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Bull's Eye InvestingTargeting Real Returns in a Smoke and Mirrors Market
By John Mauldin
John Wiley & Sons, Inc.ISBN: 0-471-65543-0
Chapter OneCar Wreck, Traffic Jam, or Freeway?
New Era economists, mutual fund managers, and sell-side investment advisors constantly argue that the stock market freeway is now finally wide open, with more lanes being built daily! Today is always a good time to buy (and hold!), and besides, the market always goes up over the long run. Don't worry about the short term!
These avant-garde investors throw out a wide range of reasons reassuring us that this time the apparently high valuations in the stock market are really different from the past high valuations, which always ended in serious corrections and decade-long secular bear markets. Furthermore, they contend all recessions in the future will be mild and short, such as the one we experienced in 2001. Therefore, the bull market of the 1990s should soon resume.
Investors are presented with so-called facts and convincing studies that interpret them. Armed with this analysis, it is easy to contend that the Dow Jones Industrial Average is going to reach 36,000 or 100,000 in the next few years, as soon as it catches its breath. The primary reasoning of these New Era cheerleaders, it seems to me, is circular logic. They tell us that investors should now see the stock market to be as safe as bonds. This means more and more investors will continue to invest in the stock market, driving up stock prices until the returns approach those of bonds. Because earnings will soon resume growing as fast as they did in the last decade (any quarter now!), we will see continued high growth in the markets even after we have driven the markets to these new bondlike valuations. This is because Peter Lynch tells us that earnings drive the stock market. Presumably ever-increasing earnings will drive the stock market to ever-increasing new highs.
These same people thought we would avoid a recession in 2001 because Alan Greenspan was lowering interest rates. These people are cheerleaders who can pose a serious danger to your investment portfolio. I will teach you how to detect and avoid cheerleaders in later chapters.
Their circular logic is enticing. It seemed to be true throughout the 1990s. We want it to be true because if it were we would have a clear road to riches. Simply save 10 to 15 percent per year, let it compound in a Roth IRA or annuity earning 15 percent, and you'll be on your way to retiring at a beachfront haven for the good life. If you save more, you can retire early.
But it flies in the face of centuries of human experience and the preceding century of modern stock market investing. I think it has the potential to be a siren song that lures hopeful investors onto a very rocky shore. Please understand me: I am not simply spreading doom and gloom. I think it is possible to save and invest and retire happily. The trick is to make sure you have the right approach. To say this as directly as possible: The recent era of profitable buy-and-hold stock market investing, using index funds and chasing high-growth large-cap stocks, has ended, and will not come our way again for many years. Until then, we need to change our investment habits to adjust with the times.
As we look at dozens of studies, reports, and essays, you will see that the evidence is overwhelming. Achieving your retirement dreams is possible, but not by using the stock market freeway of the cheerleading crowd.
The road less traveled is safer and far more certain. Let me give you the map.
Secular Bear Markets
The next few chapters make the case that we are in something called a secular bear market. As mentioned, a secular bear market is loosely defined as a long period of years or even decades when stock prices are either flat or falling (think Japan today or the United States from 1966 to 1982). Historically and classically defined, secular bear markets are as short as eight years or as long as 17.
My contention, and I think the clear lesson of history, is that we will be in this environment for a long time, and that the key to successful investing will be to acknowledge this factor and invest in the types of stocks, funds, and other investments that do well in a secular bear market, while avoiding those which history has shown us to have less opportunity for success in this type of period.
Understanding the nature of the investment environment and investing accordingly are critical to your success as an investor. But before I can tell you how to invest in a secular bear market, you need to understand for yourself what these cycles are and why and how they happen.
Rules of Engagement
Investors have been taught a philosophy of investment called Modern Portfolio Theory (MPT), which has seemed to work quite well for decades. It is belief in this theory that prompts leading investor gurus to tell us to take a deep breath and to remain calm while our portfolios are down 40 percent. It is this theory, or what is really a twisted version of it, that allows brokers to tell you to buy and hold large-cap stocks with high P/E ratios (or whatever investment they are pushing), even as the stocks tumble. There is much to be learned from this philosophy, but I think it is at the root of much of the pain individual investors have been feeling these past few years.
The rules of engagement for warfare have changed. I think it is fair to say that our nation, if not much of the world, has realized that. The end of the Cold War and the beginning of the War on Terrorism have changed the manner in which we deal with those who would attack our nation. What would have been unthinkable only a few years ago is now promoted as necessary and wise by (almost) all parts of the political equation. It is clear that our military leaders are hoping to avoid the most costly and typical of all military mistakes: using the tactics of the last war to fight the current war.
I am going to suggest that the rules of engagement, as it were, for investing have changed as well. What worked for the 1980s and 1990s will now frustrate those who want to use the old investing rules to fight the next investment war. If you do not see and adjust to these changes, you will not be happy with your investment returns over the next decade.
Future stock market returns are likely to be severely below those of recent decades and the expectations of investors. This book looks at a variety of studies and ways to understand the stock market. These views come from different premises, but they all arrive at the same conclusion: They demonstrate a very high probability that we will be in an extended period of low or negative returns, or what is called a secular bear market. (Later chapters show a whole new way to look at bear markets: one that will also give us some idea of when to actually get back in the market.)
During such a market, investors will not be able to invest in mutual funds and have a rising tide raise their funds. Index funds, despite what the fund companies may advertise, will not perform well. Equity mutual funds will increasingly be seen as bad investments. You might think this has already happened, but we are nowhere near the level of antipathy toward mutual funds that we will see in a few years and after the next few recessions. As future recessions reduce the time horizons of investors and as investors demand more immediate rewards, stock prices will continue to slide and the net asset values of mutual funds will continue to drop.
Most investors will react by chasing the latest hot fund in a desperate bid to recapture some of their losses. We will see later that this is the worst thing you can do.
So let's first look at the old rules, then survey the new territory and see if we can begin to identify some new guidelines to help us during the current cycle.
It all started in 1952 when Dr. Harry M. Markowitz wrote a series of brilliant essays for which he received the Nobel Prize in economics. His work is the foundation for Modern Portfolio Theory, which has since come to be the dominant model for investment professionals.
Put simply, Markowitz said you can reduce the overall volatility of your portfolio by diversifying your investments among a group of noncorrelating asset classes. When one asset class (such as stocks) is going down, your diversification into bonds and real estate would help hold the value of your portfolio steady.
Markowitz mathematically demonstrated how it is possible for you to combine diverse types of assets that, in and of themselves, could be quite risky and volatile, and the combination portfolio would have lower volatility and more consistent returns than the individual investments. While this seems intuitive today, it was quite novel in 1952.
At that time, it was assumed that since investors picked stocks because of the expectation of future returns, if they could truly know what those future returns would be, they would buy only the one stock or investment that would deliver the highest return.
Of course we don't know the future, so we diversify. MPT says if we diversify into different asset classes with different risk characteristics that do not have a statistical correlation with each other, and which have shown to be good investments over long periods of time, that total portfolio return would be smoother.
If we diversify into bonds, stocks, real estate, timber, oil, and so on over time our portfolio will grow and grow more smoothly than if we concentrate in one market. The key words are "over time."
Markowitz and his followers created a Greek alphabet soup of statistical measures to describe risk. Alpha, beta, gamma, delta, and their statistical cousins help analysts determine the past risk of an investment. MPT then shows professionals how to combine these investments into one portfolio with desired risk/reward characteristics. The Capital Asset Pricing Model shows us how to combine stocks into efficient indexes to achieve the lowest possible risk given their expected return.
We then are told that the market is completely efficient, and that the prices of stocks immediately reflect everything that is knowable and relevant about them. Thus, it is impossible to beat the market.
All of these analytical tools are very useful, and Modern Portfolio Theory has become the sine qua non, the gold standard of investing, especially for large institutions. No one gets fired for properly using MPT as the basis for managing large institutional money.
For the past 50 or so years it has demonstrably worked, more or less. There are hundreds of studies that illustrate the superiority of portfolios constructed with MPT.
But there are three catches to Modern Portfolio Theory that make all the difference in the world. These are three things you typically do not hear at investment sales presentations.
The first is that you have to give Modern Portfolio Theory time. Lots of time. Decades of time.
If you invested in the S&P 500 in 1966, it was 16 years before you saw a gain, and 26 years before you had inflation-adjusted gains. If you invested in the 1950s or in 1973, your gains came more quickly. If you invested in 1982 or late 1987, your gains in only a few years were spectacular. And let's not forget 1999. However, the years 2000 through 2002 were not so kind. While 2003 saw the market rally, if the market were to post similar gains for the next two to three years, valuation levels would be higher than at the peak of the recent stock market bubble.
You could make the same type of risk/reward analysis for every market: bonds, stocks, international markets, real estate, oil, and so on. They all have ups and downs and over time, they come back. Betting on America has been good.
For institutions with a 25 to 30 year time horizon, the ups and downs are annoying, but manageable. With a diversified portfolio, some holdings may decline while others perform well. In recessions, the asset mix is altered, perhaps with a slightly higher percentage of bonds, but the portfolio always contains some stocks since the institution is not attempting to time the market.
Positively, Absolutely Relative
Modern Portfolio Theory is what many investment professionals use to push their clients into a relative value game. If the market (stocks, bonds, real estate, etc.) goes down 15 percent and your portfolio is down only 12 percent, you have beaten the market and done your job. You tell your investors that they should stay with you and that in fact you deserve more of their money. If your clients are institutions, they are likely to comply.
This is one reason why you constantly hear "buy and hold" from investment professionals. It is why they want you to have a high percentage of stocks in your investment portfolio. They can trot out all sorts of studies that show that stocks are the best investment over the long term. Typically, the long term begins with a good year, but with a long enough time frame you can make a case beginning with almost any year.
"In the long run," said John Maynard Keynes, "we are all dead."
What works for institutions may not work for individuals. Most individuals do not have an extended period of years to wait for an investment to come back. How many of you are willing to let a mutual fund or an asset class go for years and years with poor performance? How many years will you stick with a technology fund that has been going down for several years? Those managers will always tell you now is the best time to buy, just as they did six months ago, one year ago, and two years ago. There is never a time to sell a fund. Every dip is just a prelude to a new high. Modern Portfolio Theory says so. Just give me time.
But study after study (we shall later view a few of them) say investors do not give them time. With remarkable consistency over many decades, investors get frustrated and buy high and sell low. Study after study shows investors, buying and selling in an attempt to boost their returns, make only a small percentage of what mutual funds make.
The plain fact is that individuals have different time frames and different needs than institutions, but have been talked into using a strategy that is psychologically opposite to their instincts. Many investors have told me they wish they had followed their intuition or their research to exit the markets in 2000 but were talked out of it by their brokers or advisors.
In a secular bear market you will not win if you're following an investment strategy that requires a 25-to-40-year time frame when your personal time frame is only a few years. Investing with a philosophy that is built on relative returns, rather than the absolute returns your instinct says you want, is a prescription for disappointing and possibly even disastrous results.
Excerpted from Bull's Eye Investing by John Mauldin Excerpted by permission.
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