Bull!

by Maggie Mahar

  Yet, Bernstein acknowledged, it would be extremely difficult for most investors to realize that “the world has changed”—that they had entered a new era of investing: “Boom and bust. That’s a familiar pattern. So what is expected is that after the bust, you pick up the pieces and go forward. That this is different I think is hard to recognize. And people are reluctant to recognize it. In particular, the difference pulls them away from traditional ways of managing their affairs. I mean, it doesn’t occur to people to say, ‘Now I have to do things differently.’

  “‘Yes,’ they think, ‘I won’t get caught in the next bubble, I’ll get out sooner.’ But that’s different from saying, ‘The basic investment structure that I’ve been using, which served me pretty well, is no longer appropriate.’ That’s a big step.”

  “THE REAL HUMDINGERS”

  Yet by failing to take that step, an investor could be walking into the bear’s den. The history of the stock market shows that magnificent bull markets beget brutal bear markets. (See chart “The Market’s Cycles 1882–2003” on page 2.)

  This is why, in the summer of 2003, The Bank Credit Analyst’s Martin Barnes was “not optimistic about stocks on a long-run basis. After a bubble has burst, the classic pattern is for the market to trade sideways for years,” he explained, pointing to a chart of past financial manias. (See chart “The Profile of a Bubble,” Appendix, page 460.)

  History does not guarantee that bull and bear markets will be symmetrical. But both economics and investor psychology suggest that Warren Buffett may well have been right when he predicted that “the hangover is likely to be proportional to the binge.” Bubbles, after all, are caused by too much cash chasing one investment theme, leading to overinvestment followed by excess supply.13 “By 1999 the cost of capital for technology stocks was zero. When the cost of capital is zero—how many businesses do you start? You’re only limited by the waiting line to get lawyers and bankers to do the paperwork,” remarked Acorn Funds founder Ralph Wanger in 2003. “Whatever the idea is, it becomes a lousy idea if you dump enough money into it. Now that all has to get unwound.”14

  That takes time. In the meantime capital spending dries up. When supply exceeds demand, prudent businessmen see no reason to expand. “Business spent $4.7 trillion on equipment and software from 1995 to 2000, 37 percent more than the prior six-year period. Now, utilization rates of this beefed up capacity are the lowest in 20 years,” Martin Feldstein, the president and chief executive of the private National Bureau of Economic Research, warned in 2003.15

  The Fed could pump liquidity into the economy, but it could not direct how it was used. In 2003, Kurt Richebächer, editor of The Richebächer Letter, measured just how much capital investment had slowed: “From the beginning of the U.S. economy’s slowdown in the third quarter of 2000 until the fourth quarter of 2002, fixed investment by businesses in the non-financial sector fell $165.9 billion, or 12.9%.” Over the same span, “consumer spending rose by 7.8% to $681.7 billion,” he reported.

  Trouble was, consumer spending could not build the base needed for a new bull market (though it could add to the mountain of consumer debt). The long-term growth and profits that an economy needs to create the foundation for a healthy stock market can come only from productive capital investments. This is what adds to the wealth of nations. An economy cannot consume its way out of a slump, Richebächer stressed—it needs to produce. Capital spending for the sake of spending (to create more profitless Internet sites, for example, or to produce more SUVs that then have to be sold with 0 percent financing and a rebate) will not help.

  And until profits revive, there will be no reason for profitable businesses to boost their investments. In 2003, Richebächer reported, “profits are down 28.6% from their 2000 peak—and 36.4% from their 1997 peak.”16 This, in a nutshell, is the economic explanation of why it can be so difficult to pull out of a major bear market: until share prices reflect the underlying economic reality, there is no basis for a new bull market to begin.

  Investor psychology also plays a role. As Charles Dow had observed: “There is always a disposition in people’s minds to think the existing conditions will be permanent. When the market is down and dull, it is hard to make people believe that this is the prelude to a period of activity and advance. When prices are up and the country is prosperous,” investors are even more loath to believe that the years of plenty will end.17

  So, in the spring of 2003, “the interesting thing is that people haven’t given up,” noted Acorn’s Ralph Wanger. “That’s the real news. People haven’t given up because the party was too good. How long will it take them? Before that happens, the stock market normally must revert to the mean—the historic average for stock prices. And, to do that, you have to spend some time below the mean—otherwise it’s not a mean. We haven’t even started doing that.”18

  The mean serves as the magnetic center of all cycles. Over the years, the S&P 500 has traded at an average of 14 to 15 times earnings. During booms, financial markets trade far above their mean; during busts, far below. “We’ve looked at the price history of every asset class—stocks, bonds, currencies, commodities—and we have not found any that didn’t revert to its mean,” reported GMO’s Jeremy Grantham. “Whatever Greenspan does, whatever happens out there in the world, however strong the economy is, there is going to be a lot of pain. And then it will overrun its course.

  “The really bad news is that all bubbles over-correct, and that the timing and extent of the over-corrections appear to be largely unknowable but they usually take several years,” he added in June of 2003.19

  Granted, the mean can move. Just because the S&P 500 has traded at 14–15 times earnings in the past doesn’t mean that it always will. Changes in global economics and politics, could, over time, take the mean P/E on U.S. equities higher or lower. At the beginning of the 21st century, Jeremy Grantham believed that, with interest rates low, the mean might have migrated to 17½. But no one believed that the mean had risen to 31—or even 21.

  Yet in June of 2003, the S&P fetched about 31 times earnings for the preceding 12 months, and roughly 19 times forecast earnings for the coming 12 months—if you believed the analysts’ earnings estimates.20 Stocks still were not cheap. This was the major reason why value investors such as Richard Russell or Warren Buffett feared that the bear market was far from over.

  Price/earnings ratios offer one rough guide to the long-term returns that investors can reasonably expect. “History tells us that when you buy stocks with average P/Es on the S&P 500 under 10, then over the coming 10 years you’ll receive a median return of 16.9%,” Russell told his readers in June of 2003. By contrast, “when you buy stocks when P/Es are 16 to 17, over the coming 10 years your median return will be 10.7%. When you buy stocks when P/Es are 18 to 20 then over the coming 10 years your median return will be 7.5%. When you buy stocks when P/Es are 22, then over the coming 10 years your median return will be 5.0%.

  “What about today? What can you expect if you buy stock here?” Russell asked early in the summer of 2003. With the S&P fetching more than 30 times trailing earnings, Russell’s answer was: “Over the coming 10 years you’ll probably show a loss.”

  P/E ratios are not the only signpost, Russell added. “Using a different method based on a 10-year average of previous earnings, Peter Bernstein has shown that if you buy stocks now the odds are that over the coming 10 years, your stocks will be down one-third on average from where they are today.”21

  Dividend yields also hinted that future returns were likely to prove paltry—especially since historically, dividends have made up such a large part of the stock market’s total return. “When you look at past secular market bottoms, the P/E on stocks was 10 and the dividend yield was 5 percent. You can talk about stocks at 15 times earnings being good value, but if you go back to 1942, 1949, 1974, 1980, and 1982, you will find P/Es of 10 and 5 percent dividend yields. We are not even close to that,” Ned Davis, founder of Ned Davis Research, an independen
t research firm, observed in June of 2003. “My guess is that, down the road, we’ll be facing another leg down—a crash more like 1973–74.”22

  Davis was not alone. In the summer of 2003, old hands on Wall Street feared that the market had not yet touched bottom. After peaking, the average bear market in the last century has given back over five years of gains. If one assumed that the millennial boom peaked at the beginning of 2000, history suggested that the market could decline to 1995 levels. When 1995 began, the S&P stood at 459 and the Nasdaq at 751. As for the Dow, it began the year at 3834.

  Five years is only a guess: history’s averages cover a broad range, and no two bear markets are alike. Each is unhappy in its own way. Nevertheless, those who believed big booms beget big busts worried that before the bear was done, the market would plunge below ’95 levels. When the bear market of 1966–82 found its low watermark in 1974, it gave back eight years of gains.

  At that point, investor psychology all but guaranteed that it would take many years to build a base for a new bull market. In a classic bear market, investors go through three stages, according to Russell: “The earliest stage is characterized by denial, increased anxiety, and fear. The second stage is panic. People suddenly say, ‘I’ve got to sell.’ The third phase is despair.”23 In the bear market that ran from ’68 to ’82, investors did not reach that third phase until after the second crash, the sickening plunge that ended in 1974. By then, the average stock purchased in ’68 had lost 70 percent of its value. A few years earlier, investors were eager to buy into the go-go market—at any price. Now investors no longer wanted to hear about stocks—at any price. This is why, in January of 1975, when Richard Russell tried to tell his readers that the market had finally scraped bottom (as indeed it had), they sent him hate mail.24 It would take another seven years for the scars to begin to heal. And it would require a new, innocent, and unscarred generation of investors to launch a full-scale bull market.

  But despite the most ominous forecasts, within even the strongest boom and bust cycles, there are always intermissions. In 1990, for example, the bull paused, and the S&P 500 fell 6.6 percent. Similarly, during the lean years that stretched from 1966 to 1982, there were bright moments: in 1975 the S&P jumped 38.3 percent. At such moments, the bull stumbles or the bear pauses to digest—these are the boomlets and corrections that economists call “cyclical” bull and bear markets. They can last a year or more. But it is the longer waves, the “secular” bull and bear markets that determine the market’s primary trend for 10 or 15 or 20 years.

  “My great belief is that the only things that really matter in the stock market are the great bull cycles and bear cycles—not the interim bull markets, [but] the real humdingers, the ones ending in 1929, 1965 and 2000,” Jeremy Grantham declared in 2002. “They’re the ones that really count. And the bear markets that follow…tend to be very long. The first one in the 20th century lasted for 10 years, 1910 to 1920. The second one lasted from 1929 to 1944. And the third one lasted from 1965 to 1982, 17 years. In between you had mega-bull markets where you made 10 times your money as we did from 1982 to 2000. So this bear cycle won’t play itself out overnight,” Grantham added.25

  Bernstein agreed. “Over, say, the next ten years, the risk of being out of the market—because it might go up—is much lower. Any upswing that you might miss is far more likely to be a short-term one, than a long-term structural opportunity,” he cautioned in February of 2003.

  THE BEAR PUTS OUT HONEY: BEAR MARKET RALLIES

  Bernstein did not rule out the possibility of “monster” bear market rallies. “Rallies of 30% and even more are common in secular bear markets. Japan has had 9 rallies greater than 25% since 1990, and 3 that were greater than 40%,” he observed. “The U.S. experienced 13 bull markets of greater than 30% during its secular bears of 1902–1921, 1929–1949, and 1966–1982.”26 The media often does not distinguish between secular (long) and cyclical (short) bull and bear markets. So, during a bear market rally, a prophet will declare that a new bull market has begun—and it has—but this is not what Grantham would call one of “the real humdingers.” It is not a bull market that will reward a buy-and-hold strategy.

  In June of 2003, the market was turning up, and investors began to ask: Could the Dow once again cross 10,000? The answer was yes. The Dow might well break 10,000—or even 11,000—but the important question was this: Could it stay there, and if so, for how long? Since Japan’s grueling bear market began in 1989, Japanese stocks had rallied four times, rising 48 percent, 34 percent, 56 percent, 62 percent—and these upturns lasted for months. But the majority of investors who got back in during the rallies had their heads handed to them. The bear is sadistic in that way: he likes to lure investors back in. This is why bear market rallies also are called “sucker rallies.”

  Should an individual investor view bear market rallies as trading opportunities—a chance to get in, make a profit, and get out? In the summer of 2003, Richard Russell said no. It is too difficult to time a saw-toothed market. At the time, Russell himself was sticking to short-term treasuries, while hedging his portfolio with gold and gold mining shares.27

  The problem is that bear markets often create the impression that something is happening, without quite delivering on the promise. “In the aftermath of a bubble, the stock market can become extremely volatile—without getting anywhere,” Ned Davis noted in the summer of 2003. “We did a study of 17 cyclical bull markets within secular bear markets,” he added. “In those markets the S&P 500 went up an average of 50% and the rally lasted an average of 371 days. But, they didn’t last as long as other cyclical bull markets—and didn’t go quite as high…. The rally was just a phase of a long-term bear market.”28

  Bull markets reward risk taking, but when the bear puts out honey, he is usually laying a trap: “In recent years, U.S. investors have felt that they must be playing the market—even when the risks are high,” Marc Faber observed. “They learned to think that they should invest like George Soros—but the average investor is not George Soros. When I play tennis, I don’t try to play like Agassi,” Faber added. “I have to play a different game. Agassi can play to win. I have to play a game where I don’t make any mistakes.”29

  In a bear market, this is what is most important: not making mistakes. The goal is to conserve capital. When a long bear market finally ends, those with cash will find bargains galore.

  But as investors learned in the late nineties, making a mistake, even on one stock, can be costly: lose 40 percent on one $50,000 investment and you need to make more than 60 percent on the remaining $30,000 investment—just to get back to square one. In the meantime, the investor has lost the opportunity to make money elsewhere—even if it was only an opportunity to make 5 percent. Over three years, 5 percent compounded, adds up to more than 15 percent.

  Investors who buy when too much money is chasing too few stocks often find that it takes a very long time to make up for what they have lost. Even the fleeting crash of 1987 could have a lasting effect on a portfolio, Steve Leuthold’s research revealed. Comparing an investor who put $1,000 into the S&P at its peak in August of ’87 to one who stashed his savings in risk-free T-bills, Leuthold showed that it would take the equity investor 3 years and 10 months to catch up with the timid T-bill investor—assuming that he constantly reinvested his dividends. If not, the “catch-up” time would be 7 years and 10 months. And this was following the briefest of cyclical bear markets: stocks snapped back from the October crash in a matter of months. High returns in the years that followed would airlift investors back to their master plan.

  By contrast, an investor who had the misfortune to invest $10,000 in the S&P 500 in January of 1973, at the peak of a bear market rally, would have to wait 12 years and 11 months to catch up with a neighbor who kept his money in T-bills—if the equity investor reinvested dividends. If he did not, the “catch-up” period would be 23 years and 1 month.30 The hypothetical example assumes that he bought at the zenith of the rally, b
ut unfortunately, that is about when individual investors are inclined to join a bear market rally—after prices have been rising for many months and they feel secure. This is what many did during the bear market rally that followed the crash of ’29, and again in 1990, when Japanese stocks rallied following that market’s first leg down.

  In each case, investors were following the rule that they learned in a bull market: “The trend is your friend.” But in a bear market, “you have a whole different rule book,” Ralph Wanger observed. “In a straight-up growth market, your rule is to be 100 percent in equities all the time. Buy strength. Disregard risk. Only look at the income statement. And all stories are true, because we want them to be true. It’s like the nice guy you met in the bar telling you he loves you truly—and he does.

  “In the volatile bear market that tends to follow an exponential growth market, many of these rules invert,” said Wanger, speaking from experience. “You don’t buy strength; you sell strength. You don’t look at the income statement, you look at the balance sheet [which shows a company’s debts]. All stories are false. It turns out that the guy in the bar is a married orthodontist from Connecticut.”31

  And “selling strength” means viewing a bear market rally, not as a buying opportunity, but as a selling opportunity—a chance to realize losses and put the money to work someplace else.

  MANAGING RISK IN A BEAR MARKET

  Ultimately, secular bear markets teach investors to learn to manage risk in a different way, focusing, not on the odds, but on the size of the risk. Just how steep is the downside?

  A practical example explains the difference. “Let’s say you’re offered a wager where you’re told that the chances are 999 out of 1,000 that you’ll make $1, but if you accept the wager, there’s a 1 in 1,000 chance that you’ll lose $10,000,” said Nassim Nicholas Taleb, author of Fooled by Randomness. “Would you take the wager? Of course not. The frequency or probability of the loss is only 1 in 1,000, but that, in and by itself, is totally irrelevant. That probability needs to be considered within the context of the magnitude of the risk—the danger of losing $10,000.”