I've given a few presentations recently to Securities Analysts groups in the Midwest. This is an updated, condensed version of those recent remarks.
Sayonara, Saddam, wherever you are. You'll be missed.
Not, don't misunderstand, that you weren't an utterly despicable despot; a merchant of mass destruction; a blight on your people, all of the Mideast and the world. It's just, now that the stock market is no longer trapped between Iraq and a hard place, that Wall Street will have to find another excuse for the beastly behavior of the indices, the ennui of the investing classes.
Preferrably, one that distracts the clientele from the harsh reality that the walls have come tumbling down on the Babyboomers' Generational Bull Market-just as, evidently, they finally did on the ruthless Iraqi strongman.
Oh well, two more illusions bite the dust. We should be getting used to it. The last several years have seen the death of many other cherished illusions – about personal and national security, the ever-upward march of high-tech earnings, the ethics of accountants, investment bankers, securities analysts and corporate managements. Anxiety levels are way up, uncertainty the order of the day. Shell-shock, not uncommon. Not without reason. The world has changed dramatically.
Consider this bit of Internet wisdom a very old friend e-mailed to me last week:
You know the world has gone mad when:
The best rapper is a White guy,
The best golfer is a Black guy,
The tallest guy in the NBA is Chinese,
The Swiss hold the America's Cup,
France is accusing the USA of arrogance,
And Germans don't want to go to war!"
But it's no joke. Our nation has been at war. Yes, against a "thug" and dictator who – for all the Weapons of Mass Destruction he undoubtedly hid under Iraq's shifting sands – clearly never had a prayer against our vastly superior armed forces. But that doesn't mean things still might not get very ugly as we try to win the peace. Or that we won't find that bringing peace, democracy, order, social and economic justice to the Mideast-not to mention the rest of the globe's hot spots – won't prove far more challenging than bombing bunkers and rolling tanks into the center of Baghdad.
Most obviously, of course, that's because there still are Iraqi troops, secret police, Saddam's Fedayheen, Muslim mercenaries and terrorist volunteers sniping, skulking and sulking in Iraq's cities and deserts; zealots unable or unwilling to accept the ramifications of regime change. Against our military, they stand not a chance. But that doesn't mean Saddam's thugs won't continue to capture the hearts and minds in the Arab Street, as the talking heads like to refer to the Muslim masses; or that everyday Arabs might not find delusions of past, insular glory preferrable to facing the hard work of building even a semblance of a modern, democratic nation out of Saddam's ruins.
Which is, sadly enough, all too similar to the situation in which many investors find themselves today, clinging to illusions of fat bull market returns, even as the beast lies in tatters at their feet. Consider this, from the Wall Street Journal: "Hedge funds now control $600 billion, channeled into strategies with names foreign to many traditional investors: convertible arbitrage,' dedicated short bias,' global macro,' distressed,' event-driven.' These pools remain minuscule next to the $6 trillion mutual fund industry, but their rapid growth makes a significant statement about a new mindset among investors: They are abandoning stocks, but not their hopes of bubble-era returns." (April 9, 2003).
Institutional Investors
They – and that's a "they" that includes a very broad swathe of the institutional investment community, not just the individual investors that the WSJ piece was describing – just don't get it, yet.
Yes, we've had three years in a row in which the broad averages lost ground. Three years in a row in which former masters of the universe posted obscenely negative portfolio returns, so it's reflexive now to moan about the bear market, to concede that a massive stock market bubble popped three years back. What else do you call it, when the last century's "Stock Market for the Next Century" is scarcely even a pale shell of its former self, shrunken in value by more than 75 percent?
But it's still axiomatic that investors of every stripe are looking for the bottom; just itching to play the next turn. What is still lacking is any sort of broad consensus that we are, indeed, in the midst of a most likely enormous secular bear market. What is missing is any true acknowledgement that this changes virtually everything for investors, analysts, portfolio managers – anyone and everyone involved in Wall Street. And what is very hard to find are investors behaving as if they believe that the investment tools and processes that worked, and worked so well – and, admit it, worked so easily, all during the 1980s and 1990s – during the late, great bull market – are quite simply, as useful now as a sauna in Baghdad. And are quite likely to remain so for years on end.
Lip Service
There's no surer sign that the notion of a secular bear market is getting no more than lip service than the professional class's still-fully evident urge to speculate; the obvious determination on the part of investment pros not to be left behind by the next rally. Just look at the volume in the QQQs next to the trading volume in all of Nasdaq, look at the staggering proportion of NYSE trading being accomplished by program traders.
Nothing, it seems, matters more than buying "insurance" of some sort against getting left behind by some average. Which implies that the portfolio pros are still living by the bull's rules: "the indexes always go up," and the name of the game is "beating your bogey."
Not much mystery why, either. It's only natural not to want such a great party to end. But the market, it's indisputable in retrospect, was in the grips of a classic speculative bubble. Actually, Alan Greenspan's protests to the contrary, it was pretty obvious, even then, that we were in a bubble. The thing was, it was infinitely easier to recognize the bubble than to guess, correctly, when it would pop. But what you could predict with extremely high confidence, given the historical record, was that the aftermath wouldn't be pleasant.
Not that anyone cared to listen.
Until it was too late.
So all right, already, the mood now is. Stocks are down, many of them big-time. Enough. Let's get back to the races.
The thing is, massive asset bubbles just aren't the sort of thing that come and go overnight, or even in the space of a typical U.S. news cycle. Too many excesses are built up during the boom, the sort of things that just aren't cured in Internet time. What too many folks still don't recognize is that the secular bear markets of the 1930s and 1970s weren't what the statisticians call "100-year floods."
The recorded history of the U.S. stock market is really quite short in any reliable statistical sense, and yet it has been pocked fairly regularly by deep and long-lasting secular bears. After the market peak in 1890, the Dow plunged 64 percent and didn't recover its past glory for 15 years. Then it peaked again in 1906, sank 48 percent and didn't recover for a decade. After the 1916 peak, the index plunged 56 percent, and took nine years to recover. Then, of course, came 1929, and 26 long years in the wilderness for the bulls. When the go-go years went the way of all manias in 1966, the plunge was 38 percent and seven years passed before the market recovered, only to peak again at the end of 1973, sinking 45 percent and going nowhere, basically for the next 10 years, before the grand bull market of the 1980s and 1990s finally got some traction in August of 1982. But it peaked in March of 2000, proving-contrary to received wisdom, that the cycle hadn't been repealed.
Market Fluctuate
I've always thought old JP Morgan had it exactly right when he said, in response to the question of what the market was going to do, "it will fluctuate." And boy have we seen that over the last three years. In spades. Post bubble funks. Bear markets. Brokerage house and mutual fund industry downsizing. Analysts laid off. Investment bankers'- gasp – bonuses slashed.
The bad news is that I suspect this continues albeit broken up by some heart-stopping rallies and even some juicy cyclical bull markets-for years. To repeat, adjustments to the sort of imbalances we built up during the mania just don't happen overnight.
In this environment (or indeed in any), the best defense for serious investors of every stripe is to know thoroughly what they are buying and selling-and why. And to be prepared to live with those decisions-until fundamental conditions change.
Believe me, they will. Forget the easy money articles of faith popularized by the cult of modern portfolio management during the long bull market. Concentrate instead on individual securities analysis, realistic valuations and on very specific investment horizons. Be flexible and opportunistic. If that be market timing, so be it. Indexing and all other forms of herd-think will amount to investment suicide while the secular bear holds sway.
New Era' Stocks
The good old days when all that mattered was going with "Mo;" when consenting adults were more than happy to trade-to borrow a wonderful phrase from an old friend, Ray DeVoe, "Pokemon Cards for Grown-Ups," are over. It will be generations before investors, again embrace en mass "new era" stocks that, like Pokemon cards, have no intrinsic value and are worth only what someone else playing "the game" is willing to pony up for them.
Hard truths about the very different, difficult investment environment in which we find ourselves have been a recurring theme in interviews featured in Welling@Weeden, this year. But most prominently in the one with Economics and Portfolio Management's Peter L. Bernstein. They bear repeating, and repeating again. Until lots more investors "get it."
To them, at the end of this piece, I'm rashly going to add a few of my own predictions and observations about how things will be different in the frustrating secular bear years that still lie ahead. I do so, I stress, fully intending in the future only to remember the ones that come true.
The harshest truth in the investment world, as Martin Barnes at the Bank Credit Analyst has pointed out, is that the ratio of equity returns to bond returns (long-run Treasurys) is now back to its level of early 1980s. In other words, a buy-and-hold investor would have done just as well holding Treasurys as investing in the S&P 500 during the past 23 years.
The only true golden periods for stocks during the past 80 years or so were the 1950s and 1960s. That was when stocks persistently outperformed bonds, with only occasional short-lived reversals. The key thing to note about this "golden era" of equity outperformance is that it began when equities were very cheap: the S&P 500 was trading at seven times trailing reported earnings in 1950.
Meanwhile, bonds were expensive because the long-term Treasury yield was pegged at around 2 percent, far below the underlying rate of inflation. What's particularly interesting, if you have my admittedly dyspeptic turn of mind, is that the cult of equities didn't even begin to take hold among institutional investors until the tail end of that period. Most market historians say that McGeorge Bundy's call for the Ford Foundation to embrace equities for the long haul really kicked off the modern era of portfolio management-and the ascendancy of that Panglossian theory.
Which made it such great fun to have one of its leading lights, Peter Bernstein, eulogizing it in my publication a few weeks back-at a point a good three years past the old bull's peak. Peter's basic point, if I can be so bold as to summarize the master, is that it's just not reasonable to believe that, in the aggregate, equity returns over the foreseeable future are going to be anywhere close to the double-digit levels we grew to know and love in the 1990s. This is because real GDP growth here looks to be anemic at best, and real growth in earnings and dividends consistently lags long-run growth rates in real GDP-and in many cases even in per capita GDP growth, not just in the U.S. but in all other developed economies. Between 1900 and 2001, for instance, U.S. GDP growth averaged 3.3 percent in real terms, vs 1.9 percent growth in GDP per capita, 1.5 percent real earnings growth and just 1.1 percent dividend growth. And, as Peter points out, the U.S. economy was the most successful on the planet over that stretch. The upshot is that starting price-and dividend yield-are going to matter very much. Real earnings growth will be recognized as the really rare phenomenon it is. And valued as such.
Now, for my rash predictions: A decade hence, or before the next truly great secular bull move begins:
* The broadly defined Wall Street community (can you think of anything that's actually less communal?) will be far smaller, measured in terms of professional participants.
* The era of imperial management prerogatives and perks, and truly obscene compensation and options grants will seem as distant as the age of "the organization man" and conglomerateurs seems today.
* "Buy and Hold" and "Buy the Dips" will be phrases just not uttered in polite company.
* Cash will be king; gold and other commodities will universally glitter.
* Indexing will have gone the way of portfolios of railroad bonds.
* Relative performance will be absolutely discredited.
* Investment bankers-well, let's just say you won't want your sons or daughters to marry one.
* Consultants and their style boxes will be considered as essential to investment portfolios as hat boxes are to today's couture fashion.
* Mention of modern portfolio theory will be greeted with the same sort of derision..
* Stocks will be sold-and bought-for their dividend yields; Revenue and earnings growth-while still much desired, will be regarded as rare, and unreliable, icing on the cake. Highly leveraged balance sheets, recognized as anathema.
* The small, hardy band of surviving independent analysts will operate with all the impunity of bond vigilantes in the '80s and '90s. Corporate managements will kowtow for coverage-any coverage.
* Baskin Robbins will once again boast far more flavors of ice cream than companies do of "earnings."
* Far more hot air will once again be expended to make cotton candy at places like Disney World than in spinning corporate outlooks.
* Accounting will no longer be quite so, as my old friend Abe Briloff once famously put it, unaccountable.
* "401(k)" backlash will force significant reform of pension structure and reintroduce some level of (expensive for shareholders) corporate responsibility and fiduciary duty in regard to employee pensions.
* Inflation, not deflation, will loom.
* Derivatives will be in the doghouse.
* Expectations for earnings growth and capital gains will be slim to none.
* EFTs will be as hard a sale as mutual funds. Hedge funds will be highly regulated.
And the SEC will still be, as my mother used to say, "a day late and a dollar short."
But all is not grim. Absolutely none of the foregoing means that we won't have plenty of volatility and opportunities to profit in special situations. None of it means, either, that we won't have a monster rally-or rallies-in the short run. As Peter Bernstein pointed out, rallies of more than 25 percent are common in secular bear markets.
"So, ironically, stocks may well be the place to be for the short run."
Kathryn M. Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
