THE INNOVATION CYCLE -- by John Mauldin
If you've spent any time reviewing Dr. Robert Shiller's
foundational work, Irrational Exuberance, you're
beginning to suspect that the next decade is going to be
a rough one in the stock market.
Shiller shows that mainstream "index investors" have
never made a profit over a period of ten years when P/E
ratios have gotten to the high valuations they have
today. It is just one clue to the puzzle of where the
investment winds will be blowing, but it is an important
clue. We find more clues in a ground-breaking book by
Michael Alexander called "Stock Cycles".
Alexander's work shows that using past stock market
"cycles" to predict the performance of the stock
market one year from now is pretty much a random chance.
Statistically, from almost any starting point, you have
about a 50/50 chance of the market going up or down,
using price movements alone to make your prediction.
But there are certain long-term cycles which are not
random, and the probabilities of them repeating
themselves are very high. As you would expect, the
patterns and techniques of successful investing changes
somewhat dramatically from pattern to pattern and cycle
to cycle. The trick, of course, is to figure out where
you are in the cycle. And the trouble with long range
stock market cycles is they ignore market fundamentals.
It is one thing to use the stars, as the ancients did,
to construct a calendar to predict seasons, planting
times and weather patterns. It is another to use the
stars to predict personal fortunes. Alexander provides
the missing link between the patterns in stock cycles
and the underlying health of the economy.
A brief look at the historical cycle of bull and
bear markets reveals that stocks have returned about
6.8% per year in real returns over the last 200 years,
but about 4.6% or two-thirds have come from dividends.
The remainder corresponds to the real annual growth in
GDP over that time. A recent National Bureau of Economic
Research study demonstrates the stock market does not
grow faster than the economy. If it goes too high or too
low, it always comes back to trend. But individual stock
prices fluctuate dramatically.
There have been 7 secular bear markets and 7 secular
bull markets since 1802. These are periods of at least 8
and up to 20 years where stocks are either generally
rising or falling over the entire period. There are, of
course, bear market rallies and bull market corrections,
but the long-term trend is still either up or down.
If you were in the stock market during the 95 years of
the bear market cycles, you only achieved a 0.3% annual
average rate of return. If you picked the 105 years of
the bull market cycles, you made a 13.2% rate of return.
Your actual returns for any one ten year period would be
totally dependent upon when you made your initial
investment.
Earnings, we are told, are what drive the price of a
stock. But earnings growth for the period 1965-1982 was
roughly the same as for 1982-1999. Yet we all know that
the S&P 500 had significantly different results. The
first period was one of no stock price growth, and the
latter saw growth of over 1000%.
What was the difference? Clearly, it was how investors
perceived the relative value of the earnings. In a
period of high inflation, earnings growth of 6-7% is not
all that impressive. When inflation ends, you get the
benefit of the old earnings growth and new growth,
giving the market a double boost. Investors become very
optimistic about earnings growth and adjust their future
value of stocks accordingly. Alas, trees cannot grow to
the sky. For 200 years, the overall market has not grown
much faster than the growth in GDP.
Now we enter a period where the expectations of earnings
growth cannot match reality. The stock market must come
back to trend...which can be a painful adjustment for
some investors. Alexander notes, "The situation is very
similar to 1929. The effect of both the monetary
conditions and a very optimistic assessment of the
earnings growth still to come are priced into the
index."
We should expect the current monetary cycle to be
followed by a "real" cycle. It should start with a
secular bear market in which lower earnings growth will
be the problem, not inflation.
The goal of every business is to grow its income and to
grow its income at a faster rate over time. However,
there appear to be very real upper limits on both the
value of - and the growth in - profits for a given level
of resources.
Why wouldn't profits remain constant, as many firms try
to do? Why can't the rate of return grow every year, as
market cheerleaders on TV constantly predict?
What appears to happen is this: firms, in a moment of
optimism, either build too much capacity or resource and
profits drop as capacity utilization drops; or, firms
invest too little and thus the growth of profits are
self-limiting.
Managers simply cannot know the exact amount of future
resource needed. They can do their best to make very
intelligent guesses, but in the end there is usually
either too much or too little resource. It is a
difficult job. Too much resource and you don't get a
reasonable return. Too little and you invite competition
or give up market share.
Further, there is that nasty thing called competition
which makes it possible for a lot of competing
businesses to build products for the same market - all
hoping to increase their business and market share. Then
you end up with too much "stuff" and no ability to raise
prices. Computers, oil, soybeans, ships, etc. The list
is endless. Supply and demand works. The business cycle
is real.
In the telecommunications industry, management decided
the world needed large amounts of fiber optics cable. We
now use less than 5% of the capacity of that new cable.
Clearly, the industry overbuilt.
But all the firms which supplied equipment for that
expansion also assumed that the future would look like
the past and built large factories capable of building
massive amounts of fiber optic cable equipment. Over-
capacity went right down the food chain.
The 90's were characterized by the growth of capacity in
almost every industry, including "mature" industries
like agriculture, shipping, mining, retailing, etc. We
now have a new level of total resources available to
U.S. businesses and the world. But since economic growth
and profits do not grow faster than GDP, whatever
growth we do have will be spread over a larger area.
This means the rate of return on resources will be
smaller than it has been for the last ten years. It
follows that the growth of earnings will be smaller as
well.
The economists Schumpeter and Mensch both tried to
establish a theoretical base for the stock market cycles
based upon bursts of innovation. More recently, Harry
Dent (the Roaring 2000's) has expanded upon their work.
Alexander uses Dent's terminology to put forth his own
new thought.
Dent sees the innovation cycle being comprised of four
periods: the innovation period, the growth boom, the
shakeout and the maturity boom. Alexander calls the end
of the maturity boom the economic peak, which is the
time when the economic impact of the new innovation has
run its course.
Basically, a new process or technology is invented, like
the cotton gin, telephone, electricity, airplanes,
computers, etc. Following a period of innovation, there
is a rapid growth of the "New Economy".
Not surprisingly, there is too much capacity built and a
number of companies falter. During the shakeout, there
is another process going on. We see a second "innovation
phase" of the mature technology. Companies which come up
with new innovations now see a second growth boom prior
to the final "maturing" seen in the economic peak.
Now we come to the best part of Alexander's work. He
goes to a number of sources and derives 9 different
innovation cycles beginning in the early 1500's. While
this or similar efforts have been done before,
what Alexander does that is new is to relate these
cycles to their importance to the overall economy: What
proportion of the GDP did these innovations contribute
to growth?
Over time, as the innovation becomes mature and new
innovations come on the scene, the talk is of the "New
Economy" changing the world and replacing the "Old
Economy." But eventually even the "New, New Thing"
becomes mature and plays a less significant part of the
economy as even newer innovations appear. It is a
repetitive cycle.
And no different than what we see today.
In the last decade, a rising tide lifted all boats. Now
things will start to be a little different. As always,
new innovations will always bring rewards to investors.
But the "winners" will be investments that focus on
absolute return strategies - as in income mutual funds
and certain types of hedge funds - and value based
investing, such as that espoused by Warren Buffet and
Graham.
Investment styles which depend upon 15% compound
earnings growth will be frustrated. There will
invariably be large rallies which could last for months
as investors yearn for the profits of "yesteryear."
Astute traders will be able to take advantage of these
moves. But as earnings growth fails to catch up with
stock prices, these rallies will falter.
Since 1800, says Alexander, there have been 15
alternating good and bad cycles of 13 years, from stocks
being undervalued to being overvalued and back again.
The year 2000 was a 13 year peak in his model.
The data suggests that "index investors" have little
hope for capital gains over the next thirteen years. Buy
and hold investors will probably be better off in money
market funds, just as they were in 1966 and 1929.
In fact, Alexander concludes that there is a 75% chance
of a negative capital gains return for index fund
investors over the next 20 years. However, returns in
any one-year period are essentially random. Even in
"over-valued" markets, the odds are essentially even
that an index fund will outperform a money market fund
for a 12-month period.
"Given today's low dividends and high valuations, a
money market fund is, on average, a better investment
over the next 5-20 years than the S&P 500 Index...In the
case of over-valued markets like today, holding for
longer time periods, even up to 20 years, does not
increase your odds of success." (Mr. Alexander wrote
that in early 2000, prior to the first crash.)
Alexander is not saying to avoid the stock market. He is
simply pointing out, that buy-and-hold index investing -
as is so popular with the investing public - is not
likely to work for the next 13 years. Simply picking any
old mutual fund and expecting a rising tide to raise
your boat will only have a random chance of success.
In other words, you have to change your investment
strategy if you want to succeed.
John Mauldin,
for The Daily Reckoning
dailyreckoning.com
2000wave.com |
