Bull: A Histroy of the Boom

Bull! A History of the Boom by Maggie Mahar, 2003 $43 Cdn 490 pages Harper Business I don't usually like books written by journalists, but Bull! was somewhat different. And Bull! was recommended by none other than Warren Buffet in his 2003 letter to shareholders. The author and journalist, Maggie Mahar, talked to the right people: Among them were: Richard Russell, James Grant, Gail Dudack, Bill Gross, Jeremy Grantham, Martin Barnes, Robert Shiller. When ever you find material written by these people, read it carefully. They are independent thinkers. For instance on page 313, about James Grant, Mahar says: Jim Grant “is one of the most interesting market analysts alive”.

DIVIDENDS There is very little in this book about dividends. However, toward the end of the book, in a section named “Income: the Royal Road to Riches”, I found some marvelous statement about dividends. This data on page 360, for instance, shows how important dividends are. Over the years, stocks have returned an average of seven percent a year after inflation. How much of this seven percent was contributed by dividends? Four point nine percent (4.9%) Could one say most of the return from stocks over time is from dividends? I think so. “Without them [dividends], an equity investor would have lost money in more than a third of those 56 years” [from 1926 through 1981] 378 “Unlike earnings, dividends are forever; they can never be restated” 380 “Investments without cash flows are risky, uncertain.” 379 MARKET CYCLES It is important to understand cycles because you are certainly not going to be informed in the press that a bull market is ending. Street people don't want to talk about bear markets. Street people like to emphasize the 20% rule: unless the market is down 20%, it's not a bear market. Of course, by the time prices are down that far, it's too late to sell. As a result, it is worthwhile reading about how a bull market tops. Tops are diffuse. Mahar goes into this on page 315. Here are some of her examples: the advance decline ratio on the NYSE topped out on April 3 1998; Dow Transports crested in May of 1999; the DJIA in January of 2000; and the Nasdaq peaked three months later. It's a gradual procedure. There are no headlines. (My own cost of dividends chart peaked in May of 1998 at $34.19) There was a lot of time to prepare if you wanted to sell. I didn't. I was buying. The best time to buy dividend-paying stocks in the last decade was in the spring of 2000. As the storm began, investors sought a haven: they bought dividend-paying stocks. Prices of the dividend-paying stocks I follow went up as the broad market crashed. You have to learn the signs of a market topping for yourself. Maggie Mahar go into some of the signals. Insider selling, for instance, began six months before the top in the fall of 1999 317. Not realizing that the market had peaked, Americans put $260 billion into equity funds in 2000 325 . Toward the end, only a few stocks lead the charge. (In Canada, in the summer of 2000, it was Nortel and BCE causing the index to be skewed.) people did not see, or want to see, the writing on the wall. Sell into strength is one of John Neff's precepts. On page 39 of Bull!, there is a terrific chart of the Dow for the period from about 1966 to 1974 supplied by Richard Russell's Dow Theory Letter. I think the first decade of this new century will unfold the way this period played out. In May of 1970, the Dow fell to 631. By January of 1973, it had rallied to 1050. Only then did the Dow take its final, fatal nosedive that ended in the crash of 1973-74. The Dow fell below its previous low to 577. The next bull run did not really arrive until 1982. One of the reasons I read about events like the great bull market was to get an inkling about people's behaviour. Why didn't they sell, for instance. Mahar did not get into this topic in a big way but I found a few ideas. 1. Most people did not realize the market was topping. For instance, inflows into mutual funds were still strong in 2000. 2. “I did not sell”, one person said, “because I didn't want to be stuck with the taxes” p336. 3. Or this thought on page 338 “I assumed it was a correction.” STOCK OPTIONS are explained in Chapter 8 124-148. This material is excellent…especially the sections about how Wall Street and corporate America combined forces to stymie reform of securities laws and accounting regulations. Here are some sample statements: 125 “options did carry a very real cost and it came directly from shareholders' pockets” 130 “by burying the cost of options, corporations were deceiving their shareholders” 133 “Options packages also encouraged management to reduce dividends.” 136 “Options grants represented an unparallel transfer of wealth from shareholders to corporate management” 138 “Stock options are the only kind of executive pay which a company can deduct from its taxes as an expense, but which it is not required to include in its books as an expense.” Arthur Levin What riles me most about executive options is that they encourage management to reduce dividends. Mahar explains why on page 133. And share buybacks. Don't get me going. Mahar handles this topic beautifully too. To this day, most investors believe that share repurchases benefit shareholders. Investors have been conned! Read Bull! Learn all kinds of 'stuff'. Reading Chapter 17 about Henry Blodget will convince you never to rely on the recommendation of an analyst again. Their guess about the future price of a stock is as good as your guess. “In truth, Blodget's research as not that cavalier. But when it came to setting a price, he was at a loss. How high? Who knew?” 290 There is more on Wall Street's analysts through out the book. Here's one: “Often their firm's profits depended on investment banking fees from the very same companies that they covered. No wonder 'sell' recommendations were rare” 29 When you read the pages in Chapter 18 about what Louis Rukeyser did to Gail Dudack because she was bearish on 'his' program before the crash, you will not listen to his program ever again. “Lou lacked the intellectual integrity to tolerate a different opinion, and to wait and see if Gail would be correct.”308 . Gail Dudack was correct: Rukeyser's other elves were wrong. About 'experts' on CNBC, Mahar quoted Mark Haines a co-anchor of a CNBC program: “Investors who didn't understand that the “experts” who appeared on CNBC would be biased were simply “too naive” to be in the game”. 30 LOOKING AHEAD Bull! is worth buying for the last chapter alone, especially pages 362 to 367. Chapter 21 is called Looking Ahead. Here's an example about avoiding mistakes from page 367.Bill Bernstein notes that in the last century, from 1901-2000, stocks rose 9.89% before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57% after inflation, giving a real yield difference of almost 5%. In the 19 century the real (inflation-adjusted) difference between stocks and bonds was only about 1.5%.

In the late '90s, stock bulls would point out that there was no 30-year period where stocks did not beat bonds in the 20 century. The 19 century for them was meaningless, as the stock market then was small, and we were now in a modern world.

But what we had was a stock market bubble, just like in 1929, which convinced people of the superiority of stocks. And then we had the crash. Also, from 1932 to 2000 stocks beat bonds rather handily, again convincing investors that stocks were almost riskless compared to bonds. But in the aftermath of the bubble, yields on stocks dropped to 1%, compared to 6% in bonds. If you assumed that investors wanted a 5% risk premium, then that means they were expecting to get a compound 10% going forward from stocks. Instead, they have seen their long-term stock portfolios collapse anywhere from 40-70%, depending on which index you use.

So what is the actual risk premium? Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point. Their conclusion was that the risk premium seems to be 2.5%. Arnott writes:

“My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5% equity risk premium is a myth. Over this full 207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history's 2.5 percentage point excess return or the five percent premium that most investors expect?

“As Peter Bernstein and I suggested in 2002, it's hard to construct a scenario which delivers a five percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day.”

One other quick point from this paper. Just as capitalization-weighted indexes will tend to emphasize the larger stocks, many bond indexes have the same problem, in that they will overweight large bond issuers. At one point in 2001, Argentina was 20% of the Emerging Market Bond Index, simply because they issued too many bonds. If you bought the index, you had large losses. The same with the recent high-yield index which had 12% devoted to GM and Ford. In general, I do not like bond index funds, and this is just one more reason to eschew them.

So Then, Bonds for the Long Run?

Let me be clear here. I am not saying you should put your portfolio in 20-year bonds, or that I even expect 20-year bonds to outperform stocks over the next 20 years. Far from it! The lesson here is to be very careful of geeks bearing charts and graphs (it will be a challenge for my Chinese translator to translate that pun!). Very often, they are designed with biases within them that may not even be apparent to the person who created them.

Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, “I have students of mine - PhDs - going around the country telling people it's a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe.”

When someone tells you that stocks always beat bonds, or that stocks go up in the long run, they have not done their homework. At best, they are parroting bad research that makes their case, or they are simply trying to sell you something.

As I point out over and over, the long-run, 20-year returns you will get on your stock portfolios are VERY highly correlated with the valuations of the stock market at the time you invest. That is one reason why I contend that you can roughly time the stock market.

Valuations matter, as I wrote for many chapters in Bull's Eye Investing, where I suggested in 2003 that we were in a long-term secular bear market and that stocks would be a difficult place to be in the coming decade, based on valuations. I looked foolish in 2006 and most of 2007. Pundits on TV talked about a new bull market. But valuations were at nosebleed levels. And now?

I have been doing a lot of interviews with the press, with them wanting to know if I think this is the start of a new bull market. There are a lot of pundits on TV and in the press who think so. I also notice that many of them run mutual funds or long-only investment programs. What are they going to do, go on TV and say, “Sell my fund”? And get to keep their jobs?

Am I accusing them of being insincere? Maybe a few of them, but most have a built-in bias that points them to the positive news that would make their fund (finally!) perform. And believe me, I can empathize. It is part of the human condition. But you just need to keep that in mind when you are thinking about investing in a new fund, or rethinking your own portfolio.

P/E Ratios at 200? Really?

Just for fun, when I was interviewing with the New York Times today, I went to the S&P web site and looked at the earnings for the S&P 500. It's ugly. The as-reported loss for the S&P 500 for the 4 quarter was $23.16 a share. This is the first reported quarterly loss in history. That almost wipes out the expected earnings for the next three quarters. For the trailing 12 months the P/E ratio, as of the end of the second quarter, is 199.97. Close enough to 200 for government work.

But it gets worse. The expected P/E ratio for the end of the third quarter is (drum roll, please) 258! However, taking the loss of the fourth quarter off the trailing returns allows us to get back to an estimated P/E of 23 by the end of 2009. The problem is that you have to believe the estimates, which I have shown are repeatedly being lowered each quarter, and which I expect to be lowered by at least another 25% in the coming months.

Now, much of that loss is coming from the financials, which showed staggering write-offs of $101 billion, $28 billion coming from (no surprise) AIG alone. Sales across the board are down almost 9%, with 290 companies reporting lower sales.

This quarter the estimated consensus GDP is somewhere between down 5% to down 7%. Last quarter we were down an annualized 6.3%. That would be two ugly quarters back to back. It is hard to believe earnings for nonfinancial companies are going to be all that much better.

Side note: The economy did not contract at 6.3% in the 4 quarter. That is an annualized number. The quarter actually contracted at about 1.6%. If we go a whole year with a 6% contraction, that would be truly horrendous. We would blow right on through 10% unemployment. While it is possible, we should start to see somewhat better numbers in the second half of the year, although I still think they will be negative.

Mark-to-Market Slip Slides Away

But it is quite possible that the financial stocks see an improvement in earnings this quarter. The US Financial Accounting Standards Board (FASB) changed the mark-to-market rules last week, which many (including your humble analyst) thought was needed. First, they suspended the mark-to-market rules for assets in distressed markets. Second, they widened the definition of “temporary” impairments of troubled assets, which will “allow banks to write up the value of some troubled assets if these have been hit by falling markets without (yet) suffering any significant credit losses.” (www.gavekal.com)

Here's the important part. The board decided to make the new changes effective immediately, prior to full board approval on April 2.

As my friend Charles Gave noted, this will allow banks to write up their paper, and it happens before Treasury Secretary Tim Geithner starts putting taxpayer money at risk. Expect to see a pop in valuations. It will be interesting to see if Citi and B of A post profits this quarter.

(I should note that the International Accounting Standards Board sent out a scathing press release. I guess from that we should assume that European banks will not be so fortunate as their US counterparts.)

In theory, as I understand it, the information will still be there, but the way it will be recorded will not be reflected in the profit and loss statement. I understand that this is a very controversial proposal, and I expect many readers will disagree. The key is whether or not the information is available to investors and how the proposals are put into actual practice. If there is abuse, and regulators should be all over this, then the old rules must quickly go back into place.

This could put some strength back into financials, at least until the commercial mortgage and credit card problems start having to be written off. At the least, it could make for another solid rise in the stock market until we start to get what I expect to be very bad 1 and 2 quarter earnings. Mahar selected a good example: If you lose 40% on one $50,000 investment, you need to make up more than 60% on the remaining $30,000 just to get back to square one. If you had chosen a more conservative 5% opportunity, over three years, 5% compounded adds up to more than 15%. The five charts in the appendix, the chart on the inside covers and the ones on pages 39 and 356 are splendid too. The graph by Martin Barnes of the Bank Credit Analyst out of Montreal is worth a good portion of the price of the book alone. It's a composite index of the peaks in the Dow Jones (1922-29), gold and silver (1973-86) and the Nikkei (1982-95). Look for a flat market going out for the next decade or so, if history is to be any guide. Other points I liked in Bull! You can't get your investment advice from the media, they tend to deal only with the white-hot stocks that make headlines. 334 “Accounting abounds with imprecision” 138 “Value investors search for…truffles on the forest floor.” 204

bull_a_history_of_the_boom.txt · Last modified: 2009/03/30 19:33 by tom
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