All I really need to know I learned in the last decade
December 31, 2009
Market Summary – 4th Quarter, 2009
Robert Fulghum’s 1980s best-selling classic, All I Really Need To Know I Learned in Kindergarten was based on the premise that the world might be a better place if adults followed basic rules we learned as children. One has to wonder if the same idea applies to investing.
The ten-year period ending December 31, 2009 is being referred to as the lost decade. The title is appropriate given what’s happened both in the financial markets and the economy:
- This decade was the first 10-year span that starts with a year ending in zero (2000s, 1990s, 1980s, etc.) where the stock market registered a negative return. It didn’t even happen during the Great Depression of the 1930s.
- $100,000 invested in the S&P 500 Index at the start of 2000 was worth just $90,900 by the end of the decade.
- Purchasing power declined by 23% over the ten-year period, even though inflation remained rather tame by historical standards.
- Private sector jobs actually declined over ten years.
- American households’ net worth (value of houses, investments and other assets minus debts) fell on an inflation-adjusted basis.
- Median household income was lower than it was ten years ago.
This litany of bad news was almost unfathomable when the decade began. If you recall, the increasingly accepted wisdom of the time was that our economy had achieved a “Great Moderation,” and business cycles, particularly deep recessions, would be a thing of the past. This accepted wisdom proved to be faulty, as we have seen in other circumstances. For example, in the 1960s and 1970s, the “Nifty Fifty” was a group of companies investors believed would grow regardless of business conditions. Then, as with the dot-com bubble of the 1990s, stock prices reached excessive levels based on a false premise.
Rather than go all the way back to kindergarten, we can simply revisit our first investing experiences. The most prominent lesson is that you learn not from your successes, but from your mistakes. If investors can recognize that lesson, not all will be lost from the last decade.
Following are other lessons we believe are particularly relevant and, if adhered to, should help investors benefit in the decades to come:
Lesson #1 – No matter how diversified you may be, you can’t beat the market if you are the market.
Conventional wisdom that refuses to die, despite the track record, states that investors are better off choosing index funds over other types of investments. But in the last decade, index investors were condemned to performance as poor, or poorer than, the market itself. In a time when selection has become paramount, buying a little bit of everything in an index fund is not an effective way to accumulate wealth. Mutual funds that own hundreds of stocks are often referred to as “closet indexers,” and the vast majority perform worse than the market.
Another misguided ideology was that the key to consistent investment gains and reduced risk was to implement an asset allocation strategy. The intellectual backing for this idea was the Efficient Market Hypothesis. It presumes that markets (and investors) act rationally. Therefore, it is impossible to outsmart the markets. If anything was proven in the last decade, it was that investors and markets are not always rational. The creator of the theory, Eugene Fama, at the University of Chicago’s School of Economics, has been criticized and discredited by many established publications (TIME, New Yorker) as well as by fellow academics. Justin Fox of TIME says Fama and his disciples, who continue to claim that it is too difficult to outperform the market “have defined themselves out of the discussion.” They refuse to learn any lessons from the last decade and stubbornly adhere to their theories. Experience has proven these theories do not work.
Index investing and asset allocation go hand in hand. They are best summed up in this statement by investment legend Gerald Loeb, who during the Great Depression wrote “Once you obtain confidence, diversification is undesirable.” Loeb continued by stating that diversification “is not knowing what to do, in an effort to strike an average.” Accepting average performance from 2000 through 2009 was the equivalent of waving the white flag and sacrificing wealth.
Lesson #2 – Valuation is as fundamental to investing as gravity is to physics.
During most of the 1990s, investors’ biggest fear was missing out on the rampaging market. The driving philosophy was that if a stock’s price was going up, buy it! Fundamentals meant almost nothing. Some equities, particularly in the technology arena, reached ridiculous levels because everybody “had to own them,” regardless of what they cost. In 2000, Fortune magazine ran a list of “10 stocks to last the decade.” Only one of the ten stocks had a price/earnings ratio of less than 50 (compared to the S&P 500’s historical average P/E ratio of 15 to 20). This group of “can’t miss” stocks did not perform over the last decade. It doesn’t help that one of the ten companies on the list was a red-hot business known as Enron!
As Wall Street focused on technology names with little or no earnings, other companies offered significant value based on their earnings and prospects, despite being boring and out of style. What was forgotten was that price is everything. Even the legendary Warren Buffet, who built his reputation by scooping up cheap, overlooked stocks and riding them to new heights, did not follow the herd. When reality set in, Buffet and others like him prospered. Solid companies well positioned for the future offering a fair and reasonable stock price tend to leave a lasting, positive impact for investors.
This is one reason why value investors are willing to hold more concentrated portfolios. They believe in their companies. Those who prefer diversifying more broadly with less focus on valuation (see Lesson #1) tend to own a little bit of a lot of things, pinning their hopes on achieving average performance from a rising tide lifting all boats. Buffet takes the valuation argument one step further, by saying “Price is what you pay. Value is what you get.”
Lesson #3 – Avoid the loss of purchasing power.
There is a serious risk, in our opinion, of higher inflation due to government debt and the Fed’s easy money policy. This is not new. Since 1913, the dollar has lost 95% of its purchasing power. Even in the last ten years, a period of generally low inflation, the dollar’s value has eroded by 23% (according to the Bureau of Labor Statistics). Another sign of the burgeoning inflation concern is the trend in the price of gold over the last decade. The London Spot Gold Price leaped from $290.25 at the end of 1999 to about $1,100.00 today (Source: Kitco.com).
Inflation, it should be noted, is not a virus, but often the result of faulty government policy. The gross debt of the U.S. government ballooned from $5.6 trillion in 2000 to about $13 trillion in 2009, projected to top $18 trillion by 2014. That is likely to mean higher taxes and the running of the printing presses to create more currency – both likely to eat away at purchasing power. You need to own assets that can grow in value to offset the erosion of purchasing power.
Lesson #4 – Observation and patience are critical.
Investors schooled by the wild bull market run of the 1980s and 1990s tended to “live in the moment” when it came to their investment strategy. They did not want to wait around for a stock to generate favorable performance. Money flowed to the hottest sectors. What happened to the dominant stocks of the 1990s that everybody invested in? A look at the 25 largest S&P 500 companies at the start of 2000 shows that 17 finished the decade in negative territory, with eight of those losing at least half of their value.
Careful observation of the big picture would have identified opportunities in the ensuing decade. For example, oil prices bottomed out at around $20/barrel. The observant investor may have noticed the rise in demand in emerging markets like China and India, combined with a peak in oil production, and surmised that a supply-demand issue would result in a dramatic rise in oil prices – which, of course, occurred.
A failure to be observant can be costly. This was true for the United States as the housing bubble erupted. Former Federal Reserve Chairman Alan Greenspan provides the perfect example. Greenspan admitted, in retrospect, his ignorance of the looming disaster. He said, “you would think I would be acutely aware (of the problems brewing in the housing market), but there were no such data at the time.” To quote Groucho Marx, “who are you going to believe, me or your own eyes?” During this time, many less economic-minded individuals observed, and even engaged in, reckless mortgage practices, such as stated income loans. Too bad Greenspan and many more of the “best and the brightest” among economists and Wall Street types overlooked the value of observation.
Lesson #5 – Engineering is best left for buildings and bridges.
Financial engineering became a tool of corporations and Wall Street as a way to market new products, boost their own balance sheets and repackage financial products with little concern for social utility. For corporations, there is plenty of manipulation of earnings numbers to meet or exceed forecast expectations. For Wall Street, engineering has been the key to generating profits by moving money around in exotic instruments that not only have little benefit for society, but often little for investors.
A critical tool in financial engineering is the excessive use of leverage. Whether it be homeowners abusing their equity, new real estate buyers taking mortgages at 100% of a property’s inflated value, or the likes of Bear Stearns and Lehman Brothers leveraging balance sheets at a 30-1 ratio, it proved to be harmful to not only the participants, but ultimately to all of us.
The business sector lost its way in the past decade. Too much power was foisted on financial geniuses playing with numbers, and too little on innovators who develop products and services that serve a societal benefit. The troubles that have resulted show that old-fashioned approaches to business were never out of fashion, just temporarily out of favor.
Back to School – Remembering Econ 101
You’re never too old to learn (as Rodney Dangerfield taught us in the 1980s movie “Back to School”). History can also tell us a lot about what may lie ahead in the markets.
Start with a basic premise from Econ 101 – there is a reward difference between assets that carry risk, and those that don’t. Much was said about investors earning better returns in the last decade by owning relatively “riskless” U.S. Government treasuries (T-Bills) rather than owning equities (the S&P 500). (Please note that we purposely put riskless in quotation marks, as astute investors appreciate that while principle is guaranteed in these instruments…purchasing power is not). Some bond professionals are selling the idea of a “new normal,” a permanent change that will result in lower equity returns over time – in other words, less reward for the risk of ownership.
There are two kinds of investors – owners (equity holders) and lenders (bond holders). Each has risks and the potential for rewards. Owners have the risk of business failure offset by the potential of almost limitless profits. Lenders tend to have limited risk and in return the lender’s rewards are generally limited.
The notion of assets of lesser risk (U.S. Treasuries), continuing to outperform assets of higher risk (S&P 500), over the foreseeable future contradicts the essence of capitalism and refutes the lessons of history.
If there is no reward for risk, there is no true capitalism. The question to ask as an investor is a simple one – do you believe in the future of American capitalism and prospects for continued global economic growth?
Respected investor and author Barton Biggs does not believe in the “new normal.” Biggs, in a Newsweek piece (Oct. 26, 2009), acknowledged the headwinds that will confront an economy on the path to recovery. Above all else, Biggs says that pessimists “are betting against America, the greatest entrepreneurial engine ever created.” The key investment lesson of history, as Biggs sees it, is that the time to buy America is when it is down.
Biggs notes that while some worry about our economic future, the 20th century was hardly a bed of roses. Two world wars left much of the globe structurally and economically decimated. A depression shook capitalism to its core. The threat of nuclear annihilation hung over the world for half a century. Yet according to Biggs, stocks generated an after-inflation return of nearly 7% per year. By comparison, bonds returned only 1.5% on an after-inflation basis. That tells you
all you need to know about Lesson #3, dealing with the loss of purchasing power.
Biggs also points out that very strong periods of stock market performance occurred after those rare times when bonds outperformed stocks:
- After the second quarter of 1932, the U.S. economy was in the depths of the Great Depression. Unemployment was 25%, people doubted the viability of America’s economic model, and in Europe, Nazi Germany began its rise. Over the next five years, the bottom did not fall out. Instead, the S&P 500 gained an average of 34.8% per year!
- In 1949, the budget deficit as a percentage of the nation’s Gross Domestic Product (GDP) was much higher than it is today. Many anticipated a post-war depression, including Sewell Avery, the head of Montgomery Ward. He was so convinced of bad times ahead that he halted expansion of store locations. This decision allowed Sears Roebuck to become the dominant retailer of the 1950s and 60s. On the international front, communism was spreading. The stock market soared 23.2% on average for the next five years!
- America clearly seemed to be on the decline at the end of the 1960s and throughout the 1970s. The period was marked by tragic assassinations, the bloody Vietnam war, then serious inflation and economic stagnation, not to mention other depressing events like Watergate and the Iran hostage crisis. The sense of a nation in decline was everywhere. Business Week magazine capped it off in August of 1979 with a cover story on “The Death of Equities.” What followed was the unprecedented bull market from 1982 through early 2000!
We raised an important point in our last newsletter that bears repeating – Weakness is your friend! After years of underperformance in equities (in general), coupled with fear and pessimism of the future, many investors have shied away from equities, instead choosing to contribute to the massive inflows of various bond funds. However, history suggests that
following periods of underperformance, substantial opportunities may exist. If the S&P 500 generated an unusual negative return over the last ten years, it is likely to be offset by a corresponding rise down the road helping the index achieve something close to its historic average. Wharton Business School Professor Jeremy Siegel shows this to be the case in three previous ten-year periods where stocks were coming off abominable performance.
History is not our only source of comfort about the future of equities. Observation (Lesson #4) plays an important role as well – and what is readily apparent is that economic growth is unstoppable. It may be slower for a time in the U.S., but the environment is different around the world, particularly in emerging economies. A look around the globe reveals important trends (some of which we have discussed before):
- The dramatic rise in the global middle class, now topping 1.5 billion and projected to reach 3.6 billion by 2030.
- For the first time in history, oil consumption in developing nations now exceeds that of the world’s 20 largest developed economies.
- Also for the first time ever, more people across the world live in urban rather than rural areas, creating an entirely new set of issues and opportunities.
Short-term thinkers and talking heads always find ways of making the future look bleak. This has been a losing proposition over time. A better solution for those concerned with long-term wealth creation and preservation (protecting purchasing power) is to think about the lessons of the past decade, the record of the markets on the heels of down periods over the past century, and the future shaped by the forces of a growing global economy.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.