to us.

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I will remind you I was big on mid-cap value stock funds last year. There will come a time when I think it is safe to get back into the water. I actually think it will be before the end of this year. When we do I think it is likely we will be looking at small and mid-cap value stocks, with a few special situations like dynamic asset allocation systems.

FYI, Three Amigo junk bonds are still in a sideways to slightly up pattern, but not yet ready for prime time or our money.

Advertisement: We represent a Bond Timing money manager who has a very good track record. If you want someone to manage a portion of your bond portfolio, e-mail me or call Wayne Anderson at my office (800-829-7273) and ask for information. If you already have information, then I suggest acting upon it, either by letting Peters do it or managing them yourselves.


You are getting this e-letter a little early, as my web-savvy assistant and brilliant daughter Tiffani is off on her own trip to Puerto Vallarta tomorrow (with her hubby), and (confession) I have not bothered to learn how to upload the file to the web site. So, I had to write this week's e-letter early. Which is just as well, as I am off for a well-deserved long weekend with my wife.

Next week we see the beginning of what is typically the roughest two month period for stocks. Even the cheerleaders on CNBC are warning us of problems. If you hold equities, and for some reason do not want to or cannot sell, consider buying some stock index puts as a precaution and as some downside protection. Hopefully they will expire worthless, but there is still a real risk for another 10% drop from here. I personally remain short the markets.

With that cheerful thought, I am off to my wife's birthday dinner.

Your still can't find a reason to go long analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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