Fleck's interview (continued)
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Have there been signs this year that we're reaching a peak or that we're coming to a point where we should worry?
Trying to determine what the end of mania is almost impossible, because, by definition, you're not talking about investment ideas and logical analysis. You're talking about the madness of crowds, which are very difficult to get a handle on. However, last year we put approximately 120 or 130 billion dollars in the stock market and the S&P 500 rose almost 40 percent. Halfway through the year we've already put in that much money and then some. And the market's up a quarter as much. So you can start to see already that we need ever-larger amounts of money to power the market higher. We will get to a point where there is not enough money to keep the market going, since it is rising faster than the underlying earnings. It is all about revaluing businesses higher.
I believe we're starting to see signs now that suggest that we may be getting nearer the end of this process. By definition, trying to figure out what will end the mania is impossible. It's about madness of crowds, not logical investment analysis. So it is very difficult. But in 1995, approximately 130 to 140 billion dollars, roughly, went into mutual funds. The S&P 500 was up 40 percent. That was the most money that had ever come into funds. In 1996, approximately -- more money than that through the first -- through the first three-quarters of the year came in and the S&P was up a quarter of that much, a sign that maybe we're running out of money to power the market ever higher. Yes, money can come in, but people forget about the fact that Wall Street does nothing but create securities for a living, so they're going to come up with a new supply, and eventually there won't be enough money to keep pushing the market up faster and faster above the underlying rate of growth in corporate earnings. We have been growing twice as fast in terms of market rate of return than the underlying earnings. And that's about revaluation. That process can only go on so long.
Is Main Street now driving the stock market?
It is 100 percent fair to say that Main Street is driving the stock market right now. That is the driving force. If you suspended mutual fund in-flows for three or four months, I would be willing to make the observation the stock market would decline 10-15-20 percent. It's not just that the money is coming in. It is the way the money is then slammed into the marketplace. When you have a year where the market gets $130 billion, like 1995, and the market goes up 40 percent, you may create almost a trillion dollars in market capitalization, so that you have sort of a ten-to-one kind of effect. And to keep that up, it is a requirement that you continue to get sufficient amounts of cash flow that can continue to get jammed into the marketplace rapidly.
What is "jammed into the marketplace"?
What I mean when I say "jammed into the marketplace" is, again, in the old days, say, even in the '80s if you were a money manager, you would get money and you'd kind of take your time about buying your stocks. You wouldn't want to go in and force the price higher simply because you wanted to own some more stock, because you were buying stocks that had some valuation compared to the underlying business. Today, part of the game is, "Hey, let's move the prices of the stock up. Let's jam it in. Let's go buy it sort of as sloppily as possible. Let's make the price go up while we're buying it and then when we get more money, we'll keep doing it." There's a very large element to the self-fulfilling prophecy aspect of this, which works until one day not enough money comes in and then you have a real debacle. This is also what increases the risk. This is why these valuations of these businesses are at record levels now.
Talk about Iomega.
I believe that when the history books are written about the year 1996, when people look back with a little perspective, the year 1996 will be remembered for the year -- sort of the Internet captivated people's imagination and not just Internet investment ideas, but the Internet as a stock-swapping or stock-touting medium. And whereas the poster boy for this go-round in the mutual fund area has been Garrett, sort of the stock poster boy, if you will, would be Iomega. It embodies everything about speculation, Internet chat rooms, taking a company with a good idea that had a decent product and taking the price of the security, i.e., the price of the business, and taking it to absolutely outlandish proportions. Everyone was willing to play that game as long as it worked. And then the stock price peaked, it started coming down, and now people aren't as interested. And it's almost a perfect little window on what can happen in the stock market in general. There was no particular cause. Nothing bad happened at Iomega. It just got too high. Finally it got too high. Marginal sellers appeared, as opposed to marginal buyers every day, and the thing tipped over and then started collapsing because the way it went up was so unhealthy. That's what happens when these kind of investment techniques, if that's what you want to call them, when they start to unwind, that's the way they unwind. Iomega was the first one that was really in the news where this happened and then unwound. But you're gonna see more of this.
What were investors after with Iomega?
They were trying' to get rich. People that owned Iomega stock were trying' to get rich. And, hey, it worked. I mean a lot of people have still made extraordinary amounts of money, depending on where they got in. I know a lot of people must have lost a lot of money, but I would have to believe -- I don't know what all the participants thought. I would have to believe there was a certain amount of just throw caution to the wind. In this environment everything works. We have fomented an environment where the more speculative, the more risk you take, the better do. Where have people been taught a lesson about these things? So far, it really hasn't happened yet. I think people were just being greedy. People get that way. People are people. Human nature never changes. That's the fallacy in this whole argument that we'll never sell. People are people.
Can one make the same argument about van Wagoner Emerging Growth Fund?
I would say, unequivocally, people that are buying Garrett van Wagoner's fund don't have the faintest idea what he does. All they know is he's been spectacular at makin' money, produced monstrously large returns, been very few set-backs, and they want to own some. They, too, want to get rich. They say to themselves, "Gosh, if I'd have put one dollar in this back then, I'd have X number of dollars today." So people are buying things for one reason, and one reason only, because they've been going up, they think it will continue, they want to get rich.
What Peter Lynch basically advocated was that you, as an investor, any person in the country, had the ability to be a successful investor by simply noticing what was going on around them. Everybody is good at something. Everybody knows a little bit more than someone else about something. What he advocated that you do is, capitalize on that. If you're in the airline business, some business that relates to that, that you can do well at. Do that. Capitalize on it and stick with it. That is a far cry from saying, "Okay. I'm going to go put money in the hottest fund around and I'm going to tell myself that if times get tough, I'll buy more." That is now what he was talking about. He was talking about investing and doing your homework and using your own good common sense and things you knew about. What's goin' on in the mutual fund business right now is simply rank speculation. People think that they have reinvented their own human nature, that they will never panic in a tough period. That is, every time in the course of history when people have said to themselves, "People are different," or "This time it's different," it is always unequivocally ended badly.
Have you been through a bear market in your life?
Yes. I've been through a bear market, although at the time in the 19-really-79-80-81 period there were some difficult times. In the first half of 1982, the problem was, you couldn't have a really violent bear market because valuations were so cheap. In 1980 and '81, stocks sold for book value. They had five percent divided yields. So a bear market -- the market went down five-six-seven-eight percent, you could find industries that did worse, but even that was a scary process. People were terrified of the stock market back then.
Isn't it true that just as today's psychology is "We can't lose in the market," the psychology then was "We can't win"?
Absolutely. The psychology in the early '80s was, "Stocks are very risky. We might speculate in them," or "We might put a little bit of money in 'em, but we're not puttin' any real money in 'em. We're puttin' our real money in these CDs where we can get 14 percent." That was a good risk-free rate of return. Bonds were for complete losers. People wouldn't even touch them. Now that stocks are now the highest valuation they've been in history, people think they can not lose in them. It is a very perverse thing about markets that almost always when the risks seem the highest, they oftentimes are the lowest, as was 1982. And when they seem the lowest, they're actually the highest, like right now.
Is a bear market inevitable at some point?
I believe a bear market is inevitable at some point, yes, simply because in Nature, in life, in everything there are cycles. There's no such thing as the elevator that only goes up, which is what the stock market is in people's minds' now. The consequence of it going up in changing people's behavior and pushing prices to where they are and all this is almost inevitably you have a bust. Similarly, when you have a bust, you set up the next boom. So these cycles occur for reasons. You sow the seeds of the next problem. I think it is inconceivable -- we will have a monstrous set-back in the stock market. I don't know whether it's gonna come from 6000 on the Dow, 8000 or 10,000.
What do you think of the idea of investing some of the Social Security money into the stock market?
That is the greatest fallacy of all time. The idea that you can take money out of the Social Security Trust Funds and put them in the equity market is completely and utterly impossible. People don't understand there is no money in the Social Security Trust Fund, no as in "none". The money was spent to operate the government. When you send money to Social Security, it goes into the government's coffers. They spend it and they place an IOU in the Social Security Trust Fund. There is no money. If they want to take Social Security Funds, they will have to sell bonds and raise the money to put the money over there. Every dollar, prospectively, that you do not send to Social Security and Social Security forwards to the equity market, they'll have to borrow an additional dollar. The government finances are set up such that any program that generates revenues currently, like Social Security, gets counted on the budget. Anything that loses money is off budget. Therefore, you have certain nonsensical trial balloons like this and when the government comes out and says, "The budget deficit is 120 billion," that is also 100 percent false. The National Debt increases at about 150 billion. It's these different programs, like Social Security, that cloud the issue.
What does it say about where we are that this would even be on the table??
It's hard to find an adjective to describe how completely ludicrous this idea is, because taking Social Security money and putting it into the equity market. It tells you you're very, very late in the game. How late is late? Well, it's not knowable, and we're talking about crowd madness here. There isn't any money! There's no money there to put into the equity market. The fact that serious people have floated this trial balloon and it's appeared on editorial pages of serious newspapers around the country, tells you how gullible and how believing everyone has become at this moment in time, I think. People have lost their sense of any sort of skepticism. Any idea, as long as it results in some way, higher stock prices, is what people want.
How about the loss of safety nets?
Yes. I think that the notion that the stock market is the only way we can retire happily and we really need it to help us is a very dangerous thought process. I think that is what people believe. The truth of the matter is you can get more and acceptable rates of return in the bond market now. This notion that the equity market is the only thing we have is just not true. From today, over the next five or six years, people will almost certainly do better in government notes than they will in equities, and, of course, the risk of not losing any real money doesn't exist. People have confused need with certainty. We need this to work. It seems like it will, therefore, it will. That's a little bit like going to the track and betting on number three and saying, "God, I really need this horse to come in for me." Well, just because you need it to come in doesn't mean that it will. However, with equities, there's been this reinforcing notion that if we all need equities to work and we all put our money there, then somehow it'll all work for us. Like everybody agrees on the same thing, that it has to work. That can be a self-fulfilling prophecy for a while, but in the end it can't work.
For all the marketing that they do, how many mutual fund managers actually beat the market in a given year?
I think when people look at performance and they see that an indexed fund would have done better and for all of this research and that some mutual funds don't do better, I think what is happening is that people are showing that their sort of lack of understanding of the exact process. The idea is, any good investment person will have good years and bad years. The trick is to find a good person who knows what they're doing and stick with it. So much of the focus has been placed on the short-term that people are looking for the hot person and then as soon as they have a bad period, they tend to get rid of 'em. And all of the types of techniques we've talked about foment lots of turnover and things like that, it's not surprising that, on average, given the frictional costs and the marketing costs and all of that, that, on average, the whole group of mutual fund managers under perform the index. It has to be. As a large group, they're going to be average and when you figure in the cost, they're gonna be below average. That's not to say you can't find people who are going to be successful.
So why should you be in mutual funds then?
I think that, well, I mean I think the case for equity -- mutual funds are equities. I know a lot of people in the country think that mutual funds are some special investment vehicle that they bought at the bank that is somehow guaranteed. That's not the case. Mutual funds are a portfolio full of equities. The reason to be in equities is historically equities have been the best asset class. That's fact. But by buying a mutual fund does not reduce the risk of holding equities. It doesn't mean simply that "It is always going to work now because I own a mutual fund instead of buying stocks in general." What people have done is, they've said, "I can't pick the equities. I'll give it to the mutual fund manager." But now what's happened is they've had such a taste of success, they want to go pick all the mutual fund managers and now they're back in the process again. It gets back to the fact that the process has appeared to become riskless.
Are people trading mutual fund managers the way they're trading stocks almost?
I can't answer that question, but I suspect people do. I mean fund prices in some of these fund groups are made up hourly. You can switch 'em hourly. Now if you're really saving for the long term, why do you need to do that? And would the mutual funds have allowed you to do that if they wasn't demand? So there's got to be a huge amount of speculation and swapping around hourly, daily. That's not about saving for my retirement. That's about speculating, which gets back to the heart of what the whole process is about.
And speculating is basically betting that something is going to go up because it's going up?
Speculating is basically betting that something is going to go up because it has gone up and you think it will go up and you forget the price of the underlying security. When you forget about the price of the underlying security, you induce the risk. When you pay more, far, far, far more than a business is worth, if the belief that nothing can go wrong is shattered, the risk you're taking is quite large.
Talk about the decline and fall of Jeff Vinik?
Well, I think that the decline and fall of Jeff Vinik, first of all, I think probably expectations got too high. It's a very, very large fund. It's a very difficult job -- I think that as people's expectations of what you can do with a 30- or 40-billion-dollar fund were too high. He made an investment decision about owning bonds and some cash and not to be as exposed to the equity market. And subsequently left Fidelity. People have tended to make a lot out of this, that this goes to show you that you can't hold cash, you can't hold bonds, you must always own stocks. If that is the right analysis, it does suggest something about how rabid people are for investment performance. Supposedly, they trusted money to a person to use his best judgment. He used his judgment and when it wasn't exactly what they wanted, they didn't like it.
And it's over a very short term.
But short-term is what this it really all about. I mean it is just another irony that while people are telling themselves that they're saving for the long term, they're looking up how they did in the paper every night, every weekend. Portfolio managers are shuffled 'cause they don't do well in the short run. And that's more because if they don't do well in the short term, then the fund company can't raise more money. It doesn't necessarily mean that the person doesn't know what they're doin'. We have these hourly switch funds, as we have seen. You can change your money around in these funds daily, hourly. So we have all these techniques set up to maximize the short run. Meanwhile, we're tellin' ourselves, "But we're really doin' it for the long run."
Do average Americans have a wherewithal, the ability to fight envy, to deal with fear and greed ...
That's a very good question. It's a very difficult question. The thing you fight as an investor is trying to make sure that you're right. I mean it's not easy to be right, you know, often enough to have a successful batting average. The other thing you have to fight are your own emotions, because along the way to being successful there are going to be a number of head fakes, where the stock you own goes down a bunch for no real good reason and you have to know to hang on. So there's a fortitude issue that people can learn. It is much easier to have the right fortitude and the right constitution about an investment, the more you know about it. And that is the fallacy with this mutual fund mania that's going on now is, people are not really sure what they own. People are smart enough to be good investors if they would just apply a certain amount of homework. A lot of times people will go buy a new car or a dishwasher or a microwave and they'll get out Consumer Reports and they'll do a ton of research. I think that people do more research on small investments around their house than they do about their investments. If they would apply that same amount of research, stick to ideas they understand, then when bad times come along, they won't be as easily shaken out. So you can be a better investor by doing more homework. I don't think the same amount of homework is going on right now in the equity market, which is one of the reasons why when the inevitable tough times come, as they always do, people will find it much harder to not sell than they think.
There have been a number of proposals about taking money out of the Social Security Trust Funds so that the money can then be invested in the equity market. Also there've been proposals about allowing people to not send money to Social Security and having that money then put in the equity market. The problem with these proposals is, there is no money in Social Security. It is not possible. Social Security only has government IOUs in 'em. That money has been spent. It is not there.
So why are people talking about these proposals?
The reason people are talking about these proposals is because it has now gone far enough -- the Social Security was meant to be a safety net. The investments were meant to be as safe as possible, since it was a safety net. People have so little regard for the risks associated with equities that they now think they can take the safety net's assets and that were supposed to be in the safest place possible, and put 'em in a risky asset class at a time when stocks have a highest valuation ever. That speaks volumes about the psychology of the day and the fact that people think stocks can only go up and contain no risk.
What is it going to take for people to realize again the risk inherent in the stock market?
I suspect that people won't realize the risk in the stock market until they start to lose money. You get to a chicken-and-egg type debate. "Well, how can the market go down as long as money keeps coming in?" And without getting into a lot of complicated discussions about marginal pricing and things, believe me, it happens. We saw it Tokyo. We saw it in our bond market here recently in 1994. There was no way the bond market group could go down, and yet it did and investors sold. What will happen is, we will simply get too high. They won't be enough new money coming in to keep the market going up. Losses will start and losses will beget losses, and then people will be people and they'll sell.
Inflation.
At the end of the '70s and the early '80s, the fear of inflation was everywhere. People believed, and you can go back and read articles that were written at the time, that there was no way the inflation rate was ever going to be brought under control. It was in an unstoppable process. And as a result, you got long-term bond rates to 14-15 percent, CD Paul Volcker took rates to 20 percent. And stock prices were very depressed. But that process, that fear the mandate the Fed was given to break the back of inflation, in fact, did. That is what set the stage for the monster bull market we've had since 1982. The breaking the back of inflation, the lowering of rates, the rise in valuations on top of the more or less up economic growth we've had for the last 15 years that has been pretty uninterrupted save for a little bit of period in '90-91, that breaking the back of inflation and the fear that it had engendered going up to that is what got us in the position to have this bull market. It got equity prices too cheap and it got economic policy set in the right direction and that's what produced this monster bull market.
Didn't it also, though, cause middle class people for the first time in a generation to have to begin to take control of their own finances ...
No. I think that what it did was, it pushed them in CDs to take advantage of the high easy rate of return. Coming out of the inflation period, stocks and bonds were dirt cheap. We were pursuing policies to break the back of inflation and make stocks and bonds a great asset class. Unfortunately, human behavior was, "Well, let's buy CDs and let's buy hard assets." People didn't buy the stock boom until it had gotten way underway. You didn't see large pick-up in mutual funds 'til '86 and '87. Then you had the crash and then there was not much activity in mutual funds until we had the recession in 1991 and the Fed Reserve took interest rates to three percent. That's what started this boom.
Do you have some stats on how much money has come into mutual funds, say, in the last three years as opposed to any other period in history?
Well, I can just to put it in perspective, in 1982 there was about a 100 to 200 billion in mutual funds. Right now there's about a trillion-five. As recently as the early '90s, stock and bond mutual funds had about the same amount of money.
Stock funds have grown dramatically in the last 14 years.
1982, stock funds had about 100 billion dollars in 'em, but the epic growth has really kind of happened since 1990. In 1990, we had about 200- to 240 billion dollars in equity mutual funds. Today, only six-seven years later, we have almost a trillion-and-half dollars in equity mutual funds. That's a staggering rate of growth.
Fleckenstein is a featured writer at the go2net site where he authors the Daily Market Rap of the go2business area.
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