Blind Dogs and Janus Managers

John Mauldin | Thoughts from the Frontline
June 21, 2002

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 rise 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 the period into which we are entering.

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. As investors, we are the buy-side of the transaction.)

Even as $6 trillion dollars has disappeared from equity valuations over the last two years, each new low is greeted as the bottom, and the sell-side brokers and 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 re selling), before the next big run-up begins.

(Disclosure: in my investment management business, I often wear a sell-side hat. I must confess that for the most part, I always think it is a good time to invest with me. Though there are some times I have fired myself. But that is another story.)

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. According to Michael Alexander in his prescient book called Stock Cycles, the average real return in a secular bear market is 0.3% (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% 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 sis 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 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.

I have written about these studies for the last two years: 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 Arnot; the trend analysis of Jeremy Grantham; different demographic analysis by both Arnot 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 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.

The numbers are misleading. The reason the investor who started out in the bear market ended up with so much more is that when he came to 1982 he was back to even, and therefore started with a much larger position. He simply started with a larger investment portfolio than someone who started in 1982. The huge compounding effect of the last bull market (1239%) grossly overstates the potential.

If the investor had been in bonds during the secular bear, and then switched, he would have been far ahead of the stock market only investor.

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.

Within two weeks I will have finished combining all the analysis mentioned above into one long white paper for your perusal. We will post it on the web. It will actually be the first part of my next book, "Absolute Returns," but I will be allowed to post chapters as I write them up until we get near publication.

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 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 this 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, after the market had dropped, 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 5-6 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 will 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 three months 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 a 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.

A Reasonable Challenge

I would like to see a statistically sound study that can demonstrate we are not in a secular bear market. I have looked. I cannot find one. I find lots of reports that only highlight data from the last two decades or that try to link two sets of numbers in a cause and effect relationship that doesn't really exist. The growth of the economy and a rising stock market is an example of such a bogus connection.

Then, of course, you see the studies which are based on Modern Portfolio Theory. These are the ones used to convince investors to stick with losing funds on the theory of diversification. I can never understand why I am supposed to diversify into losing funds. But this is what happens when you invest based upon a theory created by a grad student with no money.

If you know of a study which is positive and relevant, please forward it to me. I look forward to reading it. I would love to change my mind. I take no pleasure in pronouncing a secular bear market. This type of market costs me money, time and requires lots more work. It is a lot easier to be an investment advisor in a bull market.

Market Forecast

It has been very ugly for the markets, whether we are talking stock, bond or dollar. Where do we go from here? Next week, I will be doing my regular semi-annual economic forecast for the next six months. We will look at the dollar, the world markets, the US economy, bonds and much more. Is there a housing bubble coming to a city near you? I will offer some sobering numbers on housing that you don't want to miss. And we will look at how my last forecast did. Not bad, but not perfect. Those nasty long term bonds still won't behave rationally.

I leave Sunday for a whirlwind trip to DC and New York. I will be speaking in New York on Tuesday at a fund of hedge fund conference on how to do due diligence on hedge funds. I know you will want to pay $1,695 to hear that speech. Actually, it is not as dry as it sounds. I bet I can coax a few laughs out of the crowd. And it forced me to get the chapter on due diligence of my book finished. My publisher will be glad something is finished. I am so-o-o-o behind schedule. If you are interested, I will send it to you for free. We offer real value here, and at the right price.

Enjoy the week, and remember that you can do well in this economic climate if you simply figure out how to get the wind at your back and not in your face. I'll be trying to give you ways to do it. Until next week,

Your wondering what he will predict this time analyst,

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