John Mauldin
June 20, 2003
This week I want to briefly look at some comments by Stephen Roach and Rob
Arnott, two of my favorite analysts. Then we quickly segue into Part One of
a series showing the relationship between stock market returns, P/E ratios,
inflation/deflation and the economy. This is some of the more practical and
significant research I have written about in the last few years, and I
think you will find it very helpful in developing your own investment
strategy.
I quickly note that I will be on CNBC with Ron Insana this coming Tuesday
at around 5 pm eastern. I trust it will be an interesting interview for you
to watch. Now, on to the letter.
Serial Bubble Blowers
The dramatic fall of the Japanese Bond market this week, plus the rather
high-pitched statements from the Bank of Japan suggest the Japanese Central
Bank is close to the end of their ability to reflate their economy. But
what of our own Fed? Stephen Roach of Morgan Stanley writes today,
eloquently expressing my thoughts better than I:
"With policy makers and financial markets now fixated on the great
deflation debate, it's easy to lose sight of what precipitated this state
of affairs. In my view, it's all traceable to asset bubbles -- the
excesses they fostered on the way up and the wrenching adjustments they
require on the way down. The big problem with bubbles is that they tend to
be contagious across asset classes -- spreading from stocks to property to
bonds. That's been the case in Japan, and a similar pattern is now evident
in the United States. The result is a seemingly endless array of bubbles
that only heightens the perils of the post-bubble endgame.
"Unfortunately, the policy response to asset bubbles virtually guarantees
cross-asset contagion. That stems mainly from the behavior of central
banks. The US experience provides a classic example of this multi-bubble
syndrome. The Federal Reserve, in my view, played a key role in nurturing
the equity bubble of the late 1990s. By setting monetary policy with an
eye to the so-called New Economy -- a high-growth, low-inflation macro
scenario -- the US central bank maintained a low interest rate regime that
provided extraordinary valuation support for equities. A pre-Y2K liquidity
injection was the icing on the cake. The persistence of low interest rates
in the immediate aftermath of the popping of the equity bubble in early
2000 quickly became the great enabler for the US property bubble. And then
when the Fed began cutting interest rates aggressively in order to combat
multiple pitfalls -- recession, the subsequent anemic recovery, and newly
emerging deflation risks -- a bubble emerged in the bond market. The Fed,
in effect, has become a serial bubble blower.....
"It's hard to know where and how this all ends. The Fed's strategy seems
to be aimed mainly at buying time -- hoping for a gradual and benign
endgame to the post-bubble workout. That's certainly possible. But
there's also the distinct possibility that the Fed is hoping against hope.
I would personally assign equal odds to the chance that there will be a
more treacherous moment of reckoning.
"Until those excesses are purged, I maintain my view that America still
needs to be seen through the lens of a post-bubble workout. As one bubble
morphs into the next one, the moral hazard dilemma only deepens. And the
endgame -- including the risks of deflation and a dollar crisis -- appears
all the more treacherous."
To turn to a more positive note, I got the following reply from Rob Arnott,
editor of the prestigious Financial Analysts Journal and one of the finest
investment analysts in the country, in response to the article by Porter
Stansberry whose comments appeared in this column a few weeks ago. He was
writing about a government report which shows the US is $40 trillion in
debt and obligations. To quote:
"I'm hardly *ever* the optimist in any controversy. So, it's fun when I
have a chance to do so! The fuss and controversy over the 75-year
forecasts from the Department of Treasury is misplaced. Bush was right in
ignoring the report, and the Treasury was mistaken in even commissioning
it. Consider:
"When has the Treasury, the Dept of Commerce, the Congressional Budget
Office, etc., ever shown any aptitude for forecasting the budget more than
one year out? The ten-year forecasts that formed the basis for the first
Bush tax cut was clearly rubbish before it was a year old. Why on earth
should we care what today's economists expect as an outlook for 2078.
"Let's back up the clock 75 years, and use a perfect crystal ball. "Over
the next 5 years, the government will run a cumulative deficit amounting to
40 times the current GDP. The national debt, per family of four, will
amount to more than eighteen times today's family income. But, the stock
market will range from 80% below current levels to 3000% above current
levels and will finish the 75 years up over 2000%." Sounds like a bankrupt
nation with a stock market that is insane. A more sensible focus is:
"Recognize that Social Security is a transfer payment from those who work
to those who don't. Ignore the 75-year forecast for SS deficits. They're
not going to happen on that scale. The deal can, and will, change. The tax
rate can, and will, change. The full-benefit retirement can, and will,
change (big-time!).
"Recognize that the important thing is not whether the government will be
in deficit in 10, 20, 30, or 75 years. It's whether current spending is
sensible, and the current surplus or deficit is manageable. In this
context, a $400B deficit in a $10T economy is manageable, but would make no
sense if we weren't in recession ... no room to respond to recession. A
$5T national debt in a $10T economy is manageable. It would be desirable
for both figures to be lower.
"Recognize that long-term forecasts are useful to identify problems which
will need to be faced sooner or later. That's the only merit to the 75-
year forecast (which a 10-year forecast could as easily provide). When do
we run into trouble with current programs, operated within current
guidelines? 10-20 years hence. So, it is important to recognize that
these problems need to be addressed, eventually. The sooner the better, to
be sure, but let's not believe a 75-year forecast based on today's economy,
government, tax levels, spending programs, and rules, unless we want to
believe that this is possible."
Bull Market or Bear Market Rally?
Now, let's turn our thoughts to the future of the US stock market. Are we
in a new bull market or in a series of bear market rallies? As part one of
this series suggests, this rally has a lot of precedents for short term
gains, but long term index investors are likely to be disappointed.
"As we look further into the conditions affecting the return profile, we
note a strong relationship between the change in the P/E ratio over the
twenty-year period and the total return for the period. None - not one-
nada-zippo - of the periods of strong gains occurred without rising P/E
ratios."
P/E ratios have never risen from the levels at which we are today. Thus, as
we will see, the historical data suggests bear market rally. Enjoy it while
it lasts.
This series will be adapted from two chapters in my book-in-progress. There
are several charts you may wish to view at www.CrestmontResearch.com ,
although you can get the gist of the concepts without doing so. When you
get to the site, click on "Stock Market" on the left hand side and you will
be able to scroll down through several charts and tables. You will need
Adobe Acrobat. Be sure to increase your view size. I do recommend that you
do look at them if you have the time. Here is Part One:
Secular Bear Markets By The Numbers
The next two chapters are co-authored with Ed Easterling of Crestmont
Holdings. His research into stock market and economic cycles will give us
insight into how secular bear markets actually work. It will also give us a
clue as to how to invest in stocks even in a bear market cycle.
These are very important chapters. If you can understand the implications
of this material, I believe it will make you a better and more confident
investor.
We will make the case that it is more useful to analyze secular bear
markets in terms of value than as traditionally done in terms of price;
that volatility and frequent large rallies are the norm and not the
exception, thus giving the astute trader some terrific opportunities.
Finally, we will make a connection between inflation, interest rates and
stocks, which will give us further indications of the direction of the
stock and bond markets in the coming decade.
If the cycles of the past century continue to repeat, most of the first
decade (or more) of this century will experience a secular bear market-an
extended period of generally sideways and choppy stock market conditions.
The subsequent decade (or longer) should experience a secular bull market-
an extended period of generally upward and exciting market conditions.
These periods in the past have been the result of market valuation cycles
represented by the P/E ratio. The valuation cycles have resulted from
generally longer-term trends in inflation toward and away from price
stability. The short-term, somewhat random, market gyrations are the
result of then current circumstances and market forces wrestling stock
prices around the gravity line of the broader cyclical trend.
These cycles generally take a generation to work their way through the
investor public, have significant magnitudes of becoming undervalued and
overvalued, and have significant implications for the way that investors
should approach each of these periods.
Secular Bear Markets By The Numbers
Would you like to live in paradise? There's a place where the average
daily temperature is 66 degrees, rainy days only occur on average every 5
days, and the sun shines most of the time.
Welcome to Dallas, Texas. As most know, the weather in Dallas wouldn't
qualify as climate paradise. The summers begin their ascent almost before
spring arrives. On some days, the buds almost wilt before turning into
blooms. During the lazy days of summer, the sun is often stoking the
thermometer at times into triple digits. There are numerous jokes about the
devil, hell and Texas summers.
Once winter is in full force, some days are mild and perfect golf weather.
Yet others present frigid temperatures and the occasional ice storm. It's
good for business at the local auto body shops, though it makes for
sleepless nights at the insurance companies. Certainly the winters don't
match the chills of Chicago or the blizzards of Buffalo, but Dallas is far
from paradise as its seasons ebb and flow.
For the year though, the average temperature is paradise.
Contrary to the studies which show investors they can expect 7% or 9% or
10% by staying in the market for the long run, the stock market isn't
paradise either. Like Texas summers, the stock market often seems like the
anteroom to investment hell.
While historically the average investment returns over the very long term
have been some of the best available, the seasons of the stock market tend
to cycle with as much variability as Texas weather. The extremes and the
inconsistencies are far greater than most realize. Let's examine the range
of variability to truly appreciate the strength of the storms.
In the 103 years from 1900 through 2002, the annual change for the Dow
Jones Industrial Average reflects an average gain of 7.2% per year. During
that time, 63% of the years reflect positive returns and 37% were negative.
Only 5 of the years ended with returns between +5% and +10%-less than 5% of
the time. Most of the years were far from average-many have been
sufficiently dramatic as to drive an investor's pulse into lethal
territory.
As reflected in the tables labeled "Significant Swings", almost 70% of the
years were "double-digit years," when the stock market either increased or
decreased by more than 10%. To move out of "most" territory, the threshold
increases to 16%-half of the past 103 years end with the stock market index
either up or down more than 16%!
Read those last two paragraphs again. The simple fact is that the stock
market rarely gives you an average year. The wild rise makes for those
emotional investment decisions which are a primary cause of investment
pain.
The stock market can be a very risky place to invest. The returns are
highly erratic; the gains and losses are often inconsistent and
unpredictable. The emotional response to stock market volatility means
that most investors do not achieve the average stock market gains, as the
studies presented elsewhere in this book clearly illustrate.
Not understanding how to manage the risk of the stock market, or even what
the risks actually are, investors too often buy high and sell low based
upon raw emotion. They read the disclaimers before opening an account that
warn the stock market presents an opportunity for a loss and that the
magnitude of those losses can be quite significant. But the investor
focuses on the sales pitch, which states that research shows, "Over the
long run, history has overcome interim setbacks and has delivered an
average return of 10%, including dividends (or whatever the current number
du jour is and ignoring bad stuff like inflation, taxes and transaction
costs)."
The 20 Year Horizon: The Real Long Run
But how long is the "long run?" Investors have been bombarded for years
with the quip that one should invest for the "long run." This has
indoctrinated investors thinking to ignore the realities of stock market
investing because of the "certain" expectation of ultimate gains.
This faulty line of thinking has spawned a number of pithy principles
including: "no pain, no gain," "you can't participate in the profits if you
are not in the game," and our personal favorite: "it's not a loss until you
take it."
These and other platitudes are often brought up as reasons to leave your
money with the current management which has just incurred large losses.
Cynically restated: why worry about the swings in your life savings from
year to year if you're supposed to be rewarded in the "long run"? But what
if history does not repeat itself, or if you don't live long enough for the
long run to occur?
For many, the "long run" is about twenty years. We work hard to accumulate
assets during the formative years of our careers, yet the accumulation for
the large majority of us seems to become meaningful somewhere after
midlife. We seek to have a confident and comfortable nest egg in time for
retirement. For many, this will represent roughly a twenty-year period.
As reflected on the chart called "Generational Returns," there have been 84
twenty-year periods since 1900. The first twenty-year period began with
the two decades from 1900 to 1919. We then evaluated each rolling 20-year
period through the one from 1983 to 2002. Though most have generated
positive returns, half produced compounded returns of less than 4%. Less
than 10% generated gains of more than 10%.
In all cases, the level of returns relates to the trend in the market's
price/earnings ("P/E") ratio. The P/E ratio is the measure of valuation as
reflected by the relationship between the price paid per share to the
earnings per share ("EPS"). The chart reflects that higher returns are
associated with periods during which the P/E ratio increased and lower or
negative returns resulted from periods during which the P/E ratio declined.
This may be the single most important investment insight you will get from
this book. When P/E ratios are rising, the saying that a "rising tide lifts
all boats" has been historically true. When they are dropping, stock market
investing is tricky. Index investing is an experiment in futility. As we
will see in later chapters, in these secular bear market periods,
successful stock market investing requires a far different (and sometimes
opposite) set of skills than what is required in bull markets.
Below that chart is a scatter plot chart of each annual twenty-year return
and the corresponding starting P/E ratio. This chart emphasizes the very
high propensity for twenty-year periods that start with high P/E ratios to
experience dismal returns and for periods that start with relatively low
P/E's to generate the higher returns. This is especially true on the past
of the century.
As we look further into the conditions affecting the return profile, we
note a strong relationship between the change in the P/E ratio over the
twenty-year period and the total return for the period. None - not one-
nada-zippo - of the periods of strong gains occurred without rising P/E
ratios.
Given the current and recent level of P/E's, the prospects are not
encouraging for general market gains (the emphasis is upon general or index
funds) over the next two decades. This dismal outlook is not from some
congenital bear; it corresponds to the series of factors driving the
current secular bear market.
As in the past, after extended periods of a nonproductive market, the
future should hold solid returns. Unfortunately for those of investing age
today and during the next decade, returns from the stock market are likely
to be quite disappointing. Fortunately, no one is holding a gun to your
head and saying you must limit your investments to index funds.
(Well, that may not be true. If your 401k only has broad index fund
options, you do have a very limited option. As time wears on, and as index
funds languish, investors will clamor for other options. It is for that
reason we think certain types of absolute return hedge funds will be
available to the average investor by at least the end of the decade, if not
sooner.)
The Volatility Gremlin
The average return doesn't deliver the load to your account that you might
expect. The actual stack of money that you receive is impacted by two
dynamics. The first factor is the disproportionate impact of losses and
the second is the benefit of consistency.
For an example of the impact of losses, consider that the statistical
average of +24% and -20% is +2%. However, if your investment delivers
those two back-to-back years, the stock market gremlins will leave your
account a bit short of breaking even. It doesn't matter which year occurs
first, whether the first or the second is the positive year, the result is
the same: your account will be down almost 1%.
The greater the variability between the positives and the negatives, the
more significant the impact on your account balance. Keep in mind that it
takes a +100% gain to offset a -50% loss-yet the average calculates to a
+25% gain! Why is this so important? Almost three-quarters of the years
of the past century were double digit deliveries and half exceeded +/- 16%.
Though there have been more positive years than negative years in the past
century, we need more positive years to offset the disproportionate impact
of losses. This also gives added emphasis to the importance of avoiding
losses.
The second factor is a bit more technical and mathematical. Please be
patient with this explanation. When the numbers in a series are farther
from the average, the compounded return decreases. "Compounded return" is
the final result in your investment account following years of investing.
As an example, if the average annual return over several years is +10%, the
highest compounded return occurs when all three years deliver exactly +10%
gains. A sequence of three 10's is superior to 5-10-15, 15-10-5, 30-0-0,
and any other set that averages to 10. This is true irrespective of the
previously discussed impact of negative numbers. As the dispersion
increases, the compounded return decreases. This can be a significant
dynamic affecting the ability of annual returns from the stock market to
add cash to your stack.
A B C D
10% 5% 15% 30%
10% 10% 10% 0%
10% 15% 5% 0%
------ ----- ----- -----
Compounded Average 10.00% 9.92% 9.92% 9.14%
Simple Average 10.00% 10.00% 10.00% 10.00%
Earlier we mentioned that the simple "average" stand-alone return for the
stock market was 7.2% annually, excluding dividends and a number of other
cost factors that affect the actual profits that you receive. However, had
you invested $1,000 in the first year, your account would have only grown
by a compounded 4.8% over the subsequent 103 years. The gremlins of
volatility and negative numbers would have consumed one-third of your
return. The notion of average return is irrelevant since an investor's
actual returns can only be measured as compounded returns. This concept is
so powerful that banking regulations require interest rates on loans and
certificates of deposit to be quoted also as an Annual Percentage Rate
("APR") in addition to the stated rate to truly reflect the impact of
compounding. This impact is detailed in the charts labeled "Distorted
Averages."
None of these factors should be construed to dispel the opportunities
available through investing in the stock market. The stock market has
historically provided a solid long term rate of return and has built a
house of wealth in many investors' accounts. However, stock market returns
are quite volatile and cyclical. When you invest makes a huge difference
perhaps the most important difference - as to your long term returns. "Now"
is not always a good time to invest, contrary to the marketing pitches.
Stock market cycles are relatively long, have individual characteristics,
and are somewhat predictable. Nonetheless, the upcoming text will provide
practical insights and useful perspectives about secular stock market
cycles.
The Eagles Have Landed
I quit a little bit early today, as I must confess I am going to attempt to
"bring back those days of yester-year" by going to the Eagles concert in
Dallas tonight. My bride will accompany me, but then I went to an Olivia
Newton-John concert with her. I will be in New York next week, speaking at
a hedge fund conference, visiting hedge funds, meeting with Art Cashin and
other friends and appearing on CNBC with Ron Insana. It will be a full
week.
By the way, for old Eagles fans, Don Hensley made an album a few years ago
that is still one of our favorites.
Your more desperate than Desperado Analyst,
John Mauldin |
