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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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That stocks like Philip Morris and Procter and Gamble were looking a lot better than Intel or MicrosoftTHE FINANCIAL FRONTIER The Direction of the Markets Under the New Dominant Investment System The wilderness masters the colonist. Frederick Jackson Turner The last time we witnessed somebody pitching their Great American Companies fund by using one of those charts that shows the Dow Jones Industrial Average gently rising over the last 70 years, we began to wonder at what point Americans began to cling to the past. We didnt, after all, used to have one. The advantage this gave our economy over more established cultures such as those of Europe was that we were free of the entrenched, self-serving business bureaucracies that, in the name of convention, keep new, more productive businesses from flourishing. Only one thing mattered to the pioneering spirit: moving forward. That gutsy spark created the wealthiest nation on earth in a very short period of time. We are no longer free of entrenched, self-serving business bureaucracies. Somewhere along the line they have succeeded in making us forget that inspired innovation and brave foresight, which so threatens them today, are what brought them to power in the first place. If market history is worth exploring, it is to those early creative years that we should look the years when nothing was certain but that visionary Americans would not let anything stand in their way. In looking out at the financial frontier ahead of us in the twenty first century, we can get clues to the new markets direction from the time when the Dow itself was as new and energetic as NASDAQ companies are today. It turns out that NASDAQ is coming close to repeating the Dows performance in its earliest years. It appears that dominant investment systems begin and end in similar patterns. We had been studying this over the last seven years and in 1999 began to use the correlation between the NASDAQ and the Dow, a century apart, to help us anticipate the direction of the markets in the management of our clients and our own money. Part II puts the performances of the Dow and NASDAQ in their historic contexts. It was the historic cultural, social, and economic similarities between the beginnings of the two dominant investment systems that led us to compare market performance. Without this framework the market patterns themselves would not hold much significance. The first principle to emerge was that the early years of a dominant investment system can be divided into three distinct phases: 1. Discovery phase 2. Formulation phase 3. Acceleration phase 2.1 puts the trend of the three phases together. As you read the definitions of each phase, keep in mind that these descriptions obtain from what occurred a century ago. This puts a singularly stunning perspective on events today because they are echoing the past. DISCOVERY PHASE The securities of what will be the new dominant investment explode out of the gate. Many of the companies they represent had been around 20 years or more, but suddenly they take on a new respectability, enhanced by the fact that they are outperforming everything else by wide margins. Enthralled with new innovations, efficiencies, products, and services, investors are like kids waiting for Santa. Every wish will be granted. This is hard to argue when the market is soaring. Nothing less than immediate gratification is tolerated. Returns on investment are expected within days or weeks. There is always a new next big thing. It is unacceptable for it to take years for the new ideas to transform the world. It must happen overnight. Babbling speculators and professional investor wanna-bes crawl out of the woodwork. Near the end, the people with neither the wherewithal nor the stomach for investing jump in. For a while some of the old dominant investments were carried upward with the new (see Figure 2.2 for a comparison of the Dow and NASDAQ). There is confusion about how to analyze price levels. Companies come to market that do not deserve to and reach levels to which they are not entitled. Then things do change overnight, but not in the way most expected. The market begins a substantial and extended decline. The discovery phase is over. Discovery Phase of the Second and Third Dominant Investment Systems FORMULATION PHASE If you liked it at $120, you should love it at $60. Double up. It drops to $20. Buy more. Lower your cost basis. Itll turn around any day now. It doesnt. It is the first weeks of the formulation phase. Many are in denial. Weeks turn into months. Business needed to slow down some to prevent inflation. It has, but still the economy is better than it was seven or eight years ago, and the markets still are not bouncing back. Impatience turns to panic until finally all the air has gone out of the balloon. What will the markets do now? The consensus of the experts is about as orderly as downtown Manhattan at rush hour with the traffic lights out. Those with vested interests in the old dominant investment system adopt the I told you so attitude Indian chiefs admonishing the tribe for diverging from the old ways. The tribe seems to agree. Money begins to flow back into the securities of the previous dominant investment system. In 2001 this meant that stocks like Philip Morris and Procter and Gamble were looking a lot better than Intel or Microsoft. But only for a while. . . . The formulation phase is about those companies of the new dominant investment system that survived the abrupt market decline that signaled the start of this phase. During this phase these companies will execute their business plans, establish their brand identity, and educate investors who struggle to understand how they are making so much money. We like it when we can fit things into the right box. Into which economic sectors will the companies of the new dominant investment system fit? How do we analyze them? Which ones will succeed? These questions jostle against one another, creating the defining characteristics of the formulation phase: market volatility. But we call it the formulation phase because it is during this time that these questions are answered. There is a lot of money to be made here. Investors who understand whats happening are the ones who will profit; think Benjamin Graham of the Dow Jones Industrial Averages formulation phase. In just one short period, from 1903 to 1906, the Dow more than doubled, going from 42.25 to 103. ACCELERATION PHASE The Dows acceleration phase lasted eight years. During that time the Dow Jones Industrial Average increased 496.5%, an average of 62% per year. These were the Roaring Twenties. New services and technologies that had been created by the time of the discovery phase were refined and developed during the formulation phase and then realized their promise in the acceleration phase. The financial world enthused over the new companiespossibilities in the discovery phase, learned how to evaluate them in the formulation phase, and finally reached a new level of confidence in their value that helped to propel the acceleration phase. This was when investors came face to face with what the economy behind this dominant investment system could produce. The Wright brothers flew the first plane in 1903 (formulation phase). By the acceleration phase there were coast-to-coast passenger flights and regional airports.1 In 1903 the 12-minute drama The Great Train Robbery flick ered away in tiny nickelodeons. By the 1920s people across the country sat in movie theaters that looked like European palaces and watched The Jazz Singer 2 (see Figures 2.5 and 2.6). WHAT IT MEANS TO US TODAY We were just as glad to see the NASDAQs discovery phase end in March 2000. In the last months a person needed a black belt to fight off clients who mistook that stock tip from their dentists (teenagers, plumbers, neighbors, Web sites, etc.) for an investment. When we saw the NASDAQs gains exceed the percentage increase of the Dow during its own discovery phase, we knew that some significant declines were not far off. We increased the cash and bond allocations in portfolios, where it was appropriate, at the very end of the discovery phase. The methodology that showed us it was time to do this is in Chapter 3. In considering what to do with that money going forward, we wanted to know two things: 1. What would happen to the old dominant investment, the Dow? If it declined a great deal during the formulation phase, would it become an attractive investment? 2. How long would the NASDAQs formulation phase last? How well would it do amid the changing business and economic conditions? We will answer number one first. WHERE DO OLD DOMINANT INVESTMENT SYSTEMS GO? Here is the first thing. The Dow Jones Industrial Average will never go to 26,000 or 36,000 (or anywhere close to the projections that are made whenever times are good and stocks are rising), no matter how long your long term is. There are two reasons why this is true. The first is the word of experts. According to Warren Buffett, The Dow Jones Industrial Average should be thought of as a 13% coupon bond.3 Ron Ryan, president of Ryan Labs, noted that the S&P 500 is consistently behaving like a 15 year duration corporate bond. All large cap equity indexes behave in a similar risk/reward way.4 Warren Buffett is one of the worlds most successful Dow system investors and a master at implementing the concepts of Benjamin Graham. Ron Ryan founded Ryan Labs and created the first Lehman Brothers Corporate Bond indexes in 1991. His benchmarks are among the most popular used by todays investment professionals. Buffett and Ryan are saying that the Dow, the Standard & Poor s 500, and all the big-cap indexes act like enhanced versions of bonds. That is because many of the stocks in these indexes are enhanced versions of bonds. Consider the characteristics of the stocks we call bluechip stocks. The company is of enormous size and is considered stable, and the stock pays a steady dividend all the characteristics of a good bond. The farther we have gotten from the days of the dominant bond system, the easier it is to forget that bonds provided the soil from which the Dow system sprung. Remember that before 1958 a stock was not considered a good investment unless its dividend yield exceeded that of a bond. Just as we have come to realize the limits to which bonds will rise before they are pulled back down to earth, we will come to learn that the gravitational pull on Dow stocks may be proportionately less but that in the same way it puts a check on the heights to which they can climb. The academic view of why we should lower our growth expectations for the big-cap, blue-chip, industrial-age stock is thoroughly explained by Robert J. Arnott, managing partner of First Quadrant, a money management firm, and Ron Ryan. In a landmark paper they coauthored in 2000, the authors concluded that the returns of largecap industrial companies may average an annual return of .9% less than bonds going forward.5 Arnott updated his work in the second quarter of 2001 with the Dow at lower levels than in 2000. By then the revival of the big blue chips was in full swing. For the first time in years, so-called experts talked about buying stocks for their dividend yields. Gillette, CocaCola, DuPont, and other industrial-age icons offered a safe way to achieve superior returns, and they were at bargain prices. These arguments appealed to investors need for comfort, not common sense. Figure 2.7 shows that the performance of the big-cap blue-chip stocks has always moved in direct proportion to the U.S. gross domestic product (GDP). Today we must add the fact that not all of the GDP growth comes from big-cap blue-chip companies. At least 1% comes from entrepreneurial capitalism,6 or what we call the new dominant investment system, the NASDAQ companies where new jobs are being created. The average dividend yield on Dow-type stocks in 2002 was about 1.5%. With this information, the following simple calculation gives the returns that can be expected from Dow-type stocks.7 Note that real re turn means adjusted for inflation. Real stock returns = Dividend yield (1.5%) + GDP (3%) - entrepreneurial capitalism (1%) 1.5% + 3% - 1% = 3.5% expected real return on Dow Jones Industrial investment system stocks Figure 2.7 Estimating Real Stock Returns, 1950-2001 Note: Real stock returns equal the dividend yield plus per capital gross domestic product (GDP) growth minus dividend/GDP dilution. Source: What Risk Premium Is Normal by Robert D. Arnott, Peter L. Bernstein, 2001. Used by permission Robert D. Arnott. Smoke, mirrors, and dazzling equations may take investors expectations for the real long-term growth of the twenty-first century bigcap stocks much higher than 3.5% when times are good. But two plus two does not equal 22. Investors who cannot get used to the idea of a new dominant investment system will not find comfort in the old one. When we explore what happened to the first dominant investment, bonds, as it fell from dominance, it reinforces the conclusions just drawn. |
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