A Few Words of Caution Published on February 13, 2001

A smart friend who manages a billion dollars writes:

“I think we are in for some hard times. There is massive overcapacity in the tech area. Easy access to venture capital, both from the VC community and the public markets (which now accept venture stage companies for IPO's), has filled the world with 25 wireless software companies when we need 3, more broadband capacity at the wholesale level than can be delivered to the home in 5 years, 15 Internet retailers where one would do. It is unreasonable to assume that 10 years of economic boom will be sorted out in 90 days. I think people are engaging in serious wishful thinking. Lowering interest rates will not turn this around right away (look at Japanese interest rates). Lower interest rates and a retroactive tax cut will bring back the consumer, but it will take years to work off the excesses. I have been in cash since last March, and I see no reason to change that position right now.

“I also think we have developed a 'stock-buying culture' which stuffs stocks into 401k's, makes everyone feel they have to watch CNBC and CNNfn, and has the entire world touting stocks. These days, when a stock is downgraded on Wall Street, they go from ‘Strong Buy’ to ‘Accumulate.’ What does that mean? You should buy, but not as strong? I think this will all end in tears.”

F For so long, most financial writers like me advised that your “long-term” money all go into stocks, because over the long-run, stocks will always outperform safer investments. And that’s largely true. The market (we used to argue) – recognizing that stock returns are less certain and predictable than bond returns – in effect “pays you to take the risk.”

In the old days, stock dividend yields were actually higher than bond yields, because people knew that, in a bankruptcy, the bondholders came before the stockholders. The stockholders had to be induced to take the extra risk. (Even shy of bankruptcy, there was that risk that in hard times the dividend would be reduced or eliminated; the bondholders would still get their interest.) The millions of people who make up “the market” would stop bidding for stocks, stop driving their prices higher, when stock prices did not seem sufficiently attractive to warrant accepting the extra risk and uncertainty.

So it was safe to say that the invisible hand of the market more or less created a rational hierarchy of risk and reward. Really safe investments (federally insured savings accounts, for example) but didn’t have to pay much to attract customers. Something really risky, like stocks, let alone venture capital, did have to pay a lot to attract investors. Not that every stock or venture deal would pay off – that was precisely the point. Many would fail dismally. But on average, after taking into account all the stocks that tanked, the rewards were high enough to justify the risk.

Yes, things could get out of whack. But if the stock market fell to irrationally low levels, all the better for us steady buyers. Now the market was really paying us to take the risk. Bravo! And if it occasionally rose to irrationally high levels – got a little ahead of itself –well, it made good sense to keep buying anyway, or at least not to sell, because (a) you can’t time the market (it might seem overpriced, yet “know” something we hadn’t taken into account); (b) taxes and transaction costs make it very expensive to move in and out. Just wait. The underlying fundamentals will catch up with the stock prices and soon stocks will be fairly valued again, ready, as the economy expands, to move up some more.

And that’s still largely true, I think, especially now that much of the Internet bubble has collapsed and a good deal of the air has been let out of other sectors of the market as well.

But we could still have a lot further to fall. By historical standards, stocks are not exactly cheap. And even if they are good values here, the market is often as irrational on the downside as we have recently seen it on the upside.

As I’ve written a few times in the last couple of years, the problem with the “stocks are always a better buy than safer investments no matter what” line of argument is that at some point, if everyone comes to accept it, stock prices get bid up so high, they make no sense. Better to buy safe, solid Treasury bonds or some income-producing real estate or pay off your mortgage.

At the peak in Japan, a little more than a decade ago, not only were stock prices crazy (the Nikkei Dow was 40,000; today it is 13,000), so was the Japanese real estate market. If anything, even crazier. They had begun issuing 100-year home mortgages. To me, that was sort of the last straw, the bell going off announcing that the collapse was imminent.

Here, the sign I took that the top had been reached, or shortly would be, was publication of Dow 36,000, which makes the case that because over the long run stocks always outperform safer investments, they are not riskier for the long-term investor, and should not carry a risk premium. When you do all the math, and assume reasonable compounded growth of their now-tiny dividends, the authors conclude that the 30 stocks that make up the Dow are actually cheap these days. Fair value for the Dow, they argued in the book, would have been about 36,000. Higher, if the general level of interest rates were to decline.

So what are we to make of all this?

If you’re young and engaged in, or about to embark on, a lifetime of steady periodic investing in stocks – $100 a month, $1,000 a month, whatever you can afford – keep right on doing it. This is likely to be a highly successful life strategy.

If you’re 60 and just inherited $5 million that has to last you the next 40-plus years, I wouldn’t rush to put more than a third of it into stocks right now, even though the Dow, according to at least two authors, is selling for less than a third of its fair value.

http://www.andrewtobias.com/

-- Carl Jenkins (somewherepress@aol.com), February 13, 2001