Sorry George, just getting to the computer now....................
Can it happen again?
Stock market special report
The present financial environment has many similarities to other periods in history:
* The "Nifty-Fifty," one decision-type stocks of 1971-1972.
* The belief in instant liquidity to get out (should the need arise) due to the availability of derivatives that prevailed in 1987.
* The invincibility of the American juggernaut and the view that we have conquered the business world and possibly the economic cycle is the attitude that prevailed about Japan in 1989.
* The belief that this is truly a new era where past measures of valuation regarding the worth of businesses don't apply is eerily reminiscent of 1929.
These were all periods of unbridled optimism and obscenely high valuations that preceded horrific losses in market averages of at least 40 percent. The market manias in 1929 and in 1989 in Tokyo are most like what we are experiencing in <Picture>The market manias in 1929 and in 1989 in Tokyo are most like what we are experiencing in the United States today.the United States today.
This is what Yasushi Mieno, the former Governor of The Bank of Japan, had to say about the Japanese experience: "Looking back, we now feel that we should have applied the brakes on the excessive boom much earlier. However, back in those days, as (consumer) prices were not rising, it was difficult to obtain people's understanding for a policy aimed at achieving sustainable economic growth by monetary tightening." It is sobering to note that eight years later, their economy has still not recovered from that bubble and their stock market is still down 40 percent from the highs.
A reading of history books and old newspapers reveals that the attitudes of today are remarkably similar to those that prevailed in 1929. No less an authority than Benjamin Graham in the 1934 edition of his classic investment treatise, "Security Analysis," devoted a whole section of the book to the theory of "New-Era of Investing." What follows are excerpts from that chapter.
"Investment in common stocks was formerly based upon the threefold concept of: (1) a suitable and established divided return; (2) a stable and adequate earnings record; and (3) a satisfactory backing of tangible assets. Two of the three elements stated above lost nearly all of their significance, and the third, the earnings record, took on an entirely novel complexion. The new theory or principle may be summed up in the sentence: The value of a common stock depends entirely upon what it will earn in the future. From this dictum the following corollaries were drawn:
1. That the dividend rate should have slight bearing upon the value.
2. That since no relationship apparently existed between assets and earning power, the asset value was entirely devoid of importance.
3. That past earnings were significant only to the extent that they indicated what changes in the earnings were likely to take place in the future.
"Why did the investing public turn its attention from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend, i.e., to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and secondly, that the rewards offered by the future had become irresistibly alluring.
"The new-era concepts had their root first of all in the obsolescence of the old-established standards. During the last generation, the tempo of economic change has been speeded up to such a degree that the fact of being long established has ceased to be, as it once was a warranty of stability.
"A new conception was given central importance--that of trend of earnings. The past was important<Picture>"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. " - Benjamin Graham only in so far as it showed the direction in which the future could be expected to move. If an attempt were to be made to give a mathematical expression to the underlying idea of valuation, it might be said that it was based on the derivative of the earnings, stated in terms of time.ÿ
"Along with this idea as to what constituted the basis for common-stock selection, there emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment. This gospel was based upon a certain amount of research, showing that diversified lists of common stocks had regularly increased in value over stated intervals of time for many years past.
"The combination of these two ideas supplied the "investment theory" upon which the 1927-1929 stock market proceeded. The theory ran as follows:
1. 'The value of a common stock depends on what it can earn in the future.'
2. 'Good common stocks will prove sound and profitable investments.'
3. 'Good common stocks are those which have shown a rising trend of earnings.'
"The statements sound innocent and plausible. Yet they concealed two theoretical weaknesses which could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether it was a desirable purchase. A moment's thought will show that "new-era investment," as practiced by the representative investment trusts, was almost identical with speculation as popularly defined in pre-boom days. It would not be inaccurate to state that new-era investment was simply old-style speculation confined to common stocks with a satisfactory trend of earnings. The impressive new concept underlying the greatest stock-market boom in history appears to be no more than a thinly disguised version of the old cynical epigram: 'Investment is successful speculation.'
"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a public utility stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the <Picture>The impressive new concept underlying the greatest stock-market boom in history appears to be no more than a thinly disguised version of the old cynical epigram: 'Investment is successful speculation.'pre-boom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new-era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price it deserved to sell. This fantastic reasoning actually led to the purchase for investment at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1000, or at any conceivable price.
"An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy "good" stocks, regardless of price, and then to let nature take her upward course.
"An ironical sidelight is thrown on this 1928-1929 theory by the practice of the investment trusts. These were formed for the purpose of giving the untrained public the benefit of expert administration of its funds. But most paradoxical was the early abandonment of research and analysis in guiding investment-trust policies. However, since these financial institutions owed their existence to the new-era philosophy, it was natural and perhaps only just that they should adhere closely to it. Under its cannons, investment had now become so beautifully simple that research was unnecessary and statistical data a mere encumbrance. The investment process consisted merely of finding prominent companies with a rising trend of earnings, and then buying their shares regardless of the price. Hence the sound policy was to buy only what every one else was buying--a select list of highly popular and exceedingly expensive issues, appropriately known as the "blue chips." The original idea of searching for the undervalued and neglected issues dropped completely out of sight. Investment trusts actually boasted that their portfolios consisted exclusively of the active and standards (i.e., the most popular and highest price) common stocks.
"The man in the street, having been urged to entrust his funds to the superior skill of investment experts--for substantial compensation--was soon reassuringly told that the trusts would be careful to buy nothing except what the man in the street was buying.ÿ
"Irrationality could go no further. The self-deception of the mass speculator must, however, have its elements of justification. This is usually some generalized statement, sound enough within its proper field, but twisted to fit the speculative mania. In real-estate booms, the "reasoning" is usually based upon <Picture>It is amazing and alarming to see that the "investment" techniques used then and now are identical, driven by the great investment oxymoron "momentum investing."the inherent permanence and growth of land values. In the new-era bull market, the "rational" basis was the record of long-term improvement showed by diversified common stock holdings.
"Hence in using the past performances of common stocks as the reason for paying prices 20 to 40 times their earnings, the new-era exponents were starting with a sound premise and twisting it into a woefully unsound conclusion.
"Considering the 1927-1929 period, we observe that since the trend-of-earnings theory was, at bottom, only a pretext to excuse rank speculation under the guise of "investment," the profit-mad public was quite willing to accept the flimsiest evidence of the existence of a favorable trend. Rising earnings for a period of five, or four, or even three years only, were regarded as an insurance of uninterrupted future growth and a warrant for projecting the curve of profits indefinitely upward.
"The prevalent heedlessness on this score was most evident in connection with the numerous common-stock flotation's during this period. The craze for a showing of rising profits resulted in the promotion of many industrial enterprises which had been favored by temporary good fortune and were just approaching, or had actually reached, the peak of their prosperity."
Graham concluded the chapter on the new-era theory as follows: "This illustrates one of the paradoxes of financial history, viz., that at the very period when the increasing instability of individual companies had made the purchase of common stocks far more precarious than before, the gospel of common stocks as safe and satisfactory investments was preached to and avidly accepted by the American public."
If just a few outdated phrases were changed, the forgoing would pass for a completely accurate synopsis of the investment landscape in 1998. It is amazing and alarming to see that the "investment" techniques used then and now are identical, driven by the great investment oxymoron "momentum investing."
One difference between the two periods is that by mid-1929, the Fed realized it had created a bubble and was trying to slow it. Today's Fed, unwilling to heed Mieno's words, continues to fuel the fire.
The most intense speculation in this mania has not surprisingly been in very companies that fit the parameters described by Benjamin Graham. In large part this means technology. We have detailed our views on technology, and the areas that are at risk in past Raps. Over the past six to nine months, most all of the business developments we expected and discussed have occurred. The facts are undeniable, yet stock prices have screamed higher.
We have a very dangerous bubble in place and we have taken the psychology to its most absurd extreme. We can't know when the end will come, BUT we can know that the aftermath will be horrendous. I hope this piece helps illuminate the risks!
William A. Fleckenstein <fleckenstein@go2net.com>, special to StockSite |
