Investing: Faith Versus History

John Mauldin | Thoughts from the Frontline
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,

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