BULL, Says Less to the Bears

BUT FIRST A QUICK POLITICAL NOTE:

Apparently, the Jeb Bush attack ad on Bill McBride noted here yesterday had an unintended effect. Click here for Miami Herald star columnist Carl Hiaasen’s amusing report. I guess we’ll know in a few hours whether Jeb inadvertently put McBride over the top.

AND SECOND AN APOLOGY:

I promised yesterday to be ‘briefer’ the rest of the week. That apparently will not include today.

AND NOW BACK TO THE BULLS AND BEARS:

Joe Devney: ‘Your quote from John Mauldin included a reference to a ‘secular bear market.’ This is one of those terms that I come across that is never explained. What does ‘secular’ mean in this context?’

☞ It means ‘really long-term, with occasional interruptions.’ Those interruptions, in this case, would be characterized as rallies or little bull markets within the overarching bear market. Of course, you could describe our economic history as just the reverse – a magnificent truly overarching secular bull market, with little bear market interruptions.

John Hook: ‘Bill Gross avers that ‘at least 50% of the earnings growth over the past 40 years has been earnings of the ‘mystical’ kind – pro forma, operating, phonied up.’ Yet total net income of U.S. corporations as reported to the IRS in 1980 was $239 billion and in 1999 $929 billion. This is an annual rate of increase of 7.02% per year by accounting whose goal is legally to minimize net income.’

☞ John goes on to note that GDP growth is probably not phoney. GDP increased from $352.4 billion in 1952 to $10,371 billion today, 50 years later. That’s a 7% annual rate of increase, which suggests that profits would have increased at about the same rate (albeit by considerably less that 7% after netting out inflation).

But let’s give the last word (or the last substantive word, anyway) to our friend Less Antman, who found a lot to disagree with in the Bill Gross ‘Dow 5000‘ rant:

Stocks may or may not decline further over the short-term [Less writes], but that won’t remove the arithmetic, logical, and historical errors in legendary bond investor Bill Gross’ article. At least Warren Buffett is modest enough to stay away from areas he doesn’t understand.

Among the gross (sorry) inaccuracies in his piece are:

(1) A tripling of P/E ratios over the century would NOT explain 2.0% of annual market returns. Anyone with a calculator and the ability to press the equal key 100 times can determine that a 2% return over a century would require PE ratios to multiply more than 7 times. A tripling of the PE ratio adds only 1.1% to annualized returns. At least this has settled a question that has bothered me for years: now I know who calculated the stock returns of the Beardstown Ladies. [Less here adds an emoticon to signal us that he is kidding. But try it. If you ask your calculator what $1 growing to $3,000 over a century works out to, your calculator will tell you: 8.34% a year. Triple that end result to $9,000, and now your calculator will tell you your money has grown at 9.53%. All this before taxes and inflation of course. But is 9.53% two percent more than 8.34%, as Gross argues? No, says, Less, it is more like 1.1% (or, if my own sharp calculations are to be believed, 1.2%). The difference between 2% and 1.2% sounds trivial, but you won’t feel that way 100 years from now.]

(2) There is little evidence to support the view that P/E ratios in 1900 were as low as Gross has implied. For one thing, financial statements were not required and generally accepted accounting principles didn’t exist at that time. For another, in those days before income taxation, substantial dividends were expected from companies, and the typical company distributed most of its earnings every year (since the average investor DIDN’T trust the corporate executives and robber barons of the day). Using the 4.2% dividend yield cited by Gross (which appears to be correct) and a payout rate of 70%, an earnings yield of 6% probably existed at the time, meaning PE ratios averaged nearly 17.

(3) It is not true that starting valuations have to be reasonable for stocks to outperform bonds. Since stocks have outperformed bonds during 90% of all historical 10-year time intervals, it would be more accurate to say that bonds cannot beat stocks over any reasonable time period unless bonds are radically underpriced at the start of the period, which doesn’t describe an environment in which 30-year treasuries are yielding 4.9% (with no protection against inflation) and short-term bond yields are competitive with mattresses. Had the stock market in 1900 been obscenely priced at DOUBLE its actual level at the time (with dividend yields of only 2.1%), its gain over the century would have been reduced from 6.7% to 6.0%, still battering the 1.6% return on bonds. [This is one of the reasons I suggest in a forthcoming PARADE piece a couple of weeks from now, that it’s OK to stocks here for the really long run, especially if you plan to ‘average down’ if and as the market drops further . . . but only with money you can afford to tie up for a long time. Money you might need in a year or three might do great in the stock market, but it might not. If you will need it, you can’t afford the risk.]

(4) If unusually high valuations in the year 2000 and unusually low valuations in 1900 explain the 6.7% real return on stocks during the 20th century, how do we explain that both Siegel and Ibbotson, whose studies go back 200 years, found approximately the same real return during the 19th century?

(5) Gross has suggested that a dividend of 4.2% explains most of a 6.7% return. Apparently he forgot what he had mentioned elsewhere in the article, that 6.7% was the real return after inflation, while the dividend rate was the nominal, not the inflation-adjusted, return. In fact, nominal stock returns were around 10%, and the dividend yield explains less than half of the total return.

(6) Although dripping with sarcasm, Gross did concede that cash distributions resulting from stock repurchases and cash mergers did constitute actual transfers of money from corporations to shareholders, and generously allows the reported dividend yield of 1.7% to be increased to 2.0% to account for these. The only problem is that DMS, from which Gross quoted extensively, included a chart Gross failed to reference that indicated the total dollars distributed from stock purchases by corporations, which were statistically insignificant as recently as 1981, now slightly EXCEED the total of reported dividends, so that the 1.7% reported yield is actually around 3.5% right now, and is quite competitive with current, historically low, bond yields. And if the 2.0% yield conceded by Gross leads to a fair value of around Dow 5000, the corrected 3.5% yield suggests a Dow fair value of 8750, close to its current level.

(7) Even if none of the above errors applied to Gross’ analysis, they do not lead to the conclusion that one should remain out of stocks and invested in bonds until the Dow drops to 5000. The stock market might well simply grow at a slower pace while still substantially exceeding bonds (given the historical 5% superiority, even a much-diminished equity premium would be a premium). And the investor will still be sitting with everything in Gross’ bond funds waiting for his signal that it is safe to leave him.

Of course, even a perma-bull on stocks such as myself should remind investors that the market could still drop substantially from its current level, even below Dow 5000. In 1931, the stock market was clearly underpriced after a devastating 75% drop, but the Dow still managed to drop another 50% from that level before taking off. The extremes of short-term fear cannot be expected to end at rational and predictable levels, and an intelligent investor cannot wait for a signal that is safe to go into the stock market. It is never safe to invest in stocks, nor is it safe over the long-term to accept returns that will probably be near zero after taxes and inflation in bond investments.

This is why it is critical for a stock investor to be thoroughly, globally diversified (a broad domestic index fund and a broad international index fund, as suggested in The Only Investment Guide You’ll Ever Need, makes tremendous sense to me), and why only long-term money belongs in equities. For a globally-diversified all-stock portfolio, 5 years was enough to bring investors back to even if they foolishly put all their money into the stock market in 1929 or 1972 (or for a Japanese investor who did that in 1989). For a US-only investor without international holdings, it can take as long as 20 years to get back to even, but since we are talking in September 2002 and not March 2000, it is pointless to discuss investing at market peaks, since we are 2 1/2 years beyond the latest one. I’d be willing to bet my entire net worth that someone who put about half his portfolio into US stocks and the other half into non-US stocks over the next 10 years will trample the 4.1% available on a 10-year treasury note, or the 2.3% real yield on 10-year TIPS. Come to think of it, I already have made that bet.

☞ And now you see why I generally refer to Less as ‘the esteemed Less Antman.’ (Or in today’s feisty mood, esteamed.)

Randy Wolff: ‘Running in a marathon until your kidneys bleed is no way to live to 100. Neither is running five marathons in a row. That is a good way to live to 54.’