Latest Mauldin - even longer than usual but very insightful imho -
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The Lackluster Economy
Faith versus History
Secular Bear Markets
Blind Dogs and Janus Managers
Phony Analysis
Have We Seen the Bottom?
What's in a Name?
By John Mauldin
April 25, 2003
This week we briefly look at a few choice economic insights, and then
I once again will close with a portion of my book-in-progress about
how to successfully invest in secular bear markets. Despite some non-
writing business issues which are eating up a lot of work time, I am
making good progress (finally) on the book, which I hope to have
finished in less than a month and with some hard work on the part of
my publisher available in bookstores and over the internet this
summer. My intention was to call the book Absolute Returns, but it
seems someone has just beaten me to the title. At the end of this
letter, I will initiate a contest to help me find a new title.
The Lackluster Economy
The Fed issues something called the "Beige Book" each month,
describing economic activity around the country. Yesterday's edition
proclaimed the economy to be "lackluster." Dennis Gartman summed it up
best:
"The Fed's Beige Book yesterday offered little if anything that shall
help us define the nation's future economic prospects. Perhaps the
most important passage from the 'book' said simply that:
'...the pace of economic activity continued to be lackluster during
March and the first two weeks of April. ...Since the last Beige Book,
New York, Philadelphia, Chicago, Minneapolis, and Kansas City noted
that the recent pace of economic activity had been slower than
reported earlier. The onset of the war with Iraq appeared to have some
effect on sales and spending, although it is too early to ascertain
the full effect of the war on both consumer and business confidence.'
"We are especially 'fond' of and/or disconcerted by that last
statement: that is, the Fed is aware that the War has had some effect
upon the consumer and the economy, but it has absolutely no idea what
that effect is, has been, or shall be. The Fed has simply admitted
that it, like we, is left to flounder from one bit of economic news to
another, hoping to 'ascertain' what direction the economy shall
ultimately settle upon, but not all that confident that it shall do so
soon, despite the legion of PhD's that inhabit the hallowed halls of
the Federal Reserve banks' economic departments."
The economic data continues to be very mixed. New orders for durable
goods -- items designed to last three years or more -- rose 2.0% after
declining 1.5% in February. It was the second increase in the last
three months and a far better showing than the 0.5% decline economists
in a Reuters poll had forecast.
Earnings for corporations are generally coming in better than
expected, but revenues are typically down. This means the earnings are
coming from cost-cutting, and that means jobs. The unemployment
numbers from yesterday can only be described as ugly.
"The number of Americans lining up for state unemployment benefits
last week rose more than expected to the highest level in more than a
year, the government said on Thursday in a report showing further
labor market erosion. First-time jobless claims rose by 8,000 to
455,000 for the week ended April 19. It was the highest level since
the week ended March 30, 2002, and the tenth straight week that claims
held above the key 400,000 point, seen by economists as signaling an
unhealthy labor market." (Reuters)
As reported today, the economy grew by 1.6% in the first quarter;
economists had forecasted gains of 2.0%-2.4%, so the number came in
20% below the lower end of the forecast.
As I have written many times, and as we will see below, there is no
direct correlation between a growing economy and a rising stock
market. One of my favorite analysts, Richard Russell of the Dow
Theory Letter, writes:
"If the Dow can close above its March 21 high of 8521.97 we'll have
what I call a "Dow Theory all clear" signal in that both the
Transports and the Industrials have closed above preceding peaks.
"But what if the Dow refuses to close above 8521.97? Can the refusal
of the Dow alone reverse the course of the entire stock market? And my
answer is "Yes, a Dow non-confirmation can reverse the trend." The Dow
is still valued at about 25% of the entire US stock market. The thirty
stocks in the Dow are what I term "backbone of the economy" stocks.
What those thirty stocks do or don't do is extremely important."
Richard, like me, believes we are in a secular bear market (see more
below). That means the long term trend is down, and probably seriously
so. But that is our long term view. In the short run, both of us would
recognize that bear market rallies will occur. It is quite possible
this market will become even more over-valued.
Even during secular bear market cycles lasting 10-15 years, with very
decided down trends, the market will close up over 50% of the time on
an annual basis, and quite often up over 20%. As we noted last week,
while long term trends can be predicted within some reasonable
boundaries, one year market results are statistically random.
The Nobel prize in economics for 2002 went to a psychologist, Dr.
Daniel Kahneman, who helped pioneer the field of behavioral economics.
If I can crudely summarize his brilliant work, he basically shows that
investors are irrational.
There are many investors who are convinced that some statistic means
the market is headed in a particular direction, either up or down. I
would agree there are some indicators that have proven very reliable
over the long term. But that does not mean the market will immediately
respond to your rational view of the world.
The classic quote from Keynes should be on every investor's file
cabinet: "The market can remain irrational longer than you can remain
solvent."
Let's go back to this bit of wisdom from Russell; "One of the biggest
mistakes you can make in this business is to assume an emotional
position in the stock market. Every seasoned trader knows that. It is
essential that you keep your emotions out of your market activities.
If you can't do that, then you're better off staying out of the
market, because as sure as the sun sets every evening, your emotions
are going to cost you money.
"I'm writing this because I'm well aware that I have many bullish
subscribers who own stocks and therefore would love the market to go
up. At the same time, I have a lot of bearish subscribers who are
either short or out of the stock market, and this faction would love
stocks to go down.
"Both positions are wrong. In the business of investing, you must
learn to take what the market gives you. If you can't do that, then at
least stay out of the market until the market reaches value extremes.
By that I mean that you should not trade the secondary swings of the
market. You should move out of the market when the market reaches a
recognizable bull market top. And you should stay out of the market
until the market reaches a recognizable bear market bottom, prior to
the beginning of the next bull market. That would be the time for you
to load up with good quality stocks.
"This process requires a tremendous amount of patience, probably more
than 95% of investors can muster. But then, as I've said before,
probably 95% of investors lose money in the market over any extended
period of time."
The next segment is from my book. I have chosen this section because I
think it gives us some context for the previous comments and thoughts
on the market.
Faith versus History
In the 17 years from the end of 1964 to the end of 1981, the Dow
gained exactly one-tenth of one percent. In the bull market which
followed from 1982 to the peak in March of 2000, the Dow rose from 875
to 11,723, a spectacular gain of 1,239% or over 13 times from the
starting point.
We all remember what a difficult time that first period was. You had
three recessions, oil shocks, Viet Nam, stagflation, the collapse of
the Nifty Fifty, Watergate, short term interest rates rising to 18%,
gold at $800 and very high inflation.
"Bad news on the doorstep," seemed to be the theme of the period.
What a contrast with the next period. Tax cuts and lowering interest
rates fueled a boom in the stock market and the economy. It was
Morning in America. Computers invaded our lives, making us more
productive. By the end of the period, even Allan Greenspan was
extolling the virtues of technology led productivity growth. Inflation
became a non-factor, and mortgage rates dropped almost as fast as our
property values rose. The internet promised new ways to prosper. Peace
seemed to be breaking out, and government budgets ran to surplus.
It stands to reason, doesn't it, that the economy did poorly during
the long bear market period and far better during the bull market?
That is what one would think, but the reality is far different. Gross
Domestic Product (GDP) actually grew 374% from 1964 through 1981.
During the period from 1981 until the beginning of 2000, the economy
only grew 197%, or about half of the earlier period.
Even if you take out the effects of inflation, you find the economy
grew exactly 76% in both periods. Yet, if you factor out inflation, it
was not 1982 in which you finally saw a profit in your buy and hold
investment portfolio of Dow Jones stocks. You had to wait another ten
years, until 1992, before you saw an inflation adjusted return.
Yet, to listen to many advisors and analysts in the media today, you
should be buying stocks because the US economy is growing, or at least
getting ready to grow. "It is always a bad idea," we are told, "to bet
against the US economy."
That would be correct, if the economy was the main driver of stock
market prices. The economy more than doubled in real terms, from the
end of 1930 through 1950. Yet stocks prices were roughly the same,
after 20 years!
A reasonable analysis of the connections between stock markets and the
economy shows that stock markets do tend to go down before and during
recessions, but they do not always go back to new highs after
recessions.
Investors are told that you should invest for the long run. "It is
impossible to time the market," is the mantra of mutual fund managers
everywhere, even as they buy and sell stocks in a feverish frenzy,
trying to improve their performance. They can trot out studies which
show that long term investors always do better.
I believe these studies are grossly misleading, and are now doing
great damage to the retirement prospects of entire generations. In
fact, the advice that traditional money managers proffer is precisely
the wrong strategy for a secular bear market.
Secular Bear Markets
The received wisdom is that a bear market is when stocks go down by
20% or more. It makes for a nice neat media sound bite. Trying to time
bear markets can be a very tough task. In the recent 18 year bull
market, there were several occasions when stock markets drop by 20% or
more, only to spring back quickly to even loftier heights. Investors
were rewarded for being patient, and many became used to large swings.
Their advisors, and the mutual funds they bought, kept telling them
that new highs were around the corner. Each drop in the market was a
buying opportunity. Corporations churned out ever more glowing
earnings projections as a reason for increasingly high valuation
multiples.
Then the music stopped in the first quarter of 2000. It has been
downhill ever since. But you would not know that to hear from the
pronouncements of the "sell-side" investment community. (By "sell-
side" I mean those firms and funds who want you to give them money for
their management. Investors are the buy-side of the transaction.)
Even as $7 trillion dollars has disappeared from equity valuations
over the last three years, each new low is greeted as the bottom, and
the brokers and mutual fund managers find ever more reasons for you to
give them your money today! Bear markets, we are told, do not last
forever. The economy is out of recession and growing, and thus you
should get in the market today (preferably into whatever they are
selling), before the next big run-up begins.
Staying in the market was precisely the right strategy for the 80's
and 90's. It was the wrong strategy for 1966-1982. How can we know
what strategy is right for today?
Perhaps you have heard the term, "secular bear market" or "secular
bull market." The Latin word for cycle is "secula," so when economists
use the term secular, they mean cyclical. The term generally is used
to indicate time periods of long length.
Since 1800, there have been seven secular bull markets and seven
secular bear markets. The average real return in a secular bear market
is 0.3% [This is from a study by Michael Alexander in his prescient
book Stock Cycles, which we will discuss later.] (even though the
market was falling, investors still got dividends). The average return
during a bull market cycle is 13.2%.
Not coincidentally, this averages to the 6.7% (real or inflation
adjusted) the Ibbotson study (among many others) tells us that stock
investments return over the long haul. The average length of bear
markets is almost 14 years, and for bull market it is almost 15 years.
But the average complete cycle of a combined secular bull and bear
market is 28 years.
If you invested in a ten year period contained within a secular bear
market in the past, your real returns were quite likely to be close to
zero. And that is with the historical advantage of dividends averaging
4-5% or more. In today's world of dividends of less than 2%, if this
secular bear market should last another 10 years, staying even will be
a hard row to hoe.
Within each secular bull and bear markets, there are often
intermediate bull and bear markets. These are shorter term in nature,
but still are significant moves up or down. In a secular bull market,
each bear market fails to get to previous lows and moves on to new
highs. In a secular bear, each rally fails before it gets to the last
high mark, and then stumbles down to even deeper depths.
Blind Dogs and Janus Managers
In secular bull markets, buy and hold works, as well as momentum
investing, sector rotation and a host of strategies designed to take
advantage of a rising market. Blind dogs and Janus managers make money
in bull markets. That is because the wind is at the back of the
market.
In secular bear markets, making a profit from these strategies becomes
much more difficult, if not impossible. Money managers, who I track
for a living and who made significant and steady returns in the 90's,
now languish with flat or losing returns. In the 90's, there were many
managers with nimble strategies who significantly beat the market
while reducing risk.
Alas, these same managers are still reducing risk, but they clearly
need a bull market to give investors the returns. The number of
managers who are doing well is a much smaller list.
In secular bull markets, strategies which emphasize relative returns
work well. They are a disaster in secular bear markets. In secular
bear markets, you want your investment portfolio to be positioned in
investment programs which emphasize absolute returns and have sound
risk control policies.
Bonds, dividends, income producing partnerships, certain types of
hedging strategies, and covered call option selling would be examples
of absolute return strategies. Will these give you 10-15 % a year?
Not likely, but they will outperform stock market investments which
are going down or sideways.
Owning stocks in a secular bear market requires great skill in stock
selection. I am willing to concede that there are hundreds of stocks
that will double over the next few years. The problem is that there
will be thousands of stocks which will drop by 50%. Choose wisely.
How can we know that we are in a secular bear market? Is there any one
indicator that can yield a clue that we can trust? The answer is a
simple no.
To be statistically significant, there should be a large number of
"data points" with a given indicator that we use to verify its
reliability. A poll which interviews only 10 people has little
meaning, while one which has a thousand random interviews is far more
reliable. Since there were only 7 full bull and bear cycles in the
last 200 years, we simply do not have enough data to be absolutely
sure of any one indicator.
But we are not entirely lost at sea. If you combine the findings of a
number of studies, each of which approaches the problem of predicting
the future direction of the market from a different point, the
evidence that we have entered a long term secular bear is over-
whelming, in my opinion.
We will be looking at these studies and more in the next few chapters:
the traditional view of Price to Earnings value offered by Professor
Robert Shiller in "Irrational Exuberance"; the economic growth and
earnings studies by the National Bureau of Economic Research; the long
wave cycle analysis of Michael Alexander in "Stock Cycles"; the Risk
Premium analysis by Robert Arnott; the trend analysis of Jeremy
Grantham; different demographic analysis by both Arnott and Alexander;
the writings of Warren Buffett; and the research on the dollar and the
economy by Stephen Roach and his team at Morgan Stanley.
Most of the above are essentially mainstream analysts. They are not
bears by trade. I should also note that one common denominator is that
none of them make their living selling mutual funds. All these studies
point to conclusion that we are in the beginning of a lengthy period
of time in which US stocks, on average, will under-perform even money
market funds paying only 2%.
Phony Analysis
I am sure you have gotten one of the many direct mail packages showing
you the profits to be made by investing in the stock market. They show
how even if you started just as the secular bear market began in 1966
or 1974 and invested on the worst day each year, you would be so much
farther ahead than someone who only started to invest in the stock
market in 1982, even if he invested at the best possible time each
year.
Therefore, the reasoning goes, you should not worry about the ups and
down of the markets and invest for the long term. Except that none of
us live in the long term. We live in the here and now, and those who
are retiring certainly do not have 28 years for the long term to bail
them out.
Can you time secular bull and bear markets? I think the answer is
roughly yes. Picking the day or the month would be impossible, but
coming within a year or so is quite reasonable. And that simple,
though imprecise, edge would give an investor a huge advantage over
any buy and hold strategy.
Are We at the Bottom?
For the rest of this secular bear market, you are going to see a large
variety of studies and analysis which purports to show that we have
reached the bottom of the bear market, and NOW is the time to buy.
These studies will largely be built around the potential for the
economy to grow, with the conclusion that profits are going to grow as
well, and therefore the stock market will rebound.
Don't be misled. There is no one-to-one correlation between rising
profits and a growing economy and a rising stock market. You can have
a secular bear market, even as the economy grows and as profits rise.
It has happened many times in the past.
In August of 2000, I wrote extensively about a Fed study which showed
that an inverted yield curve was the single most reliable predictor of
recessions. Recessions appear roughly four quarters after an inverted
yield curve (when short term rates are higher than long term rates).
Since stock markets drop 43% on average during a recession, I
cautioned in that letter that it might be a good time to start getting
out of the stock market. I remember that when the Fed started to cut
rates in January, after the market had dropped only a little, many
writers started to say you had to get back in the market. Study after
study appeared that showed how much stocks went up after the Fed began
to cut interest rates.
I caught some grief from readers who were convinced that the bull
market was ready to re-ignite. I wrote a series of articles on the Fed
versus History. If you thought the Fed could keep us out of recession,
you would be a bull. If you thought History would prevail, you should
stay out of the market. I bet on History. Time has shown that History
won that fight. History is a tough opponent. Betting against History
is usually a losing proposition.
Faith versus History
Today, there is another struggle going on. I think History clearly
shows that we are in for a secular bear market for at least the next
7-10 years. The shortest secular bear cycle was 8 years. Coming off
the biggest bubble in our history, it is hard to think we can shake
off the effects in just a few years.
Faith is required to invest in this market. You have to ignore high
valuations, accounting issues, a Muddle Through Economy, and all the
myriad issues surrounding a secular bear market. You have to believe
that two centuries of trends are suddenly of no value. You have to
believe that we are in a New Economic Era. You have to have Faith that
this time, things really are different.
It's not that you can't make money investing in stocks. Very good
stock analysts may do quite well. But the large majority of investors
will get hurt. This includes large pension funds which feel they must
allocate 70-80% of their assets to stocks.
You need to be really convinced that the stock you are buying can
fight upstream. Buying a stock simply because it looks cheap is not
enough. Global Crossing and WorldCom were cheap one year ago. They are
even cheaper today.
Either that, or you have to ignore all of the above. You invest simply
because you hope that you will get back to even. It is not unlike
going to Las Vegas. Some of you will win at the tables, but most of
you will lose. In a secular bear market, just as in Vegas, the odds
are stacked against you.
History tells us one of two things: either this market has a long way
to go on the downside, or it will go sideways for an even longer
period of time, waiting for the valuations to come back to trend.
And the stock markets always come back to trend. That is the clear
lesson of History. The market is nothing if it is not a lean, mean,
reversion machine. In the past, this has usually meant large drops in
valuations, especially from the highs set during the last bubble. We
will get to see what it does this time.
[In the book, we will] look at the very diverse studies and analysis
which will lead us to the conclusion we are in a secular bear market.
After you learn which way the wind is blowing, then you will know
which way to set your sails. You will learn how to invest
successfully. You will find there are a lot more investment
possibilities than a buy and hold index fund in your future.]
What's in a Name?
I need a title for my book. As I said, I was going to call it
"Absolute Returns" with a sub-title like "How to Prosper in a Secular
Bear Market." The marketing types, who are the experts about such
things, really didn't like the title, as it does not make people want
to take action, and they are not sure how many people actually know
what a secular bear market is. So, since someone else is using it, it
makes sense to find another title. In my quest for the perfect title,
I decided to turn to my rather brilliant readers and put the question
to them. The above section should give you a reasonable idea of what
the book will be about.
Send me your suggestions. If we use you title, I will send you a
serious bottle of wine (or the equivalent if you do not indulge). Or,
as I travel a great deal, I will gladly buy you that bottle at a
dinner when I come to a city near you. Plus, you will get credit in
the book. However, you will not share in the royalties. Sharing the
"fame" does not cost me anything. With three kids in college, I need
the royalties.
I will finish this letter in Tucson, where I am speaking at a client
conference sponsored by Mission Trust and then back on Saturday. I
intend to play golf on Saturday morning for the first time in a long
time (I had stopped since getting serious about finishing the book),
although I must play with rented clubs. It seems someone got into my
garage and stole my clubs. I am not sure what the golf gods are
telling me: either I am such a miserable, no talent golfer (true) that
I should quit golf as I am embarrassment to the game, or that with new
clubs my true talent will arise. The chief concern is that with new
clubs I will still have my old game. Time will tell, I guess.
Your already dreaming about new clubs analyst,
John Mauldin
John@FrontLineThoughts.com |
