Many Happy Returns

January 14, 2005 marked an anniversary not celebrated on Wall Street: Five years earlier the Dow Jones Industrial Average, an index of well-known, predominantly blue-chip industrial stocks, hit its all-time high of 11,722.98. For most of the first half of 2005 the Dow Jones hovered around 10,500, or 10.4 percent below that high. The Standard & Poor's 500, another index used to measure the stock market's performance, had fallen 8.9 percent from its March 24, 2000 peak of 1,527.46. But the real damage investors and shareholders had suffered in the past five years could be seen on the NASDAQ Composite Index of more than 4,000 mostly high-tech stocks, which remained more than 40 percent below its high of March 10, 2000. Those were the days of unlimited optimism about stock prices, matched only by overenthusiastic projections from the managements of that era's highfliers.

When asked when bear markets start, Sir John Templeton, founder of the Templeton Funds, has a standard answer: "Bear markets start at the point of maximum bullishness, and bull markets begin at the point of maximum bearishness." That sounds prophetic in retrospect, since those three indexes peaked within two and a half months of one another. I had turned extremely bearish more than a year before that two-month period, feeling that the superspeculative mania had reached its high point. I was premature, which in the stock market translates as "I was wrong." It got even wilder, approaching insanity, and went on longer than I could have imagined. I have been through many speculative manias during my 50-year career on Wall Street, but they are typically confined to a single sector, such as technology, energy or airlines. This one was much more widespread and not limited to technology and Internet stocks, although they led the way with outrageous valuations based on overly optimistic management projections and the near panic among customers to obtain the newest equipment before their competitors did.

Any Wall Street veteran who has been through a speculative mania knows how it will end: badly and with tears. The only question is when. In early 2000, when mutual-fund investors were surveyed about their expectations for annual returns over the next decade, their answer was 18.2 percent, which was close to the S&P 500's average annual return during the previous decade. Financial behaviorists label this kind of thinking "anchoring," projecting the recent past into the future. Retirement planning was simple with those returns; all you had to do was buy and hold.

An 18 percent annual gain means almost doubling your wealth every four years. Thus, if you had 20 years before retirement, your wealth would double five times, resulting in an end value 32 times your starting investment. Though it may seem naive now, that passed as retirement planning for many at the time. It was also one of the reasons for the precipitous drop in the savings rate. Why bother to cut back consumption to save for retirement when the stock market would save for you?

Now the baby boomers are five years closer to retirement, and their 401(k)s are in disarray. This may be one reason for the recent bubble in the housing market; many disappointed stock investors are attempting to make up for lost time and money. Bubbles form when investors develop the attitude that this is a new era or that this time it's different. Investors' attitudes toward stocks five years ago were the same as those in today's housing frenzy. There is one significant difference, though: The leverage now used is much greater, another indication of complacency.

The British had a saying about the late, great bull market: "Even a blindfolded monkey with a pin should find it easy to make money." But it did not start out that way. It began in the early 1980s, when inflation, measured by the Consumer Price Index, was around 13 percent, the 30-year Treasury bond provided a yield of more than 15 percent, and the Dow Industrials sold at less than eight times earnings and yielded more than six percent. Bonds and stocks were on every investor's hate list. Bonds were considered certificates of confiscation because of high inflation, and most investors were terrified of stocks. The bear market of 1973 and 1974, the worst since the Depression, was still fresh in investors' minds; the Dow Industrials had then fallen 41.5 percent, and many stocks were down a lot more than that. Stocks were last on any investor's list of retirement investments, if they were included at all. Bank time deposits provided double-digit yields, but after taxes and inflation the investor was losing purchasing power. The nest eggs of the time were so-called collectibles, anything to protect against inflation. Those collectibles included gold (at more than $800 an ounce), art and monogrammed plates--almost anything except financial assets. It was a classic time of maximum bearishness toward stocks, when bull markets begin.

The great bull market began in fear but gained strength from a confluence of extremely favorable factors. Those included falling inflation, the longest-ever bull market in bonds (a 22-year run that brought the yield on 30-year Treasurys down from 15 percent to 4.17 percent and culminated in yields hitting a 46-year low in 2003), a robust economy with rising corporate profits and, finally, starting with the Mexican crisis of 1995, the Federal Reserve responding to every perceived crisis by cutting interest rates and flooding the banking system with liquidity.

The last factor meant that real interest rates were low and occasionally negative. This "free money" led to overexpansion in many sectors of the economy and sloshed over into the stock market, particularly into NASDAQ stocks. I mark the beginning of the technology bubble with the Netscape initial public offering in August 1995. (In 1998 Netscape was bought by America Online, which merged with Time Warner in 2000.) This coincided with the Mexican economic crisis and the beginning of the Fed's "cut and flood" policy. Offered at $28 a share, Netscape stock hit $170 a share four months later, and the Internet and its stocks were labeled the new American frontier. Underwriters, astonished to find that the public demand for Internet stocks was almost insatiable, ignored companies' short time in business (about 18 months for Netscape) and lack of profitability. And so was born the dot-com boom, which spread to anything technological, innovative or new.

Goldilocks to Gulliver

Perhaps the most overused term to describe the economy behind the stock bubble was Goldilocks, meaning not too hot, not too cold, but just right. When the business fixed-investment bubble blew up in March 2001, a year after the NASDAQ peak, all sorts of monetary and fiscal stimuli were implemented to combat the resulting recession--13 interest rate cuts by the Fed, two major tax cuts and budget deficits approaching $400 billion. The soaring trade deficit allowed foreign central banks to recycle dollars into U.S. Treasurys, bringing them to near half-century lows. Mortgage refinancing companies adopted an innovative tactic: cash-outs, by which homeowners could get lower mortgage rates while removing some of the equity in their home. The Fed estimated homeowners took out $300 billion in equity in 2001 and 2002, half of which was spent shortly afterward. Consumer homes became automated teller machines from which equity could be systematically withdrawn.

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Which brings us to the present and what to do now. First, almost all the economic factors that created the Goldilocks economy have slowed, stopped or reversed. The economy remains sluggish, and because the recession was brought about by a crash in capital spending, it has not responded well to the fiscal and monetary stimuli. The reason? Even low interest rates won't help when excess capacity is widespread and profit margins are under pressure. Inflation and interest rates are rising and in my view will continue to rise. I have no idea if consumers are "stretched to their limit," as some in the business press have argued. But retail sales this year have been mediocre, higher inflation and interest rates will pinch, and higher gasoline prices for the full year will restrain enthusiasm. Cash-out refinancings will be significantly lower, but home equity loans should continue to grow. This may reflect a fundamental change in consumer borrowing--away from more costly credit card debt. The automakers, through expensive incentive programs, have financed today's sales from future profits. Unfortunately the future is now.

The Organization of the Petroleum Exporting Countries appears to have raised its target floor for crude oil prices from $30 to $40 a barrel, probably because of strong worldwide demand, particularly from India and China. In addition, oil is denominated in dollars, so with the weakness of the dollar OPEC members receive less profit when it is converted to other currencies. Housing starts have been erratic, but prices for existing-home sales continue to rise. For April 2005 the national median home price was $206,000, up 15.1 percent from a year before. Residential real estate seems to be another avenue for investors trying to make up for their failures in stocks. It looks like another bubble to me. I don't expect housing prices to tank the way the NASDAQ did--but their mere stabilizing would remove one of the economy's major propellants.

Regarding the weak dollar, there is good news, bad news and potentially horrible news. The good news is that imported products now cost more, so domestic manufacturers have seen some improvement because their own prices are more attractive to consumers. The bad news is that higher import prices allow U.S. manufacturers some power to raise their own prices, thus raising inflationary pressures. The potentially horrible news is that foreigners may lose confidence in the dollar, starting a run on the currency. If foreigners start selling Treasury securities, yields will rise and at some point the Fed may have to intervene and raise interest rates to protect the dollar.

With the demise of the Goldilocks factors perhaps the postboom economy has entered another, more appropriate mythical land: Lilliput, the island where Gulliver, in Jonathan Swift's tale, wakes up and finds himself tied down by the six-inch-tall Lilliputians. Whereas previous conditions were "just right," the economy is now restrained by many small changes in those factors. Under these circumstances the stock market will not be as rewarding as it has been in previous decades. In another analogy, the economic tailwinds of the past have been replaced by headwinds, making progress for stocks more difficult. More difficult but not impossible--there will always be attractive individual issues.

In 2004 investors and speculators reentered the market and picked up where they had left off five years earlier. If I were to write a report titled "What Investors Learned in the First Quarter 2000 to Second Quarter 2002 Bear Market," it would contain only the phrase used in prospectuses: "This page intentionally left blank." Speculation has resumed, and it's as pronounced as it was in the late 1990s. The names of the stocks in play may be different, but the fundamentals remain highly questionable. I won't go into the individual stocks--from stun-gun makers to satellite radio systems and Internet darlings--but valuations are exceptionally high no matter how they're measured. It does not seem to matter. Some issues trade between 50 million and 90 million shares daily, which approaches the float--the amount of stock outstanding that is tradable. The game being played is to chase the stocks that are going up--and not just individuals are doing it. When done by institutions it can be called momentum investing, although it certainly is not investing.

Bad Advice

With some regularity the financial media--newspapers, magazines and TV--produce reports titled "Where to Invest in [fill in the new year]." This year some of the advice has been highly questionable: The Wall Street Journal started the trend with a lengthy article on alternative investments, titled "Investing Your 'Play Money'" and subtitled "With Market Returns Modest, Some Investors Are Placing Bets on Wall Street's Risky Corners." Some of the suggestions are really just that--bets. Some media recommendations encourage you to "have more fun with your portfolio," get "more bang for your buck" or, in the Wall Street Journal article, "dodge the tedium of what has generally been a relatively flat stock market. That boredom is likely to continue."

Two of the worst investment strategies are hope and prayer, with hope coming in second because prayers are sometimes answered. There might be a Clarence, the angel, second class, of the film It's a Wonderful Life, willing to come down to earth to boost your portfolio. The Journal article suggests that no more than five percent of a person's portfolio be put into "play money." Others advise investing no more than you can afford to lose completely, but we all know how that develops: One or two successful leveraged trades and investors are hooked and in over their head.

Some of the other suggestions to alleviate boredom:

• Stock options. These are contracts to buy or sell a stock at a specified price within a stated period and can be exciting enough to cure investors' boredom. The terror felt in losing all your money quickly is a sure cure for tedium. The rule of thumb regarding stock options is that roughly two thirds are worthless when they expire. Experts call this the aspirin game. When a person racks up staggering losses in options and the losses are still running, it is quite difficult to sleep at night. He or she will go into the bathroom and consider how much capital has been lost and what can be done now to limit the losses. If the marital partner asks what's going on, the standard reply is "Taking an aspirin."

• Microcap or small-cap stocks. The microcaps, or penny stocks, posted in the pink sheets include many that are outright pump-and-dump swindles. Good investments are available in small-capitalization stocks; the trouble is that little information is available on many of them. The many mutual funds specializing in small-cap or midcap issues would be a better way to go. The Journal article cited one stock dealing in Elvis Presley memorabilia, which went from 10 cents a share to more than $11. I thought that example was inflammatory. All too frequently when you want to sell some of your pink-sheet stocks your broker gives you the punch line to an old Wall Street joke: "Sell? Sell to whom?"

• Venture capital. As they say in New York City, Fuhgeddaboutit!"--unless you can put up several million dollars and your net worth is a lot more than that. A rule of thumb among venture capitalists is to look at 10 or more proposals before investing in one, then hope one in 10 of those selections becomes a big winner. That's one in 100 professional investments working out.

• Junk bonds. My stomach lurched when I read this suggestion. The yields may be high, but there's always a question about whether they'll offset the risk of defaults. Thousands of sophisticated investors--individuals and institutions--are looking for fallen angels that may recover. The danger here is not only that the yield may not offset the default risk but that buyers tend to leverage up. Buying a million dollars' worth of bonds for a $50,000 down payment means the price of the junk bond has to move only about two points against you and you'll be asked to put up more money.

• Futures. Usually included with the pitch to hold futures is a warning that, while a large amount of some commodity can be controlled with a "pittance of cash," it is "possible to lose more than the original investment." I question the use of the word investment--for the nonprofessional these are really just bets. Among professional futures traders, an estimated five to 10 percent make a comfortable living; most of the others are marginal and undercapitalized and have a low threshold of panic.

• Hedge funds. Because the Securities and Exchange Commission requires that investors in hedge funds be sophisticated, there is usually a minimum initial investment, as well as a minimum net worth--frequently more than $1 million. But some financial services firms now require only $100,000 as an initial investment, and one brokerage firm has a minimum of $25,000. Results, fee structures and volatility range widely, and some firms do not hedge but only buy stocks long. Critics of hedge funds maintain that there is an element of moral hazard involved with the fee structure. Frequently there is a management fee and an incentive fee of 20 percent of the profits. If the fund takes 20 percent of the profits and none of the losses, there is an incentive to take higher risks, which may not be in the best interest of the investor. There may also be difficulties or delays in withdrawing money. With roughly $1 trillion under management, many hedge funds appear to be using the same strategies with the same securities. My opinion? Hedge funds are not for everyone, but if those who qualify thoroughly investigate them, they're probably the least dangerous of the alternatives to stocks suggested in where-to-invest articles.

22 Percent of your Life

The current stock market is an odd mixture of boredom, frustration, hope, fearlessness, speculation, bullishness and occasional panic when an earnings disappointment or surprise unfavorable development is announced (think Vioxx/Merck and General Motors). TV's talking heads keep asking, "Are we in a new bull market?" The analysts generally say we are and go into contortions about why the three popular averages, all virtually unchanged through May of this year, are not applicable to the market's action over the balance of the year.

I see no indication of Templeton's "point of maximum bearishness," but the fear factor, as measured by the Chicago Board Options Exchange Volatility Index, or VIX, is quite low, just above the 10-year low of last December. Money managers appear overwhelmingly bullish, and the put-call ratio shows high levels of bullishness, but multiples remain high by historical standards, actually outrageously high for many Internet and technology companies. In addition, yields are low, speculative activity is extensive, and insider sales outnumber insider purchases by more than 40 to one; it used to be considered a bearish sign when the ratio exceeded 20 to one.

I do not think this is a new bull market in that, like a rising tide, it will lift all boats. People do not consider that the bull market of the 1990s was a decade-long aberration. Historically most bull markets last less than three years. The economic headwinds I mentioned before should restrain a broad advance in stocks for at least the balance of this year. What investors are going through now is what I'll call the trauma of withdrawal due to drastically lowered expectations. This will be compounded by another type of headwind. During the explosive part of the bull cycle, the prevailing thought on Wall Street was, "Stocks have to go up. The demand is too great--there won't be enough stocks to go around." In my experience, the demand for stocks is always vastly overestimated and the supply similarly underestimated. But now all that stock in 401(k)s, held for approaching retirements, represents supply. It will be coming into the market as baby boomers retire and cash it out or reinvest in securities providing yields.

No nest egg is safe and perfect--not collectibles, bonds, stocks, housing, art or gold. But over the longer term, stocks have outperformed all competitors. A credible study reported in the January 1, 2005 issue of The Economist concluded that over the past 100 years American stocks have outperformed U.S. Treasury bonds (and bills), property, art and gold, providing an annual average total return of 9.7 percent, or 6.3 percent after inflation. Property returned close to seven percent annually before inflation, and U.S. Treasurys less than five percent annually before inflation.

What to avoid? With inflation likely to pick up, the bond market will be under significant pressure and is one area to avoid. I would also stay away from the high-technology sector. Valuations are high, inventories are exceptionally high, and excess capacity is widespread and rising--with prices falling. More significant, many of the products once considered innovative are being commoditized--and will behave the way commodities do when there is excess supply.

I have always maintained that technology is a cyclical business and that the innovation driving it also makes it risky for investors. Just look at the personal computer--over the hill at the age of 30. (I mean it is no longer a growth product; the market is saturated.) I would also avoid many of the Internet darlings. Competitors have few barriers to entry, and competition is rising in many areas. The Internet market is not limitless, as many expected it would be. The traditional brick-and-mortar operations have already fought back, and there are signs of developing maturity. The market is growing but not exponentially, as it once was.

I still consider stocks the best investment over the longer term and not just the 100 years illustrated in that study. What got investors in trouble was not necessarily stocks but chasing hot mutual funds and new technologies that never lived up to expectations. Investors consistently overpay for growth, but the best performances derive from those stodgy companies that provide a reasonable yield and consistently raise their dividends. You pay a high price for a sexy story, but few live up to expectations. Investing in stocks is not meant to excite but to provide for a more comfortable retirement.

The first of the 77 million baby boomers will turn 62 in 2008, becoming eligible for Social Security as they enter retirement. The widely discussed problems in Social Security represent only a small part of the problem for these Americans, who are facing a full-fledged retirement crisis. Financial planners describe the three legs of the stool that workers are expected to rely on for retirement: Social Security, employer-provided retirement plans and personal savings. Even casual observers can see that all three are showing downward trends and are less likely to support retiring boomers in their current lifestyles. Roughly 60 percent of middle-class Americans do not believe Social Security will provide them with income for their retirement, and 20 percent have not even started planning for this time. The retirement crisis as I see it is a collision of demographics, economics and financial behavior that should be addressed sooner rather than later. A person retiring today at the age of 65 can expect to live another 18 years on average. So my question is, What financial plans have you made for these years, which make up 22 percent of your life?

The best retirement plan, in my opinion, would have to include stocks. Many sectors will remain attractive over the longer term--health care is one example. I expect energy prices to remain relatively high for some time too. I would recommend sector funds or exchange-traded funds focusing on health care or energy, as well as index funds. Though I was appalled by the inclusion of microcap issues in "play money" portfolios, midcap and small-cap stocks have outperformed larger-capitalization indexes for extensive periods. There are many small-cap-stock mutual funds, offering varying degrees of risk. Not enough information is available for most investors to buy individual issues, so let the professionals do it. Avoid anything to do with the pink sheets or microcap stocks. You could get a lot more excitement than you expected.

Perhaps it's best to remember the old curse "May you live in interesting times." We have gone through enough excitement. Boredom and tedium may be due to the withdrawal caused by drastically lowered expectations as investors adjust from unrealistic stock returns of 18 percent annually to something closer to six percent annually after inflation. Stocks may not be the perfect nest egg for retirement--nothing is. But a carefully selected portfolio of reasonably priced stocks with a moderate yield and a record of consistently raising dividends should be the best choice.