Second Verse, Same as the First
Many media pundits tell us that the markets may be down for the moment, but that we shouldn't worry or be bothered by bearish arguments, because the markets are just consolidating before the next move up. We are referred back to information about how stocks offer high returns and low risk over the long run. We are told that stocks have always won out through thick and thin and that if we will just stick to our plan and dollar cost average and buy the dips, we will be well on our way to financial independence. And, of course, all this is nothing new.
In 1999, two very different books hit the shelves. One, called Dow 36,000, proposed that the Dow was at the beginning of a great bull market. The other book, Irrational Exuberance, suggested that the Dow was at the top of a mania, which would end with serious economic consequences.
To be sure, the writers of these books were no slouches. Dow 36,000 was written by James Glassman and Dr. Kevin Hassett. As well as being a fellow at the Washington based think tank, the American Enterprise Institute, Glassman was a columnist for The Washington Post and host of the PBS show Techno-Politics. Dr. Hassett was a resident scholar at the American Enterprise Institute, had formerly served as a senior economist with the Federal Reserve Board and had co-authored another work with Dr. Glenn Hubbard entitled, The Magic Mountain: Defining And Using a Budget Surplus.
Dr. Robert Schiller is the Stanley B. Resor Professor of Economics at Yale University. He is also the author of The New Financial Order: Risk in the 21st Century, Market Volatility, and Macro Markets, which won the 1996 Paul A. Samuelson Award.
For the remainder of this piece, we will look at whether Wall Street Bearishness existed, much less hurt investors by causing them to fear a good thing, and whether equities indeed offer high returns and low risk over the long-term, and whether stocks have always won out through thick and thin.
Silly Analysts, Bears are for Pessimists
Glassman and Hassett note that the Wall Street analysts and press were often too bearish and that such bearishness stifled investors' participation in the markets. But, by becoming more savvy, investors were able to overcome this obstacle. In speaking about educating investors on markets and risk, they note:
"Unfortunately, financial professionals have not been much help. Most analysts were completely mystified by the huge increase in stock prices during the 1980s and 1990s, screaming 'Overvalued!' at virtually every turn. The press and the financial analysts are continually saying that stocks are overvalued, and they have continually been wrong. Ridiculed for acting like tulip-maniacs, the small investors have acted more intelligently than the professionals and, by so doing, have profited." 1
And, all this would be fine if it in any way approximated what actually happened.
Shiller's studies, and other observations in books and academic journals, note the fact that Wall Street's role was closer to that of an excited cheerleader than a strict school principal.
"According to data from Zacks Investment Research about analysts' recommendations on some 6,000 companies, only 1.0% of recommendations were 'sells' in late 1999 (while 69% were 'buys' and 30% were 'holds'). This situation stood in striking contrast to that indicated by previous data. Ten years earlier, the fraction of sells, at 9.1%, was nine times higher.
Analysts were especially reluctant to make sell recommendations near the peak of the stock market for a couple of reasons. One reason is that a sell recommendation might have incurred the wrath of the company involved, and companies could retaliate by refusing to talk and not offering them [analysts] access to key executives as they prepared earnings forecasts.
Another reason that many analysts were reluctant to issue sell recommendations is that the[y] were employed by firms that underwrite securities, and these firms did not want their analysts to do anything that might jeopardize this lucrative side of the business. Analysts affiliated with investment banks gave significantly more favorable recommendations on firms for which their employer was the co- or lead underwriter than did unaffiliated analysts." 2
The idea that Wall Street's pessimism was scaring rational investors from the stock market was simply not true.
The Unsinkable, Investor Brown
Glassman and Hassett go on to point out that investors proved, by their behavior, that they had a greater understanding of the high returns and low risks of equities, over the long term.
"One reason that stock ownership is soaring - from 10 percent of adults in 1965 to 21 percent in 1990 to 43 percent in 1997 to an estimated 50 percent today [late 1999] - is that Americans have begun to understand that equities offer both high return, and over the long term, low risk.
In 1980, just 6 million families owned mutual funds; by 1998, that figure had jumped to 44 million, or two out of five households. From 1980 to 1998, assets held in stock mutual funds have increased from $44 million to $ 3 trillion.
Starting in the early 1980s, two profound changes occurred: First, investors began to understand - thanks to better research and education - that stocks were not as risky as they had thought. And, second, stocks actually became less risky because of changes in government policies and in the way corporations did business.
Investors responded to this reduced risk- both perceived and real - by bidding up the prices of stocks because they were more confident.
Another way of saying this is that investors demanded a lower risk premium. And the process won't end here. Risk premiums will keep falling and prices will keep rising until stocks reach their perfectly reasonable price - reflected in a Dow of about 36,000.
The prices that held in the past reflected an irrationally high aversion to risk as we measure it today, but in the past, our understanding of risk and its calculation was in its infancy.
As stock ownership expands, so does education - by mutual funds, banks, more consumer- friendly brokerage firms, journalists, and scholars. There is far better research today, and it is easily disseminated on the Internet." 3 (Italics theirs)
The idea that government policies and corporations' business practices have made stocks less risky is ludicrous. Though I don't have room to expound on this topic here, those interested in further reading are welcome to read the first two sections of our research paper, "Riders on the Storm: Short Selling in Contrary Winds." The one sentence that I do agree with Glassman and Hassett upon, is their plain statement that,
"If the risk premium did return to its historic norm, the carnage would be devastating." 4
As an aside, it is worth noting that as Greenspan was covering his tracks as he exited his post as the Federal Reserve chairman, he had the following to say about reduced risk premiums. In July of 2005, before he vacated the post, Greenspan said the following.
"Nevertheless, risk takers have been encouraged by a perceived increase in economic stability. These actions have been accompanied by significant declines in measures of expected volatility in equity and credit markets inferred from prices of stock and bond options and narrow credit risk premiums. History cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress." 5
After departing as Fed head, Greenspan spoke in Seoul, Korea in February of 2006.
"A good part of this expansion is a direct function of the decline in real equity premiums, discount rates or whatever you wish to call the whole structure of returns, and that cannot go on indefinitely. Credit spreads have dropped to the lowest levels in recent memory.
When you get risk premiums, equity premiums and the like at their lowest levels they've been at in a long time, there's only one direction that they can go and that is up.
And when that happens and it will - I don't know when and I doubt very much anyone does - asset prices begin to fall. It's a wholly simple relationship which means as asset prices fall, so does liquidity." 6
While I disagree more often than I agree with what Alan Greenspan has to say, on this point, we agree.
As far as the increased participation in the stock market, which Glassman and Hassett attribute to investment savvy and better market education, Shiller sees this more as a result of the increased marketing efforts of Wall Street. After discussing the market inflating effects of the IRA and the 401k, he states the following.
"Another reason for the [mutual] funds' explosive growth is that they have paid for a great deal of advertising. Television shows, magazines, and newspapers frequently carry advertisements for them, and active investors receive unsolicited ads by mail. Mutual funds encourage more naïve investors to participate in the market, by leading them to think that the experts managing the funds will steer them away from pitfalls.
The proliferation of equity funds has therefore focused public attention on the market, with the effect of encouraging speculative price movements in stock market aggregates, rather than in individuals stocks." 7
Former SEC Chairman Arthur Levitt corroborates this fact in what he calls "The Seven Deadly Sins of Mutual Funds."
"The Fifth Deadly Sin is that mutual fund's past performance, which is the first feature that investors consider when choosing a fund, doesn't predict future performance. Funds buy expensive ads in newspapers and magazines to tout their performance over the past one, three, five, and ten years. The mutual fund industry irresponsibly promotes this 'culture of performance,' even thought it knows perfectly well that it misleads investors. When it comes to mutual fund investing, the past is not prologue." 8
Indeed, it is sometimes difficult to ascertain the difference between valuable educational and slick marketing materials.
The third, and final, point that we will discuss today, is Glassman and Hassett's assertion that stocks have always been winners through thick and thin.
"Stocks are the place for long-term investments, through thick and thin, since stocks not only return more than bonds but, over long periods, are no more risky." 9
Glassman and Hassett present an example where a person is unfortunate enough to invest $10,000 in the "S&P 500" on the very eve of the crash in October 1929, holds all of these stocks until the end of 1998, and is handsomely rewarded as this "portfolio" grows to $8.4 million. (Page 24) WOW! What an inspiration to invest in the American stock market. Never mind the fact that the S&P 500 didn't exist back then, that indexing has only been around since the 1960s, and that many of the individual companies, if they could actually find them (many scholars point out that the difficulties of such an attempt would render the results too inaccurate to depend upon), would have gone bankrupt and lost all their value, so the make up of this mock portfolio would continuously change.
They state, "we tried to pick the worst possible scenario, and then chose subsequent dates at random" to prove their point. While they did mention the major events of history that happened over this span, they seem to have left out two rather important issues. One is that even high quality bonds contain substantial risks and the other is an observational oversight of the human condition and human needs.
First, Sydney Homer and Richard Sylla, point out in their book, A History of Interest Rates, that bonds have lost substantially at times. They note that from 1946 to 1981,
"[As] yields rose from 2.46 to 15.49%, a constant maturity thirty-year 2 ½ % bond would have declined from 101 in 1946 to 17 in 1981, or 83%. [From] 1899 to 1920, the same bond would have declined 35% in price." 10
The other, more important, omission is that virtually no one who invested on the eve of the Crash of 1929 would have been willing or able to leave their original $10,000 invested in the markets for 70 years. From its peak of 386 in September of 1929, the Dow fell 89 percent to a low of 41 in June of 1932! Glassman and Hassett note, "But you decide to hang on and are rewarded, as stocks triple from 1933 to 1936." Of course, they do not explicitly point out that 89 percent off of 386 is larger than a 300 percent gain on 41. They also conveniently leave off 1937, when the Dow went form 187 to 99, for a loss of 47 percent.
Messrs Glassman and Hassett do point out that, "By the end of 1944 - fourteen years and three months since you bought your portfolio of stocks for $10,000 - you are ahead, by $400." I would like to point out that during the Great Depression, U.S. unemployment was at its highest level ever in the 20th century, and as such, it is highly possible, if not probable, that you might have needed to pull from your account before 1944 to make ends meet.
Perhaps the Morgan's and the Rothschild's and other families with similar fortunes would have had the ability to leave an investment for 70 years, but I dare say few others would.
In late 1999 Glassman and Hassett were not alone. We all felt like we were missing the train if we did not get in now. Though not all of us thought the Dow would reach 36,000 in the first decade of the new millennium, our collective behavior and actions as a society revealed that we believed what we had been taught. We had entered a "new era." We thought that something was different this time. We had beaten the business cycle. If we could only be rational enough to buy on the dips, all of our financial goals could be achieved.
By 2002, we had all experienced our first wake up call. The markets were virtually cut in half. The solution was to flood the world with credit. We re-flated the stock markets, created a housing bubble, a yen carry trade and a gargantuan (unregulated) derivatives market. Now, things are starting to look shaky again. We are running massive trade deficits; we've depleted our savings to negative territory and assumed record consumer debts. The employment picture looks bleak even with the window dressing of the BLS's net birth/death model, which accounts for upwards of 80 percent of the "jobs" that have been created in the last few years.
Many of us are still whistling "stocks for the long term" and " buy on the dips" to keep up our spirits as we walk through the dark. Why do we hold to empty rhetoric, which lacks sound reasoning, until we are left with no choice as these issues draw nearer? Though no one can answer this question completely, Schiller helps us to understand our own behavior in light of crowd behavior, and he reminds us that human nature hasn't changed over the last century and will not change over those that are to come.
"How one feels certainly depends on one's recent experience in investing. If one has been out of the market and has not participated in the profits that others have recently enjoyed, one may be feeling a sharp pain of regret. And regret is an emotion that, psychologists have found, provides considerable motivation.
Envy of others who may have made more in the stock markets is a related painful feeling, especially so in that it diminishes one's own ego. If one can participate in just one more year of an advancing stock market that will help assuage the pain.
Of course, one realizes that one takes the risk of entering the market just as it begins a downward turn. But the psychological cost of such a potential future loss may not be so much greater than the very real regret at having been out of the market in the past. Therefore - although there are many other ways to deal with the thought that one is a "loser," such as rediscovering the importance of being a good friend, spouse, or parent, or pursuing the simple things in life - it may well end up that the only really emotionally satisfying decision to make now, is to get into the stock market." 11
So, is this just the next dip that you'd be playing the fool if you sold on, or is it time to get out. As you consider your response, I leave you with these words from Frederick Lewis Allen's book, Only Yesterday, written in 1931.
"As people in the summer of 1929 looked back for precedents, they were comforted by the recollection that every crash over the past few years had ultimately brought prices to a new high point. Two steps up, one step down, two steps up again - that was how the market went. If you had sold, you had only to wait for the next crash (they came every few months) and buy in again. And there was really no reason to sell at all: you were bound to win in the end if your stock was sound. The really wise man, it appeared, was he who "bought and held on." 12
To read some of our other postings, we welcome you to visit our website. If you are growing more and more convinced that an economic storm is in front of us, then I strongly encourage you to download a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds. You will find this available to those who sign up for our monthly newsletter, The Investors Mind: Anticipating Trends through the Lens of History, which is offered at no cost.
1. Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market (1999), James K. Glassman and Kevin A. Hassett, pages 15, 17, & 58
2. Irrational Exuberance Second Edition (2005), Robert J. Shiller, pages 44 & 45
3. Dow 36,000 (1999), Glassman and Hassett, pages 16, 39, & 101
4. Ibid, page 101
7. Irrational Exuberance (2005), Shiller, page 50
8. Take on the Street: What Wall Street and Corporate America Don't Want You to Know/ Shat You Can Do to Fight Back (2002), Arthur Levitt, page 56
9. Dow 36,000 (1999), Glassman and Hassett, page 15
10. A History of Interest Rates (1996), Sydney Homer and Richard Sylla, page 367
11. Irrational Exuberance (2005), Shiller, page 66
12. Ibid, page 59