Alpha Power Investing NewsletterMay 18, 2010
Rationality and Investing
One of the greatest myths foisted upon the investment public by academics and their investment industry acolytes is the claim that the stock market is random and essentially unpredictable. This view was popularized decades ago by Burton Malkiel in his book, "A Random Walk Down Wall Street". Malkiel's basic thesis is that the market is "efficient" - meaning that all the information available which could affect stock prices is already contained in stock prices. Furthermore, any new information is rapidly assimilated by millions of investors and quickly incorporated into prices. Thus the market represents all that is relevant and digested by millions of minds, making important mispricings, which could be used to "beat the market", almost impossible.
The upshot is that investors should content themselves with "market returns" instead of actively trying to beat the market. An unspoken assumption is that market returns will deliver high returns over time reflecting the growth of our capitalistic system. Proponents of this theory usually quote 9%-10% as the "long-term" return of the market, due principally to the earnings growth rate of U.S. corporations plus the reinvestment of dividends.
The practical strategy which flows from this view is buy-and-hold indexing; namely, hold stock exposure continuously using index funds, since active management is doomed to failure and it is expensive.
One of the unintended consequences of this theory is that the words "cheap" and "expensive" lose all meaning when applied to securities and the market in general. To say that the market is "cheap" or "undervalued" is to say that millions of investors have made a pricing "mistake", which is clearly impossible. An "expensive" or "overvalued" market is one in which millions of investors have mistakenly assigned a future rate of return to stocks which is too optimistic - again, an impossibility. Besides, even if you grant that there are market mispricings, it is impossible to systematically detect them and profit from them.
It's best, they say, to simply ignore these issues and get the market return. Successful investing, by this theory, is a character issue - do you have the staying power to stick it out through thick and thin? If you do, you will be rewarded by the high long-term returns of risky assets - stocks.
It is at this point that we confront one of the ambiguities of this story - what is meant by "long-term returns of the market"?
The past ten years has proven difficult for the theory. The S&P 500, considered the benchmark index of stocks, has fallen 6.5%. This translates into an annual return of -0.7%. Clearly, in order to generate a 10% return over the 20-year period 1999-2019, the market will have to deliver annual returns in the neighborhood of 20% or more over the next ten years. The inflation-adjusted results for the past ten years are dismal: a cumulative loss of 20%, for an annual real return of -3.6%. Is this long-term or not?
An investor at age 65 is not thinking in 20-year or 30-year horizons. He or she is thinking of preserving capital and deriving income from it. It is positively misleading to assure such an investor that high stock market returns are a probability within their restricted timeframe.
Over the past 110 years of market history, approximately 50% of the time was spent in robust bull markets. The other 50% was spent in correcting the excesses of those markets. The average correction phase was about 17 years (1901-1921, 1929-1945, 1968-1982, and 2000-?). The time spent correcting excesses in real, inflation-adjusted terms was much longer.
Can these phases be predicted?
Jeremy Grantham, Chairman of the Board of Boston-based Grantham Mayo Van Otterloo (GMO), a multi-billion dollar money manager, thinks so.
Grantham uses PE ratios to determine "fair value". Specifically, he uses the PE calculation of Professor Robert Shiller of Yale University - which averages earnings over 10 years to smooth out near-term volatility.
Using these PE ratios, Grantham regularly forecasts returns over seven-year time horizons. He has performed this exercise 28 times since 1994 - forecasting returns for global asset classes - and claims that he has a perfect record of predicting returns using his "simple-minded" (his words) technique.
Here is his April 2010 seven-year projection for the S&P 500:
The market's PE is currently 22 vs. a historical average of 14. Grantham expects PE's to revert to the mean. He thinks profit margins will expand slightly, and sales growth per share will double from today's 1.8%.
Whether Grantham is right or not, in order for the market to deliver the "high" returns promised by the academics, PE multiples would have to expand back to the highs of 2000 (40), which were, at the time, almost twice as high as PE's at the 1929 peak.
A more likely scenario, based on history, is that PE's will contract below Grantham's estimate. Every long-term bull market of the past 150 years has been launched from a platform of "cheap" stocks, where PE multiples were in the 7-9 range.
Based on Grantham's work, investors with significant stock exposure who plan to hold on through thick and thin over the next seven-to-ten years will be punished by low returns as they always have when stocks are "expensive". The academic theory requires that they ignore Grantham and hold on.
One of Alpha's dominant themes is the effect of politics on the stock market. We believe strongly that the four-year political cycle systematically effects investor psychology, causing a 15-month "power zone" when the "market climate" is positive. This "power zone" has not been down since 1931, averaging a return of about 29% (Dow Industrials plus dividends).
This kind of long-term market regularity is impossible if the market is indeed random and unpredictable. Grantham's long-term forecasting success is also impossible if the market is "efficient".
The basic flaw in the Efficient Market Theory is that it looks at investors as rational, calculating machines. More and more research is now shifting the emphasis to the psychology of financial decision making.
Investors are emotional and, at times, extremely irrational. How else to explain bubbles in the stock market and real estate which, in retrospect, have us shaking our heads at the mass hysteria and lemming-like stupidity of the investment world.
The emotional and irrational tendencies of investors spring from deeper places in the human psyche than the rational mind. This explains the effect of certain cycles - such as the election cycle - on investor psychology. The promises of politicians during the "power zone" prior to the presidential election, the injection of liquidity into the system by the Federal Reserve, the absence of aggressive legislation, the "pork barrel" gifts from Washington, and the hope for "change" - all trigger the optimistic emotional base of the investor class and create a positive "climate" for the stock market. This optimism causes investors to selectively interpret events with a positive bias. "A bull market climbs a wall of worry", so they say. It's not information driving the market - it's human nature.
The upside of this is that human nature is predictable. Therefore, investment systems which incorporate this predictability will succeed over time even in poor long-term investment environments. The election cycle "power zone", for example, worked beautifully from the mid-sixties to the eighties - throughout rampant inflation and a volatile, go-nowhere stock market. So far in the 2000's, it has worked beautifully too. My bet is that it will continue to do so.
The 15-month election cycle "power zone" begins October 1, 2010. Alpha's E-System Portfolio and The FormulaTM will become invested in the S&P 500 and NASDAQ 100 at that time.
For a complete history of the cycle, go to the Alpha Research section of our website at www.alphaim.net.Sincerely,
Jerry Minton, Ph.D.
© 2010 Alpha Investment Management Inc.
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